1. 16
The Monetary System

2. The Meaning of Money Liquidity
Medium of exchange
Item that buyers give to sellers for purchases
Unit of account
Yardstick used to post prices and record debts
Store of value
Used to transfer purchasing power from present to future
Liquidity
Ease with which an asset can be converted into the economy’s medium of exchange

3. The Meaning of Money Money in the U.S. economy Demand deposits
Currency
Paper bills and coins in the hands of the public
Demand deposits
Balances in bank accounts
Depositors can access on demand by writing a check
Measures of money stock
M1, M2

4. Two measures of the money stock for U.S. economy1
Two measures of the money stock for U.S. economy
The two most widely followed measures of the money stock are M1 and M2. This figure shows the size of each measure in 2007

5. The Federal Reserve System
Federal Reserve (Fed)
The central bank of the United States
Central bank
Institution designed to
Oversee the banking system
Regulate the quantity of money in the economy

6. The Federal Reserve System
The Fed’s organization
Created in 1913
Board of governors
7 members
Appointed by the president & confirmed by the Senate
Have 14-year terms
The chairman (Janet Yellen )
Directs the Fed staff
Presides over board meetings
Appointed by the president (4-year term)

7. The Federal Reserve System
The Fed’s organization
The Federal Reserve System
Federal Reserve Board in Washington, D.C.
12 regional Federal Reserve Banks
Major cities around the country
The presidents - chosen by each bank’s board of directors

8. The Federal Reserve System
The Fed’s jobs
Regulate banks & ensure the health of the banking system (risk assessment)
Legislated by Congress
Do the banks hold enough cash to withstand another financial bubble, or are they “investing” too much in too many risky assets? (Stress Test)
Conduct Expansionary/Contractory/neutral monetary policy
Low unemployment (~5%), low inflation (~2%), sustained economic growth (rate = ~3% per year)

9. The Federal Reserve System
Fed’s role in conducting Monetary Policy
Control the money supply
Buying (contractive)/selling (expanding) of bonds
Buy bonds -> Fed injects $ (to holders of bonds)
Results in interest rates
Sell bonds -> Fed buys up $ (cash flows into market)
Interest rates
Set the Federal Discount Rate – rate at which Fed loans to member banks
Affects market interest rates
Set the Reserve Requirement
% of assets held as cash by member banks
Affects the Money Multiplier and loanable funds

10. The Federal Reserve System
The Fed’s jobs
Control the money supply
Quantity of money available in the economy
Monetary policy
Setting of the money supply (bond purchases/sales) by policymakers in the central bank
Federal Open Market Committee (FOMC)
7 members of the board of governors
5 of the twelve regional bank presidents
Meets about every six weeks in Washington, D.C.
Discuss the condition of the economy
Consider changes in monetary policy

11. The Federal Reserve System
Fed’s primary tool - open-market operation
Purchase & sale of U.S. government bonds
Bernake – purchased private (corporate and bank) debt during last recession – unusual!!!!
FOMC - increase the money supply
The Fed: open-market purchase of outstanding t-bills, bonds (corporate)
Increases the money supply
FOMC - decrease the money supply
The Fed: open-market sale of t-bills
Decreases the money supply

12. Banks and the Money Supply
Reserves – illustrating the Money Multiplier
Deposits that banks have received but have not loaned out
The simple case of 100% reserve banking (not real)
All deposits are held as reserves – can’t loan!
Banks have no influence the supply of money
FIRST NATIONAL BANK
Assets
Liabilities
Reserves
$100.00
Deposits

13. Banks and the Money Supply
Money creation: fractional reserve banking
Banking system
Banks hold only a fraction of deposits as reserves – lend remainder out
Reserve ratio
Fraction of deposits that banks hold as reserves
Reserve requirement – minimum % of assests held as cash that bank must hold –
Minimum set by the Fed (10%)
Bank may hold additional excess reserves

14. Banks and the Money Supply
Money creation: fractional reserve banking
Reserve ratio = 1/10 (10 percent, R)
Banks hold only a fraction of deposits in reserve
Banks create “additional” money
Increases in money supply > Fed injection
FIRST NATIONAL BANK
Assets
Liabilities
Reserves
Loans
$10.00
$90.00
Deposits
$100.00

