Money and the Fed

• Develop an Essay on the Following Module 10 (Money and the Fed)Topic:
o The FED. There probably is not a more powerful and influential organization in the U.S. Alan Greenspan was the chair of the Fed’s Board of Governors from 1988 till 2006 (under 4 presidents) when he was replaced by Ben Bernanke (see this for the lead author, Hubbard, of your texts take on that appointment…note:CBS is Columbia Business School). The Fed manages the U.S. Financial system. How does it do this and what is the mechanism that translates Fed monetary policy into economic activity. What sort of macroeconomic information resources are available from the Fed?
o Money (Money1, Money2, Money3, Money4, Money5) is certainly an interesting topic…What is it? In Kevin Costner’s 1995 movie “Waterworld” it was dirt and in prison contexts it has been cigarettes. What features must money have. How is it defined and measured in the U.S. What is the connection to a banking system with fractional reserves? What is a money multiplier?
• This week’s Chapter Powerpoint Presentation, which is also available at the “MyEconLab” link, are being placed here for easy access.
o View the following Powerpoint Presentation NOTE: Some presentations are large files and may take a few minutes to load, depending on your connection.
o Chapter 25 Powerpoint
Money, Banks, and the Federal Reserve System
1. Learning Objectives
Students should be able to:
• Define money and discuss its four functions.
• Discuss the definitions of the money supply used in the United States today.
• Explain how banks create checking account deposits.
• Discuss the three policy tools the Federal Reserve uses to manage the money supply.
• Explain the quantity theory of money and use it to explain how high rates of inflation occur.
2. Chapter Summary
A barter economy is an economy that does not use money and in which people trade goods and services directly for other goods and services. Barter trade occurs only if there is a double coincidence of wants, where both parties to the trade want what the other one has. Because barter is inefficient, there is strong incentive to use money, which is anything that people are generally willing to accept in exchange for goods or services or in payment of debts. Money has four functions: a medium of exchange, a unit of account, a store of value, and a standard of deferred payment. The gold standard was a monetary system under which the government produced gold coins and paper currency convertible into gold. The gold standard collapsed in the early 1930s. Today no government in the world issues paper currency that can be redeemed for gold. Instead, paper currency is fiat money, which has no value except as money.
The narrowest definition of the money supply in the United States today is M1, which includes currency, checking account balances, and traveler’s checks. A broader definition of the money supply is M2, which includes everything that is in M1, plus savings accounts, small-denomination time deposits (such as certificates of deposit (CDs)), money market deposit accounts in banks, and noninstitutional money market fund shares.
On a bank’s balance sheet, reserves and loans are assets, and deposits are liabilities. Reserves are deposits that the bank has retained, rather than loaned out or invested. Required reserves are reserves that banks are legally required to hold. The fraction of deposits that banks are required to keep as reserves is called the required reserve ratio. Any reserves banks hold over and above the legal requirement are called excess reserves. When a bank accepts a deposit, it keeps only a fraction of the funds as reserves and loans out the remainder. In making a loan, banks increase the checking account balance of the borrower.
When the borrower uses a check to buy something with the funds the bank has loaned, the seller will deposit the check in his bank. The seller’s bank will keep part of the deposit as reserves and loan out the remainder. This process will continue until no banks have excess reserves. In this way, the process of banks making new loans increases the volume of checking account balances and the money supply. This money creation process can be illustrated with T-accounts, which are stripped-down versions of balance sheets that show only how a transaction changes a bank’s balance sheet. The simple deposit multiplier is the ratio of the amount of deposits created by banks to the amount of new reserves.
