CHAPTER 13  
 Money and the Banking System

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UNIT FIVE

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          I.      What is Money?

                A.  Medium of Exchange

                B.  Store of Value

                C.  Unit of Account

        II.  Why is Money Valuable?

                A.    The main thing that makes money valuable is the same thing that generates value for other commodities: Demand relative to supply.

                B.        People demand money because it reduces the cost of exchange. When the supply of money is limited relative to the demand, money will be valuable.

        III. The Supply of Money

                A.         Components of M1 Money Supply

                        1.        Currency

                        2.                Checking Deposits (including demand deposits and interest-earning checking deposits)

                        3.        Traveler's checks

                B.    M2 money supply: broader measure that includes savings and time deposits and money market mutual funds

                C.  Credit Cards versus Money

                        1.                Money is an asset; credit card balances are a liability. Thus, credit card purchases are not money.

        IV. The Business of Banking

                A.    The banking industry includes savings and loans and credit unions as well as commercial banks.

                B.        Banks accept deposits and use part of them to extend loans and make investments.

                C.        Banks are profit-seeking institutions

                D.        Banks play a central role in the capital (loanable funds) market. They help to bring together people who want to save for the future with those who want to borrow in order to undertake investment projects.

                E.     The banking system is a fractional reserve system: Banks maintain only a fraction of their assets in reserves to meet the requirements of depositors

        V.    How Banks Create Money by Extending Loans

                A.        Under a fractional reserve system, an increase in reserves will permit banks to extend additional loans and thereby expand the money supply (create additional checking deposits)

                B.    The lower the percentage of the reserve requirement, the greater is the potential expansion in the money supply resulting from the creation of new reserves.

                C.    The fractional reserve requirement places a ceiling on potential money creation from new reserves.

                D.    The actual deposit multiplier will be less than the potential because:

                        1.        Some persons will hold currency rather than bank deposits.

                        2.        Some banks may not use all their excess reserves to extend loans.

        VI.   The Federal Reserve System

A.      The Fed is a central bank responsible for the conduct of monetary

         policy

                B.        Bankers' bank

                C.        Structure of the Fed

                D.        Independence of the Fed

                        1.                Stems from the lengthy terms—14 years—of members of the Board of Governors and that fact that its revenues are derived from interest on the bonds it holds rather than allocations from Congress.

        VII. The Three Tools the Fed Uses to Control the Money Supply

                A.        Reserve requirements

                        1.                When the Fed lowers the required reserve ratio, it creates excess reserves and allows banks to extend additional loans, expanding the money supply. Raising the reserve requirements has the opposite effect.

                B.        Open Market operations

                        1.        The buying and selling of bonds in the open market

                        2.        Primary tool used by Fed

                        3.                When the Fed buys bonds, the money supply will expand because the bond buyers will acquire money and bank reserves will increase (placing banks in a position to expand the money through the extension of additional loans).

                        4.                When the Fed sells bonds, the money supply will contract because bond buyers are giving up money in exchange for securities and the reserves available to banks will decline (causing them to extend fewer loans).

                C.        Discount rate

                        1.                An increase in the discount rate is restrictive because it discourages banks from borrowing from the Fed to extend new loans.

                        2.                A reduction in the discount rate is expansionary because it makes borrowing from the Fed less costly.

        VIII. The Difference Between the Fed and the Treasury

                A.   U.S. Treasury

                     1.        Concerned with the finance of the Federal Government

2.        Issues bonds to the general public to finance the budget deficits of

         the federal government

                     3.             Does not determine the money supply.

B.       Federal Reserve

1.            Concerned with the monetary climate for the economy.

                        2.        Does not issue bonds

                        3.                Determines the money supply—primarily through its buying and selling of bonds issued by the U.S. Treasury

        IX. Ambiguities in the Meaning and Measurement of the Money Supply

                A.        Interest earning checking deposits

                        1.        Less costly to hold than currency and demand deposits.

                        2.                Their introduction changed the nature of the M1 money supply in the 1980s.

                B.        Widespread use of the U.S. dollar outside of the United States

                        1.                More than one‑half and perhaps as much as two‑thirds of this currency is held overseas.

                        2.        This reduces the reliability of the M1 money supply measure.

                C.        Sweeping of various interest-earning checking accounts into Money Market Deposit Accounts.

                D.    The increasing availability of low fee stock and bond mutual funds.

                E.        Debit Cards and Electronic Money

                F.        Summary:

1.                Historically, the rate of change of the money supply has been used to judge the direction and intensity of monetary policy. However, recent financial innovations and other structural changes (for example, the widespread use of U.S. currency in other countries) have blurred the meaning of money and reduced the reliability of the various money supply measures. In the Computer Age, continued change in this area is likely.

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