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Chapter 5Money and the Federal Reserve
These slides supplement the textbook, but should not replace reading the textbook
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What is barter?The practice of trading one good or service for another
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What is a double coincidence of wants?
A situation in which two traders are willing to exchange their products directly
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What is currency?Anything that can be used to signify someone’s credit and someone’s debit in a financial transaction
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What are the 4 basic functions of money?
Medium of exchangeUnit of accountStore of valueStandard deferred payment
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What is amedium of exchange?
Money is accepted in exchange for a good or service
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What aunit of account?
Money is used to compare the relative value of different goods and services
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What is astore of value?
Money is used as a means of saving
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What is astandard of
deferred payment?Money is used to keep track of the method and the amount of money is to be paid back in the future
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What are the properties of money?
ScarcityPortabilityDivisibility
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What is commodity money?
Anything that serves both as money and as a commodity
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What is token money?
Money that exceeds the value from which it was made, for example, quarters
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What are examples of money?
Federal Reserve NotesCoinsChecksTravelers checks
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What does the term liquidity mean?
The easier something is to spend the more liquid it is, the more difficult it is to spend the less liquid it is
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Which form of money is most liquid?
It all depends on the circumstances
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What is fiat money?Money not redeemable for any commodity; its status as money is conferred by the government
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What is legal tender?Currency that constitutes a valid and legal offer of payment for debts
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Does gold or silver back up our money?No, our money is not backed up by anything
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What happenedin 1968?
U.S and a number of European nations stopped selling gold on the London market, allowing the market to freely determine the price of gold
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What happenedin 1971?
From 1968 to 1971, only central banks could trade with the U.S. at $35/oz. Finally, in 1971, even this bit of gold convertibility died
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Why does money have value?
It is useful and relatively scarce
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What determines the value of money?
The general price level
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Why are banks called depository institutions?
Because they accept deposits from the public
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What arecommercial banks?
Depository institutions that make loans to the public
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What aredemand deposits?
Accounts at financial institutions that pay no interest and on which depositors can write checks to obtain their deposits
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How do banks make profit?
After interest paid or services rendered minus costs equals bank’s profit
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Who were the first bankers?
Goldsmiths in the middle ages
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What is the Federal Reserve System?
The central bank and monetary authority of the United States; known as “the Fed”
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What is the function of the Fed?
To ensure the availability of enough money and credit in the banking system to support a growing economy
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When was the federal reserve
system established? The Federal Reserve Act of 1913
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Does the Fed loan money to private
companies? No, they only do business with financial institutions
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Why would the Fed want to decrease the
money supply?To lower inflation
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Why would the Fed want to increase the
money supply?To stimulate employment
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How many Federal Reserve banks are there?
The U. S. is divided into 12 Federal Reserve districts, each district has a Federal Reserve Bank
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Who makes the decisions for the
Federal Reserve? The Board of Governors and the Open Market Committee
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How long do most board members serve?
14 years, after which they cannot serve again
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How long does the chairman of
the board serve? The Chairman serves 4 years, but can serve again
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What is the Federal Open Market Committee?
Made up of the 7 board members and 5 presidents of Federal Reserve Banks
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What is the role of the Federal Open
Market Committee? The FOMC makes decisions as to the buying and selling of government securities
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Member Banks
owns stock in Federal Reserve
only national banks are required to be members
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What do the letters FDIC stand for?
The Federal Deposit Insurance Corporation
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When was the FDIC established?
1933
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What is the function of the FDIC?
To ensure deposits in any banking institution that purchases FDIC insurance
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How much are deposits insured for?
Each account in a bank is insured up to $250,000 per depositor per bank
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What is the name of the market where money is
bought and sold?The loanable funds market
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Why would the Fed want to expand the
money supply?If we have unemployment the Fed wants to increase the money supply to stimulate employment
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Why would the Fed want to contract the
money supply?If we have inflation the Fed wants to decrease the money supply to bring down prices
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What does the term liquidity mean?
