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Economics Chapter 29 - The Monetary System

Terms in this set (57)

Barter
The exchange of one good or service for another - the type of market/exchange that occurs in the absence of money
Double Coincidence of Wants
Without money, two people must have a good or service that the other wants for a trade to occur
Money
The 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 in an economy?
1) A medium of exchange
2) A unit of account
3) A store of value
A Medium of Exchange
An item that buyers give to sellers when they want to purchase goods and services.
Unit of Account
The yardstick people use to post prices and record debts
Store of Value
An item that people can use to transfer purchasing power from the present to the future
Wealth
The total of all stores of value, including both money and nonmonetary assets
Liquidity
The ease with which an asset can be converted into the economy's medium of exchange. In the U.S., liquidity is a measure of the ability and ease with which assets can be converted to cash. Liquid assets are those that can be converted to cash quickly if needed to meet financial obligations; examples of liquid assets generally include cash, central bank reserves, and government debt.
Commodity Money
Money that takes the form of a commodity with intrinsic value (i.e. cigarettes or gold)
Intrinsic Value
The item would have value even if it were not used as money (i.e. cigarettes, energy bars, or gold)
Gold Standard
When an economy uses gold as money (or uses paper money that is convertible into gold on demand
Fiat Money
Money without intrinsic value that is used as money because of government decree (i.e. paper U.S. greenbacks)
Currency
The paper bills and coins in the hands of the public
Demand Deposits
Balances in bank accounts that depositors can access on demand by writing a check
What is in M1?
Includes demand deposits, traveler's checks, other checkable deposits, and currency.
What is in M2?
Includes all of M1, and futhermore includes savings deposits, small time deposits (Certificate of Deposits [CD's]), money market funds, and a few other minor categories.
Central Bank
An institution designed to oversee the banking system and regulate the quantity of money in the economy
The Federal Reserve (Fed)
The central bank of the United States
What are the component's of the Federal Reserve System's organization?
1) Chair(wom)an: Janet Yellen

2) Board of Governors (7 members appointed by U.S. President, each with 14-year terms; includes Chairman; meets in Washington DC)

3) Twelve Regional Federal Reserve Banks located in major cities around the country
What are the Fed's two jobs?
1) Regulate banks and ensure the health of the banking system (largely done by Federal Reserve Banks). Fed is a "Lender of Last Resort" to banks who cannot borrow anywhere else.

2) Control the quantity of money that is made available in the economy (the money supply) via monetary policy
Money Supply
The quantity of money available in the economy
Monetary Policy
The setting of the money supply by policymakers in the central bank
What is the organization of the Federal Open Market Committee (FOMC)?
1) The seven members of the board of governors from the Federal Reserve System