The Federal Reserve System (the Fed) is the central bank of the United States. It was originally established in 1914 to stop banking panics, but today its main role is to control the money supply. Monetary policy refers to the actions the Federal Reserve takes to manage the money supply and interest rates to pursue economic objectives. The Fed’s three monetary policy tools are open market operations, discount policy, and reserve requirements. Open market operations are the buying and selling of Treasury securities by the Federal Reserve. The loans the Fed makes to banks are called discount loans, and the interest rate the Fed charges on discount loans is the discount rate. The Federal Open Market Committee (FOMC) meets in Washington, D.C., eight times per year to discuss monetary policy. The quantity equation relates the money supply to the price level: M X V = P X Y, where M is the money supply, V is the velocity of money, P is the price level, and Y is real output. The velocity of money is the average number of times each dollar in the money supply is spent during the year. Economist Irving Fisher developed the quantity theory of money, which assumes that the velocity of money is constant.
If the quantity theory of money is correct, the inflation rate should equal the rate of growth of the money supply minus the rate of growth of real output. Although the quantity theory of money is not literally correct because the velocity of money is not constant, it is true that in the long run inflation results from the money supply growing faster than real GDP. When governments attempt to raise revenue by selling large quantities of bonds to the central bank, the money supply will increase rapidly, resulting in a high rate of inflation.
3. Chapter Outline
McDonald’s Money Problems in Argentina
The McDonald’s Big Mac is one of the most widely available products in the world. In 2001, McDonald’s restaurants in Argentina began to suffer from the macroeconomic problems plaguing that country. People began to lose faith in the Argentine peso. Banks became cautious about making loans, which in turn led to additional reductions in spending. During the currency crisis, one Argentine province decided to issue its own currency, which it called the patacone. McDonald’s restaurants in the province decided to accept the new currency as payment for a meal they labeled the “Patacombo.”
What Is Money and Why Do We Need It?
1. Money is any asset that people are generally willing to accept in exchange for goods and services or for payment of debts. An asset is anything of value owned by a person or firm.
2. The invention of money started from barter economies, which were goods and services traded directly for other goods and services.
A. For a barter trade to take place between two people, each person must want what the other one has, known as double coincidence of wants.
B. A good used as money that also has value independent of its use as money is called a commodity money.
C. By making exchange easier, money allows for specialization and higher productivity.
3. Money should fulfill four functions:
A. Money serves as a medium of exchange when sellers are willing to accept it in exchange for goods or services.
B. Money serves as a unit of account when each good has a price in terms of dollars.
C. Money serves as a store of value when value is stored such as stock, bonds, real estate, and valuable items.
D. Money serves as a standard of deferred payment in borrowing and lending.
4. There are five criteria that make a good suitable to use as a medium of exchange:
A. The good must be acceptable to (that is, usable by) most traders.
B. It should be of standardized quality so that any two units are identical.
C. It should be durable so that value is not lost by spoilage.
D. It should be valuable relative to its weight so that amounts large enough to be useful in trade can be easily transported.
E. The medium of exchange should be divisible because different goods are valued differently.
5. Commodity money (e.g., gold) meets the criteria for a medium of exchange but its value depends on its purity.
6. Fiat money is a paper currency that is authorized by a central bank or governmental body and that does not have to be exchanged by the central bank for gold or some other commodity money.
How Do We Measure Money Today?
1. Economists have developed several different definitions of the money supply.
A. M1 is the narrowest definition of the money supply and includes:
I. All the paper money (currency) and coins that are in circulation (what is not held by banks or government)
II. The value of all checking account balances at banks.
III. The value of traveler’s checks.
B. M2 is a broader definition of the money supply and includes:
I. Everything that is in M1.
II. Savings account balances.
III. Small denomination time deposits (e.g., certificates of deposit (CDs)).
IV. Balances in money market deposit accounts in banks.
V. Noninstitutional money market fund shares.
C. M3 is a broader medium of exchange and store value and includes:
I. Everything that is in M2.
II. Large-denomination time deposits.
III. Institutional money market fund shares.
2. There are three key points about the money supply:
A. The money supply consists of both currency and balances in checking accounts and traveler’s checks.
B. Because balances in checking accounts are included in the money supply, banks play an important role in the process by which the money supply increases and decreases.
