Ch07 Monetary System

The Meaning of Money

• Barter
– Exchanging one good or service for another
– Trade requires “double coincidence of wants”
• Unlikely occurrence that two people
each have a good or service that the
other wants
•
• Money : Makes trade easier, may be defined as an asset
which can turned into any other goods or services
instantly without losing of its own value.

• Money
– Set of assets in an economy
– That people regularly use
– To buy goods and services from other people
–
• Liquidity
– Ease (how fast) with which an asset can be converted
into the economy’s medium of exchange

Functions of Money
1. Medium of exchange
– Item that buyers give to sellers when they want to
purchase goods and services
2. Unit of account (Accounting Unit)
– Yardstick people use to post prices and record debts
3. Store of value
– Item that people can use to transfer purchasing power
from the present to the future

The Kinds of Money

• Commodity money
– Money that takes the form of a commodity with
intrinsic value: such as gold, silver or cigarettes
• Intrinsic value
– Item would have value even if it were not used as
money
• Gold standard - Gold as money. Gold coin or silver coin, for
instance, has intrinsic value even though it is not used as a
money. It can be used as a jewelry or industrial purpose.
 – Or paper money that is convertible into gold on
demand. But paper money has no intrinsic value of
any kind.

• Fiat money
– Money without intrinsic value. But fiat money has
purchasing power because of “seignorage” or
“segnorage.” That is the privilege of the state to print
money as a legal tender which is good for all debts,
public and private.
– Used as money because of government decree
– “This note is legal tender for all debts, public and
private”
–
• Fiat
– Order or decree
– Credit card, debit card, checks are means of payment.
Not the money itself.
–
• Digital money
• Cryptocurrency

Money in US Economy
• Money stock
– Quantity of money circulating in the economy
• Currency
– Paper bills and coins in the hands of the public
• Demand deposits
– Balances in bank accounts; depositors can access on
demand by writing a check

• Measures of money stock (quantity of money): depending on

Liquidity
• Most liquid money is cash: instant. Real estate is the least
liquid asset. Stocks and bonds are in the middle.
– M1
• Demand deposits, Traveler’s checks
• Other checkable deposits, Currency
– M2
• Everything in M1
• Savings deposits, Small time deposits
• Money market mutual funds
• A few minor categories: MMF (money market
fund), MMDA (money market direct deposit) etc.
 •
• Two Measures of Money Stock for US Economy
•

Case Study Where is All the Currency?

• January 2019: $1.7 trillion currency outstanding
– Implies the average adult holds about $6,500 of
currency
– Much of the currency is held abroad (over half of U.S.
dollars)
– Much of the currency is held by drug dealers, tax
evaders, and other criminals
• Currency -not a good way to hold wealth
– Can be lost or stolen; doesn’t earn interest

The Federal Reserve System

• Central bank
– Institution designed to
• Oversee the banking system
• Regulate the quantity of money in the economy
• The Federal Reserve (the Fed)
– The central bank of the United States
– Created in 1913 after a series of bank failures in 1907
– Purpose: to ensure the health of the nation’s banking
system

The Fed’s Organization

• Board of governors
– 7 members, 14-year terms
• Appointed by the president and confirmed by the
Senate
– The chairman: Jerome Powell (incumbent since Feb
2018)
• Directs the Fed staff
 • Presides over board meetings
• Testifies regularly about Fed policy in front of
congressional committees.
• Appointed by the president (4-year term)

• The Federal Reserve System

– Federal Reserve Board in Washington, D.C.
– 12 regional Federal Reserve Banks
• Major cities around the country
• The presidents are chosen by each bank’s board
of directors

• The Fed’s jobs

– Regulate banks and ensure the health of the
banking system
• Regional Federal Reserve Banks
• Monitors each bank’s financial
condition
• Facilitates bank transactions -
clearing checks
• Acts as a bank’s bank
The Fed – “Lender of Last Resort”

• The Fed’s jobs

– Control the money supply
• Quantity of money available in the economy
• Monetary policy: by the Federal Open Market
Committee (FOMC)
• Money supply
– Quantity of money available in economy
• Monetary policy
– Setting of the money supply

Federal Open Market Committee (FOMC)

