The Money Supply and the Federal Reserve System

C

H A

P T

E

C H

A P

T E

RR

22

Prepared by: Fernando QuijanoPrepared by: Fernando Quijano and Yvonn Quijano and Yvonn Quijano

© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

The Money Supply andthe Federal Reserve System

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

2 of 42© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

An Overview of Money

• Money is anything that is generally accepted as a medium of exchange.

• Money is not income, and money is not wealth. Money is:

• a means of payment,

• a store of value, and

• a unit of account.

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em


What is Money?

• Barter is the direct exchange of goods and services for other goods and services.

• A barter system requires a double coincidence of wants for trade to take place. Money eliminates this problem.

• As a medium of exchange, or means of payment, money is generally accepted by buyers and sellers as payment for goods and services.

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em


What is Money?

• As a store of value, money serves as an asset that can be used to transport purchasing power from one time period to another.

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em


What is Money?

• As a unit of account, money is a standard that provides a consistent way of quoting prices.

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em


What is Money?

• Money is easily portable, and easily exchanged for goods at all times.

• The liquidity property of money makes money a good medium of exchange as well as a store of value.

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em


Commodity and Fiat Monies

• Commodity monies are items used as money that also have intrinsic value in some other use. Gold is one form of commodity money.

• Fiat, or token, money is money that is intrinsically worthless.

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em


Commodity and Fiat Monies

• Legal tender is money that a government has required to be accepted in settlement of debts.

• Currency debasement is the decrease in the value of money that occurs when its supply is increased rapidly.

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em


Measuring the Supply ofMoney in the United States

• M1, or transactions money is money that can be directly used for transactions.

M1 currency held outside banks + demand deposits + traveler’s checks + other checkable deposits

• M1 is a stock measure—it is measured at a point in time—on a specific day.

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em


Measuring the Supply ofMoney in the United States

• M2, or broad money, includes near monies, or close substitutes for transactions money.

M2 M1 + savings accounts + money market accounts + other near monies

• The main advantage of looking at M2 instead of M1 is that M2 is sometimes more stable.

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em


The Private Banking System

• Financial intermediaries are banks and other financial institutions that act as a link between those who have money to lend and those who want to borrow money.

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em


How Banks Create Money

• A Historical Perspective: Goldsmiths

• Goldsmiths functioned as warehouses where people stored gold for safekeeping.

• Upon receiving the gold, a goldsmith would issue a receipt to the depositor. After a time, these receipts themselves began to be traded for goods, and were backed 100 percent by gold.

• Then, Goldsmiths realized that they could lend out some of this gold without any fear of running out. Now there were more claims than there were ounces of gold.

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em


How Banks Create Money

• A run on a goldsmith (or a modern-day bank) occurs when many people present their claims at the same time.

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em


The Modern Banking System

• A brief review of accounting:

Assets – liabilities Net Worth, or

Assets Liabilities + Net Worth

• A bank’s most important assets are its loans. Other assets include cash on hand (or vault cash) and deposits with the Fed.

• A bank’s liabilities are its debts—what it owes. Deposits are debts owed to the bank’s depositors.

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em



• The Federal Reserve System (the Fed) is the central bank of the United States.

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em



• Reserves are the deposits that a bank has at the Federal Reserve bank plus its cash on hand.

• The required reserve ratio is the percentage of its total deposits that a bank must keep as reserves at the Federal Reserve.

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em


T-Account for a Typical Bank

• The balance sheet of a bank must always balance, so that the sum of assets (reserves and loans) equals the sum of liabilities (deposits and net worth).

T-Account for a Typical Bank (millions of dollars)

ASSETS LIABILITIES

Reserves 20 100 Deposits

Loans 90 10 Net worth

Total 110 110 Total

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em


The Creation of Money

• Banks usually make loans up to the point where they can no longer do so because of the reserve requirement restriction (or up to the point where their excess reserves are zero).

ex cess rese rv es ac tu a l re se rv es req u ired rese rv es

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em



• When someone deposits $100 in a bank, and the bank deposits the $100 with the central bank, the bank has $100 in total reserves.

Balance Sheets of a Bank in a Single-Bank Economy

In Panel 2, there is an initial deposit of $100. In Panel 3, the bank has made loans of $400.

Panel 1 Panel 2 Panel 3

ASSETS LIABILITIES ASSETS LIABILITIES ASSETS LIABILITIES

Reserves 0 0 Deposits Reserves 100 100 Deposits Reserves 100 500 Deposits

Loans 400

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em



• If the required reserve ratio is 20%, the bank has excess reserves of $80. With $80 of excess reserves, the bank can have up to $400 of additional deposits. The $100 in reserves plus $400 in loans equal $500 in deposits.

