Money and the Monetary System

1. 18 Money and the Monetary System CHAPTER The process by which banks create money is so simple that the mind is repelled. John Kenneth Galbraith Economist, Institutionalist (1908 – 2006) Bank failures are caused by depositors who don't deposit enough money to cover losses due to mismanagement. Dan Quayle 44th US Vice President (1946 - )

2. 18.1 WHAT IS MONEY? • Definition of Money • Money - commodity or token that is generally accepted as a means of payment. • The Functions of Money • Medium of exchange - generally accepted in return for goods and services. • Unit of account - agreed-upon measure for stating the prices of goods and services. • Store of value - can be held and exchanged later for goods and services.

3. 18.1 WHAT IS MONEY? • Money Today • Money in the world today is called fiat money. • Fiat money – dollars are money because the law decrees or orders them to be money. • The objects that we use as money today are • Currency outside the banks - notes (dollar bills) and coins • Deposits at banks (and other financial institutions) - Deposits are money because they can be converted into currency on demand and are used directly to make payments.

4. 18.1 WHAT IS MONEY? • Currency in a Bank Is Not Money • Bank deposits are one form of money, and currency outside the banks is another form. • Currency inside the banks is not money. • When you get some cash from the ATM, you convert your bank deposit into currency.

5. 18.1 WHAT IS MONEY? • Official Measures of Money: M1 and M2 • M1 = currency held by individuals and businesses + traveler’s checks + checkable deposits owned by individuals and businesses. • M2 = M1 + savings deposits + small time deposits, money market funds, and other deposits.

6. In billions of dollars

9. 18.2 THE BANKING SYSTEM • Reserves • A bank’s reserves = vault cash + balance in reserve account at a Federal Reserve Bank. • Required reserve ratio (reserve requirement)= minimum percentage of deposits Federal Reserve requires banks and other financial institutions to hold (cannot loan) as reserves.

10. 18.2 THE BANKING SYSTEM • Interbank Loans • Federal funds rate – Interest rate banks pay each other when borrowing excess reserves to cover reserve shortfalls. • The interbank loans market is called federal funds market. • The Fed’s policy actions target the federal funds rate.

11. 18.3 THE FEDERAL RESERVE SYSTEM • The Federal Reserve System • Federal Reserve System (Fed) - central bank of the United States. • Central bank - public authority that provides banking services to banks and regulates financial institutions and markets. • The Fed’s main task: regulate the interest rate and quantity of money to achieve low and predictable inflation and sustained economic growth.

13. 18.3 THE FEDERAL RESERVE SYSTEM • The Structure of the Federal Reserve • The key elements in the structure of the Federal Reserve are • The Board of Governors • The Regional Federal Reserve Banks • The Federal Open Market Committee

14. 18.3 THE FEDERAL RESERVE SYSTEM • The Board of Governors consist of • Seven members, appointed by the President, confirmed by the Senate. • Serve14-year terms, helps ensure nonpartisanship • One member appointed by President as chairman for 4 year renewable term. • The Regional Federal Reserve Banks • 12 Federal Reserve district banks (some have branches – one in Charlotte) • Each Federal Reserve Bank has nine directors, three of whom are appointed by the Board of Governors and six of whom are elected by the commercial banks in the Federal Reserve district.

15. 18.3 THE FEDERAL RESERVE SYSTEM • The Federal Open Market Committee • FOMC - Fed’s main policy-making committee. • The FOMC consists of • All 7 members of Board of Governors. • NY district bank president • Four presidents of other district banks (on a yearly rotating basis). • The FOMC meets approximately every six weeks, decide monetary policy actions for managing economy.

16. 18.3 THE FEDERAL RESERVE SYSTEM • The Fed’s Monetary Policy Tools • The Fed uses three main monetary policy tools: • Required reserve ratios • Discount rate • Open market operations

17. 18.3 THE FEDERAL RESERVE SYSTEM • Required Reserve Ratios • Banks hold reserves. • These reserves are • Currency in the institutions’ vaults and ATMs • Deposits held with other banks or with the Fed itself. • Banks and thrifts are required to hold a minimum percentage of deposits as reserves, a required reserve ratio.