• FOMC
– 7 members of the board of governors
– 5 of the twelve regional bank presidents
• All twelve regional presidents attend
each FOMC meeting, but only five
get to vote
– Meets about every 6 weeks in Washington,
D.C.
– Discuss the condition of the economy
Consider changes in monetary policy
 • Fed’s primary tool: open-market operation
– Purchase & sale of U.S. government bonds conducted
by New York Fed.
– New York Fed only deals (buys and sells) with 40
Primary Government Securities Dealers. These dealers
have obligations to make markets (must accept ask
orders or bid tender offers to New York Fed for smooth
buying and selling of US Gov’t bonds).
• FOMC - increase the money supply
– The Fed: open-market purchase of U.S Government
bonds
• FOMC - decrease the money supply
– The Fed: open-market sale of U.S Gov’t bonds

Primary dealers are trading counterparties of the New York Fed

in its implementation of monetary policy. They are also
expected to make markets for the New York Fed on behalf of its
official accountholders as needed, and to bid on a pro-rata
basis in all Treasury auctions at reasonably competitive prices.

List of Primary Dealers:

ASL Capital Markets Inc.
Bank of Montreal, Chicago Branch
Bank of Nova Scotia, New York Agency
BNP Paribas Securities Corp.
Barclays Capital Inc.
BofA Securities, Inc.
Cantor Fitzgerald & Co.
Citigroup Global Markets Inc.
Daiwa Capital Markets America Inc.
Deutsche Bank Securities Inc.
Goldman Sachs & Co. LLC
HSBC Securities (USA) Inc.
Jefferies LLC
J.P. Morgan Securities LLC
Mizuho Securities USA LLC
Morgan Stanley & Co. LLC
NatWest Markets Securities Inc.
Nomura Securities International, Inc.
RBC Capital Markets, LLC
Santander US Capital Markets LLC
Societe Generale, New York Branch
TD Securities (USA) LLC
UBS Securities LLC.
Wells Fargo Securities, LLC
The most common example of an open auction is an English
auction, where the price starts low and increases until the last
bidder remains. Another example is a Dutch auction, where the
price starts high and decreases until the first bidder accepts it.

Banks & Money Supply

• Money
– Currency + Demand deposits M = C + D
• Behavior of banks
– Can influence the quantity of demand deposits in the
economy (and the money supply)
–
Bank, commercial bank, plays the role of bridge between
suppliers of fund and demanders for funds. Banks have two
functions. (1) Financial intermediary function, (2) Credit creation
function.
Banks accept money from ordinary customers and pool the
money, and lend this money to other customers who have
promising investment opportunities. Risk reduction made.
• Reserves
– Deposits that banks have received but have not loaned
out. Reserve Amount =Deposit Amount - Loan Amount
• The simple case of 100% reserve banking
– All deposits are held as reserves. Zero loan amount.
• Banks do not influence the supply of money. Banks only
want to maximize its profits out of banking operation.
•

Fractional-Reserve Banking
• Fractional-reserve banking
– Banks hold only a fraction of deposits as reserves
• Reserve ratio
– Fraction of deposits that banks hold as reserves
• Reserve requirement
– Minimum amount of reserves that banks must hold; set
by the Fed or any central bank. Current rate is 8%.

• Excess reserve
 – Banks may hold reserves above the legal minimum
(above 8%)
• Example: First National Bank
– Reserve ratio 10% = Reserve/Deposits = $10/$100

• Banks hold only a fraction of deposits in reserve

– Banks create money by loaning the difference
(=Deposits-Reserves)
• Assets: anything giving future
benefit
• Liabilities (Debts): anything giving
future obligation
– Increase in money supply, but does not
create wealth

Money Multiplier:
The first customer loans $90 from First
National Bank and deposits $90 in Second
National Bank.

