Money and its forms in the U.S. U.S.

. financial institutions How banks create money and how they are regulated The Federal Reserve system Changes in the financial industry International banking and finance

Money is the set of assets in the economy that people regularly use to buy goods and services from other people. It is anything that is generally accepted in exchange for goods and services.

Portability

Divisibility
Durability Stability

Monetary

assets) Non-monetary Assets (illiquid assets)

assets (Liquid

Currency is consists of coins and/or paper created to facilitate the trade of goods and services and the payment of debts. Metal coins have for centuries been supplemented by paper currency, often in the form of bank notes.

Metallic

coins and paper currency are the only forms of legal tender. Legal tender is fiat money

Demand Deposits balances in bank accounts that depositors can access on demand 2. Transaction Deposits Deposits that can easily converted to currency or used to buy goods and services directly. 3. Traveler's check- Transaction instrument easily convertible into currency.
1.

1.

Ease and safety Transaction Paying for goods and services with check is easier and less risky than paying with paper money

2. Lower Transaction Costs Transaction deposits are popular precisely because they lower transaction costs compared with the use of metal or paper currency.

3. Transaction Records They provide a record of financial transactions

It is generally acceptable in exchange for goods and services. A guaranteed loan available on demand to the cardholder, which merely defers the cardholders payment for a transaction using a demand deposit.

Funds that cannot be used for payment directly but must be converted into currency for general use.

Nontransaction deposits that are not money but can be quickly converted into money.

Interest-earning accounts provided by brokers that pool funds into such investments as treasury bills.

The central bank substantially controls the quantity of money that circulates in an economy, the money supply.
In the US, the central banking system is the

Federal Reserve System.

The Federal Reserve System directly regulates the amount of currency in circulation.

It indirectly influences the amount of checking deposits, debit card accounts, and other monetary assets.
14-16 Copyright 2009 Pearson Addison-Wesley. All rights reserved.

M1: Spendable
Currency Demand deposits

M2: Spendable plus Convertible

Time deposits

Money market mutual

funds

Savings deposit

Define money as currency plus checkable deposits: M = C + D

M1 definition of money

The Fed can control the monetary base better than it can control reserves
Link the money supply (M) to the monetary base (MB) and let m be the money multiplier

M m MB
18

Gold standards Defining the dollar as equivalent to a set value of a quantity of gold, allowing direct convertibility from currency to gold. 2. Greshams Law The principle that cheap money drives out dear money; given an alternative, people prefer to spend less valuable money.
1.

A medium of exchange: an asset used to buy and sell goods and services A store of value: an asset that allows people to transfer purchasing power from one period to another A unit of account: a unit of measurement used by people to post prices and keep track of revenues and costs

The banking industry includes:

commercial banks, savings and loans, and, credit unions.

Banks are profit-seeking institutions:

Banks accept deposits and use part of

them to extend loans and make investments. Income from these activities is their major source of revenue.

Banks play a central role in the capital market (loanable funds market):
They help to bring together people who

want to save for the future with those who want to borrow for current investment projects.

 Collecting

higher interest payments on the loans they make than they pay their depositors for those funds.

Holdings of assets at the bank or at the Federal Reserve Bank as mandated by the Fed. Quantity of cash reserve accounts with the Federal Reserve equal to a prescribed proportion of their checkable deposits.

Deposit $100.00 90.00 81.00 72.90

Money held in Reserve by Bank $10.00 9.00 8.10 7.29

Money Total to Lend Supply $90.00 $190.00 81.00 72.90 65.61 271.00 343.00 409.51

65.61

6.56

59.05

468.56

system that requires banks to hold reserves equal to some fraction of their checkable deposits.

Money, Interest Rates and Aggregate Demand

Market where money demand and money supply determine the equilibrium nominal interest rate.

 Transaction

purposes Precautionary Reasons Asset purposes

For a given level of income, real money demand decreases as the interest rate increases.

When income increases, real money demand increases at every interest rate.

no matter what is the interest rate, whether small or big rates, banks seeking to maximize profits will increase lending as long as they have reserves above their desired level.

An increase in the money supply lowers the interest rate for a given price level

A decrease in the money supply raises the interest rate for a given price level.

The Federal Reserve (Fed) serves as the nations central bank, which is designed to oversee the banking system and regulate the quantity of money in the economy.
The Tools of the Fed in controlling the money supply Open market operations Reserve requirements Discount rate controls

Open market operations

Involve the purchase of sale and government bonds

by the Federal Reserve System

Reserve requirements The Fed possesses the power to change the reserve requirement of member banks by altering the reserve ratio This can have an immediate and significant impact on the ability of member banks to create money Frequent changes in the reserve requirement would make it very difficult for banks to plan
The Fed changes the reserve requirements infrequently, and when it does make changes, it is by very small amounts.

