Chapter 12

The functions of money: Medium of exchange - used for buying and selling Unit of account - used to measure the value of goods. Easier to compare prices and calculate taxes, GDP, etc. Store of value - enables people to transfer purchasing power from the present to the future. Most liquid of all assets. Components of the money supply: M1= currency+checkable dep. 1. Currency 1. Coins = token money. The value of the metal in the coin is worth less than its face value to prevent their melting down. 2. Paper Money = Federal Reserve Notes issued with the authorization of Congress. 2. Checkable Deposits (deposits in commercial banks that can be cashed). More convenient because theyre: 1. Safer 2. Theft doesnt mean youre screwed 3. Easier to write a check than count and carry large sums of money Institutions that offer checkable deposits: Commercial banks = accept deposits, keep money safe until it is demanded but meanwhile use it to make loans. Thrift institutions = savings and loan associations, mutual savings banks, and credit unions. S&Ls and mutual savings banks accept deposits and use them to provide loans. Credit unions accept deposits from and lend only to members. Checkable deposits AKA demand deposits, negotiable order of withdrawal accounts, automatic transfer service accounts and share draft accounts. *NOTE: currency owned by banks/the govt. is not counted. M2 = M1+near monies 1. Near monies = assets that can become money quickly 1. Savings deposits (including MMDAs) = 1. Savings account - easy to withdraw and transfer funds 2. Money Market Deposit Account - interest-bearing account containing short-term securities. Have a minimum-balance requirement and a limit on how often funds can be withdrawn 2. Small (<$100K) time deposits = certificates of deposit (CDs) that can be cashed after a certain time without a penalty or before with large penalties. Interest rates are higher than on MMDAs. 3. Money Market Mutual Funds (MMMFs) held by individuals = mutual fund companies offer MMMFs. They use the combined funds of shareholders to

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buy short-term credit instruments (CDs & securities) and offer interest on the accounts of the shareholders that own them. 3. Money Zero Maturity (MZM) = M2-small time dep. + corporate MMFs MZM includes monetary balances that are immediately available for transactions without any cost. Small time deposits are not included because they cannot be freely withdrawn at any time. Corporate MMFs are included because theyre immediately available for purchases. Advantage of MZM: includes the main items (currency, CDs, MMDAs, and MMMFs) used daily and excludes time deposits, which are mostly used to save. NOTE: if something increases M1, it will increase M2 & MZM because they include M1 --------> Are credit cards money? NO. Theyre short-term loans.

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What backs the money supply? The governments ability to keep the value of money relatively stable. Money as Debt The major components of the money supply (paper money & checkable deposits) are promises to pay. The government manages the money supply by trying to provide the amount of money needed for business activity. This is smarter than linking money to something else, like gold, because if the supply of that thing changed rapidly the economy would experience an inflation/recession. Value of Money: What gives money its value? 1. Acceptability - people accept it as a medium of exchange 2. Legal Tender - money is a legal way to pay for things. 3. Relative Scarcity - there is not an infinite supply Money and Prices Prices and the dollar have an inverse relationship. The higher prices are, the less a dollar is worth. V = 1/P An economy can use money only while its value is stable, otherwise people will refuse to accept it. When the value of money changes too quickly in one country, people resort to barter, the nation takes up another official currency or other currencies are unofficially used. Stabilizing Moneys Purchasing Power Rapid inflation is usually caused by imprudent economic policies. Price-level stability needs good monetary and fiscal policies. The Federal Reserve and the Banking System The monetary authorities are the members of the Board of Governors of the Federal Reserve System. The Fed controls the lending ability of banks and thrifts.

Historical Background: 1. Early XXcent. = unregulated banking resulted in numerous bank notes being used. The money supply was inadequate (too little/too much)

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1907 = terrible banking crisis Congress appointed the National Monetary Commission to outline a course of action 1913 = Federal Reserve Act

Parts of the Federal Reserve: Board of Governors = central authority. 14-year terms to isolate from political pressure and give them experience. 7 members are appointed by the President. II. 12 Federal Reserve Banks A. Central Bank - one bank split into twelve for practical reasons. B. Quasi-Public Banks - blend private ownership and public control. Each FRB is owned by the banks in its district. However, they act in the public interest and are govt. regulated. C. Bankers Banks - perform for banks what banks do for people. Also issue currency (FR notes) III. FOMC (Federal Open Market Committee) = 12 people. A. Board of Governors (7) B. President of the NYFRB C. Presidents of FRBs, rotate every year (4) IV. Commercial Banks A. State Banks - private banks authorized by their state to operate within it B. National banks - private banks authorized by the federal govt. to operate throughout the US V. Thrifts (mostly credit unions) A. Regulated by the Treasury Departments Office of Thrift Supervision B. Still subject to control by the Fed because they have required reserves C. Monetary policy affects them just like banks I. Fed Functions Issuing currency Setting reserve requirements and holding reserves Lending to banks and thrifts Providing for check collection - when a check from Bank A is deposited in Bank B, the Fed adjusts their reserves accordingly Acting as fiscal agent - govt. spending, tax revenues and bond exchanges occur using the Feds facilities Supervising banks Controlling the money supply ****The Fed is independent from the government so that politics will not interfere and it can do whats best in the long run without worrying about popularity.