The second customer loans $81 from

Second National Bank and deposits $81 in
Third National Bank.
 The third customer loans $72.90 from
Third National Bank and deposits $72.90
in Fourth National Bank.
If this process keeps going on, and
assume nobody withdraws money from
the bank. The whole loan amount in the
banking system will rise substantially.
• The money multiplier
– Original deposit = $100.00
– First National lending = $ 90.00 [= .9 × $100.00]
– Second National lending=$ 81.00 [= .9 × $90.00]
– Third National lending = $ 72.90 [= .9 × $81.00]
– …If this process keeps going on indefinitely, in the end
– Total money supply = $1,000.00 (Sum of total loan
amount in the banking system)
• Basic Assumption: (1) Initial deposit made at First National
Bank is never withdrawn. (2) Those who borrow money from
bank keep all their money in the banking system.
•
• The money multiplier:
– Amount of money the banking system generates with
each dollar of reserves
– Reciprocal of the reserve ratio = 1/R
– Here, R is reserve ratio 10%. Therefore, $1,000 = $100
/ 10%
– Total money supply = Initial Deposit / Reserve Ratio
• The higher the reserve ratio
– The smaller the money multiplier (=1/R=1/10%=10 is
called money multiplier)

Financial Crisis of 2008-2009

• Bank capital
– Resources a bank’s owners have put into the
institution
– Used to generate profit
 –

In reality, banks may borrow money from financial market when

they feel they don’t have enough money to support banking
business. Also banks may invest their money in some other
assets, either financial or real, to improve profitability. Banks
borrow to increase its profitability.
• Leverage
– Use of borrowed money to supplement existing funds
for purposes of investment
• Leverage ratio
– Ratio of assets ($1,000) to bank capital
($50)=1,000/50=20 above example. Here, Leverage
Ratio is 20.
• Capital requirement
– Government regulation specifying a minimum amount
of bank capital. Here, capital
ratio=capital/asset=$50/$1,000=5%. Inverse of
Leverage Ratio. 1/20=5%
– BIS (Bank for International Settlements) Rule requires
8% capital ratio. It becomes global standard.

• If bank’s assets rise in value by 5%

– Because some of the securities the bank was holding
rose in price
– $1,000 of assets would now be worth $1,050
– Bank capital rises from $50 to $100 ($50 original
capital amount + $50 asset increase)
– So, for a leverage rate of 20 : Leverage
Rate=$1,000/$50=Original amount of asset/capital
amount
– 20*5% (leverage rate*asset increase in %)=100%
(equity increase in %)
• A 5% increase in the value of assets (from $1,000
to $1,050)
• Increases the owners’ equity by 100% (from $50
to $100)
–
• If bank’s assets are reduced in value by 5%
 – Because probably some customer who borrowed from
the bank default on their loans : 20 * (-5%)=-100%
– $1,000 of assets would be worth $950 : -5% decrease in
asset
– Value of the owners’ equity falls to zero : -100%
decrease in capital
– So, for a leverage ratio of 20 (=$1,000/$50)
• A 5% fall in the value of the bank assets
• Leads to a 100% fall in bank capital (-5%*20=-
100%)

• If bank’s assets are reduced in value by more than 5%

– Because probably many more customers who borrowed
from the bank default on their loans
– For a leverage ratio of 20
• The bank’s assets would fall below its liabilities
• The bank would be insolvent: unable to pay off its
debt holders and depositors in full

• Many banks in 2008 and 2009

– Incurred sizable losses on some of their assets
• Mortgage loans and securities backed by
mortgage loans
• Many mortgage loan customers became unable to
pay monthly payments on their loans. Hugh
defaults are made in short period of time.
– Shortage of capital induced the banks to reduce
lending
• Credit crunch
• Contributed to a severe downturn in economic
activity
• Recently, last year Silicon Valley Bank (SVB)
became insolvent due to value decrease of
government bond (securities) owned by SVB.
•
• U.S. Treasury and the Fed
– Put many billions of dollars of public funds into the
banking system. The Fed took collateral of banks’
equity in return to deposit in banks.
• To increase the amount of bank capital
– Temporarily made the U.S. taxpayer a part owner of
many banks
– Goal: to recapitalize the banking system
 • So that bank lending could return to a more
normal level - occurred by late 2009

Fed’s Tools of Monetary Control

• Influences the quantity of reserves
– Open-market operations
– Fed lending to banks
• Influences the reserve ratio
– Reserve requirements
– Paying interest on reserves holding in central bank

• Open-market operations
– Purchase and sale of U.S. government bonds
by the Fed
– To increase the money supply
• The Fed buys U.S. government
bonds
– To reduce the money supply
• The Fed sells U.S. government bonds
– Easy to conduct; Used more often