Discount rate
Interest rate that the Fed changes commercial banks for the loans it extends to them.

* If the Fed wants to contract the money supply, it will raise the discount rate, making it more costly for banks to borrow reserves. * If the Fed is promoting an expansion of money and credit, it will lower the discount rate, making it cheaper for banks to borrow reserves

To increase the money supply,

1.the Fed buys government bonds from the public. 2.Lower reserve requirement 3.Lower the discount rate

To decrease the money supply

1.the Fed sells government bonds to the public 2.Raise reserve requirement 3.Raise the discount rate

When the economy is headed for a recession the and the fed wants to pursue an expansionary monetary policy to increase aggregate demand, it will buy bonds on the open market.

- When the Fed wants to contain an overhead economy, it will pursue a contractionary monetary policy to reduce aggregate demand. It will sells bonds on the open market.

Manipulate the supply of money It is the bankers bank Transfer funds and checks between various commercial banks in the banking system Serves as the primary bank for the central government Buys and sells foreign currencies and generally assist in the completion of financial transactions with other countries Serve as Lender of last resort Concern with the stability of the banking system and the money supply Can and does impose regulations on private commercial banks Implements monetary policy

Boston, New York, Philadelphia, Richmond, Atlanta, Dallas, Cleveland, Chicago, St. Louis, Minneapolis- St, Paul, Kansas City, and San Francisco

FED was created in 1913 It was privately owned by the banks that belong to it. Banks are not required to belong to the FED.

Private ownership o f the FED is essentially meaningless because the Federal RESERVED Board of Government, which controls major policy decisions, is appointed by the president of the United States and not by stockholders. The owners of the Fed have little control over its operation and receive only small fixed dividends on their modest financial stake in the system.

Feds enjoyed a considerable amount of independence from both the executive and legislative branches of the Government. No Federal reserve board will face reappointment from the president because the president appoints the seven members of the Board of Governor subject to the Senate and the term of appointments is 14yrs. Wherein the president tenure is limited to two four years term.

Many of the key policy decisions are made by its Federal Open Market Committee (FOMC) FOMC makes most of the key decisions influencing the direction and size of changes in the money supply the chair of the FED is truly the chief executive officer of the system.

Role of money is determining the equilibrium GDP, the level of prices, and real output of goods and services

M x V= P x Q M- money P- level of price goods

V- velocity Q- quantity of final

-refers to the turnover rate or the intensity with which money is used. V- represents the average number of times a dollar is used in purchasing final goods or services in a one year period P x Q- represents the dollar value of all final goods and services sold in a country in a given year

If M increases, then one of the following must happen: V must decline by the same magnitude, so that M x V remains constant, leaving P x Q unchanged. P must rise Q must rise P and Q must each rise somewhat, so that the product of P and Q remains equal to MV.

Economists once considered the velocity of money a given. The velocity is less stable when measured using the M1 definition and over shorter periods of time.

The inflation rate tends to rise more in periods of rapid monetary expansion than in periods of slower growth in the money supply. The relationship between the growth in the money supply and higher inflation is particularly strong with hyperinflation, inflation greater than 50%.

The economy faces an Inflationary Gap.

I. How the Commercial Banks Implement the Feds Monetary Policies

- monetary policy must ultimately be carried out through the commercial banking system

II. BANKS that are NOT PART of the Federal Reserve System and Policy Implementation
- The Fed can control deposit expansion at member banks, but it has no control over the global and nonbank institutions that also issue credit but are not subject to reserve requirement limitations

III. Fiscal and Monetary Problems - macroeconomic problem arise if

the federal governments fiscal decision makers differ with the Feds monetary policy

IV. Alleviating Coordination Problems

- attempt is made to reach a consensus on the appropriate policy response, both monetary and fiscal; still there is often some disagreement

V. Timing is Critical
- because of the significant lags before the fiscal and monetary policy has its impact, the increase in aggregate demand may occur at a wrong time

VI. Imperfect Information - some economists disagree on the

natural rate of real output, and it may be difficult to know where RGDP is at any given moment in time

VII. The Shape of the Aggregate Supply Curve and Policy Implications
- economists argue that the short-run aggregate supply curve is relatively flat at very low levels of RGDP, when the economy has substantial excess capacity, and very steep when the economy is near maximum capacity.

VII. Unexpected Global and Technological Events

- terrorists attacks on 09/11/11

- 1997-1998 currency crisis in East Asia, economic activity either slowed or declined