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252 CHAPTER 10 Money, Banking, and the Federal Reserve System CHAPTER 11 Measuring Economic Performance CHAPTER 12 Economic Changes and Cycles CHAPTER 13 Fiscal and Monetary Policy CHAPTER 14 Taxing and Spending
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CHAPTER 10 CHAPTER 11 · 2016-05-10 · 252 CHAPTER 10 Money, Banking, and the Federal Reserve System CHAPTER 11 Measuring Economic Performance CHAPTER 12 Economic Changes and Cycles

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Page 1: CHAPTER 10 CHAPTER 11 · 2016-05-10 · 252 CHAPTER 10 Money, Banking, and the Federal Reserve System CHAPTER 11 Measuring Economic Performance CHAPTER 12 Economic Changes and Cycles

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C H A P T E R 1 0Money, Banking, and theFederal Reserve System

C H A P T E R 1 1Measuring EconomicPerformance

C H A P T E R 1 2Economic Changes and Cycles

C H A P T E R 1 3Fiscal and Monetary Policy

C H A P T E R 1 4Taxing and Spending

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“The ideas of econo-

mists . . . are more

powerful than is com-

monly understood.

Indeed the world is

ruled by little else.”—John Maynard Keynes

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Why It Matters

Suppose that tomorrow morning you wokeup, and all the money in the world wasgone. It disappeared. How would the

world be different? Would it be a better or a worseplace to live? Would people be more greedy, lessgreedy, or about the same? Would people workharder, or work less?

When someone mentions the word money, youmight think of a $20 bill. Money is cold, hard cash to

most of us, but moneyinvolves much more thanthat $20 bill. In this chapteryou will begin to find outabout the story of money.You will learn how moneycame into existence and thepurposes it serves today. Youwill also learn about bankingand the Federal ReserveSystem, which work togetherto change the amount ofmoney in circulation at anygiven time. As you completethe chapter, you will begin tosee how the changingmoney supply can affectyour life in the years tocome.

254

Many people, when theythink about banks, thinkof safe, secure places tokeep their money andother valuables. Butbanks do much morethan store money. Theyalso participate in theprocess of creatingmoney and regulating ourmoney supply—activitiesthat have a major impacton our economy.

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The following events occurred one dayin February.

8:15 A.M. The members of the Federal Open MarketCommittee (FOMC), in Washington, D.C., will start their meetingat 9 a.m. The members of the FOMC have a lot to say on whetherthe money supply of the United States increases, decreases, orremains constant. Many people would like to hear what goes onat these meetings. If you knew what was discussed, you mightbe able to profit from it. So now, at this time, the room inwhich the meeting will take place is being swept for electronicbugs.• What specifically does the FOMC do that is soimportant?

9:00 A.M. Mrs. Harris teaches English literatureat Monroe High School and is talking about the book TheStrange Case of Dr. Jekyll and Mr. Hyde. She reads fromthe book: “It was on the moral side, and in my own per-son, that I learned to recognize the thorough and prim-itive duality of man: I saw that, of the two natures thatcontended in the field of my consciousness, even if Icould rightly be said to be either, it was only becauseI was radically both. . . .”• What does Robert Louis Stevenson’s TheStrange Case of Dr. Jekyll and Mr. Hyde haveto do with the material in an economics text?

3:44 P.M. Carl listens to the news on hiscar radio. The newscaster states, “Today, the Fedannounced that it would raise the discount rate byone-quarter of one percentage point or 25 basispoints. This decision shows that the Fed is probablyworried about the recent rapid rate of increase inthe money supply.”• What is the discount rate and how is it relatedto changes in the money supply?

5:29 P.M. At NBC Studios in Burbank,California, Jay Leno, host of the Tonight Show withJay Leno, is getting ready to go on. He tapes his showevery weekday at this time. The announcer of theTonight Show is warming up his voice. Jay goes over inhis mind his first two jokes. Although he will read all of

his jokes off large white posters held up in front of him,he still likes to go over in his mind his first few words.

• What does Jay Leno have to do with material in aneconomics text?

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What’s It Like Living in aBarter Economy?

A barter economy is an economy withno money. The only way you can get whatyou want in a barter economy is to tradesomething you have for it. Suppose you haveapples and want oranges. You trade twoapples for three oranges.

Life in a barter economy can be difficult.It can take a lot of time and effort to getwhat you want. Suppose you produce uten-sils such as forks, spoons, and knives. Noone can live on utensils alone, so you set outto trade your utensils for bread, meat, andother necessities. You come across a personwho bakes bread and ask if he is willing totrade some bread for some utensils. He says,“Thank you very much, but no. I have allthe utensils I need.” You ask him what hewould like instead of utensils. He says hewould like to have some fruit, and that ifyou had fruit he would be happy to tradebread for fruit.

You go on your way and find another per-son with bread. You ask her if she wants to

Chapter 10 Money, Banking, and the Federal Reserve System

trade bread for utensils. Like the first person,she says no, but she would be happy to tradebread for meat if you had any. You do not, soyou move on to find another person who,you hope, will be willing to trade bread forutensils.

What is the problem here? You encounterpeople who have what you want but (unfor-tunately for you) don’t want what you have.(You find the person who has the bread thatyou want, but this person doesn’t want theutensils that you have.) What makes living ina barter economy difficult is that many ofthe people you want to trade with don’twant to trade with you.

In this type of situation, trade is timeconsuming. It could take all day, if notlonger, to find a person who wants to tradebread for utensils. Economists state theproblem this way: the transaction costs ofmaking exchanges are high in a barter econ-omy. Think of the transaction costs as thetime and effort you have to spend beforeyou can make an exchange. If the transac-tion costs could somehow be lower, tradingwould be easier.

The Origins ofMoney

Focus Questions� What is a barter economy?� How did money emerge out of a barter

economy?� What is money?� What gives money its value?� What are the functions of money?

Key Termsbarter economytransaction costsmoneymedium of exchangeunit of accountstore of value fractional reserve banking

barter economyAn economy in whichtrades are made ingoods and servicesinstead of in money.

transaction costsThe costs associatedwith the time and effortneeded to search out,negotiate, and consum-mate an exchange.

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Taylor wants to buy a houseand a gallon of milk. He has to do more tobuy a house than he has to do to buy a gallonof milk. To buy a house, he has to find thehouse, inspect the house, bargain on theprice of the house, take out a loan to buy thehouse, and much more. To buy a gallon ofmilk, he simply walks into a grocery store,pays at the counter, and walks out. Thetransaction costs of buying a house aregreater than the transaction costs of buyinga gallon of milk. �

How and Why Did MoneyCome to Exist?

How can an individual living in a bartereconomy reduce the transaction costs ofmaking exchanges? In a barter economywith, say, 100 goods, some goods are morereadily accepted in exchange than others.For example, good A might be accepted (onaverage) every tenth time it is offered inexchange, while good B might be acceptedevery seventh time. If you are going outtoday to trade in a barter economy, whichgood, A or B, would you prefer to have inyour possession? The answer is B, because itis more likely to be accepted in a trade thanA. In other words, to reduce the transactioncosts of making exchanges, it is better tooffer B than A.

Before you can offer B, though, you haveto have it. So suppose someone offers totrade good B for your utensils. You don’treally want to consume good B (in the sameway that you want to consume bread), butyou realize that good B will be useful in mak-ing exchanges. You accept the trade becauselater you will use good B to lower the trans-action costs of getting what you want.

Once some people begin accepting a goodbecause it reduces the transaction costs ofexchange, others will follow. After youaccepted good B, it had greater acceptabilitythan it used to have. Because you accepted it,even though it wasn’t the good you reallywanted, perhaps it will be accepted every sixthtime now instead of every seventh time. Thisgreater acceptability makes good B more use-ful to other people than it was previously.

E X A M P L E :

Then, when Pheng accepts good B, it is evenmore likely that someone else will accept goodB. Can you see what is happening? That youaccepted good B made it more likely thatPheng would accept it. That Pheng accepted itmade it more likely that someone else wouldaccept it. Eventually, everyone will accept goodB in exchange. When this time arrives—whengood B is widely accepted in exchange—goodB is called money. Money is any good that iswidely accepted in exchange and in the repay-ment of debts. Historically, goods that evolvedinto money included gold, silver, copper,rocks, cattle, and shells, to name only a few.

You are on an island with10 other people without money. You start tomake trades with the others on the island—some shells for some mango, two smallbluish fish for one large reddish fish, somerocks for some seaweed. One day you learnthat of all things on the island, a coconut ismore widely accepted in exchange than any-thing else. In other words, if you have acoconut to trade, six out of every 10 peoplewill trade with you, but for other items(shells, fish, rocks) only four, or fewer, out ofevery 10 people will trade with you. Yourealize that those coconuts can make it awhole lot easier to trade: “I had better alwaysaccept a coconut (in a trade) when someoneoffers one to me because I can then turnaround and use the coconut to get what I

E X A M P L E :

257Section 1 The Origins of Money

� These NativeAmericans are trad-ing furs with explorerHenry Hudson.What were somedisadvantages ofliving in a bartereconomy?

moneyA good that is widelyaccepted for purposes ofexchange and in therepayment of debt.

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want from others.” So you start acceptingcoconuts in trade, even though you don’tlike coconuts, and because you do, theacceptability of coconuts is now even greaterthan before. Then someone else sees that theacceptability of coconuts is on the rise, andso she begins accepting coconuts in alltrades. On it goes until almost everyone real-izes that it is in their best interests to acceptcoconuts. Coconuts are now money. �

What Gives Money Value?Forget coconuts. Let’s turn to a $10 bill. Is

a $10 bill money? The $10 bill is widelyaccepted for purposes of exchange, ofcourse, and therefore it is money.

What gives money (say, the $10 bill) itsvalue? Like good B and the coconuts in theearlier examples of a barter economy, ourmoney (today) has value because of its gen-eral acceptability. Money has value to youbecause you know that you can use it to getwhat you want.You can use it to get what youwant, however, only because other peoplewill accept it in exchange for what they have.

