The Monetary System Highlighted Sections Money - What is it and what does it do? The Federal Reserve System Banks and the Money Supply Fed Tools for Controlling the Money Supply Money - What is it and what does it do? - (Back to Top) Money has several important functions within the economy, and can take various forms. Here is a definition of money, along with a list of functions that money performs: money - the set of assets in an economy that people regularly use to buy goods and services from other people medium of exchange - money is what sellers accept from buyers as payment for goods and services. Because money is accepted by everybody as the medium of exchange, the inefficiencies of barter are eliminated. unit of account - all prices in the US economy are expressed in ($). When there is one unit of account, like the ($) in the US, you don't have to think in relative terms when valuing goods and services. For example, if an apple costs twice as much as an orange, but there was no money, you'd have to think of 1 apple as being worth 2 oranges. With MANY goods and services, thinking in terms of relative prices would be very confusing.. store of value - people have the option to hold money over time as one way of storing their assets. Money is an important store of value, because it is the most liquid asset in the economy. liquidity - refers to the ease with which an asset can be converted into the economy's medium of exchange. Since money IS the economy's medium of exchange, it must be the most liquid store of value in the economy. Other ways to store value include buying stocks, bonds, mutual funds, gold, silver, or owning a house or other valuable property. Since it takes some time and effort to convert these assets into money, they are all LESS liquid than money. Throughout history, money can be divided into two general categories: commodity money - money that takes the form of a commodity with intrinsic value.   Commodity money has value, in and of itself, beyond its value as the medium of exchange and the unit of account. The classic example of commodity money is gold and silver coins - you could always melt the coins down and the gold and silver would have its OWN value.   fiat money - money without intrinsic value that is used as money because of government decree   The US ($) is an example of fiat money because the paper the ($) is printed on has NO value outside of being the medium of exchange and the unit of account. Before moving from money to central banking, consider first what the size of the US money stock is and how it is measured. money stock - the quantity of money circulating in the economy Q: Suppose you want to know the size of the US money stock. What should you count as money? A: Currency and demand deposits, and a few other items (detailed below) but NOT credit cards.   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 (or by using a debit card) Q: How is the US money stock measured and reported? A: Your textbook gives the two most important measures - M1 and M2 M1 - Currency, Traveler's checks, Demand deposits and Other checkable deposits   The Economic Report of the President provides data on M1 and M2. Here is a breakdown of M1 for 1996:   Item $ (Billions) % of total M1 1076.8 100.0% Currency 395.7 36.7% Travelers Checks 8.6 0.8% Demand Deposits 400.7 37.2% Other Checkable Deposits 271.8 25.3%   M2 - Everything in M1 plus Savings deposits, Small time deposits, Money market mutual funds and a few minor categories.   M2 for 1996 was $3657.4 billion. Dividing M1 by M2 shows that M1 was 29.4% of M2 during 1996. Q: Why are there different measures of the money stock? A: Because the assets that comprise M1 and M2 have varying degrees of liquidity. Notice that the assets included in M1 are very liquid, while the assets that are included in M2 are LESS liquid. You can think of M1 as the most liquid measure of the money stock, while M2 is a less liquid measure. The Federal Reserve System - (Back to Top) The Federal Reserve System is the central bank of the United States. As you can see in the map below, the Federal Reserve System is composed of the Board of Governors (in Washington, DC), and 12 regional Federal Reserve Districts.   The Fed is run by the Federal Reserve Board of Governors (the Fed Board has 7 Governors). Currently, the chairman of the Fed Board of Governors is Alan Greenspan. The Federal Reserve System has two major tasks: first, to regulate and ensure the health of the banking system, and second, to control the money supply. The first task falls primarily to the 12 regional Federal Reserve Banks. The second task falls to the Federal Open Market Committee.   The most important group within the Fed is the Federal Open Market Committee (FOMC). The FOMC has 12 voting members - 7 are the Governors of the Fed - the other 5 members are Presidents of the various Federal Reserve Banks (the New York President is always one of the 5). FOMC meetings are attended by the 7 Governors and all 12 regional bank Presidents. The FOMC controls the size of the US money supply. Banks and the Money Supply - (Back to Top) Q: How do banks operate? A: Banks accept money from people and keep that money safe until the depositor makes a withdrawal or writes a check on their account.   