18. 18.3 THE FEDERAL RESERVE SYSTEM • Discount Rate • Discount rate - interest rate Fed charges banks for borrowed reserves. (called going to the “discount window) • Open Market Operations • Open market operation - purchase or sale of government securities —U.S. Treasury bills and bonds—by the New York Fed in the open market. • Open market transactions are conducted with banks and private buyers/sellers, NOT the US government.

19. 18.3 THE FEDERAL RESERVE SYSTEM • Increasing the required reserve ratio - Fed can force banks to hold onto a larger % of deposits (so they loan less). • Raising the discount rate - Fed can make it more costly for the banks to borrow reserves (so they loan less). • Selling securities in the open market - Fed can decrease bank’s reserves (take money out of money supply). • All these actions lead to an increase in the interest rate.

20. 18.3 THE FEDERAL RESERVE SYSTEM • Decreasing the required reserve ratio - Fed can permit the banks to hold onto a smaller % of deposits (so they can loan more). • Decreasing the discount rate - Fed can make it less costly for the banks to borrow reserves (so they can loan more). • Buying securities in the open market - Fed can increase bank’s reserves (inject money into money supply). • All these action lead to a decrease in the interest rate.

21. 18.4 REGULATING THE QUANTITY OF MONEY • Creating (Money) Deposits by Making Loans • Banks create deposits when they make loans, and the new deposits created are new money. • Fractional Reserve Banking • Banks keep only a fraction of their deposits in reserve and lend out the remainder, while maintaining the obligation to redeem all these deposits upon demand.

22. 18.4 REGULATING THE QUANTITY OF MONEY • Reserves • Actual reserves - vault cash and deposits at the Fed. • Required reserves - fraction of a bank’s total deposits required by Fed to be held (not loaned). • Excess reserves = actual reserves - required reserves. • Excess reserves are what the bank can loan out, so increasing excess reserves will increase loans, increase money supply.

23. 18.4 REGULATING THE QUANTITY OF MONEY • How Open Market Operations Work • When the Fed buys securities in an open market operation, bank reserves increase. • With more reserves in the banking system: • the supply of interbank loans increases • the demand for interbank loans decreases • the federal funds rate falls. • (The federal funds rate = rate banks charge each other.)

24. 18.4 REGULATING THE QUANTITY OF MONEY • Similarly, when the Fed sells securities in an open market operation, buyers pay for them with bank reserves and money, bank reserves decrease. • With fewer reserves in the banking system: • the supply of interbank loans decreases • the demand for interbank loans increases • the federal funds rate rises. • The Fed sets a target for the federal funds rate and conducts open market operations on the scale needed to hit its target.

25. 18.4 REGULATING THE QUANTITY OF MONEY • A change in the federal funds rate is only the first stage in an adjustment process that follows an open market operation: • If banks’ reserves increase, they increase their lending, which increases the money supply. • If banks’ reserves decrease, they decrease their lending, which decreases the money supply.

26. 18.4 REGULATING THE QUANTITY OF MONEY Initial deposit multiplied 2.5 times)

27. Change in quantity of money Change in monetary base Money multiplier Currency Deposits Reserves Deposits Money multiplier ÷ = = x 18.4 REGULATING THE QUANTITY OF MONEY • The Money Multiplier • The money multiplier is the number by which a change in the monetary base is multiplied to find the resulting change in the quantity of money. • Example: Money multiplier = 2.5 = if Fed wants to increase money supply by $10 billion, they need to inject $4 billion into bank reserves (increase monetary base by $4 bil). If reserves increase, multiplier falls. + 1

29. 1.0 Below the line means for every dollar increase in the monetary base (injection into banking system), money supply increases by LESS than a dollar. SO currently, usual monetary policy to increase money supply actually decreases it! (this has never happened before)