The Money Supply

© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair

C

H A

P T

E R

C H

A P

T E

R1010

Prepared by: Fernando Prepared by: Fernando Quijano and Yvonn QuijanoQuijano and Yvonn Quijano

The Money Supply and the The Money Supply and the Federal Reserve SystemFederal Reserve System


An Overview of MoneyAn Overview of Money

• MoneyMoney is anything that is generally is anything that is generally accepted as a medium of exchange.accepted as a medium of exchange.

• Money is not income, and money is Money is not income, and money is not wealth. Money is:not wealth. Money is:

• a means of payment,a means of payment,

• a store of value, anda store of value, and

• a unit of account.a unit of account.



• Money as a means of payment, or medium Money as a means of payment, or medium of exchange, is more efficient than barter.of exchange, is more efficient than barter.

• BarterBarter is the direct exchange of goods and is the direct exchange of goods and services for other goods and services.services for other goods and services.

• A barter system requires a A barter system requires a double double coincidence of wantscoincidence of wants for trade to take for trade to take place. Money eliminates this problem.place. Money eliminates this problem.

• Money is a lubricant in the functioning of a Money is a lubricant in the functioning of a market economy.market economy.



• Money as a Money as a store of valuestore of value refers to money as refers to money as an asset that can be used to transport an asset that can be used to transport purchasing power from one time period to purchasing power from one time period to another.another.

• Money is easily portable, and easily exchanged Money is easily portable, and easily exchanged for goods at all times. The for goods at all times. The liquidity property liquidity property of moneyof money makes money a good medium of makes money a good medium of exchange as well as a store of value.exchange as well as a store of value.



• Money also serves as a Money also serves as a unit of accountunit of account, or a , or a standard unit that provides a consistent way of standard unit that provides a consistent way of quoting prices.quoting prices.

• Commodity moniesCommodity monies are items used as money are items used as money that also have intrinsic value in some other that also have intrinsic value in some other use. Gold is one form of commodity money.use. Gold is one form of commodity money.

• FiatFiat, or , or tokentoken, money is money that is , money is money that is intrinsically worthless.intrinsically worthless.

• Legal tenderLegal tender is money that a government has is money that a government has required to be accepted in settlement of debts.required to be accepted in settlement of debts.


Measuring the Supply of MoneyMeasuring the Supply of Moneyin the United Statesin the United States

• The two most common measures of The two most common measures of money are money are MM1 and 1 and MM2.2.

• MM11, or , or transactions moneytransactions money is money that is money that can be directly used for transactions. It can be directly used for transactions. It includes currency held outside banks, plus includes currency held outside banks, plus demand deposits, plus traveler’s checks, demand deposits, plus traveler’s checks, plus other checkable depositsplus other checkable deposits

• MM1 is a stock measure—it is measured at 1 is a stock measure—it is measured at a point in time—a point in time—on a specific dayon a specific day. On . On June 26, 2000, June 26, 2000, MM1 was $1,103.3 billion.1 was $1,103.3 billion.


Measuring the Supply of MoneyMeasuring the Supply of Moneyin the United Statesin the United States

• MM22, or , or broad moneybroad money, includes near , includes near monies, or close substitutes for monies, or close substitutes for transactions money.transactions money.

• MM2 2 MM1 + savings accounts + money market 1 + savings accounts + money market accounts + other near moniesaccounts + other near monies

• On June 26, 2000, On June 26, 2000, MM2 was $4,778.2 2 was $4,778.2 billion.billion.

• The main advantage of looking at The main advantage of looking at MM2 2 instead of instead of MM1 is that 1 is that MM2 is sometimes 2 is sometimes more stable.more stable.


The Private Banking SystemThe Private Banking System

• Most of the money in the United States Most of the money in the United States today is “bank money,” or money held today is “bank money,” or money held in checking accounts rather than in checking accounts rather than currency.currency.

• Financial intermediariesFinancial intermediaries are banks are banks and other financial institutions that act and other financial institutions that act as a link between those who have as a link between those who have money to lend and those who want to money to lend and those who want to borrow money.borrow money.


How Banks Create MoneyHow Banks Create Money

• To see how banks create money, consider To see how banks create money, consider the origins of the modern banking system:the origins of the modern banking system:

• Goldsmiths functioned as warehouses where Goldsmiths functioned as warehouses where people stored gold for safekeeping.people stored gold for safekeeping.

• Upon receiving the gold, a goldsmith would Upon receiving the gold, a goldsmith would issue a receipt to the depositor. After a time, issue a receipt to the depositor. After a time, these receipts themselves, rather than the gold these receipts themselves, rather than the gold that they represented, began to be traded for that they represented, began to be traded for goods.goods.

• At this point, all the receipts issued were At this point, all the receipts issued were backed 100 percent by gold.backed 100 percent by gold.



• Goldsmiths realized that people did not Goldsmiths realized that people did not come often to withdraw gold and, as a come often to withdraw gold and, as a result, they had a large stock of gold result, they had a large stock of gold continuously on hand. They could lend continuously on hand. They could lend out some of this gold without any fear of out some of this gold without any fear of running out.running out.

• There were thus more claims than there There were thus more claims than there were ounces of gold.were ounces of gold.



• Knowing there were more receipts Knowing there were more receipts outstanding than there were ounces of outstanding than there were ounces of gold, people might start to demand gold gold, people might start to demand gold for receipts.for receipts.

• A A runrun on a goldsmith (or a modern-day on a goldsmith (or a modern-day bank) occurs when many people bank) occurs when many people present their claims at the same time.present their claims at the same time.


