intro to economics - monetary system

7/31/2019 Intro to Economics - Monetary System

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Monetary System

Dr. Katherine SauerA Citizens Guide to Economics ECO 1040


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Imagine that there was no item in the economy widelyaccepted in exchange for goods and services.

People would have to rely on barter the exchange of one good or service for another to obtain the thingsthey need.


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Problems with a Barter System

1. In order for a transaction to take place, there needs tobe a double coincidence of wants.


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2. There is no common measure of value.

5 pigs = ? shoes= ? haircuts= ? insurance

Number of unique exchange rates ( prices ) in a bartereconomy:N( N-1)

2

Ex: An economy with 1000 goods would need1000(999) =

2499,500 prices


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3. Certain goods/services are not divisible .

4. Lack of standards for future payments.

5. Difficulty in storing wealth.


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Money is the set of assets that people generally use tobuy goods and services.

In order to be money, the asset has to fulfill 3 functions:


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1. medium of exchange : an item that buyers give to

sellers in exchange for goods and servicesex: paper bills, coins, shells, cigarettes

2. unit of account : the yardstick that people use to

post prices and record debtsex: your Visa bill is denominated in dollars notchickens

3. store of value : the item can be used to transferpurchasing power from the present to the future

ex: diamonds are durable, milk is not


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There are 2 kinds of money:

1. Commodity money takes the form of a commodity thathas intrinsic value.

- the material that the money is made of has usesbesides money

ex: gold, silver, cigarettes

2. Fiat money has no intrinsic value; it is a material used as

money by government decree .- the general public also has to believe it has valueex: US paper bills


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Dont be Afraid of Fiat Money

Money is simply a means to an end .

- it is a way to make transactions easier- it is a way to transfer purchasing power to the future

Money itself doesnt matter to you what matters is thatyou can trade the money for things you want and need,now or in the future.

- money is a tangible symbol of purchasing power


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Trading money for gold serves no real purpose for you.

If you want to trade money for gold so you can tradegold for goods and services, the gold is no differentthan the paper currency.

Money is simply a societal agreement that helps simplify

transactions. (but a very important one)


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The Federal Reserve System is comprised of

-Board of Governors headquartered in Washington D.C.-Federal Open Market Committee-12 Regional District Banks


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1. The Board of Governors (BoG) has 7 members whoserve 14 year terms.

Their primary responsibility is the formulation of monetary policy .- sit on the Federal Open Market Committee

It also has regulatory and supervisory responsibilitiesover banks.


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2. The Federal Open Market Committee (FOMC) makesdecisions regarding the quantity of money in the economy.

The FOMC is most important monetary policymaking bodyof the Federal Reserve System.

The monetary policy is designed to promote economic growthfull employmentstable prices

sustainable pattern of international trade & payments

At meetings they discuss economic conditions and decidehow to adjust the money supply.


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3. 12 Regional District Banks that serve as the operatingarms of the nation's central banking system. (the banksbank)

- move currency in and out of circulation- check clearing- supervise/ examine banks- hold banks cash reserves and make loans to banks


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III. The Feds Tools of Monetary Policy

When the economy is sluggish , the Fed may want to try to

stimulate it.

When the economy is experiencing inflation or is heatingup too quickly, the Fed may want to try to slow it down .


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The US has a fractional reserve banking system. Thismeans banks do not have to keep all deposits on hand,they can lend out a portion of them.

The fraction of deposits that a bank must keep on hand iscalled the reserve requirement ratio .-aka reserve requirement, reserve ratio, required ratio

- For large banks, this ratio is 10%.


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Monetary Policy Tool #1 The Fed controls the required reserve ratio .

- hugely powerful tool- almost never used

This affects the amount of money that banks can lendout.

- more lending means more economic activity


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When the reserve requirement is raised :- banks are able to lend out less- slows the economy down

When the reserve requirement is lowered:- banks are able to lend out more- speeds the economy up


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Monetary Policy #2 The Fed controls the discount rate ,which is the interest rate that the Fed charges to banks forloans (BoG - every 6 weeks)

This is the only interest rate the Fed can directly control.

This interest rate usually just acts as a signal from the Fed

to banks about what the Fed would like banks to do.


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A higher discount rate:- means that it will be more costly for banks to

borrow from the Fed (should they need to)

- so banks take this as a signal to lend out less (beless risky)

- when banks lend out less, the economy slows

down


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Monetary Policy Tool #3 Open Market Operations are thepurchase or sale of US government bonds by the Fed.(FOMC every 6 weeks)

The Fed uses Open Market Operations to target theFederal Funds Rate.

- cant control the Fed Funds Rate directly

The Federal Funds Rate is the rate that banks charge eachother on short term loans. (overnight)


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Why would banks borrow from each other overnight?- a bank might not have enough reserves on hand to

meet their requirement (made too many loans)

- books must balance at close of business

- borrow from another bank just overnight


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When the Fed buys bonds :- banks receive cash in exchange for the bondsthey were holding

- banks have more cash reserves on hand so theyare willing and able to lend it out to other banks

- this decreases the federal funds rate

- banks know it is cheap to borrow from a bank

overnight so they are willing to make more loans

- economy speeds up


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When the Fed sells bonds :- banks receive bond certificates in exchange fortheir cash

- banks have less in cash reserves on hand so theyare not as willing and able to lend it out to otherbanks

- this increases the federal funds rate

- banks know it is more expensive to borrow froma bank overnight so they want to make fewerloans

- economy slows down


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Summary of Policy Tools:

To slow down the economy, the Fed could- raise the required reserve ratio- raise the discount rate- raise the federal funds target and sell bonds

To speed up the economy, the Fed could- lower the required reserve ratio- lower the discount rate- lower the federal funds target and buy bonds


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The Feds mandate is to facilitate a sustainable pace of economic growth.

This is difficult because1.

2.

3.


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Summary:

In order for an asset to be money it must be able tofulfill 3 functions.

There are 3 branches of the US Federal ReserveSystem.

There are 3 main tools of monetary policy in the US.


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intro to economics - monetary system

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