Imagine a time in thefuture. Ryan begins to walk to a local shop-ping center. On the way, he stops by the con-venience store to buy a doughnut and milk.He tries to pay for the food with two $1bills. The owner of the store says that he nolonger accepts dollar bills in exchange for

E X A M P L E :

what he has to sell. This story repeats itselfall day with different store owners; no one iswilling to accept dollar bills for what he orshe has to sell. Suddenly, dollar bills have lit-tle or no value to Ryan. If he cannot usethem to get what he wants, they are simplypaper and ink, with no value at all. �

Between 1861 and 1865,during the Civil War, in the SouthConfederate notes (Confederate money) hadvalue because Confederate money wasaccepted by people in the South for purposesof exchange. Today in the South, Confederatemoney has little value (except for historicalcollections), because it is not widely acceptedfor purposes of exchange. You cannot pay foryour gasoline at a service station in Alabamawith Confederate notes. �

Are You Better Off Living ina Money Economy?

The transaction costs of exchange arelower in a money economy than in a bartereconomy. In a barter economy, not everyoneyou want to trade with wants to trade withyou. In a money economy, however, every-one you want to buy something from wantswhat you have—money. In short, a willingtrading partner lowers the transaction costsof making exchanges.

Lower transaction costs translate into lesstime needed for you to trade in a moneyeconomy than in a barter economy. Usingmoney, then, frees up some time for you.With that extra time, you can produce moreof whatever it is you produce (accountingservices, furniture, computers, or novels),consume more leisure, or both. In a moneyeconomy, then, people produce more goodsand services and consume more leisure thanthey would in a barter economy. The resi-dents of money economies are richer ingoods, services, and leisure than the resi-dents of barter economies.

The residents of money economies aremore specialized, too. If you lived in a bartereconomy, it would be difficult and time con-suming to make everyday transactions. Youprobably would produce many things your-self rather than deal with the hardship of

E X A M P L E :

258 Chapter 10 Money, Banking, and the Federal Reserve System

� This woodcutshows men panningfor gold in Californiain the 1850s. Whatmaterials, otherthan gold, havepeople used formoney?

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producing only one good and then trying toexchange it for so many other goods. Inother words, the higher the transaction costsof trading, the less likely you would want totrade, and the more likely you would pro-

duce the goods that you would otherwisehave to trade for.

In a money economy, however, it is nei-ther difficult nor time consuming to makeeveryday transactions. The transaction costs

259Section 1 The Origins of Money

Suppose one of today’s hip-hop artists lived in a barter

economy. Would he still be a hip-hop artist?

Before we answer this question,let’s look at what an average day,living in a money economy, lookslike for a hip-hop artist. He has towork on writing songs, rehearsingsongs, planning for a tour, workingon a video. So much of his day iswrapped up in his highly specializedwork of being a hip-hop artist.

Would he be engaged in thesame activities if he lived in a bartereconomy? Probably not. A typicalday might go like this. He wakes up,eats breakfast, and then sees if hecan trade a little of his hip-hop forsome goods. He meets a womanwith bread and asks if she is willingto trade some bread for a little hip-hop. The person tells the hip-hopartist that she is not interested inmaking a trade. She says shedoesn’t care much for hip-hop.

Onward the hip-hop artist goes,trying to find someone who willtrade goods for hip-hop. He mightrun into a few people, but we can

be sure that by the end of the daythe hip-hop artist finds it fairly hardto make simple exchanges: a songfor some steak, a song for somefruit, a song for a shirt.

What is likely to happen to thehip-hop artist? He will quickly recog-nize how difficult making trades isand decide to make a lot of what heneeds to survive himself. He mightstart making his own bread and hisown clothes instead of trying to tradehip-hop for each. In short, in a bartereconomy, because trade is so difficultand time consuming, people arelikely to try to produce for themselvesthe things they need. In the end, thehip-hop artist is so busy makingbread, clothes, and so on that hereally doesn’t have much time towork on his hip-hop. As a result, hip-hop is likely to go by the wayside.Soon, he is no longer a hip-hop artist,but just another person producingmany of the things he needs.

The lesson learned? Few peoplewould specialize in a barter econ-omy to the degree they do in amoney economy. After all, what isthe probability that everyone whosegoods you want will want the onething that you produce?

In a money economy, in con-trast, everyone is willing to tradewhat they have for money. The riskin specializing is less than in a barter

economy, so people produce onething (hip-hop songs, attorney serv-ices, corn, and so on), sell it formoney, and then use the money tomake their preferred purchases.

Do you think special-ization is more likely in

a large city (such as New York City)or a small city (some city with apopulation under 7,000 persons forexample)? Explain your answer.Also, do you think the fact that youcan buy goods online makes itmore likely or less likely that you willspecialize? Explain your answer.

THINKABOUT IT

Would You HearHip-Hop in a Barter

Economy???????????????????

Jay-Z on stage. Would Jay-Z be a hip-hop artist in a barter economy?

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of exchange are low compared to what theyare in a barter economy. You have the luxuryof specializing in the production of one thing(fixing faucets, writing computer programs,teaching students), selling that one thing formoney, and then using the money to buywhatever good or service you want to buy.

In only very few places in the worldtoday is barter still practiced. In thoseplaces, you will find that the people have alow standard of material living, and theyare not nearly as specialized as they are inmoney economies.

What Are the ThreeFunctions of Money?

Money has three major functions: amedium of exchange, a unit of account, anda store of value.

Money as a Medium of ExchangeA medium of exchange is anything that

is generally acceptable in exchange for goodsand services. As we have seen, then, the mostbasic function of money is as a medium ofexchange. Money is part of (present in)almost every exchange made.

Money as a Unit of Account A unit of account is a common measure-

ment used to express values. Money func-

tions as a unit of account, which means thatall goods can be expressed in terms ofmoney. For example, we express the value ofa house in terms of dollars (say, $280,000),the value of a car in terms of dollars (say,$20,000), and the value of a computer interms of dollars (say, $2,000).

Money as a Store of ValueA good is a store of value if it maintains

its value over time. Money serves as a storeof value. For example, you can sell yourlabor services today, collect money in pay-ment, and wait for a future date to spend themoney on goods and services. You do nothave to rush to buy goods and services withthe money today; it will store value to beused at a future date.

To say that money is a store of value doesnot mean that it is necessarily a constantstore of value. Let’s say that the only good inthe world is apples, and the price of an appleis $1. Julio earns $100 on January 1, 2006. Ifhe spends the $100 on January 1, 2006, hecan buy 100 apples. Suppose he decides tohold the money for one year, until January 1,2007. Suppose also that the price of applesdoubles during this time to $2. On January1, 2007, Julio can buy only 50 apples. Whathappened? The money lost some of its valuebetween 2006 and 2007. If prices rise, thevalue of money declines.

When economists say that money servesas a store of value, they do not mean toimply that money is a constant store of value,or that it always serves as a store of valueequally well. Money is better at storing valueat some times than at other times. (Money is“bad” at storing value when prices are rap-idly rising.)

For a summarized comparison ofthe three major functions of money, seeExhibit 10-1.

QUESTION: Can money lose its valuevery fast over a short period of time?

ANSWER: Money will lose its value fairlyquickly (and therefore not be a good storeof value) any time prices rise quickly over

260 Chapter 10 Money, Banking, and the Federal Reserve System

� Money lowers thetransaction costs ofmaking exchanges.How much moredifficult would thistransaction bewithout money?

medium of exchangeAnything that is gener-ally acceptable inexchange for goods andservices.

unit of account A common measure-ment used to expressvalues.

store of value Something with the abil-ity to hold value overtime.

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a short period of time. A classic exampleis Germany in 1923 when prices were ris-ing so quickly, and money was losing itsvalue so fast, that workers in Germanywere being paid (with money) threetimes a day. They might be paid in themorning, use the money right away tobuy goods, then be paid in the afternoon,use that money right away to buy goods,and so on. In other words, if they waitedtoo long to use the money they were paid,prices would have risen by so much thatthe amount of money they had wouldn’tbuy much. So they ended up spendingtheir money almost as quickly as theyreceived it.

Who Were the EarlyBankers?

Our money today is easy to carry andtransport, but it was not always that way.For example, when money was principallygold coins, carrying it was neither easy norsafe. Gold is heavy, and transporting thou-sands of gold coins is an activity that couldeasily draw the attention of thieves. Thus,individuals wanted to store their gold in asafe place. The person most individualsturned to was the goldsmith, someone

already equipped with safe storage facili-ties. Goldsmiths were the first bankers.They took in other people’s gold and storedit for them.

To acknowledge that they held depositedgold, goldsmiths issued receipts called ware-house receipts to their customers. For exam-ple, Adam might have a receipt from thegoldsmith Turner stating that he deposited400 gold pieces with Turner. Before long,people began to circulate the warehousereceipts in place of the gold itself (gold wasnot only inconvenient for customers tocarry, but also inconvenient for merchants toaccept). For instance, if Adam wanted to buysomething for 400 gold pieces, he might givea warehouse receipt to the seller instead ofgoing to the goldsmith, obtaining the gold,and then delivering it to the seller. Using thereceipts was easier than dealing with thegold itself for both parties. In short, thewarehouse receipts circulated as money—that is, they became widely acceptable forpurposes of exchange.

Goldsmiths began to notice that on anaverage day, few people came to redeemtheir receipts for gold. Most individualswere simply trading the receipts for goods.At this stage, warehouse receipts were fullybacked by gold. The receipts simply repre-sented, or stood in place of, the actual goldin storage.

261Section 1 The Origins of Money

EX H I B IT 10-1 The Major Functions of MoneyThe Major Functions of Money

DefinitionDefinition

Anything that is generally accept-Anything that is generally accept-able in exchange for goods andable in exchange for goods andservicesservices

An item that maintainsAn item that maintainsvalue over timevalue over time

Common measurementCommon measurementin which valuesin which valuesare expressedare expressed

ExampleExample

John uses money to buy haircuts, books, food, CDs,John uses money to buy haircuts, books, food, CDs,and computers. Money is the medium of exchange.and computers. Money is the medium of exchange.

Phil has a job and gets paid $100. He could use $100Phil has a job and gets paid $100. He could use $100to buy a ski jacket that he wants, but he decides not to.to buy a ski jacket that he wants, but he decides not to.Instead, he saves the $100 and buys the ski jacket six Instead, he saves the $100 and buys the ski jacket six months later. For Phil, money has acted as a store of months later. For Phil, money has acted as a store of value over the six-month period.value over the six-month period.

The price of a candy bar is $1, and the price of a book The price of a candy bar is $1, and the price of a book is $14. The exchange value of both goods is measuredis $14. The exchange value of both goods is measuredby dollars (unit of account). Notice that exchange by dollars (unit of account). Notice that exchangevalues can be compared easily when money is used.values can be compared easily when money is used.In this example, the book has 14 times the exchangeIn this example, the book has 14 times the exchangevalue of the candy bar.value of the candy bar.