Q: Do banks keep all of your money in their vault? A: No. Our banking system is called fractional reserve banking. Bankers understand that it is not necessary to keep 100% of a depositors money on hand at all times. As a result, bankers take some of your money and loan it out to other people. 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. Minimum reserve ratios are set by the Fed. Suppose that the Fed requires banks to keep 20% of their demand deposits on reserve.   Q: What happens when somebody brings in $100 and deposits it in a bank? A: The bank is required to keep $20 (20%) on reserve.   Q: What does the bank do with the remaining $80? A: The bank will turn around and lend it to somebody else, earning interest income for the bank.   Q: What did that $80 loan do to the size of the money supply? A: The money supply increased by $80 when the loan was made. Here's how:   When the first depositor arrived with $100 in cash, the money supply included that $100 of currency in the depositor's wallet. After the deposit, the currency was in the bank vault and NOT circulating (so OUT of the money supply). However, demand deposits increased by $100, so the money supply was unchanged (currency fell by $100, deposits increased by $100). When the bank made the $80 loan, $80 in currency reentered the money supply. Added to the $100 demand deposit, that original $100 has grown to $180.   Now suppose that the person who received the $80 loan deposits that money into their checking account.   Q: What does the bank have to do with the $80? A: Keep 20% on reserve (20% of $80 = $16).   Q: What does the second bank do with the remaining $64? A: They can lend that out to somebody else   Q: How far does this process of money creation go? A: The process of bank money creation continues until there are no more excess reserves to be lent out (did you notice that each successive loan in this example gets smaller and smaller). Economists utilize the money multiplier to quickly determine how much money can be created by a dollar of reserves. money multiplier - the amount of money the banking system generates with each dollar of reserves.   If the reserve ratio is equal to "R", then the money multiplier is equal to 1/R. In our example, the original deposit created $100 in reserves at the bank. The money multiplier is equal to 5 (1/0.2). Therefore, the original $100 deposit will eventually turn into $500 of deposits.   Q: The banking system can create money, but can it also create real wealth? A: No. Each loan has two parts. Recall that the first $80 loan generated $80 in new money. At the same time, that $80 loan ALSO created a new $80 liability for the person borrowing the money. The banking system cannot create real wealth. Fed Tools for Controlling the Money Supply - (Back to Top) The Fed has 3 main tools for controlling the size of the money supply: Open Market Operations - The Fed can buy or sell government bonds to increase or decrease the money supply.   When the Fed BUYS bonds, the money supply is INCREASED. Here is why: The Fed pays for the bonds it buys with money that was not currently a part of the money supply - hence, when the Fed buys bonds it simply increases the total amount of money in circulation.   When the Fed SELLS bonds, the money supply is DECREASED. Here is why: The Fed sells bonds in the market and receives cash in return for the bonds it sells. Once the Fed receives the cash, this cash is taken OUT of circulation - therefore, the size of the money supply is decreased.   Reserve Requirements - By controlling reserve ratios that banks must keep, the Fed also controls the amount of money that banks can lend out. In the previous section, we discussed how bank lending increases the money supply. However, when the Fed increases reserve ratios, they reduce the amount of money banks can lend and also reduce the size of the money supply. When the Fed lowers reserve ratios, they increase the amount of money banks can lend out and also increase the size of the money supply.   The Discount Rate - Another function of the Fed is to loan money to banks in the economy. Banks may need these loans for several reasons. Emergency borrowing is one reason - banks that are in trouble have the Fed as the lender of last resort - this Fed function serves to calm depositors at troubled banks. Another reason banks borrow from the Fed is to meet reserve requirements. In the course of business, banks may make too many loans, or have unusually large withdrawals by their depositors, The result of either (or both) of these situations is that the bank will NOT have met its reserve requirements.   Regardless of the reason prompting a bank to borrow from the Fed, the loan from the Fed to the bank increases the bank's reserves. As you learned in the previous section, the new reserves allow the banking system to generate more money.   The discount rate is a tool for controlling the money supply because it represents the cost to banks of borrowing from the Fed (banks pay interest to the Fed on the loan). A higher discount rate will discourage banks from borrowing reserves from the Fed. A lower discount rate encourages borrowing. (Back to top)