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Chapter 29

Chapter 29 - The Monetary System.pdf

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Department
Economics
Course
ECON 1
Professor
Enrico Moretti
Semester
Spring

Description
Chapter 29: The Monetary System • cash/check represents claim to goods/services • without money would need to barter which is inefficient b/c economy has trouble allocating scarce resources • in such an economy, trade said to require double coincidence of wants: the unlikely occurrence that 2 people each have a good or service that the other wants • money flowing in economy improves well-being of society I. The Meaning of Money • money: the set of assets in an economy that people regularly use to buy goods and services from other people A. The Functions of Money • three functions of money • medium of exchange: an item that buyers give to sellers when they want to purchase goods and services • unit of account: the yardstick people use to post prices and record debts • store of value: an item that people can use to transfer purchasing power from the present to the future • buyers giving sellers money today give them ability to become buyer tomorrow • non-monetary assets can also be stores of value (e.g. bonds) • wealth: the total of all stores of value, including both money and non-monetary assets • liquidity: the ease with which an asset can be converted into the economy’s medium of exchange • because money is economy’s medium of exchange, is most liquid • most stocks/bonds considered liquid • selling a house tends to be less liquid (more effort + time) B. The Kinds of Money • commodity money: money that takes the form of a commodity with intrinsic value • intrinsic value: the item would have value even if it were not used as money • e.g. gold • e.g. cigarettes • in WWII, prisoners traded goods/services using cigarettes as store of value, unit of account, and medium of exchange • similarly, as Soviet Union breaking up in late 1980s, cigarettes started replacing the ruble as preferred currency in Moscow • in both cases, even non-smokers were happy to accept cigarettes in an exchange • operation under gold standard: when economy uses gold as money or paper money that is convertible into gold on demand • fiat money: money without intrinsic value that is use as money because of government decree • fiat: an order or decree • e.g. paper dollars printed by US gov’t vs. paper money from Monopoly • can’t pay for stuff with Monopoly because gov’t decreed invalid C. Money in the US Economy • money stock: the quantity of money circulating in the economy • what is the quantity of money? • 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 • once start to consider this as part of money stock, led to consider large variety of other accounts people hold at banks/other financial institutions • e.g. savings accounts • in complex society, not easy to draw lines between assets that can be called “money” and assets that cannot II. The Federal Reserve System • Federal Reserve (Fed): the central bank of the United States • central bank: an institution designed to oversee the banking system and regulate the quantity of money in the economy A. The Fed’s Organization • created in 1913 after series of bank failures in 1907 • Fed run by board of governors • 7 members appointed by president and confirmed by Senate • 14-year terms • long terms to insulate them from politics; give them independence from short-term political pressures • among 7 members, chairman most important • 4-year term • Federal Reserve System made up of Federal Reserve Board • 12 regional Federal Reserve Banks • presidents chosen by each bank’s board of directors • Fed has two related jobs: • regulate banks • ensure health of banking system • monetary policy is made by Federal Open Market Committee (FOMC) • meets every 6 weeks in DC to discuss condition of economy and consider changes in monetary policy B. The Federal Open Market Committee • composition • made up of 7 members of board of governors and 5 of 12 regional bank presidents • 12 regional presidents attend each FOMC meeting, but only 5 get to vote • 5 with voting rights rotate • pres. of NY Fed always gets vote b/c NY is traditional financial center of US econ. • through their decisions, Fed has power to increase or decrease number of dollars in economy • Fed’s primary tool is open-market operation: the purchase and sale of US government bonds • if FOMC decides to increase money supply, Fed creates dollars and uses them to buy government bonds from the public --> $ in hands of public --> increase in money supply • if FOMC decides to decrease money supply, Fed sells government bonds to public --> $ out of public’s hands --> decrease in money supply • central banks = important because changes in money supply profoundly affect economy • prices rise when too much money • society faces short-run trade-off between inflation and unemployment III. Banks and the Money Supply A. The Simple Case of 100-Percent-Reserve Banking • e.g. total quantity of currency = $100 (so supply of money = $100) • First National Bank opened • only depository institution – that is accepts deposits but doesn’t make loans • reserves: deposits that banks have received but have not loaned out • express financial position with a T-account: simplified accounting statement that shows changes in bank’s assets and liabilities Asssetss Liabilitess Reserves $100.00 Deposits $100.00 • balance sheet: assets and liabilities are exactly in balance/the same • money supply in imaginary economy: • money supply = $100 of demand deposits • each deposit in bank reduces currency and raises demand deposits by same amount • money supply = unchanged • if banks hold all deposits in reserve, banks do not influence supply of money B. Money Creation with Fractional-Reserve Banking • 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 • e.g. total quantity of currency = $100 (so supply of money = $100) • First National Bank has reserve ratio of 10% Asssetss Liabilitess Reserves $10.00 Deposits $100.00 Loans $90.00 still has $100 in liabilities because making loans did not alter bank’s obligation to • depositors • however, bank now has 2 kinds of assets: • $10 of reserve $90 of loans • • in total, assets still = liabilities • consider supply of money in economy • before First National makes any loans, money supply is $100 of deposits when First National makes loans, money supply increases by amount of loans • • when banks hold only fraction of deposits in reserve, make money • note that National Bank not making wealth, making money • loans give borrowers some currency and thus ability to buy goods and services however, borrowers also taking on debts, so loans do not make them any richer • • i.e. as bank creates asset of money, also creates corresponding liability for those who borrowed the created money • at end of this process of money creation, economy is more liquid in the sense that there is more medium of exchange, but economy is no wealthier than before C. The Money Multiplier • borrow from 1st National Bank puts into 2nd National Bank • e.g. 10% reserve ratio Asssetss Liabilitess Reserves $9.00 Deposits $90.00 Asseets Labbiitess Loans $81.00 •thus 2nd National Bank creates +$81.00 • borrower from 2nd National Bank puts into 3rd National Bank e.g. 10% reserve ratio • Asseets Labbiitess Reserves $8.10 Deposits $81.00 Loans $72.90 •3rd National Bank creates +72.90 process goes on and on; each time money deposited and a bank loan made, more money • created
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