Medium ofMedium ofexchangeexchange

Store ofStore ofvaluevalue

Unit ofUnit ofaccountaccount

FunctionFunction

� This table sum-marizes the majorfunctions of money.

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Some goldsmiths, however, began to think,“Suppose I lend out some of the gold thatpeople have deposited with me. If I lend it toothers, I can charge interest for the loan. Andsince receipts are circulating in place of thegold, I will probably never be faced withredeeming everyone’s receipts for gold atonce.” Some goldsmiths did lend out some ofthe gold deposited with them and collectedthe interest on the loans. The consequence ofthis lending activity was an increase in thesupply of money, measured in terms of goldand paper receipts. Remember, both goldand paper warehouse receipts were widelyaccepted for purposes of exchange.

A numerical example can show how thegoldsmiths’ activities increased the supplyof money. Suppose the world’s entire moneysupply is made up of 100 gold coins. Nowsuppose the owners of the gold deposit their

coins with the goldsmith. To keep thingssimple, suppose the goldsmith gives out 1paper receipt for each gold coin deposited.In other words, if Flores deposits 3 coinswith a goldsmith, she receives 3 warehousereceipts, each representing a coin.

The warehouse receipts begin to circulateinstead of the gold itself, so the money sup-ply consists of 100 paper receipts, whereasbefore it consisted of 100 gold coins. Still, thenumber is 100. So far, so good.

Now the goldsmith decides to lend outsome of the gold and earn interest on theloans. Suppose Robert wants to take out aloan for 15 gold coins. The goldsmith grantsthe loan. Instead of handing over 15 goldcoins, though, the goldsmith gives Robert 15paper receipts.

What happens to the money supply?Before the goldsmith went into the lendingbusiness, the money supply consisted of 100paper receipts. Now, though, the moneysupply has increased to 115 paper receipts.The increase in the money supply (as meas-ured by the number of paper receipts) is aresult of the lending activity of the gold-smith.

The process described here was the begin-ning of fractional reserve banking. We liveunder a fractional reserve banking systemtoday. Under a fractional reserve banking sys-tem, such as the one that currently operates inthe United States, banks (like the goldsmithsof years past) create money by holding onreserve only a fraction of the money depositedwith them and lending the remainder.

262 Chapter 10 Money, Banking, and the Federal Reserve System

� A goldsmith’sshop of the sixteenthcentury. Why weregoldsmiths amongthe first to becomebankers?

Defining Terms1. Define:

a. barter economyb. transaction costsc. moneyd. medium of exchangee. unit of accountf. store of valueg. fractional reserve

banking

Reviewing Facts andConcepts2. What gives money its

value?3. Money serves as a unit of

account. Give an exampleto illustrate what thismeans.

4. What does it mean to saythat the United States hasa fractional reserve bank-ing system?

Critical Thinking5. Is specialization in a

money economy more orless likely to happen thanin a barter economy?

fractional reservebankingA banking arrangementin which banks hold onlya fraction of theirdeposits and lend outthe remainder.

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What Are the Componentsof the Money Supply?

The most basic money supply—some-times referred to as M1 (M-one)—consistsof three components we will soon identify.Other “money supplies” besides M1 includea broader measure of the money supplycalled M2 (M-two). For purposes of sim-plicity, when we discuss the money supply inthis text, we are referring to M1. The M1 inthe United States is composed of (1) cur-rency, (2) checking accounts, and (3) trav-eler’s checks.

1. Currency. Currency includes both coins(such as quarters and dimes) minted bythe U.S. Treasury and paper money. Thepaper money in circulation consists ofFederal Reserve notes. If you look at adollar bill, you will see at the top thewords “Federal Reserve Note.” TheFederal Reserve System, which is thecentral bank of the United States (dis-cussed in a later section), issues FederalReserve notes.

263Section 2 The Money Supply

The Money Supply

Focus Questions� What does the money supply consist of?� What is a Federal Reserve note?� What is and what is not “money”?� What causes interest rates to change?

Key Termsmoney supply currencyFederal Reserve notedemand depositsavings accountnear-moneyloanable funds market

2. Checking accounts. Checking accountsare accounts in which funds aredeposited and can be withdrawn sim-ply by writing a check. Sometimeschecking accounts are referred to asdemand deposits, because the fundscan be converted to currency ondemand and given to the person towhom the check is made payable. Forexample, suppose Malcolm has achecking account at a local bank with abalance of $400. He can withdraw up to$400 currency from his account, or hecan transfer any dollar amount up to$400 to someone else by simply writinga check to that person.

3. Traveler’s checks. A traveler’s check is acheck issued by a bank in any of severaldenominations ($10, $20, $50, and soon) and sold to a traveler (or to anyonewho wishes to buy it), who signs it atthe time it is issued by the bank andthen again in the presence of the personcashing it.

In August 2005, $710 billion in currencywas in circulation, along with $619 billion in

money supplyThe total supply ofmoney in circulation,composed of currency,checking accounts, andtraveler's checks.

currencyCoins issued by the U.S.Treasury and papermoney (called FederalReserve notes) issued bythe Federal ReserveSystem.

Federal Reserve notePaper money issued bythe Federal ReserveSystem.

demand depositAn account from whichdeposited funds can bewithdrawn in currency ortransferred by a check toa third party at the initia-tive of the owner.

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checking accounts, and $7 billion in trav-eler’s checks. Altogether, the money supplyequaled $1,336 billion (see Exhibit 10-2).

You might be wondering why debit cardsaren’t mentioned; after all, you can buyproducts with a debit card in the same waythat you can with currency. Do you see whythe debit cards aren’t included in our list?They are already represented in checkingaccounts. When you use a debit card,money is removed from your checkingaccount in the same way that it is when youwrite a check.

Another card that some people might inthe future think of as currency are smartcards. A smart card resembles a credit card inshape and size, but it is not just a simplepiece of plastic the way a credit card is.Inside it is an embedded 8-bit microproces-sor. A smart card can be used for manythings, and it can hold significant amountsof data. For purposes here, though, we needto point out that a monetary value can beplaced on a smart card (much like a mone-tary value can be placed on a card at a videoarcade), and then the card can be used tomake on-the-spot purchases, much like cur-rency is used for the same thing.

QUESTION: I am used to thinking thatonly the cash and change I have in mywallet is money. Are we saying cash isonly one component of money?

ANSWER: Yes, that is exactly what we aresaying. Remember that money is any-thing that is widely accepted inexchange and in the repayment of debt.The cash and change in your wallet (thecurrency in your wallet) is widelyaccepted in exchange and in the repay-ment of debt, so it is money. The checkyou might write out for $100 is alsoaccepted in exchange and in the repay-ment of debt, so it is money. Traveler’schecks are also widely accepted inexchange and in the repayment of debt,so they are money too. In summary,money consists of currency plus checkingaccounts plus traveler’s checks.

Is a Savings Account Money?A savings account is an interest-

earning account. For example, if you have$400 in your savings account and theannual interest rate you are paid is 6 per-cent, in a year your savings account willincrease to $424. With some savingsaccounts, you can write checks; others youcannot. Savings accounts on which you canwrite checks fall into the category of check-ing accounts, which were discussed earlier.A passbook savings account is an exampleof a nonchecking savings account. Whenyou deposit your money into a passbooksavings account, you are given a smallbooklet in which deposits, withdrawals,and interest are recorded.

A nonchecking savings account is notconsidered money because it is not widelyaccepted for purposes of exchange. No per-son can go into a store, show the sales-person the balance in a passbook savingsaccount, and buy a $40 sweater. However,nonchecking savings accounts are consid-ered near-money. Near-money is anythingthat can be relatively easily and quicklyturned into money. A person cannot buy asweater by telling the salesperson that shehas so much “money” in her passbook sav-ings account, but she can go to the bankand request that her nonchecking savingsbe returned to her in currency (“I’ll take itin twenties”).

264 Chapter 10 Money, Banking, and the Federal Reserve System

� The money sup-ply consists of cur-rency, checkingaccounts (balances),and traveler’s checks.The amounts shownrepresent the moneysupply in August2005.

savings accountAn interest-earningaccount.

near-moneyAssets, such asnonchecking savingsaccounts, that can beeasily and quickly turnedinto money.

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Are Credit Cards Money?You’re out on a Friday night with your

friends eating pizza. Someone asks, “Anyonehere got any money?”You say,“I have a creditcard.” Your friends say, “Good enough.”

Is a credit card money? After all, it isoften referred to as “plastic money,” andmost retailers accept credit cards as pay-ment for purchases. On closer examina-tion, we can see that a credit card is notmoney.

Consider Tina, who decides to buy apair of shoes. She hands the shoe clerk herVisa card and signs for the purchase.Essentially, what the Visa card allows Tinato do is take out a loan from the bank thatissued the card. The shoe clerk knows thatthis bank has, in effect, promised to pay thestore for the shoes. At a later date, the bankwill send Tina a credit card bill. At thattime, Tina will be required to reimbursethe bank for the shoe charges, plus interest(if her payment is made after a certaindate). Tina is required to discharge herdebt to the bank with money, such as cur-rency or a check written on her checkingaccount.

Can you see that a credit card is notmoney? Money has to be both widely usedfor exchange and be used in the repaymentof debt. A credit card is not used to repaydebt but rather to incur it. It is an instru-ment that makes it easier for the holder to

265Section 2 The Money Supply

The money supply has been increasing inthe United States over time. The following

table shows the money supply figures for theyears 1989–2005. (The figure for 2005 wasreported in August 2005.) All numbers are inbillions of dollars. Is the money supply in afollowing year always higher than the moneysupply in a prior year? If you want to find themost recent money supply figures, you cango to www.emcp.net/federalreserve and clickon Table 1.

Money supplyYear (billions of dollars)

1989 $ 793

1990 825

1991 897

1992 1,025

1993 1,129

1994 1,150

1995 1,126

1996 1,079

1997 1,072

1998 1,094

1999 1,122

2000 1,087

2001 1,179

2002 1,216

2003 1,299

2004 1,367

2005 1,336

� Today, if youhave near-money,you can quickly andeasily turn it intomoney, either at thebank or throughyour online bankingservice. What isnear-money?

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obtain a loan. The use of a credit card placesa person in debt, which he or she then has torepay with money.

