Money, The Federal Reserve System And Money Creation

By: Hussain Shiyam.

What Makes Money Money? Can exchange occur in economy without money? It can, using a traditional system called barter.  Barter is the direct exchange of one good for another good, rather than for money. The problem with barter is that it requires a coincidence of wants. The use of money simplifies and therefore increases market transactions. Money also prevents wasting time that can be devoted to production, thereby promoting economic growth by increasing a nation’s production possibilities

The three function of money Money is anything that serves as a medium of exchange, unit of account, and store of value. 1. Money as a medium of exchange. The most important function of money is to serves as a medium of exchange 2. Money as a unit of account. Unit of account is the function of money to provide a common measurement of the relative value of goods and services. 3. Money as a store of value. Store of value is the ability of money to hold value over time Conclusion: Money is a useful mechanism for transforming income in the present into future purchases The key property of money is that it is completely liquid. Money is the most liquid form of wealth because it can be spent directly in the marketplace

Other desirable properties of money  Once something has passed the three basic

requirements to serves as money, there are additional hurdles to clear.  First, an important consideration is scarcity. Money must be scarce, but not too scarce. (Counterfeiting threatens the scarcity of money)  Second, money should b portable and divisible.  Finally, money must be uniform.

What stands behind our money Historically, money played two roles. Commodity money is anything that serves as

money while having market value in other uses.  Money itself has intrinsic worth. Money can be pure gold or silver, both of which valuable for non-money uses, such as making jewelry and serving other industrial purposes Fiat money is money accepted by the law, and not because of its redeemability or intrinsic value. An item’s ability to serve as money does not depend on its own market value or the backing of precious metal

The three money supply definitions  M1 - The most narrowly defined money supply  This money definition measures purchasing power immediately available to the

public without borrowing or having to give notice.  M1 measures the currency, traveler's checks, and checkable deposits held by the public at a given time, such as a given day, month, or year.  M1 does not include the money held by the government, Federal Reserve Banks, or depository institutions.

M1= currency + traveler’s checks + checkable deposits  Currency= money include coins and paper money  Checkable deposits= Most ‘big tickets’ purchases are paid for with checks or credit

cards (which are not money), rather than currency.  Checkable deposits are the total of checking account balances in financial institutions that are convertible to currency ‘on demand’ by writing a check without advance notice

The three money supply definitions  M2 = M1 + near monies  M2 = M1 + saving deposits + small time deposits of less than

$100,000  M2 = Adding near monies to M1  Near money include passbook savings accounts, money market mutual funds, and time deposits of less than $100,000. Saving deposits  Interest bearing accounts that can be easily withdrawn. These deposits include passbook savings accounts, money market mutual funds Small time deposits  Distinction between a checkable deposit and a time deposit. A time deposit is an interest bearing account in a financial institution that requires a withdrawal notice or must remain on deposit for a specified period unless an early withdrawal penalty is paid.

The three money supply definitions M3 = M2 + large deposits of $100,000 or more  M3 = Adding large time deposits to M2  The large time deposits included in M3 are any CDs with a value of

$100,000 or more.  Why M2 and M3 include the savings and time deposits excluded from M1?  The traditional reason is that these accounts are less liquid than the items included in the narrow definition of money.  Currency plus traveler’s checks plus checkable deposits constitute the public’s most immediately spendable forms of money  M1 is more liquid than M2 or M3  The boundary lines for any definition of money are somewhat arbitrary

The Federal reserve system The Fed is the central banker for the nation and

provides banking services to commercial banks, other financial institutions, and the federal government. The Fed regulates, supervises, and is responsible for policies concerning money. Congress and the president consult with the Fed to control the size of the money supply and thereby influence the economy’s performance. The desire for more safety in banking led to the creation of the Federal reserve System by the Federal Reserve Act of 1913.

The Fed’s Organizational Chart. The Federal Reserve system is an independent

agency of the Federal government. Congress oversees the Fed. The Chair reports twice a year. Coordinates it’s actions with the US treasury and the president. Congress can abolish the Fed if it’s policies are contrary to the national interests.

The Fed’s organizational chart

The Federal Reserve system consists of

12 central banks that service banks and other financial institution within each district. The board of governors administer the Federal Reserve System.

The Board of governors is made up of 7 members appointed by

the president and confirmed by the senates. They served for 1 non renewable 14 year terms. The Chair is the principle spokesperson for the Fed and has considerable power over policy decisions.

The Federal Reserve System receives no

funding from congress. This creates financial autonomy for the Fed. The Fed earns interest income from the government security it holds, and the loans it makes to depository institutions. The board of governors is the independent self supporting authority of the Federal Reserve system.

