BackMoney, Banks, and the Federal Reserve System: Study Notes
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Money, Banks, and the Federal Reserve System
14.1 What Is Money, and Why Do We Need It?
Money is a fundamental economic invention that facilitates trade, specialization, and economic development. Economists define money as any asset that is generally accepted in exchange for goods and services or for payment of debts.
Money: Any asset widely accepted for exchange or debt payment.
Asset: Anything of value owned by a person or firm.
Before money, barter was used, requiring a double coincidence of wants. The introduction of money allowed easier trade and specialization.
The Four Primary Functions of Money
Medium of exchange: Money is accepted for payment of goods and services.
Unit of account: Money provides a standard measure of value.
Store of value: Money can be saved and used for future purchases; it is liquid.
Standard of deferred payment: Money enables transactions across time, with predictable value.
Characteristics of Effective Money
Acceptable to most people
Standardized quality
Durable
Valuable relative to weight
Divisible
Commodity Money
Has value independent of its use as money (e.g., gold, cowrie shells, animal pelts, cigarettes in prisons).
Paper Money and Fiat Money
Paper money was historically exchangeable for commodities like gold.
Fiat money: Money authorized by a central bank, not exchangeable for commodities.
Advantages: Flexibility for central banks. Disadvantages: Relies on public confidence; loss of confidence renders it useless.
14.2 How Is Money Measured in the United States Today?
Economists use different definitions to measure the money supply in the U.S., focusing on assets that serve as a medium of exchange.
M1: Currency in circulation + checking account deposits + savings account deposits.
M2: M1 + small-denomination time deposits + noninstitutional money market fund shares.
M1 is preferred for discussions of money as a medium of exchange.
Debit and Credit Cards
Debit cards access checking accounts; the card itself is not money.
Credit cards are short-term loans; not counted as money until paid off.
Cryptocurrencies and E-Money
Forms like Bitcoin, PayPal, Apple Pay are not currently included in official money supply measures.
14.3 How Do Banks Create Money?
Banks are profit-making firms that play a critical role in the money supply by lending out deposits, thereby creating money.
Bank Balance Sheets
Assets: Loans, securities, reserves.
Liabilities: Deposit accounts, debts.
Reserves
Required reserves: Legally mandated fraction of deposits held as reserves.
Excess reserves: Reserves held above the legal requirement.
Required reserve ratio (RR): Minimum fraction of deposits to be kept as reserves.
Money Creation Process
Banks lend out deposits, keeping only a fraction as reserves.
Each loan creates new checking account deposits, increasing the money supply.
Simple Deposit Multiplier
The ratio of deposits created to new reserves.
Formula:
With a 10% reserve ratio, the multiplier is 10.
Real-World Deposit Multiplier
Actual multiplier is often less than predicted due to excess reserves and currency held outside banks.
Conclusions
Banks gaining reserves expand the money supply; losing reserves contracts it.
14.4 The Federal Reserve System
The Federal Reserve (Fed) is the central bank of the U.S., established to prevent bank panics and manage the money supply through monetary policy.
Bank Runs and Panics
Bank run: Many depositors withdraw funds simultaneously.
Bank panic: Multiple banks experience runs at the same time.
The Fed acts as lender of last resort to prevent panics.
Federal Deposit Insurance Corporation (FDIC)
Insures deposits up to $250,000, reducing risk of bank runs.
Structure of the Federal Reserve
12 Federal Reserve districts
Board of Governors in Washington, D.C.
Federal Open Market Committee (FOMC): Manages open market operations and money supply.
Monetary Policy Tools
Open market operations: Buying/selling Treasury securities to control money supply.
Discount policy: Adjusting the discount rate for loans to banks.
Reserve requirements: Changing the required reserve ratio.
Interest on reserves: Paying interest on bank reserves to influence lending.
Overnight reverse repurchase agreement facility: Short-term loans backed by collateral.
Term deposit facility: Offering term deposits to banks, reducing funds available for loans.
Open Market Operations Example
Fed purchases $10 million in securities, increasing bank reserves and money supply.
Fed sells securities to decrease money supply.
The Shadow Banking System
Includes investment banks, money market mutual funds, hedge funds.
Less regulated, highly leveraged, vulnerable to runs.
Securitization
Transforming loans into securities traded in financial markets.
Financial Crisis of 2007-2009
Shadow banking system suffered losses due to mortgage defaults.
Fed responded by expanding lending and purchasing assets.
14.5 The Quantity Theory of Money
The quantity theory of money connects the money supply to the price level and inflation, formalized by the quantity equation.
Quantity Equation
M: Money supply
V: Velocity of money
P: Price level
Y: Real output
Growth Rate Form
Growth rate of money supply + growth rate of velocity = inflation rate + growth rate of real output
Quantity Theory Predictions
If money supply grows faster than real GDP, inflation occurs.
If money supply grows slower than real GDP, deflation occurs.
If money supply grows at same rate as real GDP, price level is stable.
Hyperinflation
Inflation rates above 50% per month.
Caused by rapid money supply growth, often due to government spending exceeding tax revenue.
Examples: Zimbabwe (2000s), Venezuela (2019), Germany (1920s).
Historical Example: German Hyperinflation
Government expanded money supply to pay reparations.
Price index rose dramatically, currency became worthless.
