10MONEY AND PRICES IN THE LONG RUN
The Monetary                   System                                 29Copyright © 2004 South-Western
THE MEANING OF MONEY• Money is the set of assets in an economy that  people regularly use to buy goods and services  from ...
The Functions of Money• Money has three functions in the economy:  • Medium of exchange  • Unit of account  • Store of val...
The Functions of Money• Medium of Exchange  • A medium of exchange is an item that buyers give    to sellers when they wan...
The Functions of Money• Unit of Account  • A unit of account is the yardstick people use to post    prices and record debt...
The Functions of Money• Liquidity  • Liquidity is the ease with which an asset can be    converted into the economy’s medi...
The Kinds of Money• Commodity money takes the form of a  commodity with intrinsic value.  • Examples: Gold, silver, cigare...
Money in the U.S. Economy• Currency is the paper bills and coins in the  hands of the public.• Demand deposits are balance...
Figure 1 Money in the U.S. Economy  Billionsof Dollars                                                       M2   $5,455  ...
CASE STUDY: Where Is All The Currency?• In 2001 there was about $580 billion of U.S.  currency outstanding.  • That is $2,...
THE FEDERAL RESERVE            SYSTEM• The Federal Reserve (Fed) serves as the  nation’s central bank.  • It is designed t...
THE FEDERAL RESERVE            SYSTEM• The Fed was created in 1914 after a series of  bank failures convinced Congress tha...
THE FEDERAL RESERVE            SYSTEM• The Structure of the Federal Reserve System:  • The primary elements in the Federal...
The Fed’s Organization• The Fed is run by a Board of Governors, which  has seven members appointed by the president  and c...
The Fed’s Organization• The Board of Governors  • Seven members  • Appointed by the president  • Confirmed by the Senate  ...
The Fed’s Organization• The Federal Reserve System is made up of the  Federal Reserve Board in Washington, D.C.,  and twel...
The Fed’s Organization• The Federal Reserve Banks  • Twelve district banks  • Nine directors     • Three appointed by the ...
The Federal Reserve System                    Copyright©2003 Southwestern/Thomson Learning
The Fed’s Organization• The Federal Reserve Banks  • The New York Fed implements some of the Fed’s    most important polic...
The Fed’s Organization• The Federal Open Market Committee (FOMC)  • Serves as the main policy-making organ of the    Feder...
The Fed’s Organization• The Federal Open Market Committee (FOMC)  is made up of the following voting members:  • The chair...
The Fed’s Organization• Monetary policy is conducted by the Federal  Open Market Committee.  • Monetary policy is the sett...
The Federal Open Market Committee• Three Primary Functions of the Fed  • Regulates banks to ensure they follow federal law...
The Federal Open Market Committee• Open-Market Operations  • The money supply is the quantity of money    available in the...
The Federal Open Market Committee• Open-Market Operations  • To increase the money supply, the Fed buys    government bond...
BANKS AND THE MONEY             SUPPLY• Banks can influence the quantity of demand  deposits in the economy and the money ...
BANKS AND THE MONEY             SUPPLY• Reserves are deposits that banks have received  but have not loaned out.• In a fra...
BANKS AND THE MONEY             SUPPLY• Reserve Ratio  • The reserve ratio is the fraction of deposits that    banks hold ...
Money Creation with Fractional-ReserveBanking  • When a bank makes a loan from its reserves, the    money supply increases...
Money Creation with Fractional-ReserveBanking• This T-Account shows a bank that…  • accepts deposits, First National Bank ...
Money Creation with Fractional-ReserveBanking• When one bank loans money, that money is  generally deposited into another ...
The Money Multiplier• How much money is eventually created in this  economy?                                      Copyrigh...
The Money Multiplier• The money multiplier is the amount of money  the banking system generates with each dollar  of reser...
The Money Multiplier   First National Bank             Second National Bank   Assets         Liabilities         Assets   ...
The Money Multiplier• The money multiplier is the reciprocal of the  reserve ratio:                      M = 1/R• With a r...