Don’t think of the card as moneybecause it isn’t money. Think of it as whatit is—a piece of plastic that allows you totake out a loan from the bank that issuedthe card.

In other words, when you hand the creditcard to the cashier to pay for the pizza, orshoes, or new CD, it is you and the bankstanding up there in front of the cashier—notjust you alone. The bank is saying to you,“Here, we are going to lend you some ‘money’to pay for the item. Oh, and by the way, wewant you to pay us back later, with interest.”

To get a better understanding of creditcards, turn to page 268 and read about“The Psychology of Credit Cards” in the“Your Personal Economics” feature.

Borrowing, Lending, andInterest Rates

As you know, when a person uses a creditcard, he or she is actually borrowing fundsfrom a bank. In other words, the person is aborrower and the bank is a lender. Often,when loans are made, an interest rate mustbe paid for the loan.

Now if we look at interest rates (for loans)over time, we see that sometimes interestrates are higher than at other times. Forexample, in the 1970s, interest rates wererelatively high. In 2004, interest rates wererelatively low.

Why are interest rates high at some timesand low at other times? The answer has to dowith supply and demand, which you learnedabout in Chapters 4 through 6. Interest ratesare determined in the loanable funds

266 Chapter 10 Money, Banking, and the Federal Reserve System

During World War II, anAmerican, R. A.

Radford, was captured andimprisoned in a prisoner ofwar (POW) camp. During hisstay, he noted that the Red Crosswould periodically distribute to theprisoners packages that containedgoods such as cigarettes, toiletries,chocolate, cheese, margarine, andtinned beef. Not all the prisonershad the same preferences: someliked chocolate but did not like ciga-rettes, whereas others liked ciga-

rettes but did not like cheese. Soon,the prisoners began to barter-tradewith each other. One prisoner, whohad cigarettes and wanted morechocolate, would try to find anotherprisoner who wanted less chocolateand more cigarettes.

As this chapter explained, barteris a more time-consuming and diffi-cult way to trade than trading withmoney. Soon the prisoners nolonger bartered goods; they usedmoney instead. The money was notU.S. dollars, French francs, Germanmarks, or British pounds. In fact, itwas not any national money at all;cigarettes emerged as the money inthe POW camp. They were widelyaccepted for purposes of exchange.Soon chocolate bars, cheese, andother goods were quoted in “ciga-rette prices”: 10 cigarettes for achocolate bar, 20 cigarettes forcheese, and so on.

Why did the cigaretterather than the choco-

late or cheese become money?

THINKABOUT IT

???What Is Money

in a Prisoner of

War Camp?

loanable funds market The market for loans.There is a demand forloans (stemming fromborrowers) and a supplyof loans (stemming fromlenders). It is in the loan-able funds market wherethe interest rate isdetermined.

� Cigarettes weremoney in prisonerof war camps.

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market in much the same way that appleprices are determined in the apple market,computer prices are determined in the com-puter market, and house prices are deter-mined in the housing market.

The loanable funds market includes ademand for loans and a supply of loans.The demanders of loans are called borrow-ers; the suppliers of loans are called lenders.Through the interaction of the demand forand supply of loans, the interest rate isdetermined.

What happens if the demand for loansrises? Obviously, if the demand for loansrises and the supply remains constant, theprice of a loan, which is the interest rate,rises. What happens if the demand for loansfalls? The interest rate falls. What happens ifthe supply of loans rises? The interest rate

falls. What happens if the supply of loansfalls? The interest rate rises.

Sometimes people make a distinctionbetween short-term interest rates and long-term interest rates. The terms short andlong refer to the time period of the loan. Forexample, if you were totake out a six-monthloan, it would likely bereferred to as a short-term loan, in contrast to,say, a 30-year loan, whichwould be referred to as along-term loan. The interest rate you paid(as a borrower) for the six-month loanwould be referred to as a short-term inter-est rate; the interest rate you paid for the30-year loan would be referred to as a long-term interest rate.

267Section 2 The Money Supply

� Credit cards arenot money—theycannot be used torepay debt. What isthe relationshipbetween creditcards and debt?

Defining Terms1. Define:

a. money supplyb. currencyc. Federal Reserve noted. demand deposite. savings accountf. near-money

Reviewing Facts andConcepts2. What is the official name

for a “dollar bill”? (Hint:

Look at a dollar bill andsee what is written atthe top.)

3. What is the differencebetween near-money andmoney?

Critical Thinking4. Credit cards are widely

accepted for purposes ofexchange, yet they are notmoney. Why not?

Applying EconomicConcepts5. Take a look at a Federal

Reserve note. On it, youwill read the followingwords: “This note is legaltender for all debts, publicand private.” What part ofthe definition of moneydoes this message refer to?

“There is only one way to have

your cake and eat it too: Lend

it out at interest.”

— Anonymous

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If you work to earn $50, do youuse the money in the same way

that you would use a $50 gift? Manyeconomic studies show that peopleoften are more serious with moneythey earn than with money they winor receive as a gift. In reality, a dollaris a dollar is a dollar, no matter fromwhere it came. But in everyday life,we see a dollar earned as somehowdifferent from a dollar won.

$100 “Out the Window”Suppose you plan to go to a con-

cert, and the ticket costs $100. Youbuy the ticket on Monday to attendthe concert on Friday. When Fridaynight comes, you realize you lost theticket. Assuming that tickets are stillavailable, do you buy another?Answer the question before readingfurther.

Now let’s change the circum-stances. Suppose instead of buyingthe ticket on Monday, you plan tobuy it on Friday, right before the con-

cert. At the ticket window on Fridaynight, you realize that on your way tothe concert you lost $100 out of yourwallet. You brought plenty of moneyso you still have enough to buy theticket. Do you buy it?

The Economist Says…According to economists, the two

settings present you with the samechoice. In both settings, you have tospend another $100 to see the con-cert. Because the two settings pre-sent you with the same choice,economists argue that you willbehave the same in the two settings.If you decide not to buy anotherticket in the first setting, then youshouldn’t in the second. If you dodecide to buy another ticket in thefirst setting, then you should in thesecond.

But in Real Life…People don’t seem to behave the

way that economists predict, how-ever. Many people, when asked thetwo questions in this example, saythat they will not buy a second ticketif they lost the first ticket, but they willbuy a ticket if they lost $100. Why?These people argue that spending anadditional $100 on an additionalticket is like spending $200 to seethe concert, which is too much topay. However, they don’t see them-selves spending $200 to see the con-cert when they lose $100 on the wayto the concert and pay $100 for aticket. To these people, the situationsare completely different.

Economists say that the peoplewho answer the two questions differently—although both settingsoffer the same basic choice—arecompartmentalizing. They are treat-ing two $100 amounts differently, as if they come from two differentcompartments. The concert ticketexample shows that people do com-partmentalize when it comes tomoney. They don’t always treat a dollar in the same way.

Cash Versus Credit CardsWith this example in mind, let’s

compare using cash to using a creditcard. Say a person has $500 in cashand a credit card in her wallet. Shewants to purchase something thatcosts $480. She could use the cashto make the purchase, or she couldput the purchase on her credit card(and pay off the credit card later). Inthis situation, many people will saythat it is somehow easier to use thecredit card than to pay cash. Whenthey pay cash, they say, they have aharder time making the decision topurchase the item. Somehow itseems more real to them; somehowthe purchase seems more expensive.

You and Your Lending PartnerIt may be easier to use a credit

card than to pay cash, but it certainlyis not cheaper. In fact, it can be moreexpensive. If you don’t pay creditcard balances off monthly, you willend up paying interest on the loanthe bank provided you via your creditcard purchase.

The Psychology of Credit Cards

268 Chapter 10 Money, Banking, and the Federal Reserve System

� If you lost your ticket to thisconcert, would you buy another?

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269Chapter 10 Money, Banking, and the Federal Reserve System

In a sense, when you buy some-thing with a credit card, two people,not one, stand in front of the cashiermaking the purchase. First is you,handing over your credit card. Plus,“standing” next to you, is “your part-ner” representing the bank. Thisimaginary partner is there with you,issuing you a loan to make the pur-chase with the credit card. Later, your“ partner” from the bank will comeback to you and ask to be repaid forthe loan, with interest. In other words,a $100 item will cost you $100 if youpay in cash, but it could cost you$110 if you pay with a credit card($100 for the purchase and $10interest paid for the $100 loan).

An Expensive LessonMaking a credit card purchase

might be easier (for you) than a cashpurchase of the same denomination,but often it is a costlier purchase. Notrealizing this can lead to seriousfinancial trouble, as far too manypeople have learned the hard way.

Consider Kevin (a real personwhose name has been changed).He went off to college with a credit

card. The first two months at collegehe used the credit card for all hispurchases—many purchases. Kevinpurchased new clothes, took hisfriends out to eat regularly, andbought an expensive television forhis dorm room.

When Kevin received the creditcard bill, he was shocked at just howmuch he had spent. (It seemed soeasy to spend when he was out withhis friends having a good time.) Hesaid he felt as if someone else had

spent the money. In his words, “It feltlike I was getting things for free.”Now Kevin certainly was smartenough to know that he wasn’t get-ting anything for free, but he wasn’tstating what he knew, he was tellingus how he felt. Looking back, he real-ized his compartmentalizing causedhim to buy a lot more than he wouldhave if he paid in cash. In the end hehad to work many more hours (thanhe had wanted to) to pay off hiscredit card bill.

My Personal Economics Action Plan

Here are some points you may want to consider and some

guidelines you might want to put into practice.

❑✔1. Someone once said that if you know where the holes are,

you are less likely to step in them. Does this observation

apply to credit cards? If you know that credit cards can

be abused, then you are less likely to get into financial

trouble with credit cards.

I will not use a credit card instead of a check or cash until I

am ______ years old and have proven to myself that I am

financially responsible.

❑✔2. Keep in mind that people do sometimes compartmental-

ize. For them, a dollar is not always a dollar. The truth of

the matter is, people are deceiving themselves: A

dollar is a dollar is a dollar.

In the future, I will spend only ______ percent of money

gifts I receive, and I will save ______ percent.

❑✔3. If you use a credit card to buy something that costs

$100, you may end up paying more than $100 for the

item. Generally speaking, using a credit card to buy some-

thing makes that something costlier than using cash.

I will not use a credit card unless I know for sure that I will

be able to pay my bill in full when it comes.

� You must either pay for somethingwhen you buy it or pay later. If you paylater, you often pay more.

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What Is the Federal ReserveSystem?