Federal Open Market Committee The FOMC consists of the 7 members of the board

of governors, the president of the New York Federal reserve Bank, and the president of 4 others Federal Reserve district banks. The FOMC directs the buying and selling of US government securities. FOMC expresses opinions and implementing monetary policies and issue policy statements known as FOMC directives. Federal advisory councils consists of 12 prominent commercial banks. They meet periodically, to advise the board of governors.

What Federal Reserve Bank does Controlling the money supply Clear checks Supervising and regulating banks. Works with the

FDIC to insure commercial bank deposits upto a specified limit. Maintain and circulating currency Protect consumers. (Enforces laws enacted by congress, most notably Equal Credit Opportunity Act) Maintain Federal government checking accounts and gold

The US Banking Revolution THE MONETARY CONTROL ACT of 1980 The acts for major provisions are: 1. The authority of the fed over non-member depository institutions

was increased. 2. All depository institutions are able to borrow loan reserves from the Federal Reserve banks. 3. The act allowed commercial banks, thrifts, money market mutual funds, stock brokerage firms, and retailers to offer a wide variety of banking services. 4. The act eliminated all interest rate ceilings. Before this act S&L’s were allowed to pay depositors a slightly higher interest rate on passbook savings deposits than those paid by commercial banks.  Finally, deregulation continued with the signing of the Financial Services Modernization Act of 1999 which allowed banks, securities firms, and insurance companies to merge and sell each others products.

The Savings and Loan Crisis. Monetary Control Act removed interest rate ceiling

on deposits, forcing S&L’s to pay higher interest on short term loans. S&L’s earned incomes from long-term mortgages at fixed interest rates below the rate required to keep or attract new deposits. Which forced them to seek high-interest but riskier commercial and consumer loans. Which resulted in losses and defaults. Similar to FDIC the FSLIC (Federal Savings and Loan Insurance Corporation) insured the deposits of the S&L’s. The magnitude of the losses were so high that the FSLIC ran out of funds. Congress placed FSLIC under FDIC and enacted the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), better known as the Thrift Bailout Bill.

One of the provisions in the act required

thrifts to invest a higher minimum percentage of their assets in long-term housing loans to divest themselves of certain risky assets. Another provision created the Resoultion Trust Corporation (RTC) to carry out a massive bailout of failed institutions . It bought the assets and deposits of the failed insitiutions and sold them to offset the cost borne by taxpayers. The RTC closed in 19995 and the final cost to taxpayers at over $300 Billion.

In the middle ages Gold was the money of

choice in most European countries. Gold is heavy, difficult to transact and difficult to hide from thieves. To keep it safe people deposited their gold with Goldsmiths. This inspired goldsmiths' to become the founder of modern-day banking.

•Fractional Reserve Banking. oA system in which banks keep only a percentage of their odeposits on reserve as vault cash and deposits at the Fed.

Typical bank. BALNCE SHEET 1 Assets Required Reserves Million

Liabilities 5

Excess Reserves

Checkable Deposits Million

50

0

Loans Million

45

Total Million

50

Total Million

50

BANKER BOOKKEEPING •Liabilities are the amounts the bank owes to others. •Assets are amounts the bank owns. •Required Reserves are the minimum balance that the Fed requires a bank to hold in vault cash or on deposit with the Fed. •Required Reserve Ratio is the percentage of deposits that the fed requires a bank to hold in vault or cash on deposit with the fed.

• Excess Reserves are potential loan balance

held in vault cash or on deposit with the Fed in excess of required reserve. Total Reserves = Required Reserves + Excess Reserves Or Excess Reserves = Total Reserves – Required Reserves.

Best Nation Bank BALNCE SHEET 2 Assets Required Reserves

10,000

Excess Reserves

90,000

Total

100,000

Liabilities

Change in M1

Andreas Acc 100,000

0

Total

100,00

STEP ONE: Accepting A New Deposit.

Assume Required ratio is 10%. If Andreas deposits 100,000. The bank would mark the entry as liabilities for them and increases its excess reserves to 90,000 which would allow it to make loans.

Step 2: Making a Loan

Actual money creation occurs. Now, Ricky applies for a loan to purchase

equipment to open a Spa worth 90,000 and the bank agrees after accepting Ricky’s IOU.

