monetary system.docx
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monetary system.docx
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monetarysystem
monetarysystem
THEMONETARYSYSTEMIntroduction:
NowthatwehavecompletedourstudyofthedeterminantsofrealpercapitalGDPgrowthinthelongrun,weturntoprices/inflationinthelongrun.Forthisstudy,weneedtointroduceanewplayerintothesystemTheFederalReserve(orTheFed).ThissetofnotesdetailstheFedanddiscussestheirorganizationandpurpose.ThenextsetofnoteswilllinkuptheFedsactionstopricesinthelongrun.Question:
Whywouldyougiveupsomethingofgreatvalue(acar,food,pennstateseasontickets,ect..)inexchangeforapieceofpaperthatis,onitsown,essentiallyuseless?
Answer:
Becauseyouareconfidentthattheywillbeabletogivethemoneytosomeoneelseinthefutureforsomethingyoudesiremorethanwhatyougaveup.Thereasontheywouldacceptitisthatanotherpartywouldacceptthemoney,andsoon.Thatis,thisgreenpaperisvaluablebecauseitisanacceptedmeansofpayment.Supposewehadnomoney,whatwouldwedo?
Barter:
theexchangeofonegoodorserviceforanother.Example,yougotoarestaurantforamealandinexchangeyoudosomethingthattheyarevalueenough(suchaswashingdishes).Problem:
Abartersocietyhastroubleallocatingsocietysscarceresourcesbecausesuchacaserequiresadoublecoincidenceofwantstheunlikelyoccurrencethattwopeopleeachhaveagoodorservicethattheotherwants.Further,moneymakestrademucheasier:
ARestaraunteurdoesnotcarethatyoucoulddosomethingvaluableforhimheisperfectlyhappytoacceptyourmoney,becauseheknowsthatotherswillinturnacceptitfromhim.Itallowstradetoberoundabout.Asmoneyflowstradeisfacilitated,allowingeachpersontospecializeinwhatheorshedoesbestandtherebyraisingeveryonesstandardofliving.Keys:
1.moneyallowsustospecializeratherthanproducemuchofwhatweneed2.Moneyencouragestradeandmakesitmucheasiertodoso.Amonetarysystemsignificantlyraisesacountrysstandardofliving.Agenda:
1.Whatismoney?
2.Howthebankingsystemcreatesmoney?
3.Howthegovernmentcontrolsthequantityofmoneyincirculation.4.Restoftimeisdevotedtowardslinkingmoneytootherkeymacroeconomicvariables(inflationbeingtops.).Rememberthatwearestillinthelong-run!
TheMeaningofMoney:
Whatismoney?
MoneyisNOTwealthBillgateshasmuchmorewealththanhedoesmoney.Sohowdowedefinemoney?
ByitsfunctionsFunctionsofmoney:
1.Amediumofexchange:
anitemthatbuyersgivetosellerswhentheywanttopurchasegoodsandservices.Moneyisanacceptedmediumofexchange.2.Aunitofaccount:
theyardstickpeopleusetopostpricesandrecorddebts(makescomparisonsofrelativeworthofdifferentgoodsMUCHeasiercontrastwithbarter!
3.Astoreofvalue:
anitemthatpeoplecanusetotransferpurchasingpowerfromthepresenttothefuture.Notethanmanythingsactasastoreofvalue.Wealthisthesumofallitemsthatserveasastoreofvalue.Keypoint:
Liquidity:
theeasewithwhichanassetcanbeconvertedintotheeconomysmediumofexchange.Moneyisthemostliquid(bydefinition).Somestocksandbondsarefairlyliquid.ARenoirpaintingismuchlessliquid(wineisaliquid,butitisnotaveryliquidasset!
).Hinttothefuture:
Althoughmoneyisthemostliquidwaytoholdyourwealth,itsvaluedropswhenpricesrise(unlikeotherassets).Thisnotionwillbeveryimportantinlinkingmoneytoinflation.Rememberabuildingblock:
Inflationhappenswhenthegovernmentprintstoomuchmoney.Thekindsofmoney:
Commoditymoney:
moneythattakestheformofacommoditywithintrinsicvalue.Examples:
gold,cigarettes(POWcamps,jail,theSovietUnioninthelate1980s).Fiatmoney:
moneywithoutanyintrinsicvaluethatisusedasmoneybecauseofgovernmentdecree.Thisnoteislegaltenderforalldebts,publicandprivate.Thekeyforfiatmoneytobeviableisexpectationsandconfidence.MoneyintheU.S.economy:
Whatisthemoneystock-thequantityofmoneycirculatingintheeconomy?
Howwouldyoumeasurethestockofmoney?
Totalmoneyintheeconomy=?
Componentsofmoney:
1.Currency:
thepaperbillsandcoinsinthehandsofthepublic.2.Demanddeposits:
balancesinbankaccountsthatdepositorscanaccessondemandbywritingacheck.Whataboutothers?
Savingsaccounts?
Moneymarketmutualfunds?
-shouldthesealsobeconsidered?
Inotherwords,inourcomplexeconomy,whatassetsshouldbeconsideredmoneyandwhichonesdoweleaveoutinourmeasurementofthestockofmoney?
Hardtoanswer,sowehavevariousdefinitionsofthestockofmoney:
M1:
Currency,travelerschecks,demanddeposits,othercheckabledepositsM2:
M1+savingsdeposits,smalltimedeposits,moneymarketmutualfunds.Keypoint:
moneyismorethanjustcurrency:
Interestingsidebar:
whereisallthecurrency?