In 1913, Congress passed the FederalReserve Act. This act set up the FederalReserve System, which began operation in1914. (The popular name for the FederalReserve System is “the Fed.”) The Fed is acentral bank, which means it is the chiefmonetary authority in the country. A centralbank has the job of determining the moneysupply and supervising banks, among otherthings. Today, the principal components ofthe Federal Reserve System are (1) the Boardof Governors, and (2) the 12 Federal Reservedistrict banks.

Board of GovernorsThe Board of Governors of the Federal

Reserve System controls and coordinatesthe Fed’s activities. The board is made upof seven members, each appointed to a 14-year term by the president of the UnitedStates with Senate approval. The presidentalso designates one member as chairpersonof the board for a 4-year term. The Board

270 Chapter 10 Money, Banking, and the Federal Reserve System

The Federal Reserve System

Focus Questions � What is the Federal Reserve System

(the Fed)?� How many persons sit on the Board of

Governors of the Federal Reserve System?� What are the major responsibilities of the

Federal Reserve System?� How does the check-clearing process work?

Key Terms Federal Reserve System (the Fed)Board of Governors of the Federal Reserve

SystemFederal Open Market Committee (FOMC)reserve account

of Governors is located at 20th Street andConstitution Avenue in Washington, D.C.

QUESTION: Do other countries have aFederal Reserve System?

ANSWER: As stated earlier, the FederalReserve System is a central bank, andother countries do have central banks.Whereas we, in the United States, callour central bank the Federal ReserveSystem, in most other countries the cen-tral bank is either called “the centralbank” or “the bank” of that particularcountry. For example, the Bank of Japan,the Bank of Ghana, the Central Bank ofIceland, and so on.

The 12 Federal Reserve District BanksThe United States is broken up into 12

Federal Reserve districts. Exhibit 10-3 showsthe boundaries of these districts. Each districthas a Federal Reserve district bank. (Think ofthe Federal Reserve district banks as “branch

Federal Reserve System(the Fed)The central bank of theUnited States.

Board of Governors ofthe Federal ReserveSystemThe governing body ofthe Federal ReserveSystem.

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offices” of the Federal Reserve System.) Eachof the 12 Federal Reserve district banks has apresident. Which Fed district do you live in?

An Important Committee: The FOMCThe major policy-making group within

the Fed is the Federal Open MarketCommittee (FOMC). A later part of thischapter will consider what the FOMC does,but for now you need only note that theFOMC is made up of 12 members. Seven ofthe 12 members are the members of theBoard of Governors. The remaining fivemembers come from the ranks of the presi-dents of the Federal Reserve district banks.

What Does the Fed Do?The following is a brief description of six

major responsibilities of the Fed.

1. Control the money supply. A full explana-tion of how the Fed controls the moneysupply comes later in the chapter.

2. Supply the economy with paper money(Federal Reserve notes). As stated in anearlier section, the pieces of papermoney we use are Federal Reserve notes.Federal Reserve notes are printed at theBureau of Engraving and Printing inWashington, D.C. The notes are issuedto the 12 Federal Reserve district banks,

271

1

Boston2

New York

3Philadelphia

EX H I B IT 10-3 Federal Reserve Districts and Federal Reserve Bank LocationsFederal Reserve Districts and Federal Reserve Bank Locations

9

sMMinneapoli

Alaska andHawaii are partof the San Francisco District

7Chhicago

10

Kansas City

12

San Frraanciscora

Cleveland

4

8

11Dallas

6

ntaAttlan

5Richmond

Board of Governors(Washington, D.C.)

St. LoouisLouis

� The FederalReserve Board con-trols the nation’smoney supply, butthe Fed does notactually print money.What governmentagency is respon-sible for printingour paper money?

Federal Open MarketCommittee (FOMC) The 12-member policy-making group within theFed. This committee hasthe authority to conductopen market operations.

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which keep the money on hand to meetthe demands of the banks and the pub-lic. For example, suppose it is the holi-day season, and people are going to theirbanks and withdrawing greater thanusual numbers of $1, $5, and $20 notes.Banks need to replenish their supplies ofthese notes, and they turn to theirFederal Reserve district banks to do so.

The Federal Reserve district banks meetthis cash need by supplying more papermoney. (Remember, the 12 FederalReserve district banks do not print thepaper money; they only supply it.)

3. Hold bank reserves. Each commercialbank that is a member of the FederalReserve System is required to keep areserve account (think of it as a check-ing account) with its Federal Reservedistrict bank. For example, a banklocated in Durham, North Carolina,would be located in the fifth FederalReserve district, which means it dealswith the Federal Reserve Bank ofRichmond (Virginia). The local bank inDurham must have a reserve account,or checking account, with this reservebank. Soon we will see what role abank’s reserve account with the Fedplays in increasing and decreasing themoney supply.

4. Provide check-clearing services. Whensomeone in Miami (Florida) writes acheck to a person in Savannah(Georgia), what happens to the check?The process by which funds changehands when checks are written is calledthe check-clearing process. The Fedplays a major role in this process.Here is how it works (see Exhibit 10-4):

a. Suppose Harry writes a $1,000 checkon his Miami bank and sends it bymail it to Ursula in Savannah. Torecord this transaction, Harryreduces the balance in his checkingaccount by $1,000. In other words,if his balance was $2,500 before hewrote the check, it is $1,500 after hewrote the check.

b. Ursula receives the check in the mail.She takes the check to her localbank, endorses it (signs it on theback), and deposits it into her check-ing account. The balance in heraccount rises by $1,000.

c. Ursula’s Savannah bank sends thecheck to its Federal Reserve districtbank, which is located in Atlanta.The Federal Reserve Bank of Atlantaincreases the reserve account of the

272 Chapter 10 Money, Banking, and the Federal Reserve System

You can read the bios of themembers of the Board ofGovernors at www.emcp.net/

Board. The Fed operates an educa-tional Web site at www.emcp.net/federalreserveeducation. Gothere and click “American Currency Exhibit” to see some ofthe various currencies used in the United States at varioustimes. You may want to click “In Plain English: Making Senseof the Federal Reserve.”

Banks BecomingPartners As the globalization trend con-tinues, countries will open up

their banking sectors to the out-side world. For example, on April 21,

2005, the Hangzhou City CommercialBank, a local bank in Zhejiang Province, east China,and the Commonwealth Bank of Australia signed anagreement on strategic cooperation. The Australianbank purchased a 19.9 percent interest in the Chinesebank for 625 million yuan ($75 million). One of thereasons an Australian bank might want to be partnerswith a Chinese bank is because lending activities mightbe more advantageous (at some points in time) inChina than in Australia.

What might stimulate more of these typesof bank partnerships in the future?

ECONOMICTHINKING

reserve account A bank’s checkingaccount with its FederalReserve district bank.

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Savannah bank (Ursula’s bank) by$1,000 and decreases the reserveaccount of the Miami bank (Harry’sbank) by $1,000.

d. The Federal Reserve Bank of Atlantasends the check to Harry’s bank inMiami, which then reduces the bal-ance in Harry’s checking account by$1,000. Harry’s bank in Miami eitherkeeps the check on record or sends italong to Harry with his monthlybank statement.

5. Supervise member banks. Without warn-ing, the Fed can examine the books ofmember commercial banks to see whatkind of loans they made, whether theyfollowed bank regulations, how accu-rate their records are, and so on. If theFed finds that a bank has not followedestablished banking standards, it canpressure the bank to do so.

6. Serve as the lender of last resort. A tradi-tional function of a central bank is toserve as the “lender of last resort” forbanks suffering cash managementproblems. For example, let’s say thatbank A lost millions of dollars and findsit difficult to borrow from other banks.At this point, the Fed may step in andact as lender of last resort to bank A. Inother words, the Fed may lend bank Athe funds it wants to borrow when noone else will.

273Section 3 The Federal Reserve System

EXHIB IT 10-4

Harry Jones1234 Anywhere

Miami, FL 91005

P ay tothe order ofayy

West Bank of California

5678 Cashier Ave.

Miami, FL

16-4

52

$

19

The Check-Clearing ProcessThe Check-Clearing Process

Harry and UrsulaHarry writes a $1 000 check

2.

3.

Ursula‘s local (Savannah) banksends the check to the FederalReserve Bank of Atlanta, which

increases the reserve account ofthe Savannah bank by $1,000 anddecreases the reserve account of

the Miami bank by $1,000.

4.

ythen reduces the balance in Harry‘s account by $1,000.

� An example showing how the check-clearing process works.

Defining Terms1. Define:

a. Federal Open MarketCommittee (FOMC)

b. Federal ReserveSystem (the Fed)

c. Board of Governors ofthe Federal ReserveSystem

d. reserve account

Reviewing Facts andConcepts2. In what year did the Fed

begin operating?3. Explain how a check is

cleared.4. What does it mean when

we say the Fed is thelender of last resort?

Critical Thinking5. Economists speak about

printing, issuing, andsupplying paper money.

Are these different func-tions? Where is eachfunction performed?

Applying EconomicConcepts6. Do you think banks need

the Fed to act as “lenderof last resort” more oftenduring good economictimes or bad economictimes? Explain youranswer.

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Different Types of ReservesHere you are going to learn how the

money supply in the United States isincreased (more money) and decreased (lessmoney). Before you can understand the dif-ference, it is important to know the differenttypes of a bank’s reserves. The followingpoints and definitions are crucial to anunderstanding of how the money supplyrises and falls.

1. The previous section mentioned thateach member bank has a reserveaccount, which is simply a checkingaccount that a commercial bank haswith its Federal Reserve district bank. Ifwe take the dollar amount of a bank’sreserve account and add it to the cashthe bank has in its vault (called, simplyenough, vault cash), we have the bank’stotal reserves.

Total reserves � Deposits in the reserve accountat the Fed � Vault cash

The president of bank A, asmall commercial bank, notes that the bank

E X A M P L E :

274 Chapter 10 Money, Banking, and the Federal Reserve System

The Money Creation Process

Focus Questions� What do total reserves equal?� What are required reserves? Excess

reserves?� How do banks use checking accounts to

increase the money supply?� What do banks do with excess reserves?� Knowing the reserve requirement, how can

you calculate the maximum change in themoney supply resulting from bank loans?

