Econ 1a, Macro

The Monetary System

Taylor 15 - money and banks

* Money: a medium of exchange, and the final means of payment.

A claim on goods.

Without money, people exchange with barter: goods directly for goods.

It is inconvenient. Requires a double coincident of wants.

Historically, widely used commodities became a medium of indirect exchange.

For example, a farmer would trade vegetables for salt, and then trade salt for shoes.

Salt was used for indirect exchange because most folks usually wanted salt at some times.

Salt then became money.

Various commodities were used for money: cacao beans, shells, cattle, salt, and metal.

Gold and silver became the most widely used commodities for money.

They hold a lot of value in a small volume.

They can be divided into small units.

They can be shaped into standard units, coins.

When gold was used as money, banks issued paper money - bank notes or bills

as money substitutes. They were convertible into gold or silver on demand.

*A medium of exchange implies a unit of account, the units the money is counted in.

Such as the US dollar, the British pound, the Japanese yen, the European Union’s euro.

A unit of account measures and records economic value.

Good money is a store of value, keeping its purchasing power over time.

When there is high price inflation, money is not a good store of value.

* Money provides the service of liquidity - being able to exchange the asset for goods immediately. People hold cash either as currency or in bank accounts for liquidity as well as for a store of value.

*When commodities with intrinsic value, such as gold, are used for money, this is called commodity money. When gold is money, the system is called the “gold standard.”

*Money that is not based on any commodity is called “fiat money.”

Fiat money is a medium of exchange by government law.

Fiat lux - let there be light. Fiat money - let there be money.

A federal reserve note is legal tender, as inscribed on the bill.

When tendered for a debt, it must be accepted as payment.

Measuring the supply of money.

There are different ways to measure money, depending on what kind of money is counted.

Currency means coins and paper bills.

There is about $1.3 trillion in U.S. currency. $4000 per adult.

That includes $40 billion worth of coins.

Federal Reserve notes are printed by US Bureau of Engraving and Printing in DC.

Coins are made by the US mint.

Much of US currency is used abroad and also is held for illegal transactions.

Deposits in checking accounts are also money, since they can be withdrawn on demand.

That means the contractual right to an immediate withdrawal.

So these accounts are called “demand deposits.”

We can withdraw the money by writing checks, using debit cards, or getting currency.

*The measurement of money called M1 includes currency and demand deposits.

It totals about $3 trillion.

M2 includes M1 plus savings and small time deposits and money market mutual funds.

It is about $12 trillion.

M3: M2 plus large-denomination time deposits at all depository institutions,

and shares in money market mutual funds restricted to institutional investors.

Currently $16 trillion.

* MZM: money zero maturity.

M2 + institutional money-market funds minus small time deposits.

About $14 trillion. Velocity 1.3

Many economists consider MZM to be the best measurement of the money supply,

since it is the broadest measure of the most liquid funds.

The Federal Reserve System

There are two ways to have a banking system:

central banking and free-market banking (free banking).

A central bank is a government institution

that regulates the banks and controls the money supply.

*In the United States, the central bank is the Federal Reserve system, or the Fed.

Our paper money consists of federal reserve notes, issued by the Fed.

In the UK, the central bank is the Bank of England.

The euro is issued by the European Central Bank.

“Free banking”means a banking system with no central bank

and no government regulation

other than the prohibition of force and fraud.

Banks are free to issue private bank notes.

Historically, free banking used gold as money.

Private bank notes were money substitutes.

The Federal Reserve system was created by Congress in 1913.

Prior to the Fed, the US Treasury served as a central bank, issuing currency.

The U.S. never had free banking.

The Fed is controlled by a Board of Governors, the members appointed by the U.S. President, with the approval of the Senate.

The Fed is supposed to be independent of the rest of the government.

The head of the Fed is Janet Yellen.

There are 12 regional Federal Reserve Banks.

They act as bankers’ banks and help regulate the banks.

They loan money to banks.

The Federal Reserve Bank in the US west is at San Francisco.

* Monetary policy concerns variations in the supply of money.

In the US, monetary policy is made by the Federal Open Market Committee of the Fed.

It conducts “open market operations,” buying and selling US bonds.

The Fed increases the money supply by buying bonds, and decreases it by selling bonds.

