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The Monetary System
Terms in this set (36)
Set of assets in an economy that people regularly use to buy goods and services from other people
What are the three functions of money?
1. Medium of exchange - item buyers give to sellers when they want to purchase goods and services
2. Unit of account - yardstick people use to post prices and record debts
3. Store value - an item people can use to transfer purchasing power from the present to the future
Ease with which an asset can be converted into the economy's medium of exchange
What are the two kinds of money?
1. Commodity money - item would have value even if it were not used as money (gold coins)
2. Fiat money - money without intrinsic value, used as money because of government decree (US dollar)
Quantity of money available in the economy
What two assets make up the money supply?
2. Demand deposits
The paper bills and coins in the hands of the (non-bank) public
Balances in bank accounts that depositors can access on demand by writing a check
currency, demand deposits, traveler's check, and other checkable deposits
M1 + saving deposits, small time deposits, money market mutual funds, and a few minor categories
An institution that oversees the banking system and regulates the money supply
The setting of the money supply by policymakers in the central bank
Federal Reserve (Fed)
The central bank of the US
What is the structure of the Fed?
1. board of governors - 7 members
2. 12 regional Fed banks
3. Federal Open Market Committee (FOMC) - decides monetary policy
Fractional reserve banking system
Banks keep a fraction of deposits as reserves and use the rest to make loans
Established by Fed - sets minimum amount of reserves that banks must hold against deposits
reserve ratio - fraction of deposits that banks hold as reserves
Simplified accounting statement that show's a banks assets and liabilities
What are a bank's assets?
Reserves and loans
What are a bank's liabilities?
Amount of money the banking system generates with each dollar of reserve
What is the formula for the money multiplier?
What are the Fed's three tools of monetary control?
1. Open-Market Operations
2. Reserve Requirements
3. The Discount Rate
Open-Market Operations (OMO)
Buying and selling of US government bonds by the Fed
How can the Fed use OMOs to increase money supply?
Fed buys government bonds, new dollars deposited in banks, reserves increase, banks use reserves to make more loans, money supply expands
How can the Fed use OMOs to reduce money supply?
Fed sells government bonds, taking dollars out of circulation, less reserves available for banks to loan out, money supply decreases
Reserve Requirements (RR)
Affect how much money banks can create by making loans
How can the Fed use RRs to increase money supply?
Reduce RR, banks make more loans from each dollar of reserves, money multiplier increases, money supply increases
How can the Fed use RRs to reduce money supply?
Raise RR, banks decrease amount of loans they make, money multiplier decreases, money supply decreases
The Discount Rate
When banks are running low on reserves, they may borrow reserves from the Fed. The discount rate refers to the interest rate on loans the Fed makes to banks.
How can the Fed use the Discount Rate to increase money supply?
Lower discount rate, encourages banks to borrow more reserves, banks make more loans, money supply increases
How can the Fed use the Discount Rate to reduce money supply?
Raise discount rate, discourage banks from borrowing reserves, banks make less loans, money supply decreases
Federal Funds Rate
Interest rate on loans between banks - when one borrows reserves from the other
How can the Fed raise the federal funds rate?
-Fed sells government bonds (OMO)
-Removes reserves from banking system
-Reduces supply of federal funds
-Federal funds rate raises
What are some problems encountered when trying to control the money supply?
1. Households hold more of their currency
2. Banks hold more reserves than required
(both reduce money supply)
When people suspect bank is in trouble, they may run to the bank to withdraw their funds, holding more currency and less deposits (banks don't have enough reserves to pay off ALL depositors)
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