Chapter 29: The Monetary System

29-1: The Meaning of Money

  • Money: The assets in an economy that people use to regularly purchase goods and services from each other
    • Cash, credit cards, etc. are considered money while houses, investments are not

The Functions of Money

  • Three functions: medium of exchange, unit of account, and store of value
  • A medium of exchange is an item that buyers give to sellers in exchange for their goods and services
  • A unit of account is a method to compare the value of two goods in an economy
    • In prisons and extremely poor nations, cigarettes are often used as a unit of account
  • A store of value is an item that people use to transfer purchasing wealth from the present to the future
    • A seller receives money now so they can buy something else in the future
  • Liquidity is the ease of which an asset can be turned into a medium of exchange
    • Money is the most liquid while houses, paintings, etc. are not as liquid
    • Must balance liquidity with store of value; money is very liquid but can lose value easily with inflation, while paintings can increase in value over time but are not very liquid

The Kinds of Money

  • Commodity money is money that takes the form of a commodity that has intrinsic value
    • Gold has historically been used as money because it has many uses, thus giving it a high intrinsic value
    • Economies using gold (or that can easily turn their currency into gold) are said to be under a gold standard
  • Fiat money is money without intrinsic value, such as paper bills
    • Fiat money is established as money by governments, but the value of fiat money is highly dependent on the confidence of the public in the government issuing the fiat money

Money in the U.S. Economy

  • Money stock represents the amount of money circulating in an economy, but there are many different ways to measure it
    • Currency is always included in the measurement of the money stock, but other things like demand deposits (money that can be easily accessed from a bank account) should also be included
    • Things like savings accounts, purchasing power on margin, etc. could all be considered part of the money stock; makes it difficult to measure
  • For the rest of this book, the money stock will include currency and deposits in banks and other institutions that can be easily accessed to buy goods and services

29-2: The Federal Reserve System

  • The agency responsible for regulating fiat money is the Federal Reserve (Fed) which is an example of a central bank in the United States

The Fed’s Organization

  • Headed by a Board of Governors and one chair with 14-year terms and who are appointed by the president
    • Federal Reserve System consists of the Federal Reserve Board and 12 regional Federal Reserve Banks around the country
  • The Fed has two jobs
    • Regulate banks and make sure the banking system is healthy, which is done by monitoring banks’ actions, loaning money to banks, and acting as a lender of last resort to failing banks
    • Control the quantity of money supply, or money available in the economy, through monetary policy

The Federal Open Market Committee (FOMC)

  • The FOMC consists of all of members of the Board of Governors and all presidents of the regional banks
    • Only 5 of the regional presidents get to vote with the votes rotating, but the New York branch president always gets to vote because NYC is considered the financial center of the United States
  • The FOMC decides to increase or decrease the number of dollars in the economy through open-market operation, or the sale and purchase of US government bonds
    • If they want to increase money, they purchase bonds (money out, bonds in); if they want to decrease money, they sell bonds (money in, bonds out)
  • The Fed’s decisions regarding money supply highly infuence inflation in the long run and employment + production in the short run

29-3: Banks and the Money Supply

The Simple Case of 100-Percent-Reserve Banking

  • Assume that there is only 100 dollars of currency, so the total supply of money is 100 dollars, and one bank that only takes deposits + doesn’t make loans
    • Money that banks have received but not loand out are reserves
    • Because all deposits are treated as reserves, this system is called 100-percent-reserve-banking
  • The money in the bank can be represented with a T-account which is an accounting statement showing liabilities and assets image
    • Because the assets and liabilities are equal, this is considered a balance sheet
    • Because all deposits are kept in reserves, the supply of money remains unchanged; thus, if banks hold all deposits in reserve, banks do not influence the supply of money

Money Creation with Fractional-Reserve Banking

  • When a bank begins using the money in the reserves to give out loans, they keep a fraction of their deposits in reserve; thus, they are practicing fractional-reserve banking
    • The fraction of deposits kept in reserves is known as the reserve ratio, and the Fed typically sets a minimum amount (called a reserve requirement) for the reserve ratio so bank runs don’t occur
    • Banks can also hold more than the reserve requirement for safety; known as excess reserves
  • Assume that the same bank uses a reserve ratio of 1/10, leading to this T-account: image
    • The amount of liabilities remains unchanged because making loans doesn’t change the amount the bank has to pay back to their depositors
    • The bank now has two assets: reserves and loans
      • Loans effectively increase the money supply by $90, as there are 90 more dollars for borrowers to use
    • When banks hold only a fraction of deposits in reserve, the banking system creates money
  • Technically this doesn’t “create money”, as borrowers also take on liabilities by taking the loans, but the money in the economy becomes more liquid

