Textbook Guide Economics: Federal Open Market Committee, Federal Reserve System, Fiat Money

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1 Dec 2016
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Monetary System
The Meaning of Money
Money is any set of assets in an economy that people use regularly to buy
goods and services.
The three functions of money in the economy are:
o Medium of exchange is any item that buyers give to sellers when
purchasing goods or services.
o Unit of account The unit of measure when recording and quoting
prices. In the United States, this unit of measure would be the dollar.
o Store of value An item that someone can use to transfer
purchasing power from the present to the future. Any form of modern
money would be an example of this.
Liquidity refers to the ease with which an asset can be converted into the
economy’s medium of exchange. Cash or cash equivalent is the most
liquid asset.
The Kinds of Money
Commodity money is a medium of exchange with intrinsic value.
Intrinsic value means that the item would have value even if it were not
used as money. Gold is a common example of this. An economy that uses
gold as money is said to be operating under a gold standard.
Fiat money is money without intrinsic value. A fiat is an order or a decree,
and fiat money is assigned value by government decree. A good example
of this is paper money. The paper would be worthless if it were not issued
by the government.
Money in the U.S. Economy
The money stock is the quantity of money in circulation in the economy.
Currency consist of the paper bills and coins in the hands of the public.
Demand deposits are funds in checking or savings accounts that
depositors can access simply by writing a check or using a debit card.
The Federal Reserve System
The Federal Reserve, often called the Fed, is the central bank of the
United States.
A central bank is an institution that oversees the banking system and
regulates the quantity of money in the economy.
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The Fed regulates banks and works to ensure the health of the banking
system. This task is largely the responsibility of the regional Federal
Reserve banks around the United States.
The Fed also controls the money supply, or the quantity of money
available in the economy.
Monetary policy, or decisions by policymakers concerning the money
supply, are made by the Federal Open Market Committee (FOMC) which
meets about every six weeks in Washington D.C.
The primary method for controlling the money supply is by open-market
operations which is the purchase and sale of government bonds.
Money Creation with Fractional-Reserve Banking
Fractional-reserve banking is a bank system in which the banks only
hold a small fraction of deposits as reserves.
The fraction of total deposits that the bank holds as reserves is called the
reserve ratio. The reserve ratio is determined by government policy and
bank regulation.
The minimum amount of reserves that a bank must hold is called the
reserve requirement and is set by the Fed.
Banks often hold reserves that exceed the legal minimum, or excess
reserves, so that they will not run out of cash in the course of normal
operations.
The money multiplier is the amount of money the banking system
generates with each dollar of reserves.
Bank Capital, Leverage, and the Financial Crisis of 2008-2009
The resources that that the owners of a bank have invested into the
institution is called bank capital.
Leverage is the use of borrowed money for investment purposes. The
leverage ratio is the ratio of the bank’s total assets to bank capital.
Leverage is very important for banks because borrowing and lending is at
the core of what they do.
Bank regulators require banks to have a certain amount of capital to
ensure that they can pay their depositors. This is called a capital
requirement.
How the Fed Influences the Quantity of Reserves
The fed conducts open-market operations when it buys and sells
government bonds. To increase the money supply, the government will
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