#4 The Monetary System Flashcards
Money
Stock of assets (something that is worth something) that can be readily used to make transactions
Money functions
- Medium of exchange (used to buy stuff)
- Store of value (transfers purchasing power from present to future)
- Unit of account (common unit by which everyone measures prices/values)
Money types
- Fiat money —> no intrinsic value, paper currency
- Commodity money —> has intrinsic value, Gold, cigarettes
Money supply
Quantity of money available in the economy
Monetary policy
Control over money supply
It’s conducted by central bank (FED)
Open market operations
To control money supply, Fed uses purchases and sale of government bonds
Money supply measures
C - currency
M1 - currency + demand deposits + travelers checks + other checkable deposits
M2 - M1 + retail monetary market mutual fund balances + saving deposits + {……}
Money supply =
Currency + demand (checking account deposits)
M = C + D
Reserved
R
Portion of deposits that banks haven’t lent
100% reserve banking
Banks hold all deposits as reserves
No impact on money supply
Fractional reserve banking
Banks hold fraction of deposits as reserves
Creates money, not wealth —- loan = debt
Total money supply =
( 1 / rr ) 1000$
rr —> ratio of reserves to deposits
Bank capital
Resources bank’s owners have put into the bank
Difference between banks assets and liabilities
Leverage
Use of borrowed money to supplement existing funds for purposes of investment
Leverage ratio
Assets / Capital
What being highly leveraged does to banks?
Makes them vulnerable
Capital requirement
- Main amount of capital mandated by regulators
- Intended to {…..} that banks will be able to pay off depositors
- {…..}
A model of money supply
Exogenous variables
- Monetary base,
B = C + R,
controlled by central bank - Reserve-Deposit ratio,
rr = R / D,
depends on regulations, bank policies - Currency-Deposit ratio,
cr = C / D,
depends on households, preferences
M =?
M = mB
m = cr + 1 / cr + rr
M = cr + 1 / cr + rr
- if rr < 1, then m > 1
- if mon.base changes by 🔺B, then 🔺M = m🔺B
- m is the money multiplier, the increase in the money supply, resulting from a 1$ increase in monetary base
Money multiplier
m
The increase in the money supply, resulting from a 1$ increase in monetary base
The Fed can change monetary base by using
• open market operations
~» To increase the base, Fed buying gov.bonds with new $
• the discount rate - interest rate Fed charges on loans to banks
~» To increase the base, Fed could lower the discount rate, encouraging banks to borrow more reserves
The Fed can change the Reserve-Deposit ratio by using
• Reserve requirements Fed regulations impose a minimum Reserve-Deposit ratio
~» to reduce reserved ratio, could reduce reserve requirements
• Interest on reserves Fed pays interest on bank reserves deposited with the Fed
~» to reduce reserved ratio, could lower interest rate on reserves
Excess reserves
Reserves above the reserve requirement banks hold often
m = mB
m = cr + 1 / cr + rr
Households can change…
cr, causing m and M to change
Banks changing…
Excess reserves causing rr, m and M change
