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Money and the Monetary System

Money and the Monetary System. Outline The definition and functions of money Measuring the money supply Financial institutions The Federal Reserve system (the “FED”) The FED’s policy tools. What is money?. Money is anything that serves as a means of payment or method of settling debts.

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Money and the Monetary System

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  1. Money and the Monetary System • Outline • The definition and functions of money • Measuring the money supply • Financial institutions • The Federal Reserve system (the “FED”) • The FED’s policy tools.

  2. What is money? Money is anything that serves as a means of payment or method of settling debts.

  3. Functions of Money? • Money is a medium of exchange • Money is a unit of account • Money is a store of value or wealth

  4. Fiat Money: Anything which serves as a means of payment by government declaration This Note Is Legal Tender For All Debts, Public and Private You are willing to accept money not because it is “backed” by precious metals; but rather because you know it is generally acceptable in exchange

  5. What is liquidity? • Liquidity refers to two properties of assets or stores of value, namely: • The ready convertibility of the asset to generalized purchasing power (or money) • The comparative safety of the asset. Money is the most liquid asset available under normal circumstances

  6. The liquidity scale Farmland, commercial real estate Treasury bills, commercial paper Ceramics, art, rugs, rare coins Least liquid Most liquid Government and corporate bonds, equities Currency, checkable deposits Specialized equipment Savings and time deposits Home equity

  7. Deposits are Money—But Checks are Not (a) Rick’s Account at Delta Bank

  8. (b) The Flower Shop’s Account at Delta Bank

  9. Measuring the money supply To measurethe moneysupply, we sum upassets to the far rightof the liquidity spectrum MostLiquid Non-money assets money

  10. M1 M1 includes: • Currency in circulation • Demand deposits at commercial banks • Travelers’ checks • Other checkable deposits including NOW accounts, ATS accounts, and checkable deposits at credit unions and mutual savings banks

  11. Components of M1, July 17, 2000 (in billions) OCDs means “other checkable deposits.” Source: Federal Reserve Bulletin

  12. M2 M2 includes M1 plus • Savings deposits • Small time deposits (less than $100,000) • Retail money market mutual fund balances

  13. Components of M2, July 17, 2000 (in billions) Source: Federal Reserve Bulletin

  14. The Monetary System The monetary system consists of the Federal Reserve and the banks and other institutions that accept deposits and provide the services that enable people and businesses to make and receive payments.

  15. Financial Institutions • 3 types of institutions accept deposits that are a part of the nation’s money supply: • Commercial banks • Thrift institutions • Money market funds: A financial institution that obtains funds by selling shares and uses these funds to purchase assets such as U.S. Treasury bills.

  16. U.S. Commercial Banks, 1997 Source: FDIC

  17. Depository institutions are required by law to hold a minimum fraction of their liabilities on account at the FED • Legislation: • Federal Reserve Act of 1913 • DIDMCA of 1982

  18. The Fractional Reserve System • Reserves: The currency in a bank’s vaults plus the balance on its reserve account at the Federal Reserve Bank. • Required reserve ratio: The minimum percentage of deposits that banks and other financial institutions must hold in reserves. • Excess reserves: Banks reserves that exceed those needed to meet the required reserve ratio.

  19. Federal Funds • Banks that have excess reserves may loan them to banks with reserve deficiencies • These loans are made in the interbank loan, or federal funds, market. • The interest rate on loans in the interbank market is the federal funds rate.

  20. A Typical Bank Balance Sheet

  21. The Economic Functions of Monetary Institutions • Create liquidity (money) • Lower costs • Pool risks • Make payments

  22. The Federal Deposit Insurance Corporation (FDIC) • Created in 1933 • A government agency that insures deposits in commercial banks (up to $100,000 per account). • Banks pay premiums to the FDIC Bank failureswere often a “self-fulfilling prophesy.”

  23. Board of Governors7 members appointed by the President Federal Open Market CommitteeBoard of Governors plus 5 Federal Reserve Presidents Appoint 3 directors 12 Federal Reserve Banks Elect 6 directors Organization of the Federal Reserve System 3,500 member commercial banks

  24. Consolidated balance sheet of the Federal Reserve system (August 31, 1999) (in millions) Source: Federal Reserve Bulletin

  25. The instruments of monetary policy • Reserve requirements • The discount rate • Open market operations

  26. Open market operationsare the purchase or sale ofU.S. government securitieson the open market by the Federal Reserve system

  27. The FED Open Market Committee is the unit in charge ofopen market operations

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