Key Termstotal reservesrequired reservesreserve requirementexcess reserves

has $15 million in its (bank) vault. (In otherwords, if the bank were robbed right now,the most the thieves would get is $15 mil-lion.) The bank president also notes thatthe bank has $10 million in its reserveaccount at the Fed. If we add the vault cashof $15 million (the money in the vault) tothe $10 million deposit in the reserveaccount, we get a total of $25 million. Thisdollar sum—$25 million—is the bank’stotal reserves. �

2. A bank’s total reserves can be dividedinto two types: required reserves andexcess reserves. Required reserves arethe amount of reserves a bank musthold against its checking accountdeposits, as ordered by the Fed. Forexample, suppose bank A holds check-ing account deposits (checkbookmoney) for its customers totaling$100 million. The Fed requires,through its reserve requirement, thatbank A hold a percentage of this totalamount in the form of reserves—thatis, either as deposits in its reserveaccount at the Fed or as vault cash

total reserves The sum of a bank’sdeposits in its reserveaccount at the Fed andits vault cash.

required reserves The minimum amountof reserves a bank musthold against its depositsas mandated by the Fed.

reserve requirement The regulation thatrequires a bank to keepa certain percentage ofits deposits in its reserveaccount with the Fed orin its vault as vault cash.

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(because both of these are reserves). Ifthe reserve requirement is 10 percent,bank A is required to hold 10 percentof $100 million, or $10 million, in theform of reserves. This $10 million iscalled required reserves.

Required reserves �Reserve requirement � Checking account deposits

3. Excess reserves are the differencebetween total reserves and requiredreserves. For example, if total reservesequal $25 million and required reservesequal $10 million, then excess reserveswould be $15 million. See Exhibit 10-5for a review of these points.

4. Banks can make loans with their excessreserves. For example, if bank A hasexcess reserves of $15 million, it canmake loans of $15 million.

(You may not realize it, but you just read avery short but very important section ofthis chapter. In this section you were intro-duced to four new terms—total reserves,required reserves, reserve requirement, andexcess reserves. If you are not absolutelysure what each term refers to, you should goback and read this section again. These fourterms will be used often in the discussionthat follows. You don’t want to be in thethick of the discussion asking yourself,“What are required reserves again?”)

How Banks Increase theMoney Supply

Earlier we said that the money supply isthe sum of three components: currency(coins and paper money), checking accountdeposits, and traveler’s checks. For example,$710 billion in currency, $619 billion inchecking account deposits, and $7 billion intraveler’s checks mean that the money supplyis $1,336 billion. You will recall that checkingaccount deposits are sometimes referred to asdemand deposits because a checking accountcontains funds that can be withdrawn notonly by a check but also on demand.

Banks (such as your local bank down thestreet) are not allowed to print currency.Yourbank cannot legally print a $10 bill. (No mat-ter how hard you look, you are not going tofind a money-printing machine in the bank.)However, banks can create checking accountdeposits (checkbook money), and if they do,they increase the money supply. The follow-ing discussion explains the process.

Creating Checking Account DepositsTo see how banks use checking account

deposits to increase the money supply, let’simagine a fictional character named Fred.(His name rhymes with Fed for a reason youwill learn later.) Fred is somewhat of a magi-cian: he can snap his fingers and create a$1,000 bill out of thin air. On Monday

275Section 4 The Money Creation Process

E X H I B I T 10-5 Reserves: Total, Required, and ExcessReserves: Total, Required, and Excess

What it equalsWhat it equals

Total reserves = Deposits in theTotal reserves = Deposits in the

reserve account at the Fed +reserve account at the Fed +

Vault cashVault cash

Excess reserves = Total reserves Excess reserves = Total reserves ––

Required reservesRequired reserves

Required reserves = ReserveRequired reserves = Reserve

requirementrequirement �� Checking Checking

account depositsaccount deposits

Numerical exampleNumerical example

Deposits in the reserve account = $10 millionDeposits in the reserve account = $10 million

Vault cash = $15 millionVault cash = $15 million

Total reserves = $25 millionTotal reserves = $25 million

Total reserves = $25 millionTotal reserves = $25 million

Required reserves = $10 millionRequired reserves = $10 million

Excess reserves = $15 millionExcess reserves = $15 million

Reserve requirement = 10%Reserve requirement = 10%

Checking account deposits = $100 millionChecking account deposits = $100 million

Required reserves = $10 millionRequired reserves = $10 million

Total reservesTotal reserves

Excess Excess

reservesreserves

RequiredRequired

reservesreserves

Kind of reservesKind of reserves

� A summary of thedifferent types ofreserves.

excess reserves Any reserves heldbeyond the requiredamount.

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morning at 9:00, outside bank A, Fred snapshis fingers and creates a $1,000 bill. He imme-diately walks into the bank, opens up a check-ing account, and tells the banker that he wantsthe $1,000 deposited into his checkingaccount. The banker gladly complies. Entry(a) in Exhibit 10-6 shows this deposit.

Now what does the bank physically dowith the $1,000 bill? It places it into its vault,which means the money found its way intovault cash, which is part of total reserves.(Total reserves � Deposits in the reserveaccount at the Fed � Vault cash.) Thus, ifvault cash goes up by $1,000, total reservesincrease by the same amount. (If you need tocheck back to the earlier equations to see thistotal, do it now.)

To keep things simple, let’s assume thatbank A had no checking account depositsbefore Fred walked into the bank. Now it has$1,000. Also, let’s say that the Fed set thereserve requirement at 10 percent. What arebank A’s required reserves? Required reservesequal the reserve requirement multiplied bychecking account deposits. Bank A’s $1,000

� 10 percent � $100, which is the amountbank A has to keep in reserve form—eitherin its reserve account at the Fed or as vaultcash. Look at entry (b) in Exhibit 10-6.

Currently, however, bank A has morethan $100 in its vault; it has the $1,000 thatFred handed over to it. What, then, do itsexcess reserves equal? Because excessreserves equal total reserves minus requiredreserves, it follows that the bank’s excessreserves equal $900, the difference between$1,000 (total reserves) and $100 (requiredreserves), as in entry (c) in Exhibit 10-6.

What Does the Bank Do with Excess Reserves?

What does bank A do with its $900 inexcess reserves? It creates new loans with themoney. For example, suppose Alexi walksinto bank A and asks for a $900 loan. Theloan officer at the bank asks Alexi what shewants the money for. She tells the loan offi-cer she wants a loan to buy a television set,and the loan officer grants her the loan.

276 Chapter 10 Money, Banking, and the Federal Reserve System

EX H I B IT 10-6 The Banking System Creates Demand Deposits (Money)The Banking System Creates Demand Deposits (Money)

New checkingNew checkingaccount depositsaccount deposits(new reserves)(new reserves)

RequiredRequiredreservesreserves

Excess reserves, new loans,Excess reserves, new loans,or new bank-created or new bank-created

checking account depositschecking account deposits

BankBank

AA

BB

CC

DD

EE

TotalsTotals

$1,000$1,000

$900$900

$810$810

$729$729

$10,000$10,000

$100$100

$90$90

$81$81

$72.90$72.90

$1,000$1,000

$900

$810$810

(a)(a)

(d)(d)

(b)(b)

(e)(e)

(c)(c)

(f(f))

$729$729

$656.10$656.10

$9,000$9,000

CreatedCreatedby Fredby Fred

Created byCreated bybanking systembanking system

Created by FredCreated by Fredand banking systemand banking system

$1,000$1,000 $9,000$9,000 $10,000$10,000+ =

This amount was created by the banks.

This amount was created by Fred.

� Follow this dia-gram and the expla-nation in the text tosee how banksincrease the moneysupply.

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Some people may think that at this pointthe loan officer of the bank simply walksover to the bank’s vault, takes out $900 incurrency, and hands it to Alexi. It does nothappen this way. Instead, the loan officeropens up a checking account for Alexi atbank A and informs her that the balance inthe account is $900. See entry (c) in Exhibit10-6. In other words, banks give out loansin the form of checking account deposits.(This point is important to remember aswe continue.)

What has bank A done by opening up achecking account (with a $900 balance) forAlexi? It has, in fact, increased the moneysupply by $900. Remember that the moneysupply consists of (1) currency, (2) check-ing account deposits, and (3) traveler’schecks. When bank A opens up a checkingaccount (with a balance of $900) for Alexi,the dollar amount of currency has notchanged, nor has the dollar amount of trav-eler’s checks. The only thing that haschanged is the dollar amount of checkingaccount deposits, or checkbook money. It is$900 higher, so the money supply is $900higher, too.

At this point you might ask,“But isn’t the$900 Alexi receives from the bank part of themoney that Fred deposited in the bank?” Tosay that Fred does not have the $1,000 any-more, but Alexi has $900 of it, is not exactlycorrect. Fred does not have the $1,000 incurrency anymore, but he does still have$1,000. In other words, he doesn’t have the$1,000 on him, in his wallet. It is now in thebank vault. He does have a checking accountwith a balance of $1,000. Alexi now has $900in her checking account as well, an addi-tional $900, created by the bank, that did notexist before.

QUESTION: Does the bank have to createa loan with its excess reserves?

ANSWER: No, it does not have to createa loan with its excess reserves, but lend-ing money is what banks do. That ishow banks generate income. A bank is abusiness like any other business, trying

to make a profit. Banks extend loans tocustomers to earn income in much thesame way that a farmer grows and sellscorn to earn an income. If a bank wereto hold on to its excess reserves, it wouldbe ignoring an opportunity to earnincome.

What Happens After a Loan IsGranted?

So far, Alexi is given a loan in the form ofa $900 balance in a new checking account.She now goes to a retail store and buys a$900 television set. She pays for the set bywriting out a check for $900 drawn on bankA. She hands the check to the owner of thestore, Roberto.

At the end of the business day, Robertotakes the check to bank B. For simplicity’ssake, we assume that checking accountdeposits in bank B equal zero. Roberto, how-ever, changes this situation by depositing the$900 into his checking account. See entry(d) in Exhibit 10-6.

At this point, the check-clearing process(described earlier) kicks in. Bank B sends thecheck to its Federal Reserve bank, whichincreases the balance in bank B’s reserveaccount by $900. At the same time, theFederal Reserve bank decreases the funds inbank A’s reserve account by $900. Once theFederal Reserve bank increases the balance inbank B’s reserve account, total reserves for

277Section 4 The Money Creation Process

� Bank employeesmust decide what todo with the bank’sexcess reserves. Thebank’s successdepends on thesepeople being able tomake good loanswith the excessreserves.