The Fed’s Tools of Monetary Control• The Fed has three tools in its monetary toolbox:  • Open-market operations  • Changin...
The Fed’s Tools of Monetary Control• Open-Market Operations  • The Fed conducts open-market operations when it    buys gov...
The Fed’s Tools of Monetary Control• Reserve Requirements  • The Fed also influences the money supply with    reserve requ...
The Fed’s Tools of Monetary Control• Changing the Reserve Requirement  • The reserve requirement is the amount (%) of a   ...
The Fed’s Tools of Monetary Control• Changing the Discount Rate  • The discount rate is the interest rate the Fed charges ...
Problems in Controlling the Money Supply• The Fed’s control of the money supply is not  precise.• The Fed must wrestle wit...
Summary• The term money refers to assets that people  regularly use to buy goods and services.• Money serves three functio...
Summary• The Federal Reserve, the central bank of the  United States, regulates the U.S. monetary  system.• It controls th...
Summary• When banks loan out their deposits, they  increase the quantity of money in the economy.• Because the Fed cannot ...
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  1. 1. 10MONEY AND PRICES IN THE LONG RUN
  2. 2. The Monetary System 29Copyright © 2004 South-Western
  3. 3. THE MEANING OF MONEY• Money is the set of assets in an economy that people regularly use to buy goods and services from other people. Copyright © 2004 South-Western
  4. 4. The Functions of Money• Money has three functions in the economy: • Medium of exchange • Unit of account • Store of value Copyright © 2004 South-Western
  5. 5. The Functions of Money• Medium of Exchange • A medium of exchange is an item that buyers give to sellers when they want to purchase goods and services. • A medium of exchange is anything that is readily acceptable as payment. Copyright © 2004 South-Western
  6. 6. The Functions of Money• Unit of Account • A unit of account is the yardstick people use to post prices and record debts.• Store of Value • A store of value is an item that people can use to transfer purchasing power from the present to the future. Copyright © 2004 South-Western
  7. 7. The Functions of Money• Liquidity • Liquidity is the ease with which an asset can be converted into the economy’s medium of exchange. Copyright © 2004 South-Western
  8. 8. The Kinds of Money• Commodity money takes the form of a commodity with intrinsic value. • Examples: Gold, silver, cigarettes.• Fiat money is used as money because of government decree. • It does not have intrinsic value. • Examples: Coins, currency, check deposits. Copyright © 2004 South-Western
  9. 9. Money in the U.S. Economy• Currency is the paper bills and coins in the hands of the public.• Demand deposits are balances in bank accounts that depositors can access on demand by writing a check. Copyright © 2004 South-Western
  10. 10. Figure 1 Money in the U.S. Economy Billionsof Dollars M2 $5,455 • Savings deposits • Small time deposits • Money market mutual funds • A few minor categories ($4,276 billion) M1 $1,179 • Demand deposits • Everything in M1 • Traveler’s checks ($1,179 billion) • Other checkable deposits ($599 billion) • Currency ($580 billion) 0 Copyright©2003 Southwestern/Thomson Learning
  11. 11. CASE STUDY: Where Is All The Currency?• In 2001 there was about $580 billion of U.S. currency outstanding. • That is $2,734 in currency per adult.• Who is holding all this currency? • Currency held abroad • Currency held by illegal entities Copyright © 2004 South-Western
  12. 12. THE FEDERAL RESERVE SYSTEM• The Federal Reserve (Fed) serves as the nation’s central bank. • It is designed to oversee the banking system. • It regulates the quantity of money in the economy. Copyright © 2004 South-Western
  13. 13. THE FEDERAL RESERVE SYSTEM• The Fed was created in 1914 after a series of bank failures convinced Congress that the United States needed a central bank to ensure the health of the nation’s banking system. Copyright © 2004 South-Western
  14. 14. THE FEDERAL RESERVE SYSTEM• The Structure of the Federal Reserve System: • The primary elements in the Federal Reserve System are: • 1) The Board of Governors • 2) The Regional Federal Reserve Banks • 3) The Federal Open Market Committee Copyright © 2004 South-Western