The Creation of MoneyThe Creation of Money

• Banks usually make loans up to the point Banks usually make loans up to the point where they can no longer do so because where they can no longer do so because of the reserve requirement restriction (or of the reserve requirement restriction (or up to the point where their excess up to the point where their excess reserves are zero).reserves are zero).

ex cess rese rv es ac tu a l re se rv es req u ired rese rv es


The Federal Reserve SystemThe Federal Reserve System

• The The Federal Open Market Committee Federal Open Market Committee (FOMC)(FOMC) sets goals regarding the money sets goals regarding the money supply and interest rates and directs the supply and interest rates and directs the operations of the Open Market Desk in operations of the Open Market Desk in New York.New York.

• The The Open Market DeskOpen Market Desk is an office in the is an office in the New York Federal Reserve Bank from New York Federal Reserve Bank from which government securities are bought which government securities are bought and sold by the Fed.and sold by the Fed.


Functions of the FedFunctions of the Fed

• Clearing interbank payments.Clearing interbank payments.

• Regulating the banking system.Regulating the banking system.

• Assisting banks in a difficult financial Assisting banks in a difficult financial position.position.

• Managing exchange rates and the nation’s Managing exchange rates and the nation’s foreign exchange reserves.foreign exchange reserves.

The Fed performs important functions for The Fed performs important functions for banks including:banks including:


Functions of the FedFunctions of the Fed

• Control of mergers between banks.Control of mergers between banks.

• Examination of banks to ensure that they Examination of banks to ensure that they are financially sound.are financially sound.

• Setting of reserve requirements for all Setting of reserve requirements for all financial institutions.financial institutions.

• Lender of last resort.Lender of last resort.

The Fed performs important functions for The Fed performs important functions for banks including:banks including:


The Fed’s Balance SheetThe Fed’s Balance Sheet

• Although it is unrelated to the money Although it is unrelated to the money supply, the Fed’s gold counts as an asset supply, the Fed’s gold counts as an asset on its balance sheet.on its balance sheet.

• The largest of the Fed’s assets, by far, The largest of the Fed’s assets, by far, consists of government securities consists of government securities purchased over the years.purchased over the years.

• A dollar bill is a liability, or IOU, of the Fed.A dollar bill is a liability, or IOU, of the Fed.


How the Fed ControlsHow the Fed Controlsthe Money Supplythe Money Supply

• The required reserve ratio establishes a link The required reserve ratio establishes a link between the reserves of the commercial between the reserves of the commercial banks and the deposits (money) that banks and the deposits (money) that commercial banks are allowed to create.commercial banks are allowed to create.

• If the Fed wants to increase the money If the Fed wants to increase the money supply, it creates more reserves, thereby supply, it creates more reserves, thereby freeing banks to create additional deposits freeing banks to create additional deposits by making more loans. If it wants to by making more loans. If it wants to decrease the money supply, it reduces decrease the money supply, it reduces reserves.reserves.


The Discount RateThe Discount Rate

• Banks may borrow from the Fed. The Banks may borrow from the Fed. The interest rate they pay the Fed is the interest rate they pay the Fed is the discount ratediscount rate..

• Bank borrowing from the Fed leads to an Bank borrowing from the Fed leads to an increase in the money supply. The higher increase in the money supply. The higher the discount rate, the higher the cost of the discount rate, the higher the cost of borrowing, and the less borrowing banks borrowing, and the less borrowing banks will want to do.will want to do.


The Discount RateThe Discount Rate

• In practice, the Fed does not often use the In practice, the Fed does not often use the discount rate to control the money supply.discount rate to control the money supply.

• The discount rate cannot be used to The discount rate cannot be used to control the money supply with great control the money supply with great precision, because its effects on banks’ precision, because its effects on banks’ demand for reserves are uncertain.demand for reserves are uncertain.

• Moral suasionMoral suasion is the pressure exerted by is the pressure exerted by the Fed on member banks to discourage the Fed on member banks to discourage them from borrowing heavily from the Fed.them from borrowing heavily from the Fed.


Open Market OperationsOpen Market Operations

• Open market operations is the purchase Open market operations is the purchase and sale by the Fed of government and sale by the Fed of government securities in the open market; a tool used securities in the open market; a tool used to expand or contract the amount of to expand or contract the amount of reserves in the system and thus the reserves in the system and thus the money supply.money supply.

• Open market operations is by far the most Open market operations is by far the most significant tool of the Fed for controlling significant tool of the Fed for controlling the supply of money.the supply of money.



• An open market An open market purchasepurchase of securities by of securities by the Fed results in an the Fed results in an increaseincrease in reserves in reserves and an and an increaseincrease in the supply of money by in the supply of money by an amount equal to the money multiplier an amount equal to the money multiplier times the change in reserves.times the change in reserves.

• An open market An open market salesale of securities by the of securities by the Fed results in a Fed results in a decreasedecrease in reserves and in reserves and a a decreasedecrease in the supply of money by an in the supply of money by an amount equal to the money multiplier amount equal to the money multiplier times the change in reserves.times the change in reserves.



• Open market operations are the Fed’s Open market operations are the Fed’s preferred means of controlling the money preferred means of controlling the money supply because:supply because:

• they can be used with some precision,they can be used with some precision,

• are extremely flexible, andare extremely flexible, and

• are fairly predictable.are fairly predictable.

The Money Supply

Economy & Finance

money supply

supply of money

deposits money

bank money

money goldsmiths

orbroad money

creation of money banks

money market accounts