Balance Sheets of a Bank in a Single-Bank Economy

In Panel 2, there is an initial deposit of $100. In Panel 3, the bank has made loans of $400.

Panel 1 Panel 2 Panel 3

ASSETS LIABILITIES ASSETS LIABILITIES ASSETS LIABILITIES

Reserves 0 0 Deposits Reserves 100 100 Deposits Reserves 100 500 Deposits

Loans 400

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em



The Creation of Money When There Are Many Banks

Panel 1 Panel 2 Panel 3ASSETS LIABILITIES ASSETS LIABILITIES ASSETS LIABILITIES

Reserves 100 100 Deposits Reserves 100Loans 80

180 Deposits Reserves 20Loans 80

100 Deposits

Reserves 80 80 Deposits Reserves 80Loans 64

144 Deposits Reserves 16Loans 64

80 Deposits

Reserves 64 64 Deposits Reserves 64 115.20 Deposits Reserves 12.80 64 Deposits

.00500Total

.

.

.

.

.

.

.2051Bank 464Bank 380Bank 2

100Bank 1DepositsSummary:

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em


The Money Multiplier

• The money multiplier is the multiple by which deposits can increase for every dollar increase in reserves.

• In the example above, the required reserve ratio is 20%. Each dollar increase in reserves could cause an increase in deposits of $5 when there is no leakage out of the system. An additional $100 of reserves result in additional deposits of $500.

M o n ey m u ltip lie r =1

R eq u ired rese rv e ra tio.00500Total

.

.

.

.

.

.

.2051Bank 464Bank 3

80Bank 2

100Bank 1DepositsSummary:

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em


The Federal Reserve System

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em



C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em



• The Federal Open Market Committee (FOMC) sets goals regarding the money supply and interest rates and directs the operations of the Open Market Desk in New York.

• The Open Market Desk is an office in the New York Federal Reserve Bank from which government securities are bought and sold by the Fed.

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em


Functions of the Federal Reserve

• Clearing interbank payments.

• Regulating the banking system.

• Assisting banks in a difficult financial position.

• Managing exchange rates and the nation’s foreign exchange reserves.

• Control of mergers between banks.

The Fed performs important functions for banks including:

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em


Functions of the Federal Reserve

• Examination of banks to ensure that they are financially sound.

• Setting of reserve requirements for all financial institutions.

• Lender of last resort: The Fed provides funds to troubled banks that cannot find any other sources of funds.

The Fed performs important functions for banks including:

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em


The Federal Reserve Balance Sheet

Assets and Liabilities of the Federal Reserve System, June 30, 2003(millions of dollars)

ASSETS LIABILITIES

Gold $ 11,045 $593,031 Federal Reserve notes (outstanding)

Loans to banks 36,538 Deposits:

U.S. Treasury securities

550,314 20,359 Bank reserves (from depository institutions)

6,219 U.S. Treasury

All other assets 46,268 24,556 All other liabilities and net worth

Total $644,165 $644,165 Total

Source: Federal Reserve Bulletin, August 2003, Table 1.18.

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em


The Federal Reserve Balance Sheet

• Although it is unrelated to the money supply, the Fed’s gold counts as an asset on its balance sheet.

• The largest of the Fed’s assets, by far, consists of government securities purchased over the years.

• A dollar bill is a liability, or IOU, of the Fed.

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em


How the Federal ReserveControls the Money Supply

• Three tools are available to the Fed for changing the money supply:

1. changing the required reserve ratio;

2. changing the discount rate; and

3. engaging in open market operations.

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em


The Required Reserve Ratio

• The required reserve ratio establishes a link between the reserves of the commercial banks and the deposits (money) that commercial banks are allowed to create.

• If the Fed wants to increase the money supply, the Fed can decrease the required reserve ratio, which allows the bank to create more deposits by making loans.

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em


The Required Reserve Ratio

A Decrease in the Required Reserve Ratio From 20 Percent to 12.5 Percent Increases the Supply of Money (All Figures in Billions of Dollars)

PANEL 1: REQUIRED RESERVE RATIO = 20%

Federal Reserve Commercial Banks

Assets Liabilities Assets Liabilities

Government $200 $100 Reserves Reserves $100 $500 Deposits

securities $100 Currency Loans $400

Note: Money supply (M1) = Currency + Deposits = $600.

