PRINCIPLE OF ECONOMIC
6 EDITION
KARL CASE, RAY FAIR
PRENTICE HALL BUSINESS PUBLISHING
COPY RIGHT 2002
An Overview of Money
•
Money
is anything that is generally accepted as a medium of exchange.
•
Money is not income, and money is not
wealth. Money is:
•
a means of payment,
•
a store of value, and
•
a unit of account.
•
Money as a means of payment, or medium
of exchange, is more efficient than barter.
•
Barter
is the direct exchange of goods and services for other goods and services.
•
A barter system requires a double
coincidence of wants for trade to take place. Money eliminates this problem.
•
Money is a lubricant in the functioning
of a market economy.
An Overview of Money
•
Money as a store of value
refers to money as an asset that can be used to transport purchasing power from
one time period to another.
•
Money is easily portable, and easily
exchanged for goods at all times. The liquidity
property of money makes money a good medium of exchange as well as a
store of value.
An Overview of Money
•
Money also serves as a unit of
account, or a standard unit that provides a consistent way of quoting
prices.
•
Commodity monies
are items used as money that also have intrinsic value in some other use. Gold is one form of commodity money.
•
Fiat,
or token, money is money that is intrinsically worthless.
•
Legal tender
is money that a government has required to be accepted in settlement of debts.
Measuring the Supply of
Money in the United States
•
The two most common measures of money
are M1 and M2.
•
M1,
or transactions money is money that can be directly used for
transactions. It includes currency held
outside banks, plus demand deposits, plus traveler’s checks, plus other
checkable deposits
•
M1 is a stock
measure—it is measured at a point in time—on a specific day. On June 26, 2000, M1 was $1,103.3
billion.
•
M2,
or broad money, includes near monies, or close substitutes for
transactions money.
•
M2 / M1 +
savings accounts + money market accounts + other near monies
•
On June 26, 2000, M2 was $4,778.2
billion.
•
The main advantage of looking at M2
instead of M1 is that M2 is sometimes more stable.
The Private Banking
System
•
Most of the money in the United States
today is “bank money,” or money held in checking accounts rather than currency.
•
Financial intermediaries
are banks and other financial institutions that act as a link between those who
have money to lend and those who want to borrow money.
How Banks Create Money
•
To see how banks create money, consider
the origins of the modern banking system:
•
Goldsmiths functioned as warehouses
where people stored gold for safekeeping.
•
Upon receiving the gold, a goldsmith
would issue a receipt to the depositor.
After a time, these receipts themselves, rather than the gold that they
represented, began to be traded for goods.
•
At this point, all the receipts issued
were backed 100 percent by gold.
•
Goldsmiths realized that people did not
come often to withdraw gold and, as a result, they had a large stock of gold
continuously on hand. They could lend
out some of this gold without any fear of running out.
•
There were thus more claims than there
were ounces of gold.
•
Knowing there were more receipts
outstanding than there were ounces of gold, people might start to demand gold
for receipts.
•
A run on a goldsmith (or a
modern-day bank) occurs when many people present their claims at the same time.
The Modern Banking
System
•
A brief review of accounting:
Assets – liabilities /
Net Worth, or
Assets / Liabilities +
Net Worth
•
A bank’s most important assets are its loans. Other assets include cash on hand (or vault
cash) and deposits with the Fed.
•
The Federal Reserve System (the
Fed) is the central bank of the United States.
•
A bank’s liabilities are the promises to
pay, or IOUs, that it has issued. A
bank’s most important liabilities are its deposits.
The Creation of Money
•
Banks usually make loans up to the point
where they can no longer do so because of the reserve requirement restriction
(or up to the point where their excess reserves are zero).
•
When someone deposits $100, and the bank
deposits the $100 with the central bank, it has $100 in reserves.
•
If the required reserve ratio is 20%,
the bank has excess reserves of $80.
With $80 of excess reserves, the bank can lend $400 and have up to $400
of additional deposits. The $100 in
reserves plus $400 in loans equal $500 in deposits.
The Money Multiplier
•
The money multiplier is the multiple by
which deposits can increase for every dollar increase in reserves.
The Federal Reserve
System
•
The Federal Open Market Committee
(FOMC) sets goals regarding the money supply and interest rates and
directs the operations of the Open Market Desk in New York.
•
The Open Market Desk is an
office in the New York Federal Reserve Bank from which government securities
are bought and sold by the Fed.
Functions of the Fed
The Fed performs
important functions for banks including:
•
Clearing interbank payments.
•
Regulating the banking system.
•
Assisting banks in a difficult financial
position.
•
Managing exchange rates and the nation’s
foreign exchange reserves.
The Fed performs
important functions for banks including:
•
Control of mergers between banks.
•
Examination of banks to ensure that they
are financially sound.
•
Setting of reserve requirements for all
financial institutions.
•
Lender of last resort.
The Fed’s Balance Sheet
•
Although it is unrelated to the money
supply, the Fed’s gold counts as an asset on its balance sheet.
•
The largest of the Fed’s assets, by far,
consists of government securities purchased over the years.
•
A dollar bill is a liability, or IOU, of
the Fed
How the Fed Controls the
Money Supply
•
The required reserve ratio establishes a
link between the reserves of the commercial banks and the deposits (money) that
commercial banks are allowed to create.
•
If the Fed wants to increase the money
supply, it creates more reserves, thereby freeing banks to create additional
deposits by making more loans. If it
wants to decrease the money supply, it reduces reserves.
The Discount Rate
•
Banks may borrow from the Fed. The interest rate they pay the Fed is the discount
rate.
•
Bank borrowing from the Fed leads to an
increase in the money supply. The higher
the discount rate, the higher the cost of borrowing, and the less borrowing
banks will want to do.
The Discount Rate
•
In practice, the Fed does not often use
the discount rate to control the money supply.
•
The discount rate cannot be used to
control the money supply with great precision, because its effects on banks’
demand for reserves are uncertain.
•
Moral suasion
is the pressure exerted by the Fed on member banks to discourage them from
borrowing heavily from the Fed.
Open Market Operations
•
Open market operations is the purchase
and sale by the Fed of government securities in the open market; a tool used to
expand or contract the amount of reserves in the system and thus the money
supply.
•
Open market operations is by far the
most significant tool of the Fed for controlling the supply of money.
•
An open market purchase of
securities by the Fed results in an increase in reserves and an increase
in the supply of money by an amount equal to the money multiplier times the
change in reserves.
•
An open market sale of securities
by the Fed results in a decrease in reserves and a decrease in
the supply of money by an amount equal to the money multiplier times the change
in reserves.
•
Open market operations are the Fed’s
preferred means of controlling the money supply because:
•
they can be used with some precision,
•
are extremely flexible, and
•
are fairly predictable.
The Supply Curve for
Money
•
A vertical money supply curve says the
Fed sets the money supply independent of the interest rate.
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