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Recent Developments in Money and Banking Relative decline of banks & thrifts = although theyre the only institutions that offer unrestricted checkable deposits, other institutions have expanded their shares of financial assets (see table below). Consolidation among banks & thrifts = many banks have merged with others or purchased thrifts. The point of merging is to create larger banks that compete better. Convergence of services provided by financial institutions = since 1999, banks and other financial institutions can merge and sell each others products, which is more convenient for consumers and increases competition. However, financial losses could increase the number of bank failures. Globalization of financial markets = major companies (US or foreign) are available all over the world. Electronic payments credit cards debit cards fedwire transfers - banks transfer funds to other banks automated clearinghouse transactions (ACHs) - households can send funds to businesses stored value cards (gift cards, prepaid phone cards, etc) FUTURE = electronic money (PayPal), smart cards (cards for electronic money) Major categories of the financial services industry Institution Comm. Banks Thrifts Insurance cos. Mutual fund cos. Pension funds Securities firms Description provide checking/savings accounts, sell CDs, make loans S&Ls, mutual saving banks, and credit unions offer contracts through which individuals pay to insure against some loss pool deposits by customers to buy stocks/bonds collect employee savings and buy stocks/bonds with the proceeds and make monthly retirement payments stock brokerage firms. Buy/sell stocks/bonds for clients and offer security advice

Chapter 13
The Fractional Reserve System Only a portion of checkable deposits are backed by cash in bank vaults or deposits at the central bank. This idea originated with the goldsmiths, who were primitive bankers. People realized gold was unsafe and inconvenient and began to deposit it and use goldsmith receipts instead. This was the first kind of paper money. The goldsmiths soon realized that people rarely took out their gold and began making loans with money they didnt really have - the beginning of the fractional reserve banking system. Important characteristics of fractional reserve banking: Banks create money by lending (how much they can lend is limited by how much money theyre required to keep in currency reserves by the law These banks are vulnerable to panics where too many people try to withdraw their money at the same time. Highly unlikely when banks are prudent. A single Commercial Bank In the balance sheet, assets = liabilities + net worth. Transactions: 1. Creating a Bank - get permission from govt. and begin selling stock. Cash obtained is held as vault cash. 2. Acquiring Property and Equipment - making it physical 3. Accepting Deposits - Receive cash as checkable deposits 4. Depositing Reserves in the FRB reserve ratio = req. res. / checkable dep. liabil. excess res. = actual - required *Required reserves purpose is to help the Fed control the lending abilities of banks They also facilitate the clearing of checks. 5. Clearing a Check drawn against the Bank Money-Creating Transactions: 6. Granting a Loan - when banks lend money, they create checkable deposits that are actual money. The reserve ratio limits banks lending ability

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Buying Government Securities - when a bank buys bonds from the public, it takes something that is not money and gives people money (as checkable deposits) in exchange.

Profits, Liquidity, and the Federal Funds Market The asset items on a comm. banks balance sheet show the bankers conflict: Profit = why the bank makes loans and buys securities Liquidity = safety lies in the liquidity of cash and excess reserves. Bankers must balance by getting assets with high returns and highly liquid assets with no returns. They can also lend temporary excess reserves to other banks for interest (Federal Funds Rate).

The Banking System: Multiple Deposit Expansion The commercial banking system can lend by a multiplier of its excess reserves because reserves lost by a single bank are deposited in another bank, so theyre not lost to the banking system. The monetary multiplier is the reciprocal of required reserve ratio. m = 1/R SO.... maximum checkable-deposit creation = excess res. X monetary multiplier (OR) D=ExM *Since checkable deposit money is destroyed when loans are repaid, there is a multiple destruction of money, as well.

Chapter 14
Interest Rates Price lenders charge borrowers for the use of money. Determined by money supply and demand. Why do people demand money? Transactions demand = to buy and sell things. Directly related to nom. GDP. Assets demand = to keep it as a store of value. Inv. related to interest rates. Total demand for money = transactions demand + assets demand *Graphically, changes in nom. GDP will shift the whole curve The equilibrium interest rate is where demand and supply for money intersect. The interest rate is inversely related to bond prices. The Consolidated Balance Sheet of the Federal Reserve Banks Assets Securities short-term: bills mid-term: notes long-term: bonds Loans to Commercial Banks Liabilities Reserves of Commercial Banks

Treasury Deposits Federal Reserve Notes (bills)

Tools of Monetary Policy:

