In this chapter, look for the answers to these questions:

1. In this chapter, look for the answers to these questions: • What assets are considered “money”? What are the functions of money? The types of money? • What is the Federal Reserve? • What role do banks play in the monetary system? How do banks “create money”? • How does the Federal Reserve control the money supply? 0

2. What Money Is and Why It’s Important Without money, goods and services have to be exchanged Every transaction would require a Most people would have to spend time With money peopleand hence society saves on Hence money fosters 0

3. The 3 Functions of Money Medium of exchange: Unit of account: Store of value: 0

4. The 2 Kinds of Money Commodity money: 0 Fiat money:

5. Measures of the U.S. Money Supply M1: M2: 0

6. Central Banks & Monetary Policy Central bank: Monetary policy: Federal Reserve (Fed): 0

7. The Structure of the Fed The Federal Reserve System consists of: Board of Governors(7 members), located in Washington, DC 12 regional Fed banks, located around the U.S. Federal Open Market Committee (FOMC), includes the Bd of Govs and presidents of some of the regional Fed banks The FOMC decides monetary policy. 0 Ben S. BernankeChair of FOMC, Feb 2006 – present

8. Bank Reserves In a fractional reserve banking system, The Fed establishes Banks may hold more than The reserve ratio, 0

9. Bank T-account T-account: Example: 0 • Banks’ liabilities include • In this example,

10. Banks and the Money Supply: An Example Suppose $100 of currency is in circulation. To determine banks’ impact on money supply, we calculate the money supply in 3 different cases: 1. No banking system 2. 100% reserve banking system: banks hold 100% of deposits as reserves, make no loans 3. Fractional reserve banking system 0

11. Banks and the Money Supply: An Example CASE 1: No banking system 0

12. Banks and the Money Supply: An Example CASE 2: 100% reserve banking system Public deposits the $100 at First National Bank (FNB). 0 FNB holds Money supply = In a 100% reserve banking system, THE MONETARY SYSTEM

13. Banks and the Money Supply: An Example CASE 3: Fractional reserve banking system 0 Suppose R = 10%. Money supply =

14. Banks and the Money Supply: An Example How did the money supply suddenly grow? 0 CASE 3: Fractional reserve banking system A fractional reserve banking system

15. Banks and the Money Supply: An Example CASE 3: Fractional reserve banking system 0 Suppose borrower deposits the $90 at Second National Bank (SNB). Initially, SNB’s T-account looks like this: If R = 10% for SNB, it will

16. Banks and the Money Supply: An Example CASE 3: Fractional reserve banking system 0 The borrower deposits Initially, TNB’s T-account looks like this: If R = 10% for TNB, it will

17. Banks and the Money Supply: An Example CASE 3: Fractional reserve banking system 0 The process

18. The Money Multiplier Money multiplier: The money multiplier equals In our example, 0

19. Exercise - 1 While cleaning your apartment, you look under the sofa cushion find a $50 bill (and a half-eaten taco). You deposit the bill in your checking account. The Fed’s reserve requirement is 20% of deposits. A. What is the maximum amount that the money supply could increase? B. What is the minimum amount that the money supply could increase? 18

20. The Fed’s 3 Tools of Monetary Control 1. Open-Market Operations (OMOs): 0 • To increase money supply • To reduce money supply,

21. The Fed’s 3 Tools of Monetary Control 2. Reserve Requirements (RR): 0 • To increase money supply, • To reduce money supply,

22. The Fed’s 3 Tools of Monetary Control 3. The Discount Rate: 0 • When banks are running low on reserves, • To increase money supply, • To reduce money supply,

23. The Federal Funds Rate On any given day, banks with insufficient reserves The interest rate on The FOMC uses OMOs to Many interest rates are 0

24. The Fed Funds Rate and Other Rates, 1970-2008 Fed funds prime 3-month Tbill mortgage 20 15 (%) 10 5 0 1970 1975 1980 1985 1990 1995 2000 2005

25. Monetary Policy and the Fed Funds Rate rf Federal funds rate 3.75% 3.50% D1 F F2 F1 Quantity of federal funds 0 The Federal Funds market

26. Problems Controlling the Money Supply If households hold more of their money as currency If banks hold more reserves than required, Yet, Fed can compensate 0

27. Bank Runs and the Money Supply A run on banks: Under fractional-reserve banking, Also, banks may make These events 0

28. Bank Runs and the Money Supply During 1929-1933, a wave of bank runs and bank closings caused money supply to fall 28%. Many economists believe this contributed to the severity of the Great Depression. Since then, federal deposit insurance has helped prevent bank runs in the U.S. In the U.K., though, Northern Rock bank experienced a classic bank run in 2007 and was eventually taken over by the British government. 0