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bank B rise by $900. (Total reserves � Depositsin the reserve account at the Fed � Vaultcash.) Again, see entry (d) in Exhibit 10-6.

What happens to the checking accountdeposits at bank B? They rise to $900, too.Bank B is required to keep a percentage ofthe checking deposits in reserve form. If thereserve requirement is 10 percent, then $90has to be maintained as required reserves asin entry (e) in Exhibit 10-6. The remainder,or excess reserves ($810), can be used bybank B to extend new loans or create newchecking account deposits (which aremoney), as in entry (f) in Exhibit 10-6. The

QUESTION: In the story so far, bank Acreates a loan, then bank B creates aloan, then bank C creates a loan and soon. Does this process ever stop?

ANSWER: Yes, it stops when the dollaramounts that a bank can lend outbecome tiny. For example, notice that

278 Chapter 10 Money, Banking, and the Federal Reserve System

Money emerged (orevolved) out of a barter

economy. In a barter economymany goods were traded. Onegood, among all goods, was morewidely accepted for purposes ofexchange. People started holdingthis good to reduce their transactioncosts. Soon, everyone was accept-ing this good for purposes ofexchange and thus it becamemoney.

Have you ever thought thatthe same process might be atwork when it comes to various lan-guages? Many languages are spokenin the world today. A few languagesare widely spoken, such as Spanishand English. Increasingly, though, onelanguage is becoming the language

that you hear spoken all over theworld, and that language is English.

You can see English on postersin India, Japan, China, and manyother countries. You can hearEnglish in pop songs sung inTokyo, Hong Kong, Mexico City,and Moscow. English is the lan-guage of 98 percent of Germanresearch physicists. It is the officiallanguage of the European CentralBank, even though the bank isin Frankfurt, Germany. Englishis found in official documents inPhnom Penh, Cambodia. Alcatel,a French telecommunicationscompany, uses English as its internallanguage.

In a barter economy, we knowthat the more people who accept aparticular good in exchange, themore other people will accept thatgood in exchange. Might the samebe the case of a language? Might itbe the case that the more people(as a percentage of the world’s pop-ulation) who speak English, themore people will want to learn and

speak English? Just as money low-ers the transaction costs of makingexchanges, English might lower thetransaction costs of communicating.

Is the world evolvingtoward one universal

language and is that languageEnglish? Explain your answer.

THINKABOUT IT

?How Is theEnglishLanguage Like Money?

story continues in the same way with otherbanks (banks C, D, E, and so on).

� How might the fact that theseyoung ladies in Agra, India, speakEnglish lower transaction costsfor you?

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bank A created a loan of $900, but bankB created a loan of only $810, and bankC created a still smaller loan of $729. Inother words, the loans become smallerand smaller. At some point, the dollaramount becomes so small that it doesn’tmake sense to create a loan.

How Much Money Was Created?So far, bank A created $900 in new loans

or checking account deposits, and bank Bcreated $810 in new loans or checkingaccount deposits. If we continue by bringingin banks C, D, E, and so on, we will find thatall banks together—that is, the entire bank-ing system—create $9,000 in new loans orchecking account deposits (money) as aresult of Fred’s deposit. This dollar amountis boxed in Exhibit 10-6. This $9,000 is newmoney—money that did not exist beforeFred snapped his fingers, created $1,000 outof thin air, and then deposited it into achecking account in bank A.

The facts can be summarized as follows:

1. Fred created $1,000 in new paper cur-rency (money) out of thin air.

2. After Fred deposited the $1,000 in bankA, the banking system as a whole created

$9,000 in additional checking accountdeposits (money).

Thus, Fred and the banking systemtogether created $10,000 in new money. Fredcreated $1,000 in currency, and the bankingsystem created $9,000 in checking accountdeposits. Together, they increased the moneysupply by $10,000.

You can use the following simple formulato find the (maximum) change in the moneysupply ($10,000) brought about in theexample:

Change in money supply � 1/Reserve require-ment � Change in reserves of first bank

In the example, the reserve requirementwas set at 10 percent (0.10). The reserves ofbank A, the first bank to receive the injectionof funds, changed by $1,000. Put the datainto the formula:

Change in the money supply �1/0.10 � $1,000 � $10,000

The idea here is that $1,000 created byFred ends up increasing the money supplyby a specific multiple (in this example, themultiple is 10).

279Section 4 The Money Creation Process

Defining Terms1. Define:

a. total reservesb. required reservesc. reserve requirementd. excess reserves

Reviewing Facts andConcepts2. Fred creates $2,000 in

currency with the snap ofhis fingers and deposits itin bank A. The reserverequirement is 10 percent.By how much does themoney supply increase?

3. Bank A has checkingaccount deposits of $20

million, the reserverequirement is 10 per-cent, vault cash equals $2million, and deposits inthe reserve account at theFed equal $1 million.What do requiredreserves equal? What doexcess reserves equal?

Critical Thinking4. The numerical examples

in this section always hadbanks creating loans (newchecking accountdeposits) equal to theamount of excess reservesthey held. For example, if

bank A had $900 in excessreserves, it would createnew loans equal to $900,not something less. Inreality, banks may notlend out every dollar oftheir excess reserves, butthey usually come close.Why would a bank wantto lend out nearly all (ifnot all) of its excessreserves?

Applying EconomicConcepts5. Is a $100 check money?

Explain.

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Changing the ReserveRequirement

Think of the Fed as having three “but-tons” to push. Every time it pushes one ofthe three buttons, it either raises or lowersthe money supply. The first button is thereserve requirement button. To understandhow a change in it can change the moneysupply, let’s consider three cases. In eachcase, the money supply is initially zero, and$1,000 is created out of thin air. The differ-ence in the three cases is the reserve require-ment, which is 5 percent in the first case, 10percent in the second, and 20 percent in thethird. Let’s calculate the change in themoney supply in each of the three cases. Forthese calculations we will use the formulayou learned in the last section:

Change in money supply �1/Reserve requirement � Change in reserves

of first bank

Case 1: (Reserve requirement � 5%);Change in money supply �1/0.05 � $1,000 � $20,000

280 Chapter 10 Money, Banking, and the Federal Reserve System

Fed Tools forChanging the Money Supply

Focus Questions� How does a change in the reserve require-

ment change the money supply?� How does an open market operation

change the money supply?� How does a change in the discount rate

change the money supply?

Key Termsopen market operationsfederal funds ratediscount rate

Case 2: (Reserve requirement � 10%);Change in money supply �1/0.10 � $1,000 � $10,000

Case 3: (Reserve requirement = 20%);Change in money supply �1/0.20 � $1,000 � $5,000

Note that the money supply is the largest($20,000) when the reserve requirement is 5percent. The money supply is the smallest($5,000) when the reserve requirement is 20percent. You can see that the smaller thereserve requirement, the bigger the change inthe money supply. So, ask yourself what hap-pens to the money supply if the reserverequirement is lowered? Obviously, the moneysupply must rise.What happens to the moneysupply if the reserve requirement is raised?Obviously, the money supply must fall.

Thus, the Fed can increase or decreasethe money supply by changing the reserverequirement. If the Fed decreases the reserverequirement, the money supply increases; ifit increases the reserve requirement, themoney supply decreases.

Lower reserve requirement → Money supply rises

Raise reserve requirement → Money supply falls

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QUESTION: Why would the Fed want toincrease or decrease the money supply?Why not simply leave the money supplyalone?

ANSWER: You are asking a questionabout monetary policy, a topic we willdiscuss more fully in a later chapter. Fornow, though, let us just say that the Fedmay increase or decrease the money sup-ply to deal with some economic problem.For example, if businesses are not doingwell, and the unemployment rate is ris-ing, the Fed might want to increase themoney supply to stimulate consumerspending.

Open Market OperationsThe second button the Fed can “push” to

change the money supply is the open marketoperations button. Remember that earlierwe mentioned an important committee inthe Federal Reserve System, the FederalOpen Market Committee (FOMC). Thiscommittee of 12 members conducts openmarket operations. Open market opera-tions are simply the buying and selling ofgovernment securities by the Fed. Before wediscuss open market operations in detail, weneed to provide some background informa-tion that relates to government securitiesand the U.S. Treasury.

The U.S. Treasury is an agency of the U.S.government. The Treasury’s job is to collectthe taxes and borrow the money needed torun the government. Suppose the U.S.Congress decides to spend $1,800 billion onvarious federal government programs. TheU.S. Treasury has to pay the bills. It noticesthat it collected only $1,700 billion in taxes,which is $100 billion less than Congresswants to spend. It is the Treasury’s job toborrow the $100 billion from the public. Toborrow this money, the Treasury issues orsells government (or Treasury) securities tomembers of the public. A government secu-rity is no more than a piece of paper promis-ing to pay a certain dollar amount of moneyin the future; think of it as an IOU statement.

The Fed (which is different from theTreasury) may buy government securitiesfrom any member of the public or sell them.When the Fed buys a government security, itis said to be conducting an open market pur-chase. When it sells a government security, itis said to be conducting an open market sale.These operations affect the money supply.

Open Market PurchasesLet’s say that you currently own a govern-

ment security, which the Fed offers to pur-chase from you for $10,000. You agree tosell your security to the Fed. You hand itover, and in return you receive a check madeout to you for $10,000.

It is important to realize where the Fedgets this $10,000. It gets the money “out ofthin air.” Remember Fred, who had the abil-ity to snap his fingers and create a $1,000bill out of thin air? Obviously, no such per-son has this power. The Fed, however, doeshave this power—it can create money “outof thin air.”

How does the Fed create money out ofthin air? Think about the answer in this way:You have a checking account, and the Fedhas a checking account. Each account has acertain balance (amount in the account).The Fed can take a pencil and increase thebalance in its account at will—legally. You,on the other hand, cannot, nor can anyone

281Section 5 Fed Tools for Changing the Money Supply

� These clerks atthe Chicago Board ofTrade are buying andselling U.S. Treasurybonds. Why doesthe U.S. Treasuryissue bonds?

open market operations Buying and selling ofgovernment securitiesby the Fed.

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else. If you decide to pencil in a new balanceand then write a check for an amount youdon’t have in your checking account, yourcheck bounces and you pay the bank apenalty charge. Fed checks do not bounce.The Fed can, and does, create money at will“out of thin air.”

Let’s return to the example of an openmarket purchase. Once you have the $10,000check from the Fed, you take it to your localbank and deposit it in your checkingaccount. The total dollar amount of check-ing account deposits in the economy is now$10,000 more than before the Fed purchasedyour government security. Because no othercomponent of the money supply (not cur-rency or traveler’s checks) is less, the overallmoney supply has increased.

