Principle of economics session XIV the monetary system

Session XIV The Monetary System Principles of Economics Overview What are the functions of money? The types of money? What is the central bank (Federal Reserve, BOK)? What role do banks play in the monetary system? How do banks “create money”? How does the central bank control the money supply? 1 Learning Objectives By the end of this session, students should understand: –what money is and what functions money has in the economy. –what the Federal Reserve System is. –how the banking system helps determine the supply of money. –what tools the Federal Reserve uses to alter the supply of money 2 Part I Money Supply The Monetary System 4 The Meaning of Money Money –Set of assets in an economy –That people regularly use –To buy g&s from other people 5 The Three Functions of Money Medium of exchange: an item buyers give to sellers when they want to purchase g&s Unit of account: the yardstick people use to post prices and record debts Store of value: an item people can use to transfer purchasing power from the present to the future 6 The Money Supply The money supply (or money stock): the quantity of money available in the economy What assets should be considered part of the money supply? Two candidates: –Currency: the paper bills and coins in the hands of the (non-bank) public –Demand deposits: balances in bank accounts that depositors can access on demand by writing a check (in Korea: 요구불예금) 7 Measures of the U.S. Money Supply M1: currency, demand deposits, traveler’s checks, and other checkable deposits. M1 = $1.4 trillion (June 2008) M2: everything in M1 plus savings deposits, small time deposits, money-market deposit accounts for individuals M2 = $7.7 trillion (June 2008) The distinction between M1 and M2 will usually not matter when we talk about “the money supply” in this course. 8 Two Measures of the Money Stock for the U.S. Economy The two most widely followed measures of the money stock are M1 and M2. This figure shows the size of each measure in January 2013. Source: Mankiw (2013) 9 The Federal Reserve System The Federal Reserve (the Fed) –The central bank of the United States –To ensure the health of the nation’s banking system –Control the money supply Central bank (Bank of Korea in Korea) –Institution designed to • Oversee the banking system • Regulate the quantity of money in the economy [...]... not change 24 The Monetary System Part II Tools for Monetary Policy The 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 26 The Fed’s Tools of Monetary Control 1 Open-Market Operations (OMOs): the purchase and sale of U.S government bonds by the Fed To... in the interest rate on reserves • Increase the reserve ratio • Lower the money multiplier • Lower the money supply 32 Problems in Controlling the Money Supply 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 In a system of fractional-reserve banking, the. .. Reciprocal of the reserve ratio – The higher the reserve ratio, the smaller the money multiplier In our example, R = 10%, money multiplier = 1/R = 10  $100 of reserves creates $1000 of money 21 Exercise XIV- 1: Banks and the Money Supply While cleaning your apartment, you look under the sofa cushion find a $50 bill (and a half-eaten taco) You deposit the bill in your checking account The Fed’s reserve... 29 The Fed’s Tools of Monetary Control 2 The Discount Rate: the interest rate on loans the Fed makes to banks  The Fed uses discount lending to provide extra liquidity when financial institutions are in trouble, e.g after the Oct 1987 stock market crash, 2008-2009 global financial crisis  If no crisis, Fed rarely uses discount lending – Fed is a “lender of last resort.” 30 The Fed’s Tools of Monetary. .. fractional-reserve banking, the amount of money in the economy depends in part on the behavior of depositor and bankers 33 The Federal Funds Rate On any given day, banks with insufficient reserves can borrow from other banks with excess reserves The interest rate on these loans is the federal funds rate (in Korea, similar to call rate, 콜금리) The Fed has set a target goal for the fed funds rate Many interest... banking system The process continues, and money is created with each new loan Original deposit FNB lending SNB lending TNB lending = = = = $ 100.00 $ 90.00 $ 81.00 $ 72.90 Total money supply = $ 1000.00 In this example, $100 of reserves generates $1000 of money 20 The Money Multiplier Money multiplier (1/R) – amount of money the banking system generates with each dollar of reserves The money... requirement is 20% of deposits A What is the maximum amount that the money supply could increase? B What is the minimum amount that the money supply could increase? Source: Mankiw (2011) 22 Exercise XIV- 1 Answer A: Banks and the Money Supply A What is the maximum amount that the money supply could increase? You deposit $50 in your checking account If banks hold no excess reserves, then money multiplier... and sells RPs 28 The Fed’s Tools of Monetary Control 2 The Discount Rate: (재할인율) the interest rate on loans the Fed makes to banks  When banks are running low on reserves, they may borrow reserves from the Fed  To increase money supply, Fed can lower discount rate, which encourages banks to borrow more reserves from Fed  Banks can then make more loans, which increases the money supply  To reduce money... banking system How did the money supply suddenly grow?  When banks make loans, they create money The borrower gets – $90 in currency (an asset counted in the money supply) – $90 in new debt (a liability) A fractional reserve banking system creates money, but not wealth 17 Banks and the Money Supply: An Example – Case 3-3 CASE 3: Fractional reserve banking system Suppose borrower deposits the $90... dollar of reserves, which increases money multiplier and money supply  To reduce money supply, Fed raises RR, and the process works in reverse  Fed rarely uses reserve requirements to control money supply: Frequent changes would disrupt banking system 31 The Fed’s Tools of Monetary Control 4 Paying interest on reserves – Since October 2008 (new) – The higher the interest rate on reserves • The more . Session XIV The Monetary System Principles of Economics Overview What are the functions of money? The types of money? What is the central bank (Federal. Reserve System is. –how the banking system helps determine the supply of money. –what tools the Federal Reserve uses to alter the supply of money 2 Part I Money Supply The Monetary System. Reserve System The Federal Reserve (the Fed) –The central bank of the United States –To ensure the health of the nation’s banking system –Control the money supply Central bank (Bank of Korea