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Hubbard Macro Sg 13

Hubbard Macro Sg 13

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Chapter13 (25)
Money, Banks, and the
Federal Reserve System
Chapter Summary
Money plays a key role in the functioning of an economy by facilitating trade in goods and services and
by making specialization possible. No advanced economy can prosper without specialization. This
chapter explores the functions of money, the definitions of money, and how banks create money.
A barter economy is an economy that does not use money and in which people trade goods and services
directly for other goods and services. Because barter is inefficient, there is strong incentive to usemo ney,
which is anyasset that people are generally willing to accept in exchange for goods or services or in
payment of debts. Money has four functions. It is:
1. a medium of exchange
2. a unit of account
3. a store of value
4. a standard of deferred payment
The narrowest definition of the money supply in the United States today isM1, which includes currency,
checking account balances, and traveler’s checks. A broader definition of the money supply isM2, which
includes everything that is in M1, plus savings accounts, small-denomination time deposits (such as
certificates of deposit (CDs)), money market deposit accounts in banks, and noninstitutional money
market fund shares.
Reserves are deposits that the bank has retained rather than loaned out or invested. Required reserves
are reserves that banks are legally required to hold. The fraction of deposits that banks are required to
keep as reserves is called the required reserve ratio. Any reserves banks hold over and above the legal
requirement are called excess reserves. When a bank accepts a deposit, it keeps only a fraction of the
funds as reserves and loans out the remainder. In making a loan, a bank increases the checking account
balance of the borrower. When the borrower uses a check to buy something with the funds the bank has
loaned, the seller deposits the check in his bank. The seller’s bank keeps part of the deposit as reserves
and loans out the remainder. This process continues until no banks have excess reserves. In this way, the
process of banks making new loans increases the volume of checking account balances and the money
supply. The simple deposit multiplier is the ratio of the amount of deposits created by banks to the
amount of new reserves. An expression for the simple deposit multiplier is 1/RR.
The United States has a fractional reserve banking system in which banks keep less than 100 percent of
deposits as reserves. In a bank run, many depositors decide simultaneously to withdraw money from a
bank. In a bank panic, many banks experience runs at the same time. The Federal Reserve System (the
Fed) is the central bank of the United States. It was originally established in 1913 to stop bank panics, but
CHAPTER 13 (25)|Money, Banks, and the Federal Reserve System
358
today its main role is to carry out monetary policy. Monetary policy refers to the actions the Federal
Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy objectives.
The Fed’s three monetary policy tools are open market operations, discount policy, and reserve
requirements. Open market operations are the buying and selling of Treasury securities by the Federal
Reserve. The loans the Fed makes to banks are called discount loans, and the interest rate the Fed
charges on discount loans is the discount rate. The Federal Open Market Committee (FOMC) meets
in Washington, DC, eight times per year to discuss monetary policy.
The quantity equation relates the money supply to the price level:M ×V =P ×Y, whereM is the money
supply,V is the velocity of money,P is the price level, andY is real output. The velocity of money is the
average number of times each dollar in the money supply is spent during the year. Economist Irving
Fisher developed the quantity theory of money, which assumes that the velocity of money is constant.
Learning Objectives
When you finish this chapter, you should be able to:
1.Define money and discuss its four functions. A barter economy is an economy that does not use
money and in which people trade goods and services directly for other goods and services. Barter
trade only occurs if there is a double coincidence of wants, where both parties to the trade want what
the other one has. Because barter is inefficient, there is strong incentive to usemoney, which is
anything that people are generally willing to accept in exchange for goods or services or in payment
of debts. Money has four functions: a medium of exchange, a unit of account, a store of value, and a
standard of deferred payment. The gold standard was a monetary system under which the government
produced gold coins and paper currency convertible into gold. The gold standard collapsed in the
early 1930s. Today, no government in the world issues paper currency that can be redeemed for gold.
Instead, paper currency is fiat money, which has no value except as money.
2.Discuss the definitions of the money supply used in the United States today. The narrowest
definition of the money supply in the United States today isM1, which includes currency, checking