TotalcurrencyintheU.S.economyis$380billion.Divideby200million(numberofadults)andyougetalmost$1900!
!
!
Howmanyofyouhave$1900incurrency?
Wherediditgo?
?
?
(Illegalactivities,lost,abroad).Nowfortheimportantstuff!
TheFederalReserve:
TheFed:
thecentralbankoftheUnitedStatesaninstitutiondesignedtooverseethebankingsystemandregulatethequantityofmoneyintheeconomy.Organizationofthefed:
FedisrunbyitsBoardofGovernors:
sevenmembersappointedbythepresidentandconfirmedbytheSenate.14yeartermsdesignedtoinsulatethemfrompoliticalpressures.ChairmanoftheBoard:
AlanGreenspan(4yeartermappointedbythepresident).FedsystemismadeupoftheFederalreserveboardand12Federalreservebanks(oneinRichmond).Primaryjobsofthefed:
1.regulatebanksandensurethehealthofthebankingsystem(regionalbanksjob).Notethatthefedisalsothebankersbank2.controlthequantityofmoneythatisavailableintheeconomycalledthemoneysupplymonetarypolicy:
thesettingofthemoneysupplybypolicymakersinthecentralbank.AttheFed,monetarypolicyismadebytheFederalOpenMarketCommittee.FederalOpenmarketcommittee:
7membersoftheboardand5ofthe12regionalbankpresidents.Theymeeteverysixweeksinordertodiscusstheconditionoftheeconomyandconsiderchangesinmonetarypolicy.intuition:
imaginethefeddroppingbagsofmoneyfromhelicoptersrandomlythroughouttheU.S.(inpracticeitismuchmorecomplicated).Punchlineinthefuture:
theyreallychangethemoneysupplythroughopen-marketoperationsthepurchaseandsaleofU.S.governmentbonds.Iftheywanttoincreasethemoneysupplytheybuygovernmentbondsfromthepublic,therebyputtingmoneyinthehandsofthepublic.Iftheywanttodecreasethemoneysupplythentheysellgovernmentbonds,therebytakingmoneyawayfromthepublic.MoreonthislaterImportanceofmonetarypolicy:
inflationinthelong-run,employmentandproductionintheshort-run.Banksandthemoneysupply:
Whatroletoregularbanksplayinthemonetarysystem?
Recall,demanddeposits(apartofmoney)isheldinbanks,sothebehaviorofbankscaninfluencethequantityofdemanddepositsintheeconomy,and,therefore,themoneysupply.Supposetherearenobanks,andcurrencyistheonlyformofmoney.Supposethatthereis$100ofcurrency,hencethemoneysupply=$100.NowsupposesomeoneopensupabankFirstnationalbank.Supposefurtherthatthebankdoesnotmakeanyloans.Reserves:
depositsthatbankshavereceivedbuthavenotloanedout.So,thusfar,wehave100%reservebanking!
Tosummarize,hereisaT-accountforfirstnationalbank:
FirstNationalBankAssetsLiabilitiesReserves$100Deposits$100.00Assets:
(reservesitholdsinitsbank).Liabilities:
amountitowesdepositors.Note:
eachdepositinthebankreducescurrencyandraisesdemanddepositsbyexactlythesameamount,leavingthemoneysupplyunchanged.Nowletsmoveontoamorerealisticcase.Moneycreationwithfractionalreservebanking:
Fractional-reservebanking:
abankingsysteminwhichbanksholdonlyafractionofdepositsasreserves.Supposefirstnationalbankdecidestokeep10%ofitsdepositsinreserveandtoloanouttherest.Reserveratio:
thefractionofdepositsthatbanksholdasreserves.FirstNationalBankAssetsLiabilitiesReserves:
$10.00Deposits:
$100.00Loans:
$90.00Question:
Nowwhatisthemoneysupply?
Currencyplusdemanddeposits:
$90+100=$190.Byloaningoutafractionofreserves,banksincreasethemoneysupply.Anyquestions?
?
?
?
TheMoneymultiplier:
Thecreationofmoneydoesntstopwithfirstnationalbank.Supposethe$90loanwasusedtobuyabikefromsomeone,andtheydepositthe$90intotheSecondnationalbank.Thisleadsto:
SecondnationalbankAssets:
Liabilities:
Reserves:
$9Deposits:
$90Loans:
$81Afterthedeposit,thebankkeeps10percentasreserves($9)andloansouttherest($81).Thus,secondnationalbankcreated$81innewmoney.Theprocessgoesonandon.Eachtimemoneyisdepositedandabankloanismade,moremoneyiscreated.Question:
Howmuchmoneyiseventuallycreatedbythatinitial$100deposit?
100+90+81+72.90+..=$1,000.Moneymultiplier:
theamountofmoneythebankingsystemgenerateswitheachdollarofreserves.Inthiscase$100ofreservesgenerates1,000ofmoney,sothemoneymultiplieris10.Question:
Whatdeterminesthesizeofthemoneymultiplier?
Answer:
moneymultiplier=1/RwhereR=reserveratio.Thehigherthereserveratio,thelessofeachdepositbanksloanout,thesmallerthemoneymultiplier.TheFedstoolsofmonetarycontrol:
TheFedscontrolofthemoneysupplyisindirect;itworksthroughthebankingsystem.Tools:
1.open-marketoperations(buyingandsellingU.S.bonds)2.reserverequirements3.discountrateOpenmarketoperations:
Openmarketoperations:
thepurchaseand
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