Macroeconomics

Lecture 15

The Monetary System

Questions

1. What are the three functions of money?

2. What is the difference between good money and bad money?

3. What is liquidity?

4. What is more liquid, a share of Apple stock, or a house?

5. What is the difference between commodity and fiat money?

6. What is an example of commodity money?

7. Who issues the U.S. Currency?

8. What is a gold standard?

9. Are any countries on a gold standard?

10. What is one word that describes money?

11. Are credit cards considered money?

12. What is a central bank.

13. Does every country have a central bank?

14. What is the central bank in the U.S.?

15. When was the FED established?

16. How many board members does the FED have?

17. How long do FED board members serve?

18. Who is the current FED chairman?

19. How many regional FED banks are there?

20. What is the FMOC?

medium of exchange, unit of account, store of value

fails in one of the functions

convert to cash

Apple stock

Commodity has other use, fiat is declared by government

gold

Federal Reseve Bank

Convert currency to gold

no

Trust

no

an institution that oversees the baking system and money supply

Yes

Federal Reseve Bank

1913

7

14 years

Janet Yellen

12

Sets monetary policy

Fed Functions• Issues national currency

• Clearing of checks 

• The bank of banks - lender of last resort

• Control the money supply

Federal Open Market Committee

FMOC7 board governors12 regional banks

5 of the regionals votealways NY Fed

Money Supply

The quantity of money available in a country.

Monetary Policy

Setting the money supply by the central bank policymakers

Two Types of Banks

100 Percent Reserve

Fractional Reserve

100-Percent Reserve Bank

All the deposits are kept in a safe vault.

No loans

Fractional-Reserve Bank

Bank only holds a fraction of the deposits

as reserves

Loans out the remainder

Reserve Ratio

The fraction of deposits that banks hold as

reserves

Fractional-Reserve Banking

Creates money

Bank DepositReserve

10%Loan

Remainder

1000 100 900

900 90 810

810 81 729

• • • •

• • • •

• • • •

Total 10,000

How does 1000 become 10,000?

Reserve Ratio

Fraction Reciprocal MoneyMultiplier

100% 1 1÷1 1

50% 0.5 1 ÷ 0.50 2

25% 0.25 1 ÷ 0.25 4

10% 0.1 1 ÷ 0.10 10

5% 0.05 1 ÷ 0.05 20

1% 0.01 1 ÷ 0.01 100

Money multiplier is the reciprocal of the reserve ratio

Bank Capital

The money the bank’s shareholders have put in

to the bank

Leverage

OPM

Using other people’s money

Leverage1. I have 10

2. I borrow 90 from you

3. I buy something for 100

4. I resell the item for 150

5. I pay back your 90

6. I keep the 60

7. I earned 50 profit on my 10

Leverage Ratio

The ratio of assets to bank capital

AssetsBank Capital

Bank Balance Sheet

AssetsLiabilities and Owner Equity

Reserves 200 Deposits 800

Loans 700 Debt 150

Securities 100 Capital 50

Total 1000 Total 1000

Totals must balance or be equal

What is the leverage ratio?

AssetsLiabilities and Owner Equity

Reserves 200 Deposits 950

Loans 800 Capital 50

Total 1000 Total 1000

Assets ÷ Capital1000 ÷ 50 = 20

Leverage is Risky!If leverage ratio is 20,

5% increase in asset value = 100% return to owners

5% decrease in asset value = 100% loss to owners

Capital Requirement

Government rule on minimum amount of

bank capital

Three Tools of Central Banks

Open-Market Operations

Discount Rate

Reserve Ratio

Open-Market Operations

Purchase and sale of government bonds

Buy bonds increases supply

Sell bonds decreases supply

Banksnow have

more cash to loan

Central Bank

Public Banks

Increase Money Supply?Buy bonds for cash

Banksnow have less cash to loan

Central Bank

Public Banks

Decrease Money Supply?Sell bonds for cash

Two RatesDiscount Rate

Federal Funds Rate

Discount RateThe rate the FED charges to make loans to member banks

Today is 1.0%

Federal Funds Rate

The rate banks charge each other

Today is 0.5%

Remember

Discount Rate: What the FED charges banks

Federal Funds Rate: What banks charge other

banks

Reserve Ratio

Increase reserve ratio will reduce money multiplier

Decrease reserve ratio will increase money multiplier

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1 2 4 6 8 10 12 14 16 18 20

ReserveRatio

Money Multiplier

The Power of the Reserve Ratio to Multiply Money

Reserve RatioNot changed very often

What is the current reserve ratio in the U.S.? 3% to 10%

What is the Money Multiplier?

1÷3% = 33.33 1÷10% = 10

Bank Deposit Insurance

Protects against bank runs

Moral Hazard to take more risk because government

will pick up losses

Bank RunCustomers all want their money at the same time

Many banks runs at once

Bank Panic