* The way the Fed expands the money supply with its open-market operations:

1. Fed buys a bond in the market, paying with a Fed check.

2. Seller deposits Fed check in his bank.

3. Bank deposits the check in its account in a Federal Reserve Bank.

4. The Fed covers the check by expanding the reserves of the bank.

Presto! The Fed has created money out of nothing.

* The Fed faces a knowledge problem of how fast to expand the money supply.

Too fast, we get inflation.

Too slow, we can get a recession, since interest rates would rise and investment would fall.

Another problem is that the effect of expansion takes place months in the future.

Since the Fed does not know the future, it often expands too much or not enough.

Errors in money expansion led to economic distortions, inflation, and recessions.


Fractional Reserve Banking.

The money that banks hold is called “reserves”.

Some of these reserves are held at the Federal Reserve Banks.

That is why it is called the Federal Reserve system.

* A “T account” is used to record a bank’s balance sheet, of assets and liabilities.

Suppose Jane deposits $100 of currency in the Bank of Clara.

In the T account, assets are on the left side of the vertical bar of the T.

The bank has $100 of assets, since it has Jane’s cash.

But these belong to Jane, not the bank, so the bank has a liability of $100.

Assets equal liabilities.

A bank is solvent when its assets are greater than its liabilities.

A bank starts out with positive assets, so normally a bank is solvent.

If depositors think a bank is losing money and may fail,

they may run to the bank to get their money out.

This is called a “run on the bank.”

Nowadays, there are very few runs, because deposits are insured.

A federal government agency, the Federal Deposit Insurance Corporation,

insures accounts up to $100,000.

There is also private insurance that brokerage firms, credit unions, and other firms use.

A problem with federal deposit insurance is that it reduces the incentive of a bank to be safe.

The financial system uses fractional-reserve banking.

That means that only a fraction of money deposited needs to be held by banks in reserve.

The Fed imposes a minimum reserve requirement on banks. It is about 10 percent.

*Reserves beyond the required amount are called excess reserves.

The excess reserves are the funds available to loan out.

Suppose that the required reserves are 10 percent.

The T account has $10 in required reserves and $90 in excess reserves.

The bank loans out $90 in currency to Ralph.

What is the money supply now? $190.

Jane still has $100, in a demand deposit.

But Ralph has $90 in cash.

The bank has created $90 by loaning it to Ralph.

But note: Ralph’s $90 in cash assets is offset by his $90 loan liability.

In accounting terms, Ralph’s assets net out to zero.

The bank’s accounts also net to zero.

Only Jane has a positive asset value, $100.

The net money assets are still $100, the same as before Jane deposited her cash.

The new money is not an addition to economic assets, because it is also a liability.

What Jane wants to withdraw her money, and the bank has no excess reserves?

The Bank of Clara borrows money from a bank that has excess reserves.

It is usually only for a short time, often just overnight.

The interest rate on these bank-to-bank loans is called the federal funds rate.

Because the term originally applied to banks with federal charters.

The federal funds interest rate is usually lower than loans to individuals or companies,

because there is little risk and no opportunity cost.

It is now 1/2%.

Suppose that a bank needs to borrow funds to meet the required reserve,

and all the other banks are also all loaned out.

As the last resort, the bank can borrow from its regional Federal Reserve Bank.

The rate of interest that the Fed charges on its loans to banks is called the discount rate.

Banks avoid borrowing from the Fed unless they have to, because the discount rate may be higher than the federal funds rate, and also because such borrowing raises suspicion.

So what does Ralph do with his $90?

He borrowed the money to buy an electronic piano keyboard.

He pays the $90 to the Music Company.

The Music Company deposits the cash in its account at the Bank of Assisi.

Assisi must keep 10% of that, or $8.10, in reserve.

The rest, $72.90 are excess reserves.

Maria Elena borrows the $72.90 to invest in a power drill capital good.

The seller, San Jose Drilling and Boring, deposits this in its account at the Bank of Clara.

The bank keeps 10% of that in reserve and loans out the rest, $65.61.

So that process continues until there are no more excess reserves.

If we add up all the money created by the banks from the initial $100 deposit,

it is $900. If you deposit $100 in cash in a bank, you help create $900 in new money.

* The money multiplier tells how much an initial amount of money is expanded to.

Since $1000 was created from $100, the multiplier is 10.

10 is the reciprocal of the required reserve, .1 or 10%.

So if the Fed lowers the reserve requirement, what does this do to the money supply?

But the Fed rarely changes the required reserves, since this is very disruptive.