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ECN 253 Money, Financial System and Federal Reserve

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Yuanyuan Chen

on 27 February 2013

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Transcript of ECN 253 Money, Financial System and Federal Reserve

Money, Bank, and Financial System Dr. Chen Structure of This Chapter Barter and Money Money Assets that people are generally willing to accept in exchange for goods and services or for payment of debts. How Do Banks Create Money? Financial System The Macroeconomics of Saving and Investment Money Bank Balance Financial
System Definition
Function T-Account
Deposit Multiplier Financial System & Federal Reserve Economies where goods and services are traded directly for other goods and services are called barter economies. What can Serve as Money? For a barter trade to take place between two people, each person must want what the other one has, a requirement economists refer to as a double coincidence of wants. Commodity Money Independent of its use as money, the value of commodity money, such as gold, depends on its purity. Fiat Money Money, such as paper currency, that is authorized by a central bank or governmental body and that does not have to be exchanged by the central bank for gold or some other commodity money. By making exchange easier, money allows people to specialize and become more productive while pursuing their comparative advantage. Asset Anything of value owned by a person or a firm. Five criteria make a good suitable for use The good must be acceptable to (that is, usable by) most people.
It should be of standardized quality so that any two units are identical.
It should be durable so that value is not lost by spoilage.
It should be valuable relative to its weight so that amounts large enough to be useful in trade can be easily transported.
It should be divisible because different goods are valued differently. The Functions of Money Medium of Exchange Money serves as a medium of exchange when sellers are willing to accept it in exchange for goods or services. Unit of Account Once a single good is used as money, each good has a single price rather than many prices as in a barter system---money can measure the value of the good. Store of Value Money allows value to be stored from today to the future. Standard of Deferred Payment Money can facilitate exchange at a given point in time by providing a medium of exchange and unit of account, and it can facilitate exchange over time by providing a reliable store of value and standard of deferred payment in borrowing and lending. U.S. Money System M1 M2 The narrowest definition of the money supply: The sum of currency in circulation, checking account deposits in banks, and holdings of traveler’s checks. A broader definition of the money supply: It includes M1 plus savings account balances, small-denomination time deposits, balances in money market deposit accounts in banks, and noninstitutional money market fund shares. Credit Cards and Debit Cards Buying things with credit cards is in effect taking out loans from the banks that issued them, so they are not included in definitions of the money supply. In contrast, with a debit card, the funds to make the purchase are taken directly from your checking account. In either case, the cards themselves do not represent money. Reserves Deposits that a bank keeps as cash in its vault or on deposit with the Federal Reserve. Required reserves Reserves that a bank is legally required to hold, based on its checking account deposits. Required reserve ratio The minimum fraction of deposits banks are required by law to keep as reserves.---RR Excess reserves Reserves that banks hold over and above the legal requirement. Banks make consumer loans to households and commercial loans to businesses. A loan is an asset to a bank because it represents a promise by the person taking it out to make certain specified payments to the bank. Using T-Accounts to Show How a Bank Can Create Money Simple Example: Suppose you deposit $1,000 in currency into an account at Bank of America. The currency component of the money supply declines by $1,000 because the $1,000 you deposited is no longer in circulation and, therefore, is not counted in the money supply. BUT The decrease in currency is offset by a $1,000 increase in the checking account deposit component of the money supply. NEXT Similar T-account will show in PNC bank. This increases the money supply. Suppose the person who took out the $900 loan buys a used car car for exactly $900 and pays by writing a check on his account at Bank of America. The seller of the used car then deposits the check in her account at a branch of PNC Bank. Banks are required to keep 10 percent of deposits as reserves, on which the Federal Reserve pays only a low rate of interest. Thus, banks have an incentive to loan out or buy securities with the other 90 percent. suppose Bank of America keeps $100 as required reserves and loans out the $900 of excess reserves. By making this $900 loan, Bank of America has increased the money supply by $900.
The initial $1,000 in currency you deposited into your checking account has been turned into $1,900 in checking account deposits—a net increase in the money supply of $900. Deposit Multiplier Simple deposit multiplier The ratio of the amount of deposits created by banks to the amount of new reserves. In previous case, the simple deposit multiplier is equal to $10,000/$1,000 = 10.There are two ways to explain how we know your initial $1,000 deposit ultimately leads to a total increase in deposits of $10,000:1. Each bank in the process is keeping reserves equal to 10 percent of its deposits. For the banking system as a whole, the total increase in reserves is $1,000—the amount of your original currency deposit—so the system as a whole will end up with $10,000 in deposits because $1,000 is 10 percent of $10,000.2.The other way to explain this is by deriving an expression for the simple deposit multiplier. Financial system The system of financial markets and financial intermediaries through which firms acquire funds from households. Financial markets Markets where financial securities, such as stocks and bonds, are bought and sold. Remember: The total value of saving in the economy must equal the total value of investment. In a closed economy, there is no trading or borrowing and lending with other economies, so net exports are zero and the relationship between GDP and its components is: Saving and Investment Private saving is equal to what households retain of their income after purchasing goods and services (C) and paying taxes (T). Public saving equals the amount of tax revenue the government retains after paying for government purchases and making transfer payments to households: Total saving in the economy (S) is equal to the sum of private saving and public saving: or Thus, Market for loanable funds Market for loanable funds The interaction of borrowers and lenders that determines the market interest rate and the quantity of loanable funds exchanged. The nominal interest rate is the stated interest rate on a loan.
The real interest rate corrects the nominal interest rate for the effect of inflation and is equal to the nominal interest rate minus the inflation rate. The Federal Reserve System A central bank, like the Federal Reserve in the United States, can help stop a bank panic by acting as a lender of last resort. With the intention of putting an end to bank panics and their accompanying recessions, Congress passed the Federal Reserve Act in 1913, setting up the Federal Reserve System—often referred to as “the Fed.” How the Federal Reserve Manages the Money Supply Monetary policy The actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy objectives. To manage the money supply, the Fed uses three monetary policy tools: Open market operations The buying and selling of Treasury securities by the Federal Reserve in order to control the money supply. Discount Policy By lowering the discount rate, the Fed can encourage banks to take more loans and thereby increase their reserves, giving them a stronger incentive to make more loans to households and firms, which will increase checking account deposits and the money supply. Reserve Requirements When the Fed reduces the required reserve ratio, it converts required reserves into excess reserves. Federal Open Market Committee (FOMC) The Federal Reserve committee responsible for open market operations and managing the money supply in the United States. Financial intermediaries Firms, such as banks, mutual funds, pension funds, and insurance companies, that borrow funds from savers and lend them to borrowers. Regulator Bank run A situation in which many depositors simultaneously decide to withdraw money from a bank. Bank Panic A situation in which many banks experience
runs at the same time. Discount Rate: The interest rate the Federal Reserve charges on the loans made to the banks,
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