PANEL 2: REQUIRED RESERVE RATIO = 12.5%



Government $200 $100 Reserves Reserves $100 $800 Deposits

securities $100 Currency Loans(+ $300)

$700 (+ $300)


C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em


The Discount Rate

• The discount rate is the interest rate that banks pay to the Fed to borrow from it.

• Bank borrowing from the Fed leads to an increase in the money supply. The higher the discount rate, the higher the cost of borrowing, and the less borrowing banks will want to do.

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em


The Discount Rate

The Effect On the Money Supply of Commercial Bank Borrowing from the Fed (All Figures in Billions of Dollars)

PANEL 1: NO COMMERCIAL BANK BORROWING FROM THE FED



Securities $160 $80 Reserves Reserves $80 $400 Deposits

$80 Currency Loans $320Note: Money supply (M1) = Currency + Deposits = $480.

PANEL 2: COMMERCIAL BANK BORROWING $20 FROM THE FED



Securities $160 $100 Reserves(+ $20)

Reserves(+ $20)

$100 $500 Deposits(+ $300)

Loans $20 $80 Currency Loans(+ $100)

$420 $20 Amount owed to Fed (+ $20)


C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em


The Discount Rate

• Moral suasion is the pressure that was exerted in the past by the Fed on member banks to discourage them from borrowing heavily.

• On January 9, 2003, the Fed announced a new procedure that sets the discount rate above the rate that banks pay to borrow in the private market. It is thus clear that the Fed is not using the discount rate as a tool to try to change the money supply on a regular basis.

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em


Open Market Operations

• Open market operations is the purchase and sale by the Fed of government securities in the open market; a tool used to expand or contract the amount of reserves in the system and thus the money supply.

• Open market operations is by far the most significant tool of the Fed for controlling the supply of money.

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em


The Mechanics ofOpen Market Operations

Open Market Operations (The Numbers in Parentheses in Panels 2 and 3 Show the Differences Between Those Panels and Panel 1. All Figures in Billions of Dollars)

PANEL 1Federal Reserve Commercial Banks Jane Q. Public

Assets Liabilities Assets Liabilities Assets LiabilitiesSecurities $100 $20 Reserves Reserves $20 $100 Deposits Deposits $5 $0 Debts

$80 Currency Loans $80 $5 Net WorthNote: Money supply (M1) = Currency + Deposits = $180. $80 Currency


Assets Liabilities Assets Liabilities Assets LiabilitiesSecurities( $5)

$95 $15 Reserves ( $5)

Reserves ( $5)

$15 $95 Deposits ( $5)

Deposits ( $5)

$0 $0 Debts

$80 Currency Loans $80 Securities(+ $5)

$5 $5 Net Worth



Assets Liabilities Assets Liabilities Assets Liabilities

Securities( $5)

$95 $15 Reserves ( $5)

Reserves ( $5)

$15 $75 Deposits ( $25)

Deposits ( $5)

$0 $0 Debts

$80 Currency Loans( $20)

$60 Securities(+ $5)

$5 $5 Net Worth


C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em



• An open market purchase of securities by the Fed results in an increase in reserves and an increase in the supply of money by an amount equal to the money multiplier times the change in reserves.

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em



• An open market sale of securities by the Fed results in a decrease in reserves and a decrease in the supply of money by an amount equal to the money multiplier times the change in reserves.

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em



• Open market operations are the Fed’s preferred means of controlling the money supply because:

• they can be used with some precision,

• are extremely flexible, and

• are fairly predictable.

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em


The Supply Curve for Money

• Through open market operations, the Fed can have the money supply be whatever value it wants.

C

H A

P T

E R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em

C H

A P

T E

R

22:

The M

on

ey S

upply

an

d t

he F

ed

era

l R

ese

rve S

yst

em


Review Terms and Concepts

barter

commodity monies

currency debasement

discount rate

excess reservesexcess reserves

Federal Open Market Committee (FOMC)

Federal Reserve System (the Fed)

fiat, or token, money

financial intermediariesfinancial intermediaries

legal tenderlegal tender

lender of last resortlender of last resort

liquidity property of moneyliquidity property of money

MM1, or transactions money1, or transactions money

MM2, or broad money2, or broad money

medium of exchange, or means of medium of exchange, or means of paymentpayment

money multipliermoney multiplier

near moniesnear monies

Open Market DeskOpen Market Desk

open market operationsopen market operations

required reserve ratiorequired reserve ratio

reservesreserves

run on a bankrun on a bank

store of valuestore of value

unit of accountunit of account

The Money Supply and the Federal Reserve System

Documents

Transcript of The Money Supply and the Federal Reserve System