A measure of the ease with which an asset can be converted into money without significant loss in its value
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What does liquidity have to do with the
money supply?With inflation the Fed wants banks to be less liquid
With unemployment the Fed wants banks to be more liquid
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What makes a bank more or less liquid?A lot of cash in excess reserves - very liquid
Little cash in excess reserves - less liquid
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What is arequired reserve ratio?
The ratio of reserves to deposits that banks are required to hold
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What arerequired reserves?
The dollar amount of reserves a bank is legally required to hold
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Where are bank’s reserves held?
Deposits with the Fed and cash in the bank’s vault
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What are excess reserves?
Bank reserves in excess of required reserves
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What money do banks lend out?Excess reserves
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If a bank has $6,000 in checkable deposits with a
reserve ratio of .2 how much can the bank lend?
No more than $4,800
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How does the Fed influence the money
supply?Change reserve requirements
Change discount rateChange federal funds rateBuy/sell govt. securities
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What arereserve requirements?The percentage of a bank’s assets that must be kept in cash and therefore cannot be lent out
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Who setsreserve requirements?Reserves are determined by the Fed for all financial institutions
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If we have inflation what will the Fed do to reserve requirements?
Raise reserve requirements thereby decreasing bank’s excess reserves
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If we have unemployment what will the Fed do to reserve requirements?
Lower reserve requirements thereby increasing bank’s excess reserves
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What is thediscount rate?
The interest that banks pay when they borrow money from the Fed
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What will the Fed do to the discount rate during periods
of inflation?The Fed will raise the discount rate to discourage borrowing and thus spending
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What will the Fed do to the discount rate during periods of unemployment?
The Fed will lower the discount rate to encourage borrowing and thus spending
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What is thefederal funds rate?
The interest rate that banks pay to borrow excess reserves from another bank
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What will the Fed do to the federal funds rate
during periods of inflation?
The Fed will raise the federal funds rate to discourage borrowing and thus spending
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What will the Fed do to the federal funds rate
during periods of unemployment?
The Fed will lower the federal funds rate to encourage borrowing and thus spending
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What is theprime interest rate?The interest rate that big banks charge their best and most credit worthy customers
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What is a government security?A short term bond that the federal government sells
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What is the open market?
A place where bonds are bought and sold
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What areopen market operations?
The act of the Fed buying or selling government securities at the open market
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Why does the government sell
securities?This is its way of borrowing money
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What will the Fed do if we have unemployment?
The Fed will buy government securities making banks more liquid so they can lend out more money
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What will the Fed do if we have inflation?
The Fed will sell securities making banks less liquid so they will have less money to lend
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Which monetary tool is most often used?Open-market operations
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What is moral suasion?
A host of different measures that the Fed uses to influence the activities of banks in one way or another
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What is the largest component of
assets of the Fed?U.S. government securities
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What is the largest component of the Fed’s liabilities?
Federal Reserve notes
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Why is the Fed so profitable?
Because it pays no interest on its liabilities but earns interest on its assets
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If the Fed wants to increase the money
supply by $1,000 million, what should it do?
With a reserve requirement of 10% it should increase the money supply by $100 million
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What is the money multiplier with a
reserve requirement of 1/10?
10
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What is the Money Multiplier formula?
1/Required reserve ratio
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If the required reserve ratio is 1/10 and all banks are exactly
meeting their reserve requirement - how do
we calculate the money multiplier?
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One divided by one tenth equals 10
11..10
=
1 X10
1=
Multiplier
10
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$100$90$81$74$63...
$1,000
original deposit
total money
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If the Fed wants to decrease the money
supply by $1,000 million, what should it do?
With a reserve requirement of 10% it should decrease the money supply by $100 million
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Why is the Fed better at fighting inflation
than unemployment?The Fed can’t force people to borrow more money
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What things will cause interest rates to rise?
Demand for money increasesThe Fed raises the Discount
or Federal Funds RateThe Fed sells government
securities
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What things will cause interest rates to fall?
Demand for money decreasesThe Fed lowers the Discount
or Federal Funds RateThe Fed buys government
securities
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What is Quantitative Easing?
A politically polite term for monetizing the debt, the Fed creates money to buy bonds
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END
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