I. Functions of money
A. Medium
of exchange: facilitate exchange eliminating barter which requires people
with mutually needs.
B. Standard of value: allows for
the pricing of heterogeneous goods.
C. Store of value: maintains
value and provides liquidity so extra spending power is available as needed.
D. Standard of deferred payment:
makes credit contracts possible so credit transactions are possible.
II. The money supply
A. Three categories of money
1.
M1 = Currency, coins, and demand deposits (checking accounts).
2. M2 = M1 plus near
monies such as small time deposits (savings accounts) and short-term government
securities.
3. M3 = M2 plus large
time deposits (over $100,000)
B. What backs the dollar?
1.
It is a debt of the federal government.
2.
Backed by faith in the government's ability to control inflation.
3.
Value is determined by acceptability (it is legal tender and
scarce).
4.
It's fiat (by decree of the government) money.
5.
Coins have little intrinsic value (a small % of face value) so
they are called token money.
6.
Commodity money such as tobacco used as money in the Virginia colony has
intrinsic value of its own.
III. Maintaining money's value requires
A. A sound fiscal
policy (a reasonable federal debt)
B. A sound monetary policy
(not using inflation to pay the federal debt)
IV. United States private banking system
A. Two kinds of banks
1.
Commercial banks offer demand deposits (checking accounts)
2.
Savings and loan associations used to specialize in time deposits (saving
accounts) and home mortgages.
Now, because of deregulation during the early 1980's, they are similar to
commercial banks.
B. Federal deregulation contributed to banking
difficulties in the 1980's.
C. Visit
History
provided
by the Federal Reserve Bank of St. Louis for a time line of the U.S.
banking System.
Be sure to point at each
date to see what happens during that period.
V. The Federal Reserve System
A.
Organization Chart
1. Board of Governors oversee the Federal Reserve System
a. Seven governors
b. Governors are appointed by the President and confirmed by the
Senate.
c. The
chair is appointed by the President for a four-year term.
1) To foster independence, the term does not coincide with the President's term.
2) Other board members are appointed to
14-year terms on a staggered basis to insure an experienced board.
2. Federal Open Market Committee
a. Membership consists of the Board of Governors and 5 of the 12 Federal Reserve bank
presidents with the
N.Y. president always a member because
N.Y. City
is the financial center for U.S. international trade.
b. The Committee tries to affect interest rates by affecting the supply of money by buying
and selling U.S. government
bonds (See Chapter 15).
3. Federal Advisory Council 12
prominent commercial bankers, one from each district, who
advise the Board of
Governors
4. Twelve Federal Reserve Banks
a. The United States is divided into 12 homogenous districts and each has
its own bank
b. Bank for the federal government
c. Bank for member banks
d. Graphic is complements of the Board of Governors of the Federal Reserve
System.
5.
Member commercial banks
6. Nonmember commercial banks and thrifts are regulated by
other government agencies
B.
Functions of the Federal Reserve
1.
Regulate the money supply
3.
Oversea the financial system
4.
Check collection and clearing
5.
Fiscal agent for the government
6.
Supervise (audit) member banks
7.
Hold reserves (deposits) for member banks
8.
Compile economic statistics such as the
Beige
book, which is
a quarterly summary of each districts'
recent economic activity.
9. Many Federal Reserve publications are free.
10.
2008/05/Paul Volcker
on the
2007-08 financial crisis and the Federal Reserve bailout of Bear Stearns.
C.
Philadelphia Reflections:
Whither, Federal Reserve?
is a well done, concise history of banking in the United States.
VI. The fractional reserve system and the creation of money
A. Commercial banks are
required to keep a reserve (cash) of about 12% of their demand deposits
(checking accounts)
at their bank or on
deposit
with the Federal Reserve (required reserves). The remainder, (Excess
Reserves) may
be loaned out even though they support deposits.
B. Money is created by these loans as long as the
demand deposits (DD) created by them stay within the banking system,
that is,
the money loaned is redeposit as a DD into a
bank within the system. The banks owe the demand deposits created
by the loans
to each other. These inter-brain debts are canceled with a
bookkeeping entry. It should be pointed out that the
demand deposits created by such loans are spent, and goods transferred,
just as if the
transaction involved currency.
C. Example: Bank A has $50,000 in
demand deposits. A reserve requirement of 10% would yield required reserves of
.10 x $50,000 = $5,000. If Bank A had $7,000 in
reserve, it could loan up to $2,000 in the form of demand deposits.
