Monetary System

Dr. Katherine Sauer A Citizens Guide to Economics ECO 1040

I. Money
The social custom of using money for transactions is extraordinarily useful in a large, complex society. The existence of money makes trade between people easier.

Imagine that there was no item in the economy widely accepted in exchange for goods and services.

People would have to rely on barterthe exchange of one good or service for anotherto obtain the things they need.

Problems with a Barter System

1. In order for a transaction to take place, there needs to be a double coincidence of wants.

2. There is no common measure of value. 5 pigs = ? shoes = ? haircuts = ? insurance Number of unique exchange rates (prices) in a barter economy: N( N-1) 2

Ex: An economy with 1000 goods would need 1000(999) = 2 499,500 prices

3. Certain goods/services are not divisible.

4. Lack of standards for future payments.

5. Difficulty in storing wealth.

Money is the set of assets that people generally use to buy goods and services.
In order to be money, the asset has to fulfill 3 functions:

1. medium of exchange: an item that buyers give to sellers in exchange for goods and services ex: paper bills, coins, shells, cigarettes 2. unit of account: the yardstick that people use to post prices and record debts ex: your Visa bill is denominated in dollars not chickens 3. store of value: the item can be used to transfer purchasing power from the present to the future ex: diamonds are durable, milk is not

There are 2 kinds of money:

1. Commodity money takes the form of a commodity that has intrinsic value. - the material that the money is made of has uses besides money ex: gold, silver, cigarettes 2. Fiat money has no intrinsic value; it is a material used as money by government decree. - the general public also has to believe it has value ex: US paper bills

Dont be Afraid of Fiat Money Money is simply a means to an end. - it is a way to make transactions easier - it is a way to transfer purchasing power to the future Money itself doesnt matter to you what matters is that you can trade the money for things you want and need, now or in the future. - money is a tangible symbol of purchasing power

Trading money for gold serves no real purpose for you. If you want to trade money for gold so you can trade gold for goods and services, the gold is no different than the paper currency. Money is simply a societal agreement that helps simplify transactions. (but a very important one)

II. The Federal Reserve System The Federal Reserve (the Fed) is the Central Bank of the United States. federalreserve.gov A Central Bank is an institution which oversees the banking system and regulates the quantity of money in the economy. The Fed was created by Congress in 1913 after a series of bank failures.

The Federal Reserve System is comprised of

-Board of Governors headquartered in Washington D.C. -Federal Open Market Committee -12 Regional District Banks

1. The Board of Governors (BoG) has 7 members who serve 14 year terms. Their primary responsibility is the formulation of monetary policy. - sit on the Federal Open Market Committee It also has regulatory and supervisory responsibilities over banks.

2. The Federal Open Market Committee (FOMC) makes decisions regarding the quantity of money in the economy. The FOMC is most important monetary policymaking body of the Federal Reserve System. The monetary policy is designed to promote economic growth full employment stable prices sustainable pattern of international trade & payments At meetings they discuss economic conditions and decide how to adjust the money supply.

3. 12 Regional District Banks that serve as the operating arms of the nation's central banking system. (the banks bank) - move currency in and out of circulation - check clearing - supervise/ examine banks - hold banks cash reserves and make loans to banks

III. The Feds Tools of Monetary Policy When the economy is sluggish, the Fed may want to try to stimulate it. When the economy is experiencing inflation or is heating up too quickly, the Fed may want to try to slow it down.

The US has a fractional reserve banking system. This means banks do not have to keep all deposits on hand, they can lend out a portion of them.

The fraction of deposits that a bank must keep on hand is called the reserve requirement ratio. -aka reserve requirement, reserve ratio, required ratio - For large banks, this ratio is 10%.

Monetary Policy Tool #1 The Fed controls the required reserve ratio. - hugely powerful tool - almost never used This affects the amount of money that banks can lend out. - more lending means more economic activity

Suppose a bank has $200 million worth of deposits. That bank has to keep at least (200m)(0.10) = $20million on hand at all times. It can lend out the other $180million if it wants to. The $20 million is called required reserves. The $180 million is called excess reserves.

When the reserve requirement is raised: - banks are able to lend out less - slows the economy down When the reserve requirement is lowered: - banks are able to lend out more - speeds the economy up

Monetary Policy #2 The Fed controls the discount rate, which is the interest rate that the Fed charges to banks for loans (BoG - every 6 weeks)

This is the only interest rate the Fed can directly control.
This interest rate usually just acts as a signal from the Fed to banks about what the Fed would like banks to do.

A higher discount rate: - means that it will be more costly for banks to borrow from the Fed (should they need to) - so banks take this as a signal to lend out less (be less risky) - when banks lend out less, the economy slows down

A lower discount rate: - means that it will be less costly for banks to borrow from the Fed (should they need to) - so banks take this as a signal to lend out more (okay to be more risky) - when banks lend out more, the economy speeds up

Monetary Policy Tool #3 Open Market Operations are the purchase or sale of US government bonds by the Fed. (FOMC every 6 weeks) The Fed uses Open Market Operations to target the Federal Funds Rate. - cant control the Fed Funds Rate directly The Federal Funds Rate is the rate that banks charge each other on short term loans. (overnight)

Why would banks borrow from each other overnight? - a bank might not have enough reserves on hand to meet their requirement (made too many loans) - books must balance at close of business - borrow from another bank just overnight

When the Fed buys bonds: - banks receive cash in exchange for the bonds they were holding

- banks have more cash reserves on hand so they are willing and able to lend it out to other banks
- this decreases the federal funds rate - banks know it is cheap to borrow from a bank overnight so they are willing to make more loans - economy speeds up

When the Fed sells bonds: - banks receive bond certificates in exchange for their cash

- banks have less in cash reserves on hand so they are not as willing and able to lend it out to other banks
- this increases the federal funds rate - banks know it is more expensive to borrow from a bank overnight so they want to make fewer loans

- economy slows down

Summary of Policy Tools:

To slow down the economy, the Fed could - raise the required reserve ratio - raise the discount rate - raise the federal funds target and sell bonds

To speed up the economy, the Fed could - lower the required reserve ratio - lower the discount rate - lower the federal funds target and buy bonds

The Feds mandate is to facilitate a sustainable pace of economic growth. This is difficult because 1.
2. 3.

Summary: In order for an asset to be money it must be able to fulfill 3 functions.

There are 3 branches of the US Federal Reserve System.

There are 3 main tools of monetary policy in the US.

What did you learn today? Please explain 2 concepts from todays class.