Money and the Monetary System

Outline

•The definition and functions of money

•Measuring the money supply

•Financial institutions

•The Federal Reserve system (the “FED”)

•The FED’s policy tools.

What is money?

Money is anything that serves as a means of payment or method of

settling debts.

Functions of Money?

Money is a medium of exchange

Money is a unit of account Money is a store of value

or wealth

This Note Is Legal Tender For All Debts, Public and Private

Fiat Money: Anything which serves as a means of payment by government declaration

You are willing to accept money not because it is

“backed” by precious metals; but rather because you know it is generally acceptable in

exchange

Liquidity refers to two properties of assets or stores of value, namely:

•The ready convertibility of the asset to generalized purchasing power (or money)

•The comparative safety of the asset.

Money is the most liquid asset available under normal circumstances

Least liquid

Most liquid

Currency, checkable deposits

Savings and time deposits

Treasury bills, commercial paper

Government and corporate bonds, equities

Specialized equipment

Ceramics, art, rugs, rare coins

Farmland, commercial real estate

Home equity

Deposits are Money—But Checks are Not

Date Item Debit Credit Balance

1-Jul-03 Opening Balance $500.00

11-Jul-03 The Flower Shop $50.00 $450.00

(a) Rick’s Account at Delta Bank

Date Item Debit Credit Balance

1-Jul-03 Opening Balance $3,000.00

11-Jul-03 Rick’s check $50.00 $3,050.00

(b) The Flower Shop’s Account at Delta Bank

MostLiquid

Non-money assets

money

To measurethe money

supply, we sum upassets to the far right

of the liquidity spectrum

M1 includes:

Currency in circulation

Demand deposits at commercial banks

Travelers’ checks

Other checkable deposits including NOW accounts, ATS accounts, and checkable deposits at credit unions and mutual savings banks

9.2 / .8%

237.2 / 21.6%

326.7 / 29.8%

523.2 / 47.7%

Travelers' Checks

OCDs

Demand deposits

Currency

Components of M1, July 17, 2000 (in billions)

Source: Federal Reserve BulletinOCDs means “other checkable deposits.”

M2 includes M1 plus

Savings deposits

Small time deposits (less than $100,000)

Retail money market mutual fund balances

3694.4 / 48.6%

1016.0 / 13.4%

1799.2 / 23.7%

1096.3 / 14.4%

MMMFs

Small time deposits

Savings deposits

M1Components of M2, July 17, 2000 (in billions)

Source: Federal Reserve Bulletin

The Monetary System

The monetary system consists of the Federal

Reserve and the banks and other institutions that accept

deposits and provide the services that enable people

and businesses to make and receive payments.

Financial Institutions

3 types of institutions accept deposits that are a part of the nation’s money supply:

1. Commercial banks

2. Thrift institutions

3. Money market funds: A financial institution that obtains funds by selling shares and uses these funds to purchase assets such as U.S. Treasury bills.

Institution Type Number

National Unit Banks 821

National Banks 1,905

National Bank Branches 30,809

State Unit Banks 2,457

State Banks 4,325

State Bank Branches 26,450

U.S. Commercial Banks, 1997

Source: FDIC

Type of Deposit Minimum required reserve (%)

Very large checkabledeposits (over $54

million)

3

Other checkable deposits 10All other deposits 0

Legislation:

•Federal Reserve Act of 1913

•DIDMCA of 1982

Depository institutionsare required by law to

hold a minimum fractionof their liabilities on account at the FED

The Fractional Reserve System

•Reserves: The currency in a bank’s vaults plus the balance on its reserve account at the Federal Reserve Bank.

•Required reserve ratio: The minimum percentage of deposits that banks and other financial institutions must hold in reserves.

•Excess reserves: Banks reserves that exceed those needed to meet the required reserve ratio.

Federal Funds

•Banks that have excess reserves may loan them to banks with reserve deficiencies

•These loans are made in the interbank loan, or federal funds, market.

•The interest rate on loans in the interbank market is the federal funds rate.

Assets Liabilities Cash in vault Demand(checkable)

deposits Reserves on account

Savings deposits

Federal funds sold

Time deposits

Government securities

Federal funds bought

Loans

A Typical Bank Balance Sheet

The Economic Functions of Monetary Institutions

Create liquidity (money) Lower costs Pool risks Make payments

The Federal Deposit Insurance Corporation (FDIC)•Created in 1933

•A government agency that insures deposits in commercial banks (up to $100,000 per account).

•Banks pay premiums to the FDIC

Bank failureswere often a

“self-fulfilling

prophesy.”

Board of Governors

7 members appointed by the President

Federal Open Market Committee

Board of Governors plus 5 Federal Reserve Presidents

12 Federal Reserve Banks

3,500 member commercial banks

Appoint 3 directors

Elect 6 directors

Consolidated balance sheet of the Federal Reserve system (August 31, 1999)

Assets Liabilities

Gold certificates, coin, special drawing rights

19,593 Federal Reserve Notes

511,545

Loans to Commercial Banks

338 Bank reserves

18,800

Treasury securities 492,773 Treasury Deposits

5,559

(in millions)

Source: Federal Reserve Bulletin

The instruments of monetary policy

Reserve requirements

The discount rate Open market

operations

Open market operationsare the purchase or sale ofU.S. government securitieson the open market by the

Federal Reserve system

The FED Open Market Committee is the unit in

charge ofopen market operations