Suppose Bank
B does exactly the same with both banks' customers
depositing their DD in the other bank. Banks would
owe cashed checks to each
other, would cancel interbank debts, and money has been created.
D. The system works in reverse
with money destroyed if reserves leave the system.
E. Required reserves, reserves
not loaned, and loans of cash (reserves) represent a leakage which
eventually stops money
supply growth.
VII. The monetary multiplier
A. An infusion of
reserves into the system by the Treasury as directed by the Federal Reserve can
be loaned a number of times
by the commercial banking system. For
example, the Federal Reserve may buy a $100 Treasury bond from Ms. A who
deposits
the Federal Reserve check (reserves) into Bank A.
B. Bank A's new DD of $100
requires them to keep $10 (10%) in reserve leaving $90 excess to loan to Mr. B
who
deposits it in Bank B.
C. Bank B needs to keep
only $9 ($90 x .1) in reserve and may loan out $81.
D. This process continues and as long as the
demand deposits being created by the loans stay within the commercial
banking
system, interbank debts are canceled and
money has been created
E. Monetary multiplier (M)
sets the upper limit of the expansion
1. R = reserve
requirement = 10% = .1
2. M = 1/R =
1/.1 = 10
F. In the above example the total
amount of DD created beginning with Bank A's $90 in excess reserves would
equal
Excess Reserves
x M = $90 x 10 = $900. If the $100 infusion by the Federal Reserve
is included, the increase is
10 x 100 = $1,000.
G. For more Information visit
The Banking System and the Money Multiplier
from Jay Kaplan of the University of Colorado at Boulder.
VIII. The quantity theory of money
A.
Represents the basic theory behind macroeconomics prior to the Keynesian Revolution
B. Believed that changes in the
money supply would only affect price and not economic
activity.
C. The
equation of exchange
MV = PT
Money Supply X
Velocity of Money = Average Price Level X
Number of Transactions
1. Velocity of money is how often the money supply is spent.
2. Number of transactions is real economic activity
3. The equation is an identity
a. Dollars spent = dollars received
b. MV = Aggregate Demand and PT = Nominal GDP = C + I + G + XN = GDP
4. Classical theory stated that V was basically stable and that
there existed some natural level of growth for T.
a. This natural level was a function of individual and business interaction.
b. V and T were
essentially unalterable which meant changes in M would change P and not the natural level of T.
c. Government should therefore
refrain from interfering with market activity by adjusting
the money supply.
D. Came
into disfavor in the 1930's with the popularity of Keynesian economics which
stated that real output could
be changed by affecting
aggregate
demand.
IX. Monetarism
A. Monetarists believe
that changes in the money supply are both a necessary and sufficient condition
to cause inflation.
B. If AD was low,
increasing the money supply would only increase short-run
economic activity.
1.Eventually short-term expansion stops and increasing
M only adds to inflation.
2. Public anticipation stops the process from being repeated.
3. Monetarists believe
that government involvement in the economy, especially monetary
intervention, increases
the magnitude of the business cycle.
C. Keynes believed changing the
money supply would affect interest rates which would affect investment which in
turn
would affect Real GDP
D. To some degree monetarism is
an extension of classical economics. Its advocates believe
that a competitive market,
free from government
interference, results in economic
stability and a reasonable growth rate.
E. For more on Monetarism visit
Monetarism
from The Concise Encyclopedia Of Economics and
Monetarism
from
The History of Economic
Thought Website.
X. New classical economists
A. Lead by Milton Friedman, these
economists revived the quantity theory of money.
B. They rely on market forces and not government
manipulation of aggregate demand and the money supply to control
economic
activity.
C. This economic school of thought has much in common
with those who believe in rational expectations.
1. This recently
formed school does not assume market participants have perfect knowledge.
2. Instead, it assumes
market participants will learn from experience and use current information to
predict and
adjust to the expected future.
3. The result is not the
disequilibrium of Keynesian economics with its inflationary and deflationary
gaps but a constant
equilibrium with economic
behavior adjusting to be compatible with different levels of economic
activity.
4. As with the classical
school, the new classical school, monetarist, and those
believing in rationalist expectation feel
government involvement in
economic activity is not beneficial.
D. For more on New Classical Economics visit
New
Classical Macroeconomics, by Robert King: The Concise
XI. Supply-side Economists
A. Slow economic growth and high inflation of the
1970's caused some economists to emphasize increasing Aggregate Supply.
B. Known as Supply-Side Economics, this theory is
discussed in chapter 16.
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