The Money Multiplier

  • Assume that the person who took the $90 from the first bank purchased something from a seller who deposited it into another bank
    • The T-account for the secound bank would then look like this: image
    • The total liabilities is $90 because the person deposited $90 and the bank can then loan out $81 out of the $90
  • This pattern would continue if someone took a loan out from the second bank and bought from a member of a third bank: image
  • Eventually, the total money supply jumps to $1000 after money is loaned out and reused again (100 + 90 + 81 + 72.90 + … + 0.9n * 100)
    • The amount of money that the banking system generates with each dollar of reserves is called the money multiplier (10 dollars for each dollar)
    • The money multiplier is equal to the reciprocal of the resrve ratio
      • Therefore, the lower the reserve ratio, the higher the money multiplier is and vice versa

Bank Capital, Leverage, and the Financial Crisis of 2008–2009

  • The example in the last two sections has been simplified, but most bank balance sheets also include equity and debt
    • The resources that a bank gets from issuing equity to its owner is called bank capital which is used to make profit for its owners through actions such as purchasing stocks and bonds
  • Here is a T-account of a more realitic bank: image
    • The right side includes all of the liabilities and capital
    • The money on the right side is used to fund the items on the left, and the two sides must balance because of the rules of accounting
  • Businesses rely on leverage, or borrowing money in order to fund themselves and invest in capital
  • The leverage ratio is the ratio of the bank’s total assets to the bank capital; in the above example, this ratio is 1000 to 50, or 20
    • This means that for each $20 of assets, $19 are financed with borrowed money
    • Assume that the value of the bank above’s assets rise by 5%
      • This means that the assets are now worth $1050 while the liabilities remain the same (value of deposits and debt stay the same)
      • The owner’s equity now becomes $100 (1050 - 950) and thus increases by 100%, so a 5% increase turns into a 100% increase for owners
      • The opposite also applies; if there is a 5% decrease, then the owner’s quity goes down 100% as well
      • If the value of assets ever fall below the value of the liabilities, then tthe bank is considered insolvent and unable to pay off its debts in full
  • Banks are required to hold a certain amount of capital known as a capital requirement so they are guaranteed to pay off their depositors
    • Illustrated in 2007 and 2008 crisis where the value of assets decreased so heavily that banks could no longer pay off their depositors and were forced to not loan out their money
    • Solved by adding money back to the economy which, in turn, made taxpayers partial owners of banks

29-4: The Fed’s Tools of Monetary Control

How the Fed Influences the Quantity of Reserves

  • Open-Market Operations
    • Open-market operations is when the Fed buys or sells government bonds to decrease or increase the money supply, respectively
    • Easiest to do and does not require changes to laws or policy; used the most often
  • Fed Lending to Banks
    • The Fed can lend money to banks, which happens most commonly when banks lack reserves
    • Banks typically borrow money from the Fed through the Fed’s discount window and pay an interest rate on the loan called the discount rate
      • Giving banks money allows the banking system to create more money
      • Changing the discount rate changes the money supply; higher discount rate discourages banks from borrowing, thus decreasing the supply, while the opposite happens when the discount rate is lowered
    • Another way for the Fed to give money is through Term Auction Facitlities where loans were created and given to the highest bidder who would pay back the highest interest rate
    • The Fed lends money to banks when financial institutions are in trouble, such as during financial crises

How the Fed Influences the Reserve Ratio

  • Reserve Requirements
    • The Fed can change the reserve requirements which state the minimum amount of money the banks must hold in reserve
    • Increasing the requirement increases the reserve ratio which decreases the money supply, and vice versa for decreasing the requirement
    • Reserve requirements are rarely changed because they can cause banks to stop loaning money out and are less effective due to the common practice of holding excess reserves
  • Paying Interest on Reserves
    • The Fed pays interest on reserves that banks hold at the Fed, thus encouraging saving money in reserves
    • The higher this interest rate, the more reserves are held and the lower the reserve ratio is; vice versa applies

Problems in Controlling the Money Supply

  • There are two main issues that arise with attempting to control the money supply
    • The Fed cannot control the amount of money that households decide to deposit into banks
      • Especially problematic if a large number of households decide to take out their money and run the bank; causes issues without the Fed being able to do anything
    • The Fed cannot control the amount that banks lend to people
      • Banks might decide to stop loaning money for an arbitrary reason outside of the Fed’s control, thus lowering the money supply
  • These two problems illustrate the dependence of the economy on the behavior of both banks and households, but they can be mitigated through careful observation

The Federal Funds Rate

  • The federal funds rate is the interest rate that banks charge one another for loans
    • These loans are typically short and only used for small injections
    • Different than the discount rate, as banks are borrowing from other banks instead of the Fed
      • Discount rate and federal funds rate is typically pretty similar
    • The federal funds rate influences the entire market due to its effects on banks
    • Open-market purchases raise the federal funds rate while open-market sales decrease it (less money means more banks need loans and vice versa)
    • A decrease in the target goal for the federal funds rate means the money supply will increase while an increase in the target goal signals a decrease in money supply