15. Banks and the Money Supply
The money multiplier
SECOND NATIONAL BANK
Assets
Liabilities
Reserves
Loans
$9.00
$81.00
Deposits
$90.00
THIRD NATIONAL BANK
Assets
Liabilities
Reserves
Loans
$8.10
$72.90
Deposits
$81.00

16. Banks and the Money Supply
The money multiplier
Original deposit = $100.00
First National lending = $ [= .9 × $100.00]
Second National lending = $ [= .9 × $90.00]
Third National lending = $ [= .9 × $81.00] …
Total money supply = $1,000.00

17. Banks and the Money Supply
The money multiplier
Amount of money the banking system generates with each dollar of reserves
Reciprocal of the reserve ratio = 1/R
Max for money multiplier
Assumes banks hold only minimum R
The higher the reserve ratio
The smaller the money multiplier
Recent requirement from stress test for more risky investments

18. Banks and the Money Supply
The Fed’s tools of monetary control
Open-market operations
Purchase and sale of U.S. government bonds by the Fed (to public and domestic/foreign investors)
To increase the money supply
The Fed buys U.S. government bonds
To reduce the money supply
The Fed sells U.S. government bonds
This is the Fed’s preferred tool

19. Current Fed Policy Quantitative easing (QE)
unconventional monetary policy to stimulate the economy when standard monetary policy has become ineffective
implemented by buying financial assets from commercial banks and other private institutions,
Raises prices of those financial assets and lowering their yield, while simultaneously increasing the monetary base.[4][5]

20. Traditional Fed Policy
QE differs from is more usual policy of buying or selling short term government bonds in order to keep interbank interest rates at a specified target value
Expansionary monetary policy to stimulate the economy typically involves the central bank buying short-term government bonds in order to lower short-term market interest rates.[10][11][12][13] However, when short-term interest rates have reached or are close to reaching zero, this method can no longer work.[14] Quantitative easing may then be used by monetary authorities to further stimulate the economy by purchasing assets of longer maturity than short-term government bonds, and thereby lowering longer-term interest rates further out on the yield curve.[15][16]

21. Banks and the Money Supply
The Fed’s tools of monetary control
Reserve requirements
Regulations on minimum amount of reserves
That banks must hold against deposits
An increase in reserve requirement
Decrease the money supply
A decrease in reserve requirement
Increase the money supply
Used rarely – disrupt business of banking

22. Banks and the Money Supply
The Fed’s tools of monetary control
The discount rate
Interest rate on the loans that the Fed makes to banks
Higher discount rate
Reduce the money supply
Smaller discount rate
Increase the money supply

23. Banks and the Money Supply
Problems in controlling the money supply
The Fed
Does not directly control the amount of money in circulation (M1 or M2)
Households choose to portion of wealth held as deposits in banks and portion held as cash/ demand deposit
Does not control the amount portion of assets bankers choose to lend

24. Bank runs and the money supply
Depositors suspect that a bank may go bankrupt
“Run” to the bank to withdraw their deposits
Problem for banks under fractional-reserve banking
Cannot satisfy withdrawal requests from all depositors
When a bank run occurs
The bank - is forced to close its doors
Until some bank loans are repaid
Or until some lender of last resort provides it with the currency it needs to satisfy depositors
Complicates the “exact” control of the money supply

25. Bank runs and the money supply
Great Depression, early 1930s
Wave of bank runs and bank closings
Households and bankers - became more cautious
Households
Withdrew their deposits from banks
Hold their money – currency
Bankers - responded to falling reserves
Reducing bank loans
Increased their reserve ratios
Smaller money multiplier
Decrease in money supply

26. Bank runs and the money supply
Bank runs today - not a major problem
The federal government
Guarantees the safety of deposits at most banks
Federal Deposit Insurance Corporation (FDIC)
No bank runs
Depositors are confident
FDIC will make good on the deposits
Government deposit insurance
Cost: Bankers - little incentive to avoid bad risks
Benefit: a more stable banking system

27. Banks and the Money Supply
The federal funds rate
Interest rate at which banks make overnight loans to one another
A change in federal funds rate
Changes other interest rates
Can be targeted by the Fed
Open-market operations
The Fed buys – decrease in federal funds rate
Increase in money supply
The Fed sells – increase in federal funds rate
Decrease in money supply