1. Introduction to Macroeconomics
Chapter 26
Money, Banking and
the Federal Reserve

2. Money, Banking, & the Federal Reserve
1. Barter Economy
2. Characteristics of Money
3. Definition of Money
4. Fractional Reserve Banking
5. How Banks Create Money
6. Federal Reserve Policy Tools

3. 1. Barter Economy Transaction Costs
Barter - direct trade of one good for another
Transaction Costs:
double coincidence of wants
problem of divisibility
negotiating relative values

4. 2. Characteristic of Money General Characteristics
Medium of Exchange - item generally acceptable as payment for goods and services. Avoids double coincidence of wants.
Store of Value - money can be accumulated without deterioration or loss. No problem with divisibility.
Unit of Account - money is a standard unit for quoting prices and establishing relative values. Reduces negotiation costs.

5. 2. Characteristics of Money Commodity Money
scarce relative to other commodities
stable in supply
portable
divisible
durable
Problems:
opportunity cost
debasing (Gresham’s Law)
can’t directly control supply

6. 2. Characteristics of Money Representative Money
Paper money that can be exchanged for a specific commodity, like silver or gold.
Advantages:
Lower opportunity cost
Eliminates debasing
Problems:
Depends on value of underlying commodity
Counterfeiting
Lower Opportuinity Cost - don’t have to hold gold reserves equivalent to all money in circulation. Can purchase/trade for commodity if needed.

7. 2. Characteristics of Money Fiat Money
Paper money that is solely money because the government says it is
Generally not backed by a valuable commodity such as god but is backed by the “full faith and credit of the government”
Advantages:
No opportunity cost
Not dependent on value of a commodity
Disadvantages
No restraint in printing money

8. 3. Definitions of Money Categorized by Liquidity
Liquidity - how easily money can be used to make purchases
Monetary Base - currency held by public + currency held in bank vaults (reserves)
M1 = currency held by public plus checking deposits
M2 = M1 + savings deposits + small (less than $100,000) time deposits (CDs)
M3 = M2 + large (more than $100,000) time deposits

9. 3. Definitions of Money M1
Source: Federal Reserve, H-6 Statistical Release, Table 4, September 2001.

10. 3. Definitions of Money M2
Source: Federal Reserve, H-6 Statistical Release, Table 5, September 2001.

11. 4. Fractional Reserve Banking
Banks hold reserves (cash in their vault) that are only a fraction of their demand deposits (e.g., checking and savings accounts)
Banks make a profit by charging a higher interest rate for loans than is paid for deposits.

12. 4. Fractional Reserve Banking Risks
Bank runs
Bank failures because of bad loans
Institutions to reduce risks:
FDIC deposit insurance
Federal Reserve System bank regulations

13. 4. Fractional Reserve Banking
Key Measurements
Demand Deposits (D) - total of checking and savings account
Required Reserve Ratio (r) - fraction of D established by Federal Reserve
Required Reserves, RR = r * D
Total Reserves = cash in bank vaults
Excess Reserves = Total Reserves - RR

14. 5. How Banks Create Money Money Multiplier
Money Multiplier = 1 / r
Maximum Possible Increase in Money Supply
= Initial change in monetary base
x money multiplier

15. 5. How Banks Create Money Money Multiplier at Work

16. 6. Federal Reserve Policy Tools The Federal Reserve System
Created by act of Congress in 1913
The Federal Reserve System (often called "the Fed") was formed in 1913 after panic of The Fed is the primary regulatory agency covering commercial banking. The responsibilities of the Fed include:
- Controlling amount of money in U.S.
- Lender of last resort
- Acts as "bankers" bank (e.g., go through Fed on wire transfers, makes loans)
- Supervises and inspects local banks
- Acts as the Federal government's bank

17. 6. Federal Reserve Policy Tools Policy Options
Open Market Operations - buy and sell T-Bills
Discount Rate - interest rate charged by Fed for overnight loans to banks
Required Reserve Ratio
Stock Market Margin Requirements
Moral Persuasion

18. 6. Federal Reserve Policy Tools Open Market Operations
Open Market Operation - purchase or sale of government securities (T-bills) on the open market
T-Bill Par Value: cash-in value when T-Bill matures
Interest Rate - difference between par value of T-Bill and and purchase price

19. 6. Federal Reserve Policy Tools Expansionary Policy
Objective: Lower Interest Rate
Fed buys T-Bills (increase in money supply)
Market price of T-Bills increase
Difference between market price and par value declines.
Result: Lower interest rate

20. 6. Federal Reserve Policy Tools Open Market Operations
+ represents increase, - represents decrease

21. 6. Federal Reserve Policy Tools Summary of Policy Options

22. 6. Federal Reserve Policy Tools Money and the Unemployment Rate
Ratio: Reserves-to-Required Reserves
Monetary Base
Unemployment Rate