  15. 15. The Fed’s Organization• The Fed is run by a Board of Governors, which has seven members appointed by the president and confirmed by the Senate.• Among the seven members, the most important is the chairman. • The chairman directs the Fed staff, presides over board meetings, and testifies about Fed policy in front of Congressional Committees. Copyright © 2004 South-Western
  16. 16. The Fed’s Organization• The Board of Governors • Seven members • Appointed by the president • Confirmed by the Senate • Serve staggered 14-year terms so that one comes vacant every two years. • President appoints a member as chairman to serve a four-year term. Copyright © 2004 South-Western
  17. 17. The Fed’s Organization• The Federal Reserve System is made up of the Federal Reserve Board in Washington, D.C., and twelve regional Federal Reserve Banks. Copyright © 2004 South-Western
  18. 18. The Fed’s Organization• The Federal Reserve Banks • Twelve district banks • Nine directors • Three appointed by the Board of Governors. • Six are elected by the commercial banks in the district. • The directors appoint the district president, which is approved by the Board of Governors. Copyright © 2004 South-Western
  19. 19. The Federal Reserve System Copyright©2003 Southwestern/Thomson Learning
  20. 20. The Fed’s Organization• The Federal Reserve Banks • The New York Fed implements some of the Fed’s most important policy decisions. Copyright © 2004 South-Western
  21. 21. The Fed’s Organization• The Federal Open Market Committee (FOMC) • Serves as the main policy-making organ of the Federal Reserve System. • Meets approximately every six weeks to review the economy. Copyright © 2004 South-Western
  22. 22. The Fed’s Organization• The Federal Open Market Committee (FOMC) is made up of the following voting members: • The chairman and the other six members of the Board of Governors. • The president of the Federal Reserve Bank of New York. • The presidents of the other regional Federal Reserve banks (four vote on a yearly rotating basis). Copyright © 2004 South-Western
  23. 23. The Fed’s Organization• Monetary policy is conducted by the Federal Open Market Committee. • Monetary policy is the setting of the money supply by policymakers in the central bank • The money supply refers to the quantity of money available in the economy. Copyright © 2004 South-Western
  24. 24. The Federal Open Market Committee• Three Primary Functions of the Fed • Regulates banks to ensure they follow federal laws intended to promote safe and sound banking practices. • Acts as a banker’s bank, making loans to banks and as a lender of last resort. • Conducts monetary policy by controlling the money supply. Copyright © 2004 South-Western
  25. 25. The Federal Open Market Committee• Open-Market Operations • The money supply is the quantity of money available in the economy. • The primary way in which the Fed changes the money supply is through open-market operations. • The Fed purchases and sells U.S. government bonds. Copyright © 2004 South-Western
  26. 26. The Federal Open Market Committee• Open-Market Operations • To increase the money supply, the Fed buys government bonds from the public. • To decrease the money supply, the Fed sells government bonds to the public. Copyright © 2004 South-Western
  27. 27. BANKS AND THE MONEY SUPPLY• Banks can influence the quantity of demand deposits in the economy and the money supply. Copyright © 2004 South-Western
  28. 28. BANKS AND THE MONEY SUPPLY• Reserves are deposits that banks have received but have not loaned out.• In a fractional-reserve banking system, banks hold a fraction of the money deposited as reserves and lend out the rest. Copyright © 2004 South-Western
  29. 29. BANKS AND THE MONEY SUPPLY• Reserve Ratio • The reserve ratio is the fraction of deposits that banks hold as reserves. Copyright © 2004 South-Western
  30. 30. Money Creation with Fractional-ReserveBanking • When a bank makes a loan from its reserves, the money supply increases. • The money supply is affected by the amount deposited in banks and the amount that banks loan. • Deposits into a bank are recorded as both assets and liabilities. • The fraction of total deposits that a bank has to keep as reserves is called the reserve ratio. • Loans become an asset to the bank. Copyright © 2004 South-Western
