Ch. 11 The Monetary System

Functions and Types of Money

The monetary system is central to macroeconomics, providing the foundation for trade, value measurement, and economic stability. Money is a set of assets widely accepted in exchange for goods and services, eliminating the need for barter and the "double coincidence of wants."

• Medium of Exchange: Money is used to trade goods and services, rather than for its intrinsic value. For example, US Dollars are not consumed but are exchanged for goods and services.

• Unit of Account: Money provides a common measure for valuing goods and services, allowing for standardized pricing (e.g., one lumber = $5).

• Store of Value: Money preserves purchasing power over time, enabling individuals to save and spend later.

• Standard of Deferred Payment: Money allows for borrowing and lending, facilitating transactions over time.

• Liquidity: Refers to how easily an asset can be converted into cash. Money is the most liquid asset.

Kinds of Money:

• Fiat Money: Government-mandated currency with no intrinsic value (e.g., US Dollars).

• Commodity Money: Has intrinsic value and is used as money (e.g., gold, which can be used for jewelry, electronics, or dental work).

Defining the Money Supply: M1 and M2

Economists define the money supply using two main categories: M1 and M2. These categories differ in liquidity, with M1 being more liquid than M2.

• M1: Includes currency in circulation and checkable deposits (e.g., checking accounts).

• M2: Includes all of M1 plus savings deposits, money market funds, and certificates of deposit (CDs).

Table: Comparison of M1 and M2

Additional info: M1 is considered the most liquid form of money, while M2 includes assets that are less liquid but still easily converted to cash.

Required Reserves and the Deposit Multiplier

Banks play a crucial role in the money supply through their management of reserves and lending. The reserve ratio determines how much of deposits banks must keep in cash, affecting the money supply.

• Reserves: Deposits that banks have received but not loaned out.

• Reserve Ratio: Fraction of deposits banks must keep as reserves.

• 100-percent-reserve banking: All deposits are held as reserves (Reserve Ratio = 1).

• Fractional-reserve banking: Only a fraction of deposits are held as reserves (Reserve Ratio < 1).

• Required Reserves: Legally mandated reserves based on the reserve ratio.

• Excess Reserves: Reserves held above the legal requirement.

When banks loan out excess reserves, the money supply increases through the deposit multiplier effect.

• Money Multiplier: The amount of money the banking system generates for each dollar of reserves.

Formula:

Example: If the reserve ratio is 10%, the money multiplier is .

Introduction to the Federal Reserve

The Federal Reserve (the Fed) is the central bank of the United States, created in response to banking failures. It regulates banks, ensures the health of the banking system, and controls the money supply through monetary policy.

• Board of Governors: Central authority with members appointed by the President and confirmed by the Senate, serving long terms.

• Chairperson: Leader of the Board of Governors, serves a shorter term and may be re-appointed.

• Federal Reserve Banks: Twelve regional banks with their own boards and presidents.

• Federal Open Market Committee (FOMC): Makes decisions on monetary policy, composed of the Board of Governors and regional bank presidents.

The Fed acts as the lender of last resort, provides discount loans to banks, and sets the discount rate and federal funds rate. It controls the money supply through open market operations, discount policy, and reserve requirements.

History of the US Banking System

The US banking system has evolved in response to financial crises, leading to increased regulation and the creation of central institutions.

• Pre-1864: Banks printed their own notes, no uniform currency, little regulation.

• 1864–1913: Federally regulated national banks, uniform currency, but no central bank.

• Panic of 1907: Trusts speculated in risky investments, leading to bank panics and intervention by JP Morgan.

• 1913: Creation of the Federal Reserve.

• Great Depression: Bank runs led to the Glass-Steagall Act of 1933, creating FDIC insurance and separating commercial and investment banks.

• Savings and Loan Crisis (1980s): Risky investments and deregulation led to insolvency and government intervention.

Table: Types of Banks

Financial Crisis of 2007–2009

The financial crisis was triggered by risky home lending and the collapse of the real estate market. Securitization bundled home loans into mortgage-backed securities (MBS), which became popular investments. When homeowners defaulted, MBS failed, causing losses for investment banks.

• Sub-prime mortgage loans: High-interest loans to riskier buyers, often with little down payment.

• Shadow Banking System: Unregulated financial activities that loosened credit.

• Troubled Asset Relief Program (TARP): $700 billion bailout to prevent a domino effect of failures.

• Moral Hazard: Tendency to take riskier positions due to insurance or bailouts.

Example: Investment banks suffered huge losses from the failure of MBS, leading to government intervention.

Additional info: The image of the 1971 Ford Pinto is directly relevant as it is referenced in the example of money supply expansion through banking transactions, illustrating how deposited money is used in the economy.