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The Money Supply Reserve

System

An Overview of Money

Money is anything that


is generally accepted as
a medium of exchange.
Money is not income, and money is not
wealth. Money is:
a means of payment,
a store of value, and
a unit of account.
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What is Money?
Barter is the direct exchange of goods and
services for other goods and services.
A barter system requires a double
coincidence of wants for trade to take
place. Money eliminates this problem.
As a medium of exchange, or means of
payment, money is generally accepted by
buyers and sellers as payment for goods
and services.

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What is Money?

As a store of value, money


serves as an asset that can be
used to transport purchasing
power from one time period to
another.

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What is Money?

As a unit of account, money


is a standard that provides a
consistent way of quoting
prices.

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What is Money?
Money is easily portable,
and easily exchanged for
goods at all times.
The liquidity property
of money makes money
a good medium of
exchange as well as a
store of value.

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Commodity and Fiat Monies


Commodity monies are items
used as money that also have
intrinsic value in some other
use. Gold is one form of
commodity money.
Fiat, or token, money is
money that is intrinsically
worthless.

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Commodity and Fiat Monies


Legal tender is money that a
government has required to be
accepted in settlement of
debts.
Currency debasement is the
decrease in the value of money
that occurs when its supply is
increased rapidly.

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Measuring the Supply of


Money in the United States
M1, or transactions money is
money that can be directly
used for transactions.

M1 currency held outside


banks + demand deposits +
travelers checks + other
checkable deposits
M1 is a stock measureit is
measured at a point in time
on a specific day.
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Measuring the Supply of


Money in the United States
M2, or broad money, includes
near monies, or close
substitutes for transactions
money.
M2 M1 + savings accounts +
money market accounts + other
near monies

The main advantage of looking


at M2 instead of M1 is that M2
is sometimes more stable.
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The Private Banking System


Financial
intermediaries are
banks and other
financial institutions
that act as a link
between those who
have money to lend
and those who want to
borrow money.

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The Modern Banking System


A brief review of accounting:
Assets liabilities Net Worth, or
Assets Liabilities + Net Worth
A banks most important assets are its
loans. Other assets include cash on hand
(or vault cash) and deposits with the Fed.
A banks liabilities are its debtswhat it
owes. Deposits are debts owed to the
banks depositors.
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The Modern Banking System

The Federal Reserve System (the


Fed) is the central bank of the United
States.
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The Modern Banking System

Reserves are the deposits that a


bank has at the Federal Reserve
bank plus its cash on hand.
The required reserve ratio is the
percentage of its total deposits that a
bank must keep as reserves at the
Federal Reserve.

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T-Account for a Typical Bank


The balance sheet of a bank must always
balance, so that the sum of assets
(reserves and loans) equals the sum of
liabilities (deposits and net worth).
T-Account for a Typical Bank (millions of dollars)
ASSETS

LIABILITIES

Reserves

20

100

Deposits

Loans

90

10

Net worth

110

110

Total

Total

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The Creation of Money


Banks usually make loans up to the
point where they can no longer do so
because of the reserve requirement
restriction (or up to the point where
their excess reserves are zero).

e x c e s s re s e rv e s a c tu a l re s e rv e s re q u ire d re s e rv e s

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The Money Multiplier


Summary:
Bank 1
Bank 2
Bank 3
Bank 4

Deposits
100
80
64
51.20

.
.
.

.
.
.

Total

500.00

The money multiplier is the multiple by


which deposits can increase for every
dollar increase in reserves.
1
M o n e y m u ltip lie r =
R e q u ire d re s e rv e ra tio

In the example above, the required reserve ratio


is 20%. Each dollar increase in reserves could
cause an increase in deposits of $5 when there is
no leakage out of the system. An additional $100
of reserves result in additional deposits of $500.
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The Discount Rate


The discount rate is the interest
rate that banks pay to the Fed to
borrow from it.
Bank borrowing from the Fed leads
to an increase in the money supply.
The higher the discount rate, the
higher the cost of borrowing, and the
less borrowing banks will want to do.

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Open Market Operations


Open market operations is the
purchase and sale by the Fed of
government securities in the open
market; a tool used to expand or
contract the amount of reserves in
the system and thus the money
supply.
Open market operations is by far the
most significant tool of the Fed for
controlling the supply of money.
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Open Market Operations

An open market purchase of


securities by the Fed results in
an increase in reserves and an
increase in the supply of
money by an amount equal to
the money multiplier times the
change in reserves.

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Open Market Operations

An open market sale of


securities by the Fed results in
a decrease in reserves and a
decrease in the supply of
money by an amount equal to
the money multiplier times the
change in reserves.

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Open Market Operations

Open market operations are the


Feds preferred means of controlling
the money supply because:
they can be used with some

precision,
are extremely flexible, and
are fairly predictable.

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