Open market purchase → Money supply rises

Open Market SalesSuppose the Fed has a government secu-

rity that it offers to sell you for $10,000.You agree to buy the security. You write outa check to the Fed for $10,000 and give it tothe Fed. The Fed, in return, turns the gov-ernment security over to you. Next, thecheck is cleared, and a sum of $10,000 isremoved from your account in your bankand transferred to the Fed. Once this sumis in the Fed’s possession, it is removed

from the economy altogether. It is as if itdisappears from the face of the earth. Asyou might have guessed, the Fed also hasthe power to make money disappear intothin air.

The total dollar amount of checkingaccount deposits is less than before the Fedsold you a government security. An openmarket sale reduces the money supply.

Open market sale → Money supply falls

Changing the Discount RateThe third button the Fed can push to

change the money supply is the discount ratebutton. Suppose bank A wants to borrow $1million. It could borrow this dollar amountfrom another bank (say, bank B), or it couldborrow the money from the Fed. If bank Aborrows the money from bank B, bank Bwill charge an interest rate for the $1 millionloan. The interest rate charged by bank B iscalled the federal funds rate. If bank A bor-rows the $1 million from the Fed, the Fed willcharge an interest rate, called either the primary credit rate or the discount rate.

Whether bank A borrows from bank B orfrom the Fed depends on the relationshipbetween the federal funds rate and the dis-count rate. If the federal funds rate is lowerthan the discount rate, bank A will borrow

282 Chapter 10 Money, Banking, and the Federal Reserve System

� The FederalReserve Bank ofChicago. What aresome of the func-tions this bankperforms for thecommercial banksin its district?

federal funds rate The interest rate onebank charges another fora loan.

discount rate The interest rate the Fedcharges a bank for aloan.

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from bank B instead of from the Fed. (Whypay a higher interest rate if you don’t haveto?) If, however, the discount rate is lowerthan the federal funds rate, bank A willprobably borrow from the Fed.

Whether bank A borrows from bank B orfrom the Fed has important consequences. Ifbank A borrows from bank B, no newmoney enters the economy. Bank B simplyhas $1 million less, and bank A has $1 mil-lion more; the total hasn’t changed.

If, however, bank A borrows from theFed, the Fed creates new money in theprocess of granting the loan. Here is how itworks: the bank asks for a loan, and the Fedgrants it by depositing the funds (createdout of thin air) into the reserve account ofthe bank. For example, suppose the bankhas $4 million in its reserve account when itasks the Fed for a $1 million loan. The Fedsimply changes the reserve account balanceto $5 million.

If the Fed lowers its discount rate so thatit’s lower than the federal funds rate, and ifbanks then borrow from the Fed, the moneysupply will increase.

Lower the discount rate → Money supply rises

If the Fed raises its discount rate so thatit is higher than the federal funds rate,banks will begin to borrow from each other

rather than from the Fed. At some point,though, the banks must repay the fundsthey borrowed from the Fed in the past(say, funds they borrowed many monthsago), when the discount rate was lower.When the banks repay these loans, moneyis removed from the economy, and themoney supply drops. We conclude that ifthe Fed raises its discount rate relative tothe federal funds rate, the money supplywill eventually fall.

Raise the discount rate → Money supply falls

See Exhibit 10-7 for a review.

283Section 5 Fed Tools for Changing the Money Supply

Defining Terms1. Define:

a. discount rate b. federal funds ratec. open market operation

Reviewing Facts andConcepts2. The Fed wants to increase

the money supply.a. What can it do to the

reserve requirement?b. What type of open

market operation canit conduct?

c. What can it do to thediscount rate?

3. The Fed conducts an openmarket sale. Does themoney for which it sellsthe government securitiesstay in the economy?Explain your answer.

Critical Thinking4. When the Fed conducts

an open market purchase,it buys government secu-rities. As a result, themoney supply rises.Could the Fed raise themoney supply by buyingsomething other thangovernment securities?

For example, suppose theFed were to buy applesinstead of governmentsecurities. Would applepurchases (by the Fed)raise the money supply?Explain your answer.

Applying EconomicConcepts5. If the Fed wants the

money supply to rise bya ridiculously highpercentage—say, 1 mil-lion percent—could itaccomplish this objective?Explain your answer.

� This table sum-marizes the ways inwhich the Fed canchange the moneysupply.

EX H I B IT 10-7 Fed Monetary Tools and Their Fed Monetary Tools and Their EffectsEffects on the Money Supplyon the Money Supply

Money supplyMoney supply

Open market operationOpen market operationBuys government securitiesBuys government securitiesSells government securitiesSells government securities

IncreasesIncreasesDecreasesDecreases

Discount rateDiscount rateRaises discount rate (relative to the federal funds rate)Raises discount rate (relative to the federal funds rate)Lowers discount rate (relative to the federal funds rate)Lowers discount rate (relative to the federal funds rate)

DecreasesDecreasesIncreasesIncreases

Reserve requirementReserve requirementRaises reserve requirementRaises reserve requirementLowers reserve requirementLowers reserve requirement

DecreasesDecreasesIncreasesIncreases

Fed monetary toolFed monetary tool

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284 Chapter 10 Money, Banking, and the Federal Reserve System

Economics Vocabulary

To reinforce your knowledge of the key terms inthis chapter, fill in the following blanks on a sepa-rate piece of paper with the appropriate word orphrase.

1. A(n) ______ is an economy in which trades aremade in terms of goods and services instead ofmoney.

2. Anything that is generally accepted in exchangefor goods and services is a(n) ______.

3. A banking arrangement in which banks holdonly a fraction of their deposits and lend outthe remainder is referred to as ______.

4. The ______ is composed of currency, checkingaccounts, and traveler’s checks.

5. When the Fed buys or sells government securi-ties, it is conducting a(n) ______.

6. The governing body of the Federal ReserveSystem is the ______.

7. Total reserves minus required reserves equals______.

8. ______ are the minimum amount of reserves abank must hold against its checking accountdeposits, as mandated by the Fed.

9. The interest rate that one bank charges anotherbank for a loan is called the ______.

10. The interest rate that the Fed charges a bank fora loan is called the ______.

Understanding the Main Ideas

Write answers to the following questions to reviewthe main ideas in this chapter.

1. A person goes into a store and buys a pair ofshoes with money. Is money here principallyfunctioning as a medium of exchange, a store ofvalue, or a unit of account?

2. Explain how money emerged out of a bartereconomy.

3. Why is a checking account sometimes called ademand deposit?

4. What is currency?5. Explain how a check clears. Illustrate this

process using two banks in the Federal Reservedistrict in which you live.

Chapter Summary

Be sure you know and remember the followingkey points from the chapter sections.

Section 1� Transaction costs—the time and effort required

in an exchange—are high in a barter economy.� Money is any good that is widely accepted in

exchange and in repayment of debts.� The value of money comes from its general

acceptability in exchange.� Money has three major functions: a medium

of exchange, a unit of account, and a store ofvalue.

� Early bankers were goldsmiths who gave thecustomers a warehouse receipt for the goldthey stored with the goldsmith.

Section 2� The most basic money supply in the United

States is called M1 (M-one).� M1 consists of currency, checking accounts,

and traveler’s checks.� Currency is coins and paper money, or Federal

Reserve notes.� Checking accounts are also known as demand

deposits, money deposited that can be with-drawn by writing a check.

� A traveler’s check is issued by a bank in specificdenominations and sold to travelers for theiruse.

� A savings account is considered near-money.� Credit cards are not money because they can-

not be used as repayment of debt.

Section 3� As a central bank, the Federal Reserve System

is the chief monetary authority in the country.� The Federal Reserve’s main activities include

the following: control the money supply, sup-ply the economy with paper money, hold bankreserves, provide check-clearing services,supervise member banks, and act as lender oflast resort.

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6. List the locations of the 12 Federal Reserve dis-trict banks.

7. State what each of the following equals:a. total reservesb. required reservesc. excess reserves

8. Determine which of the following Fed actionswill increase the money supply: (a) lowering thereserve requirement, (b) raising the reserverequirement, (c) conducting an open marketpurchase, (d) conducting an open market sale,(e) lowering the discount rate relative to thefederal funds rate, (f) raising the discount raterelative to the federal funds rate.

9. What do we mean when we say that the Fed cancreate money “out of thin air”?

10. Explain how an open market purchase increasesthe money supply.

11. What is the relationship between changes in thereserve requirement and changes in the moneysupply?

12. Suppose the Fed sets the discount rate muchhigher than the existing federal funds rate. Withthis action, what signal is the Fed sending tobanks?

Doing the Math

Do the calculations necessary to solve the followingproblems.

1. A tiny economy has the following money in cir-culation: 25 dimes, 10 nickels, 100 one-dollarbills, 200 five-dollar bills, and 40 twenty-dollarbills. In addition, traveler’s checks equal $500,balances in checking accounts equal $1,900, andbalances in savings accounts equal $2,200. Whatis the money supply? Explain your answer.

2. A bank has $100 million in its reserve accountat the Fed and $10 million in vault cash. Thereserve requirement is 10 percent. What do totalreserves equal?

3. The Fed conducts an open market purchase andincreases the reserves of bank A by $2 million.The reserve requirement is 20 percent. By howmuch does the money supply increase?

Working with Graphs

and Tables

1. In Exhibit 10-8, fill in the blanks (a), (b),and (c).

Solving Economic Problems

Use your thinking skills and the information youlearned in this chapter to find solutions to the fol-lowing problems.

1. Cause and Effect. In year 1, reserves equal$100 billion, and the money supply equals$1,000 billion. In year 2, reserves equal $120 bil-lion, and the money supply equals $1,200 bil-lion. Did the greater money supply in year 2cause the higher dollar amount of reserves, ordid the higher dollar amount of reserves causethe greater money supply? Explain.

2. Writing. Write a one-page paper about some-thing you enjoy that would not exist in a bartereconomy. Explain why it would not exist.

Go to www.emcp.net/economics and choose Economics:New Ways of Thinking, Chapter 10, if you need more help inpreparing for the chapter test.

EX H I B IT 10-8

Fed buysgovernmentsecurities

Fed raises reserverequirement

Fed raises thediscount rate(relative to federalfunds rate)

Money supply (a) .

Money supply (b) .

Money supply (c) .

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