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Open-Market Operations = exchange of govt. bonds with comm. banks or the public a. Buying i. From comm. banks: bank gives Fed bond and pays by increasing excess res. ii. From the public: person gives Fed bond, Fed gives check against itself, which is deposited in a bank, increasing checkable deposits. Excess reserves are increased minus the required reserves. b. Selling i. To comm. banks: Fed give bank bond and reduces excess res. as payment ii. To the public: Fed gives person bond and receives a check drawn against a bank. Fed reduces that banks excess and required reserves and checkable deposits 2. Reserve Ratio a. Raised - banks excess res. are diminished or depleted, in which case theyll need to contract checkable deposits and sell their bonds b. Lowered - banks gain excess reserves and can loan more. This changes the size of the monetary multiplier. 3. Discount Rate = a. Raised - doesnt want banks to borrow b. Lowered - wants banks to borrow **When banks borrow from the Fed, only their excess reserves increase. 1% above Federal Funds Rate FFR = rate banks charge one another on overnight loans. Prime interest rate = benchmark rate used by banks as a reference. Higher than FFR. Disequilibrium 1. Shortage of Money Need more money = bonds sold --> prices fall --> interest rates up --> less demand 2. Surplus of Money Need less money = bonds bought --> prices rise --> interest up --> more demand

Monetary Policy Expansionary FFR down Interest rates down (Investment up) Money supply up AD up Contractionary FFR up Interest rates up (Investment down) Money supply down AD down

Expansionary FFR down Advantages Speed Flexibility Unaffected by politics

Contractionary FFR up Disadvantages Recognition lags Operational lags Cyclical asymmetry (better for inflation)

Management Discretion = Fed should consider and choose what to do Inflation Targeting = Fed should set goals and be held accountable if it doesnt reach them. Some say role is too limited. Taylor Rule: GDP 1% > Potential GDP = FFR up 0.5pts Inflation 1% > ideal (2%) = FFR up 0.5pts When in balance = FFR 4, Real Interest Rate 2. Portrayals of the Fed: Mechanic (BEST) Warrior Fall guy Cosmic Force

Glossary (not finished because life sucks)

1. 2. 3. 4. 5. 6. 7. Medium of Exchange = any item accepted by buyers and sellers (money) Unit of Account = standard unit in which prices can be stated Store of Value = an asset set aside for future use M1 = currency (bills+coins) + checkable deposits Token money = when the face value of a coin is worth more than the metals in it Federal Reserve Notes = bills issued by the... you guessed it! Federal Reserve. Checkable Deposits = any deposit in a comm. bank or thrift a check may be drawn against 8. Commercial Banks = primary depository institutions 9. Thrift Institutions = S&Ls, mutual savings banks or credit unions 10. Near-monies = financial assets that are not a medium of exchange that is easily turned into money 11. M2 = 12. Savings account = a deposit in a comm. bank or thrift on which interest is received

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MMDA = Money Market Deposit Accounts. Bank and thrift provided interest-bearing accounts that contain short-term securities and have min. balance requirements and limited withdrawals. 14. Time Deposits = interest-earning deposits in comm. banks or thrifts that can be withdrawn after a certain time for free or before with a large penalty 15. MMMF = Money Market Mutual Funds. Interest-bearing accounts offered by insurance companies that pool depositors funds to purchase short-term securities. Depositors can write checks. 16. MZM = Money Zero Maturity. M2 - small time deposits + MMMFs owned by businesses 17. Legal Tender = 18. Federal Reserve System 19. Board of Governors 20. Federal Reserve Banks 21. FOMC 22. Financial Services Industry 23. Electronic Payments 24. Fractional Reserve Banking System 25. Balance Sheet 26. Vault Cash 27. Required Reserves 28. Reserve Ratio 29. Excess Reserves 30. Actual Reserves 31. Federal Funds Rate 32. Monetary Multiplier 33. Monetary Policy = series of changes made by the Federal Reserve to influence total spending and interest rates. Goal = full-employment GDP without inflation 34. Interest = price charged for the use of money. Depends on supply & demand 35. Transactions Demand = need for money as a method of exchange 36. Asset Demand = need for money as a store of value 37. Total Demand for Money = transactions + asset 38. Open-Market Operations = the buying and selling of US securities (bonds) in the open-market (to comm. banks and the public) 39. Reserve Ratio = percentage of checkable deposits banks must keep as vault cash or in the FRB 40. Discount Rate = interest the Fed charges banks to loan them reserves 41. Federal Funds Rate = interest banks charge one another when loaning reserves 42. Expansionary Monetary Policy = monetary policy to expand real GDP 43. Prime Interest Rate = used by banks as a benchmark 44. Restrictive Monetary Policy = monetary policy to contract real GDP 45. Taylor Rule = GDP 1% > Potential GDP = FFR up 0.5pts

Inflation 1% > ideal (2%) = FFR up 0.5pts When in balance = FFR 4, Real Interest Rate 2. 46. Cyclical Asymmetry = the idea that monetary policy is better at controlling inflation than getting us out of a recession 47. Inflation Targeting = states that the FR should set itself inflation targets and be held accountable if theyre not met