account balances, and traveler’s checks. A broader definition of the money supply isM2, which
includes everything that is in M1, plus savings accounts, small-denomination time deposits (such as
certificates of deposit (CDs)), and noninstitutional money market fund shares.
3.Explain how banks create money. On a bank’s balance sheet, reserves and loans are assets, and
deposits are liabilities.Re serves are deposits that the bank has retained, rather than loaned out or
invested. Required reserves are reserves that banks are legally required to hold. The fraction of
deposits that banks are required to keep as reserves is called the required reserve ratio. Any reserves
banks hold over and above the legal requirement are called excess reserves. When a bank accepts a
deposit, it keeps only a fraction of the funds as reserves and loans out the remainder. In making a
loan, banks increase the checking account balance of the borrower. When the borrower uses a check
to buy something with the funds the bank has loaned, the seller will deposit the check in his bank. The
seller’s bank will keep part of the deposit as reserves and loan out the remainder. This process will
continue until no banks have excess reserves. In this way, the process of banks making new loans
increases the volume of checking account balances and the money supply. This money creation
process can be illustrated with T-accounts, which are stripped down versions of balance sheets that
show only how a transaction changes a bank’s balance sheet. The simple deposit multiplier is the
ratio of the amount of deposits created by banks to the amount of new reserves.
CHAPTER 13 (25)|Money, Banks, and the Federal Reserve System359
4.Discuss the three policy tools the Federal Reserve uses to manage the money supply. The Federal
Reserve System (the Fed) is the central bank of the United States and was created by Congress in
1913. It was originally established to stop banking panics, but today its main role is to control the
money supply. Monetary policy refers to the actions the Federal Reserve takes to manage the money
supply and interest rates to pursue economic objectives. The Fed’s three monetary policy tools are:
open market operations, discount policy, and reserve requirements. Open market operations are the
buying and selling of Treasury securities by the Federal Reserve. The loans the Fed makes to banks
are called discount loans, and the interest rate the Fed charges on discount loans is the discount rate.
The Federal Open Market Committee (FOMC) meets in Washington, D.C. every six weeks to
discuss monetary policy. Required reserves are the reserves that the Fed requires banks to hold, based
on their checking account deposits.
5.Explain the quantity theory of money and use it to explain how high rates of inflation occur.
The quantity equation relates the money supply to the price level:M xV =P xY, whereM is the
money supply,V is the velocity of money,P is the price level, andY is real output. The velocity of
money is the average number of times each dollar in the money supply is spent during the year.
Economist Irving Fisher developed the quantity theory of money, which assumes that the velocity
of money is constant. If the quantity theory of money is correct, then the inflation rate should equal
the rate of growth of the money supply minus the rate of growth of real output. Although the quantity
theory of money is not literally correct because the velocity of money is not constant, it is true that in
the long run inflation results from the money supply growing faster than real GDP. When
governments attempt to raise revenue by selling large quantities of bonds to the central bank, the
money supply will increase rapidly, resulting in a high rate of inflation.
Chapter Review
Chapter Opener: McDonald’s Money Problems in Argentina (pages 430-431)
Money is an asset with one special feature: It can be used to purchase goods and services. Today our
money has value not because of the materials used to make it, but because people have confidence that if
they accept it in exchange for goods and services they will be able to use it to purchase goods and
services. In Argentina recently, the public lost confidence in the official currency, the peso, and people
resorted to using barter (or U.S. dollars) instead of using Argentina’s official money. One Argentine
province decided to issue its own money, called the patacone. McDonalds franchises in Argentina decided
to accept that new currency for a meal they labeled the Patacombo: two cheeseburgers, an order of French
fries, and a soft drink. When people lack confidence in money, there are serious macroeconomic
consequences.
Helpful Study Hint
Read An Inside Look at the end of the chapter to learn how China’s
central bank is trying to control the money supply by raising banks’
reserve requirement in order to slow bank lending.
Would you like to live in a country where the purchasing power
of your money rose every year? The Economics in YOUR Life! at the
start of this chapter poses this question. Keep the question in mind as you
read the chapter. The authors will answer the question at the end of the
chapter.

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