Chapter 13 - Money and the Banking System
- Our nation’s central bank, the Federal Reserve, is responsible for controlling the money supply.
13.1 What is Money?
- Money: Any items that are regularly used in economic transactions or exchanges and accepted by buyers and sellers.
- Economic exchange: One party hands over currency and the other party hands over goods and services.
- Currency is money and checks also function as money because they are used to pay suppliers.
Three Properties of Money
- Medium of Exchange: Any item that buyers give to sellers when they purchase goods and services.
- Barter: The exchange of one good or service for another.
- Double Coincidence of Wants: The problem in a system of barter is that one person may not have what the other desires.
- Principle of Voluntary Exchange: A voluntary exchange between two people makes both people better off.
- Without money, we would be left with a barter system, and most transactions that make both people better off would not be possible.
- Unit of Account: a standard unit in which we can state prices and compare the value of foods and services.
- In our economy, money is the unit of account because we quote all prices in terms of money.
- Store of value: the property of money that holds that money preserves value until it is used in an exchange.
- Money is actually a somewhat imperfect store of value because of inflation.
- Commodity Money: A monetary system in which the actual money is a commodity, such as gold or silver.
- Gold standard: A monetary system in which gold backs up paper money.
- Fiat money: A monetary system in which money has no intrinsic value but is backed by the government.
Measuring Money in the U.S. Economy
- M1: The sum of currency in the hands of the public, demand deposits, other checkable deposits, and traveler’s checks.
- The first part of M1 is currency held by the public, that is, all currency held outside bank vaults.
- The second component is deposited in checking accounts, called demand deposits.
- The third component, other checkable deposits, was introduced in the early 1980s and did pay interest.
- M2: M1 plus other assets, including deposits in savings and loans accounts and money market mutual funds.
13.2 How Banks Create Money
A Bank’s Balance Sheet: Where the Money Comes From and Where It Goes
- Balance sheet: An account statement for a bank that shows the sources of its funds (liabilities), as well as the uses of its funds (assets).
- Liabilities: The sources of funds for a bank, including deposits and owners’ equity.
- Assets: The uses of the funds of a bank, including loans and reserves.
- Owners’ equity: The funds provided to a bank by its owners.
- Reserves: The portion of banks’ deposits set aside in either vault cash or as deposits at the Federal Reserve.
- Required reserves: The specific fraction of their deposits that banks are required by law to hold as reserves.
- Excess reserves: Any additional reserves that a bank holds above-required reserves.
How Banks Create Money
- Reserve ratio: The ratio of reserves to deposits.
How the Money Multiplier Works
- The total increase in checking account balance throughout all banks = (initial cash deposit) x 1/(reserve ratio)
- Money Multiplier: The ratio of the increase in total checking account deposits to an initial cash deposit.
How the Money Multiplier Works in Reverse
- The expansions and contractions offset each other when private citizens and firms write checks to one another.
13.3 A Banker’s Bank: The Federal Reserve
- Central bank: A banker’s bank-an an official bank that controls the supply of money in a country.
- Lender of last resort: A central bank is the lender of last resort, the last place, all others have failed, from which banks in emergency situations can obtain loans.
Functions of the Federal Reserve
- The Fed supplies currency to the economy
- The Fed provides a system of check collection and clearing
- The Fed holds reserves from banks and other depository institutions and regulates banks.
- The Fed conducts monetary policy
- Monetary Policy: The range of actions taken by the Federal Reserve to influence the level of GDP or inflation.
The Structure of the Federal Reserve
- Federal Reserve Bank: One of 12 regional banks that are an official part of the Federal Reserve System.
- Board of Governors of the Federal Reserve: The seven-person governing body of the Federal Reserve System in Washington, D.C.
- Federal Open Market Committee (FOMC): The group that decides on monetary policy. It consists of the seven members of the Board of Governors plus five of 12 regional bank presidents on a rotating basis.
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