ch29 The Monetary System

CHAPTER29THEMONETARYSYSTEMInthischapter,lookfortheanswerstothesequestions:Whatassetsareconsidered“money”?Whatarethefunctionsofmoney?Thetypesofmoney?WhatistheFederalReserve?Whatroledobanksplayinthemonetarysystem?Howdobanks“createmoney”?HowdoestheFederalReservecontrolthemoneysupply?1THEMONETARYSYSTEM2WhatMoneyIsandWhyIt’sImportantWithoutmoney,tradewouldrequirebarter,theexchangeofonegoodorserviceforanother.Everytransactionwouldrequireadoublecoincidenceofwants–theunlikelyoccurrencethattwopeopleeachhaveagoodtheotherwants.Mostpeoplewouldhavetospendtimesearchingforotherstotradewith–ahugewasteofresources.Thissearchingisunnecessarywithmoney,thesetofassetsthatpeopleregularlyusetobuyg&sfromotherpeople.THEMONETARYSYSTEM3The3FunctionsofMoneyMediumofexchange:anitembuyersgivetosellerswhentheywanttopurchaseg&sUnitofaccount:theyardstickpeopleusetopostpricesandrecorddebtsStoreofvalue:anitempeoplecanusetotransferpurchasingpowerfromthepresenttothefutureTHEMONETARYSYSTEM4The2KindsofMoneyCommoditymoney:takestheformofacommoditywithintrinsicvalueExamples:goldcoins,cigarettesinPOWcampsFiatmoney:moneywithoutintrinsicvalue,usedasmoneybecauseofgovtdecreeExample:theU.S.dollarTHEMONETARYSYSTEM5TheMoneySupplyThemoneysupply(ormoneystock):thequantityofmoneyavailableintheeconomyWhatassetsshouldbeconsideredpartofthemoneysupply?Twocandidates:Currency:thepaperbillsandcoinsinthehandsofthe(non-bank)publicDemanddeposits:balancesinbankaccountsthatdepositorscanaccessondemandbywritingacheckTHEMONETARYSYSTEM6MeasuresoftheU.S.MoneySupplyM1:currency,demanddeposits,traveler’schecks,andothercheckabledeposits.M1=$1.4trillion(June2008)M2:everythinginM1plussavingsdeposits,smalltimedeposits,moneymarketmutualfunds,andafewminorcategories.M2=$7.7trillion(June2008)ThedistinctionbetweenM1andM2willusuallynotmatterwhenwetalkabout“themoneysupply”inthiscourse.THEMONETARYSYSTEM7CentralBanks&MonetaryPolicyCentralbank:aninstitutionthatoverseesthebankingsystemandregulatesthemoneysupplyMonetarypolicy:thesettingofthemoneysupplybypolicymakersinthecentralbankFederalReserve(Fed):thecentralbankoftheU.S.THEMONETARYSYSTEM8TheStructureoftheFedTheFederalReserveSystemconsistsof:BoardofGovernors(7members),locatedinWashington,DC12regionalFedbanks,locatedaroundtheU.S.FederalOpenMarketCommittee(FOMC),includestheBdofGovsandpresidentsofsomeoftheregionalFedbanksTheFOMCdecidesmonetarypolicy.BenS.BernankeChairofFOMC,Feb2006–presentTHEMONETARYSYSTEM9BankReservesInafractionalreservebankingsystem,bankskeepafractionofdepositsasreservesandusetheresttomakeloans.TheFedestablishesreserverequirements,regulationsontheminimumamountofreservesthatbanksmustholdagainstdeposits.Banksmayholdmorethanthisminimumamountiftheychoose.Thereserveratio,R=fractionofdepositsthatbanksholdasreserves=totalreservesasapercentageoftotaldepositsTHEMONETARYSYSTEM10BankT-accountT-account:asimplifiedaccountingstatementthatshowsabank’sassets&liabilities.Example:FIRSTNATIONALBANKAssetsLiabilitiesReserves$10Loans$90Deposits$100Banks’liabilitiesincludedeposits,assetsincludeloans&reserves.Inthisexample,noticethatR=$10/$100=10%.THEMONETARYSYSTEM11BanksandtheMoneySupply:AnExampleSuppose$100ofcurrencyisincirculation.Todeterminebanks’impactonmoneysupply,wecalculatethemoneysupplyin3differentcases:1.Nobankingsystem2.100%reservebankingsystem:bankshold100%ofdepositsasreserves,makenoloans3.FractionalreservebankingsystemTHEMONETARYSYSTEM12BanksandtheMoneySupply:AnExampleCASE1:NobankingsystemPublicholdsthe$100ascurrency.Moneysupply=$100.THEMONETARYSYSTEM13BanksandtheMoneySupply:AnExampleCASE2:100%reservebankingsystemPublicdepositsthe$100atFirstNationalBank(FNB).FIRSTNATIONALBANKAssetsLiabilitiesReserves$100Loans$0Deposits$100FNBholds100%ofdepositasreserves:Moneysupply=currency+deposits=$0+$100=$100Ina100%reservebankingsystem,banksdonotaffectsizeofmoneysupply.THEMONETARYSYSTEM14BanksandtheMoneySupply:AnExampleCASE3:FractionalreservebankingsystemMoneysupply=$190(!!!)Depositorshave$100indeposits,Borrowershave$90incurrency.FIRSTNATIONALBANKAssetsLiabilitiesReserves$100Loans$0Deposits$100SupposeR=10%.FNBloansallbut10%ofthedeposit:1090THEMONETARYSYSTEM15BanksandtheMoneySupply:AnExampleHowdidthemoneysupplysuddenlygrow?Whenbanksmakeloans,theycreatemoney.Theborrowergets$90incurrency(anassetcountedinthemoneysupply)$90innewdebt(aliability)CASE3:FractionalreservebankingsystemAfractionalreservebankingsystemcreatesmoney,butnotwealth.THEMONETARYSYSTEM16BanksandtheMoneySupply:AnExampleCASE3:FractionalreservebankingsystemIfR=10%forSNB,itwillloanallbut10%ofthedeposit.SECONDNATIONALBANKAssetsLiabilitiesReserves$90Loans$0Deposits$90Supposeborrowerdepositsthe$90atSecondNationalBank(SNB).Initially,SNB’sT-accountlookslikethis:981THEMONETARYSYSTEM17BanksandtheMoneySupply:AnExampleCASE3:FractionalreservebankingsystemIfR=10%forTNB,itwillloanallbut10%ofthedeposit.THIRDNATIONALBANKAssetsLiabilitiesReserves$81Loans$0Deposits$81Theborrowerdepositsthe$81atThirdNationalBank(TNB).Initially,TNB’sT-accountlookslikethis:$8.10$72.90THEMONETARYSYST