2) An additional five of the twelve regional bank presidents (all twelve regional presidents attend each FOMC meeting, but only five get to vote. The five with voting rights rotates among the twelve regional presidents, with the exception of New York Fed's president, who always gets to vote)
What is the purpose of the FOMC?
Through the FOMC, the Fed has the power to increase or decrease the number of dollars in the economy.
What is the Fed's primary tool/the one it uses most often?
Open-market operations
Open-Market Operations
The purchase and sale of U.S. government bonds. When the Fed sells bonds it decreases the money supply. When the Fed buys those bonds back, it increases money supply.
Reserves
Deposits that banks have received but have not loaned out
100-percent Reserve Banking
An imaginary economy where all deposits are held as reserves and no deposits are lent out.
T-Account (AKA Balance Sheet)
A simplified accounting statement that shows changes in a bank's assets and liabilities. In a T-Account, the assets and liabilities exactly balance/are equal, hence the name "balance sheet"
How is the supply of money affected by an increase in deposits with 100-Percent Reserve Banking?
If banks hold all deposits in reserve, banks do not influence the supply of money
Fractional-Reserve Banking
A banking system in which banks hold only a fraction of deposits as reserves
Reserve Ratio
The fraction of deposits that banks hold as reserves
Reserve Requirements
Regulations on the minimum amount of reserves that a bank must hold against deposits. (A minimum amount of reserves that banks must hold) (NOTE: this is not necessarily the actual reserve ratio, rather it is just the minimum reserve ratio)
Excess Reserves
The amount in reserves that banks hold above the legal minimum. Usually, banks hold excess reserves so they can be more confident that they will not later run out of cash.
How is the money supply affected with fractional-reserve banking?
When banks hold only a fraction of deposits in reserve, the banking system creates money
Money Multiplier
The amount of money that the banking system generates with each dollar of reserves. It is equal to the reciprocal of the Reserve Ratio, R. Thus Money Multiplier = 1/R.
How do higher reserve ratios affect the amount banks loan out and the money multiplier?
The higher the reserve ratio, the less of each deposit banks loan out, and the smaller the money multiplier. The lower the reserve ratio, the more of each deposit banks loan out, and the greater the money multiplier.
Bank Capital
Also known as "owner's equity". It is the resources that a bank's owners have put into the institution. More specifically, it is the resources that a bank obtains from issuing equity to its owners/investors. Capital acts as a financial cushion to absorb unexpected losses. Bank Capital is equal to the difference between all of a bank's assets and its liabilities. To remain solvent, the value of a bank's assets must exceed its liabilities.
Leverage
The use of borrowed money to supplement existing funds for purposes of investment
Leverage Ratio
The ratio of the bank's total assets to bank capital = Assets/Capital. A leverage ratio of 20, for example, means that for every dollar that the bank owners have contributed, the bank has $20 of assets. Of the $20 of assets, $19 are financed with borrowed money - either by taking in deposits or issuing debt.
Insolvent
When the value of the bank's assets fall below the value of the bank's liabilities. In this case, the bank is unable to pay off its debt holders and deposirtors in full.
Capital Requirement
A government regulation specifying a minimum amount of bank capital
How does the Fed control the supply of money in the economy?
1) By influencing the quantity of reserves
2) By influencing the reserve ratio
How does the Fed influence the Quantity of Reserves?
1) Open-Market Operations
2) Fed Lending to Banks
Discount Rate
The interest rate on the loans that the Fed makes to banks
How does the Fed giving loans to banks increase affect the money supply?
When the Fed makes a loan to a bank, the banking system has more reserves than it otherwise would, and these additional reserves allow the banking system to create more money
How does increasing the discount rate affect the money supply?
A higher discount rate discourages banks from borrowing reserves from the Fed. This reduces the quantity of reserves in the banking system, which in turn reduces money supply
The Term Auction Facility
The mechanism through which the Fed sets a quantity of funds it wants to lend to banks, and eligible banks then bid to borrow those funds. Loans go to the highest bidders.
How does an increased reserve requirement affect money supply?
For a given level of reserves, a higher reserve requirement is associated with a smaller money supply. At the higher reserve requirement, banks must hold a larger fraction of their deposits as reserves. This keeps more reserves away from the money creation process (it keeps new loans from being made, which would lead to more deposits, which would lead to more loans, and so on). Therefore, the higher the reserve requirement, the fewer demand deposits are generated in the money creation process from a given change in reserves.. Thus an increase in reserve requirements raises the reserve ratio, lowers the money multiplier, and decreases the money supply.
Interest on Reserves
As of Oct. 2008, the Fed began paying interest on reserves that banks hold on deposit at the Fed.
How does an increased interest on reserves held at the Fed affect money supply?
An increase in interest rate on reserves will increase the reserve ratio, lower the money multiplier, and lower the money supply
What are some of the problems with the Fed's ability to control the money supply?
1) The Fed does not control the amount of money that households choose to deposit in banks
2) The Fed does not control the amount that bankers lend.
Federal Funds Rate
The interest rate at which banks make overnight loans to one another
In summary, what are four ways that the Fed can expand the money supply?
1) Buy bonds
2) Decrease discounting rate
3) Increase lending to banks
4) Lower reserve requirements
5) Decrease interest rate on reserves held at the Fed
In summary, what are four ways that the Fed can contract the money supply?
1) Sell bonds
2) Increase discounting rate
3) Decrease lending to banks
4) Increase reserve requirements
5) Increase interest rate on reserves held at the Fed
How can the Fed make the federal funds rate hit a certain target?
When the Fed buys bonds in open-market operations, it injects reserves into the banking system. With more reserves, fewer banks find themselves needing to borrow reserves to meet reserve requirements. The fall in demand for borrowing reserves decreases the price of such borrowing, which is the federal funds rate.
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