Chapter 17: Money and the Federal Reserve Flashcards
The paper bills and coins used to buy goods and services
Currency
Any generally accepted means of payment.
Money
Functions of a money:
(1) Medium of exchange
(2) Unit of account
(3) Store of value
What people trade for goods and services
Medium of Exchange
Involves the trade of a good or service in the absence of a commonly accepted medium of exchange
Barter
The use of an actual good for money such as gold or silver.
Commodity Money
Money you can exchange for a commodity at a fixed rate. Solved transportation problem of using commodity money.
Commodity-Backed Money
Money with no value except as the medium of exchange
Fiat Money
Commodity Money
- Links money to something tangible
- Limits inflation
- Fluctuations in the commodity value changes all prices
- New gold discovery leads to inflation
Fiat Money
- Not backed with a commodity
- Not subject to macroeconomic risk by changing commodity value
- Subject to rapid monetary expansion and inflation
The measure in which prices are quoted
Unit of Account
Unit of Account
- Creates a common language and unit of measurement
- Enables people to make accurate comparisons between items
- Creates a consistent method of record keeping
A means for holding wealth
Store of Value
The money supply measure composed of currency and checkable deposits
M1
Are deposits in bank accounts from which depositors may make withdrawals by writing checks
Checkable Deposits
The money supply measure that includes everything in M1 plus savings deposits, money market mutual funds, and small-denomination time deposits (CDs)
M2
Access checking and/or savings accounts
Debit Cards
Technically not a part of the money supply
Credit Cards
Banks have two important roles in the economy
(1) They are critical participants in the loanable funds market
(2) Play a role in determining the money supply
Interest Rates on Bank Deposits and Loans
- Banks charge more interest for loans than they pay for deposits
- The difference pays the bank’s expenses and produces profits
The items a firm owns
Assets
The financial obligations a firm owes to other
Liabilities
The difference between a firm’s assets and its liabilities
Owner’s Equity
The portion of bank deposits that are set aside and not loaned out. No “lock box” mayonnaise jars!
Reserves
When banks hold only a fraction of deposits on reserve
Fractional Reserve Banking
Banks hold deposits for two reasons:
(1) To accommodate withdrawals by depositors
(2) Because they are legally bound to hold a fraction of their deposit on reserve
The portion of deposits that banks are required to keep on reserve
Required Reserve Ratio (rr)
Required Reserves =
rr x deposits
Are any bank reserves held in excess of those required
Excess Reserves
Total Reserves =
= Required Reserves + Excess Reserves
Money Creation
Banks do not mint money but through their daily activities they do help to create new money
Two simplifying (but unrealistic) assumptions of Money Creation:
(1) All currency is deposited in a bank
(2) Banks hold no excess reserves
The rate at which banks multiply money when all currency is deposited into banks and they hold no excess reserves
Simple Money Multiplier
Central bank of United States
Federal Reserve
Three Responsibilities of the Fed:
(1) Monetary Policy
(2) Central Banking
(3) Bank Regulation
Roles of the Fed:
- The Fed acts as a “bank for banks”
- The Fed also acts as a lender of last resort
- The Fed also serves as a regulator of individual banks
The Fed has several tools it can use to alter the money supply:
(1) Open market operations
(2) Quantitative easing
(3) Reserve requirements
(4) Discount rates
The purchase or sale of bonds by a central ban
Open Market Operations
Buys securities →
Increase money supply
Sells securities →
Decrease the money supply
When performing open market operations, the Fed typically buys and sells short-term Treasury securities for two reasons:
- The Fed’s goal is to get the funds directly into the market
- The market for Treasury securities is big enough to where the Fed can buy and sell without difficulty
The targeted use of open market operations in which the central bank buys securities specifically targeting certain markets
Quantitative Easing
During the Great Recession:
- In late 2008, Fed injected almost $2 trillion worth of new funds
- Included $1.25 trillion in mortgage backed securities
- Bought long-term Treasury securities in addition to targeting short-term ones
Reserve Requirements
- The Fed can change the money multiplier by changing the reserve requirement
- Imprecise and unpredictable
Discount Rate
- Fed would increase the discount rate to discourage borrowing by banks and decrease money supply (or vice versa)
- Used actively until Great Depression era
- No longer considered useful
Excess Reserves, 1990-2018
It is no coincidence that the excess reserves climbed immediately after the Fed began paying interest on reserves