C. Credit cards are not included in the money supply because they are considered a loan from the bank that issued the credit card.
How Do Banks Create Money?
1. A bank balance sheet lists a firm’s assets on the left and its liabilities and stockholders’ equity on the right.
A. The key assets on a bank’s balance sheet are its reserves, loans, and holdings of securities, such asU.S. Treasury bills.Reserves are deposits that a bank keeps as cash in its vault or on deposit with the Federal Reserve.
B. Required reserves are reserves that a bank is legally required to hold, based on its checking account deposits.
C. A required reserve ratio is the minimum fraction of deposits banks are required to keep as reserves (currently 10 percent).
D. Any reserves banks hold over and above the legal requirement are called excess reserves.
E. Banks make consumer loans to households and commercial loans to business.
2. A T-account is a stripped-down version of a balance sheet that shows only how a transaction
changes a bank’s balance sheet.
3. The ratio of the amount of deposits created by banks to the amount of new reserves is called the simple deposit multiplier.
4. Whenever banks gain reserves, they make new loans and the money supply expands.
5. Whenever banks lose reserves, they reduce their loans and the money supply contracts.
The Federal Reserve System
1. The fractional reserve banking system is a banking system in which banks keep less than 100 percent of deposits as reserves.
A. When many depositors simultaneously decide to withdraw their money from a bank, there is a bank run.
I. If many banks experience runs at the same time, the result is a bank panic.
II. A central bank, like the Federal Reserve in the U.S., can help stop a bank panic by acting as a lender of last resort.
2. With the intention of putting an end to banking panics, in 1913 Congress passed the Federal Reserve Act setting up the Federal Reserve System, which began operation in 1914.
3. The actions the Federal Reserve takes to manage the money supply and interest rates to pursue economic objectives is known as the monetary policy, which uses three tools:
A. TheFederal Open Market Committee (FOMC), or the Federal Reserve committee, is responsible for open market operations and managing the money supply.
I. The buying and selling of Treasury securities is called open market operations.
II. There are three reasons the Fed conducts monetary policy principally through open market operations.
i. The Fed initiates open market operations; it completely controls their volume.
ii. The Fed can make both large and small open market operations.
iii. The Fed can implement its open market operations quickly, with no administrative delay or required changes in regulations.
B. The loans the Fed makes to banks are called discount loans, and the interest rate it charges on the loans is called the discount rate.
C. When the Fed reduces the required reserve ratio, it converts required reserves into excess reserves.
4. Using the above-mentioned three tools, the Fed has substantial influence over the money supply, but that influence is not absolute. There are two other actors that also influence the money supply in practice: the nonbank public and banks.
The Quantity Theory of Money
1. In the early twentieth century, Irving Fisher, an economist at Yale, formalized the connection between money and prices using the quantity equation.
A. The equation states that the money supply (M) multiplied by the velocity of money (V) equals the price level (P) multiplied by real output (Y).
I. The velocity of money is the average number of times each dollar in the money supply is used to purchase goods and services included in GDP.
II. The quantity theory of money is a theory of the connection between money and prices that assumes that the velocity of money is constant.
2. Irving Fisher stated that when velocity is constant, the growth rate of velocity will be zero, which allowed us to rewrite the equation (Inflation rate = Growth rate of the money supply – Growth rate of real output) and led to the following predictions:
A. If the money supply grows at a faster rate than real GDP, there will be inflation.
B. If the money supply grows at a slower rate than real GDP, there will be deflation (decline inprices).
C. If the money supply grows at the same rate as real GDP, the price level will be stable, and there will be neither inflation nor deflation.
3. Very high rates of inflation are known as hyperinflation. It is caused by central banks increasing the money supply at a rate far in excess of the growth rate of real GDP. The link between rapid money growth and high inflation was evident in the experience of Argentina during the 1980s.

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