Best National Bank Balance Sheet 3 Assets

Liabilities

Change in M1

Required Reserves

19,000

Andres Acc

100,000

Excess Reserves

81,000

Ricky Acc

90,000

Total

190,000

90,00 Total

190,000

90,000

Step 3: Clearing the Loaning Check Now Ricky buy’s equipment from Better

Health Spa and pays thorough check. Better Health Spa then deposits the amount into their account at Yazoo National Bank. BEST NATIONAL BANK Balance Sheet 4 Assets

Liabilities

Cahnge in M1 0

Required Reserves

10,000

Andreas Acc100,000

Excess Reserves

0

Ricky Acc

0

Loans

90,000

Total

100,000

Total

100,000

The Fed, Clears the check by debiting the reserve account of Best National Bank and then crediting the reserve account of Yazoo National Bank YAZOO NATIONAL BANK Balance Sheet 5 Assets Required Reserves

Liabilities 9,000

Better Health Spa Acc

90,000

Total

90,000

Excess Reserves 81,000 Total

90,000

Multiplier Expansion of Money by the Banking System Exhibit 2, EXPANSION OF THE MONEY SUPPLY Round

Bank

Increase in Checkable Deposits

Increase in Required Reserves

Increase in Excess Reserves

Rnd1

Best National Bank

100,000

10,000

90,000

Rnd 2

Yazoo National Bank 90,000

9,000

81,000

Rnd 3

Bank A

81,000

8,100

72,000

Rnd 4

Bank B

72,000

7,290

65,610

Rnd 5

Bank C

65,610

6,561

59,049

Rnd 6

Bank D

59,049

5,905

53,144

Rnd 7

Bank E

53,144

5,314

47,830

…

…

…

…

..

…

…

…

…

Total

All other Banks

578,297

47,830

430,467

Total Increase

$ 1,000,000

$ 100,000

$ 900,000

.

The Money Multiplier Money Multiplier us the maximum change in the money

supply (checkable deposits) due to an initial change in the excess reserves banks hold. Money Multiplier is Equal to 1 divided by the required ratio Money Multiplier = 1÷ Required Ratio  = 1÷(1/10) =10 Actual Money supply change= Initial Change in Excess Reserve (ER) × Money Multiplier  ΔM1 = ΔER × MM $ 900,000 = $ 90,000 × 10

How Monetary Policy Creates Money Monetary policy is the federal Reserve’s use

of:  open market operations changes in the discount rate, and changes in the required reserve ratio to change

the money supply (M1).

OPEN MARKET OPERATIONS. The FOMC determines the money supply through Open

Market Operations. Open Market Operations is the buying and selling of government securities by the Federal Reserve System. The NY Fed’s trading desk executes these orders. A purchase of government securities by the fed injects reserves into the banking system and increases the money supply. A sale of government securities by the Fed reduces reserves in the banking system and decreases the money supply.

The Discount Rate Discount rate is the rate the Fed charges on

loans of reserves to banks. A higher discount rate discourages banks from borrowing reserves andmaking loans. If the Fed wants to expand the money supply, it reduces the discount rate. If the objective is to contract the money supply, the Fed raises the discount rate.

Banks can also turn to the Federal Funds

Market to seek profitable loan opportunities. Federal Fund Market is a private market in which banks lend reserve to each other for less than 24 hours. Banks short on reserves can borrow excess reserves of another bank to pay the Federal Funds Rate. Federal Funds Rate is the interest rate banks charge for overnight loans of reserves to other banks.

The Required Reserve Ratio The Fed can set reserve requirements by law for

all banks and savings and loans associations. There is an inverse relationship between the size of the required reserve ratio and the money multiplier. If the fed wishes to increase the money supply, it decreases the required reserve ratio. If the objective is to decrease the money supply, the Fed increases the required reserve ratio. Changing the required reserve ratio is considered a heavy handed approach that is an infrequently used too to monetary policy.

Monetary Policy Shortcomings. MONEY MULTIPLIER INACCURACY The value of the Money Multiplier can be uncertain and subject to decisions independent of the fed. Such as the public’s decision to hold cash and the willingness of banks to make loans. NONBANKS Nonbanks are not directly under the Fed’s jurisdiction. Nonbanks provide financial services but do not offer checkable depositis included in M1. Example of nonbanks are brokerage firms, finance companies etc

WHICH MONEY DEFINITION SHOULD THE FED CONTROL? What if the Fed controls M1 but the public transfers its deposits to M2? What if the Fed responds and focuses more on M2? In recent years the Fed has focused more on M2 because it more closely correlates with changes to GDP.

LAGS IN MONETARY POLICY VERSUS FISCAL POLICY. Firstly and Inside Lag exists. An Inside lag exists between the time a policy change is need and the time the Fed identifies the problem and decides which policy tool to use. Inside lag is fairly short. Financial data is available daily. Data on inflation and unemployment are available monthly. GDP data is available every three months. Once data is available the Fed can decide which policies need to be changed and adjusted. The inside lag for monetary policy is shorter than for fiscal policy because the fiscal policy is the result of a long political budget process.

Second, there is an outside lag. This lag refers to the length of time it takes

the money multiplier or spending multiplier to have its full effect on aggregate demand and, in turn, employment, the price level, and real GDP.