  31. 31. Money Creation with Fractional-ReserveBanking• This T-Account shows a bank that… • accepts deposits, First National Bank • keeps a portion Assets Liabilities as reserves, • and lends out Reserves Deposits the rest. $10.00 $100.00 • It assumes a Loans reserve ratio $90.00 of 10%. Total Assets Total Liabilities $100.00 $100.00 Copyright © 2004 South-Western
  32. 32. Money Creation with Fractional-ReserveBanking• When one bank loans money, that money is generally deposited into another bank.• This creates more deposits and more reserves to be lent out.• When a bank makes a loan from its reserves, the money supply increases. Copyright © 2004 South-Western
  33. 33. The Money Multiplier• How much money is eventually created in this economy? Copyright © 2004 South-Western
  34. 34. The Money Multiplier• The money multiplier is the amount of money the banking system generates with each dollar of reserves. Copyright © 2004 South-Western
  35. 35. The Money Multiplier First National Bank Second National Bank Assets Liabilities Assets LiabilitiesReserves Deposits Reserves Deposits $10.00 $100.00 $9.00 $90.00Loans Loans $90.00 $81.00Total Assets Total Liabilities Total Assets Total Liabilities $100.00 $100.00 $90.00 $90.00 Money Supply = $190.00! Copyright © 2004 South-Western
  36. 36. The Money Multiplier• The money multiplier is the reciprocal of the reserve ratio: M = 1/R• With a reserve requirement, R = 20% or 1/5,• The multiplier is 5. Copyright © 2004 South-Western
  37. 37. The Fed’s Tools of Monetary Control• The Fed has three tools in its monetary toolbox: • Open-market operations • Changing the reserve requirement • Changing the discount rate Copyright © 2004 South-Western
  38. 38. The Fed’s Tools of Monetary Control• Open-Market Operations • The Fed conducts open-market operations when it buys government bonds from or sells government bonds to the public: • When the Fed buys government bonds, the money supply increases. • The money supply decreases when the Fed sells government bonds. Copyright © 2004 South-Western
  39. 39. The Fed’s Tools of Monetary Control• Reserve Requirements • The Fed also influences the money supply with reserve requirements. • Reserve requirements are regulations on the minimum amount of reserves that banks must hold against deposits. Copyright © 2004 South-Western
  40. 40. The Fed’s Tools of Monetary Control• Changing the Reserve Requirement • The reserve requirement is the amount (%) of a bank’s total reserves that may not be loaned out. • Increasing the reserve requirement decreases the money supply. • Decreasing the reserve requirement increases the money supply. Copyright © 2004 South-Western
  41. 41. The Fed’s Tools of Monetary Control• Changing the Discount Rate • The discount rate is the interest rate the Fed charges banks for loans. • Increasing the discount rate decreases the money supply. • Decreasing the discount rate increases the money supply. Copyright © 2004 South-Western
  42. 42. Problems in Controlling the Money Supply• The Fed’s control of the money supply is not precise.• The Fed must wrestle with two problems that arise due to fractional-reserve banking. • The Fed does not control the amount of money that households choose to hold as deposits in banks. • The Fed does not control the amount of money that bankers choose to lend. Copyright © 2004 South-Western
  43. 43. Summary• The term money refers to assets that people regularly use to buy goods and services.• Money serves three functions in an economy: as a medium of exchange, a unit of account, and a store of value.• Commodity money is money that has intrinsic value.• Fiat money is money without intrinsic value. Copyright © 2004 South-Western
  44. 44. Summary• The Federal Reserve, the central bank of the United States, regulates the U.S. monetary system.• It controls the money supply through open- market operations or by changing reserve requirements or the discount rate. Copyright © 2004 South-Western
  45. 45. Summary• When banks loan out their deposits, they increase the quantity of money in the economy.• Because the Fed cannot control the amount bankers choose to lend or the amount households choose to deposit in banks, the Fed’s control of the money supply is imperfect. Copyright © 2004 South-Western
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