• Fed lending to banks

• To increase the money supply
• Discount window
• At the discount rate: interest rate set by central
banks lending between commercial banks.
• Term Auction Facility
• To the highest bidder

• The discount rate:

– Interest rate on the loans that the Fed makes to banks
– Higher discount rate
• Reduce the money supply
• Banks may be encouraged to borrow more money
from central bank
– Smaller discount rate
• Increase the money supply
• Banks may be discouraged to borrow more money
from central bank

• Term Auction Facility (2007 to 2010)

– The Fed sets a quantity of funds it wants to lend to
banks
– Eligible banks bid to borrow those funds
 – Loans go to the highest eligible bidders
• Acceptable collateral, usually equity shares of the
banks
• Pay the highest interest rate

• Reserve requirements
– Minimum amount of reserves that banks must
hold against deposits
• An increase in reserve requirement:
decrease the money supply, less
loans available
• A decrease in reserve requirement:
increase the money supply, more
loans available
– Used rarely – disrupt business of banking
– Less effective in recent years
Many banks hold excess reserves

• Paying interest on reserves

– Since October 2008, before that no interest accrues on
reserves holding in central bank
– The higher the interest rate on reserves
• The more reserves banks will choose to hold
– An increase in the interest rate on reserves
• Increase the reserve ratio
• Lower the money multiplier
• Lower the money supply

Problems
• The Fed’s control of the money supply
– Not precise
• The Fed does not control:
– The amount of money that households choose to hold
as deposits in banks
– The amount that bankers choose to lend

Case Study Bank Runs & Money Supply

• Bank runs
– Depositors fear that a bank may be having financial
troubles
• “Run” to the bank to withdraw their deposits
– Problem for banks under fractional-reserve banking
• Cannot satisfy withdrawal requests from all
depositors
• When a bank run occurs
– The bank is forced to close its doors
– Until some bank loans are repaid
– Or until some lender of last resort provides it with the
currency it needs to satisfy depositors
– Complicate the control of the money supply

• Great Depression, early 1930s

– Wave of bank runs and bank closings
– Households and bankers - more cautious
– Households
• Withdrew their deposits from banks
– Bankers - responded to falling reserves
• Reducing bank loans,
• Increased their reserve ratios
• Smaller money multiplier
• Decrease in money supply

• No bank runs today

– Depositors are confident
– FDIC (Federal Depositary Insurance Corporation) will
make good on the deposits
• Government deposit insurance
– Guarantees the safety of deposits at most banks:
Federal Deposit Insurance Corporation (FDIC)
– Cost: Bankers - little incentive to avoid bad risks
– Benefit: A more stable banking system

Federal Fund Rate

• The federal funds rate
– Interest rate at which banks make overnight
loans to one another
• Lender – has excess reserves
• Borrower – needs reserves
– A change in federal funds rate
Changes other interest rates

• The federal funds rate

– Differs from the discount rate
– Affects other interest rates as well
– Is determined by supply and demand in the market for
loans among banks
– Targeted by the Fed
 • Change the federal funds rate
• Change the money supply

• The federal funds rate

– Differs from the discount rate
– Affects other interest rates as well
– Is determined by supply and demand in the
market for loans among banks
– Targeted by the Fed
• Change the federal funds rate
Change the money supply

Supplement

Base Money (High Powered Money) and Quantity of Money

Money supplied from government (central bank) is call Base

money or High Powered Money. This base money is composed of
cash holdings among people (C) and reserves by banks (R).
B=C+R
B = kD + zD
Here, k=C/D=Cash/Demand Deposit, Cash-Demand Ratio
z=R/D=Reserve/Demand, Reserve Requirment
Suppose “z” and “k” are stable.
M = C + D = kD +D
M kD+ D k +1
=
B kD+ zD
= k+z
=m
Here, “m” is called Money Multiplier.
Δ M k +1
= =m
Δ B k+z

k +1
ΔM = (ΔB)=m(ΔB)
k+z
Here, if reserve requirement “z” rises, “m” money multiplier
falls.
This equation requires several hypothesis.
(1) Customers who borrow money from bank must
deposit the whole money in the banking system/
(2) Banks don’t hold excess reserve. Banks lend all
the money except required reserves.
4. If these conditions are not met, money
multiplier will fall.