Chapter 14 Summary – Flashcards

Money is an asset that can easily be used to make purchases of goods and services. Money includes cash, which is liquid, plus other assets that are highly liquid. • Currency in circulation consists of cash in the hands of the public. Checkable bank deposits are bank accounts that provide check-writing privileges to the owners of these accounts. • The money supply is the total value of financial assets in the economy that are considered money. There are multiple definitions of the money supply based on the degree of liquidity of the assets included in the particular measure of the money supply. • Debit cards automatically transfer funds from the buyer's bank account, while credit cards access funds that can be borrowed by the user of the credit card. Debit cards allow the user to access part of the money supply while credit cards create a liability for the user and therefore are not part of the money supply.

Money enhances gains from trade by making indirect exchange possible. In a barter economy, exchange can only occur when there is a double coincidence of wants: you must want the good or service I offer and I must want the good or service you offer. Money, by increasing gains from trade, increases welfare.

Money acts as a medium of exchange, a store of value, and a unit of account. • An asset that is used to make purchases of goods and services serves as a medium of exchange. Over time many different kinds of assets have served in this role. • Money acts as a store of value due to its ability to maintain its purchasing power over time, provided there is little inflation. • Money is a measure people use to set prices and make economic calculations. We refer to this role for money as the unit of account.

The types of money fall into three broad categories. • Commodity money refers to the use of an asset as a medium of exchange that has useful value independent of its role as a medium of exchange. • Commodity-backed money refers to items used as medium of exchange that have no intrinsic value (for example, paper currency) but whose ultimate value rests on the promise that they could be exchanged for valuable goods. • Fiat money refers to money whose value derives strictly from the government's decree that it be accepted as a means of payment.

The Federal Reserve (the Fed) provides two measures of the money supply. These monetary aggregates—M1 and M2—measure the money supply using different definitions. M1 defines money most narrowly as the sum of currency in circulation, travelers' checks, and checkable bank deposits. M2 is comprised of M1 plus other near-monies, which are financial assets that are easily converted into cash or checkable bank deposits. M1 measures the money supply from a liquidity perspective: all items included in M1 are highly liquid. M2 includes the liquid assets of M1 as well as a group of less liquid assets.

A T-account is a type of financial spreadsheet that displays an institution's financial position. On the left-hand side of the T-account, the institution's assets and their value are listed; on the right-hand side of the T-account, the institution's liabilities and their values are listed. Banks hold reserves in order to meet the demand for funds from their depositors. Bank reserves are composed of the currency in the banks' vaults and the bank deposits held by the Fed in each bank's own account. The reserve ratio is the fraction of bank deposits a bank holds as reserves: in the United States the reserve ratio is regulated by the Fed.

Banks receive deposits of funds from their customers and then use these funds to make interest-earning financial transactions. For example, banks make loans to customers and purchase Treasury bills: both financial transactions provide income in the form of interest to the bank.

Bank runs occur when many depositors at a bank, fearing a bank failure, simultaneously decide to withdraw their funds. Banks can find themselves in a situation where they lack the liquidity to satisfy these depositor demands since many of the deposited funds are used to finance relatively illiquid bank loans.

Bank regulation reduces the probability of bank runs. • The Federal Deposit Insurance Corporation (FDIC) provides deposit insurance, a guarantee by the federal government that depositors will be paid up to a designated maximum amount per account (currently $250,000 per depositor at any given bank) even if the bank fails. When there is deposit insurance depositors have no incentive to remove their funds from a bank, even if there are rumors that the bank is in financial trouble. • The existence of deposit insurance creates an incentive problem: banks, knowing they are insured, are apt to engage in overly risky behavior while depositors, knowing they are insured, are inclined to not monitor bank behavior. Capital requirements address this incentive problem by requiring owners of banks to hold more assets than the value of their bank deposits. Should some loans prove bad, the bank will still have assets larger than their deposits: the bank owners, rather than the government, can absorb the loss from the bad loans. • Bank runs are also prevented by requiring banks to hold a higher reserve ratio than the banks would otherwise choose to hold. • Banks that are in financial trouble can borrow money from the Fed through an arrangement referred to as the discount window. This enables banks to get funds instead of being forced to sell their assets at prices below their value when confronted by a sudden demand for funds from depositors.

Banks affect the money supply in two ways. First, they remove some money out of circulation by holding currency in their bank vaults and in their reserve accounts at the Fed. Second, banks create money when they accept deposits and make loans.

Excess reserves are those reserves held by a bank that exceed the level of reserves required by the Fed. • In a simplified model where banks lend out all their excess reserves and borrowers hold their loans as bank deposits and not currency, the increase in bank deposits from lending out the excess reserves equals the excess reserves divided by the required reserve ratio. We can write this money multiplier as 1/rr, where rr is the required reserve ratio. • In the real world the money multiplier is smaller than the money multiplier in our simplified model. The monetary base equals the sum of currency in circulation and reserves held by the bank. The monetary base is controlled by the monetary authorities. The money supply equals currency in circulation plus bank deposits. The money multiplier is the ratio of the money supply to the monetary base. The actual money multiplier is smaller than our simple model predicted because a dollar of currency in circulation, unlike a dollar in reserves, does not support multiple dollars of the money supply.

Central banks oversee and regulate the banking system and they control the monetary base. In the United States the central bank is the Federal Reserve. The Federal Reserve consists of a Board of Governors and 12 regional Federal Reserve Banks. The Board of Governors has seven members including the Chairman of the Federal Reserve. • The Federal Reserve Bank of New York carries out open-market operations in which the Fed buys or sells some of the existing stock of U.S. Treasury bills. • Monetary policy decisions are made by the Federal Open Market Committee (FOMC), whose members include the Board of Governors and five of the regional bank presidents. The president of the Federal Reserve Bank of New York is always a member of the FOMC while the other 11 presidents rotate on and off the FOMC. • The Fed's organizational structure creates an organization that is accountable to the voting public while simultaneously insulated from short-term political pressures.

The Fed possesses three monetary policy tools: the reserve requirement, the discount rate, and open-market operations. • The reserve requirement sets the minimum level of reserves each bank must hold. Penalties are assessed on banks that fail to meet the required reserve ratio on average over a two-week period. The Fed seldom changes the required reserve ratio. • The discount rate is the interest rate banks must pay the Fed if they borrow additional reserves from the Fed. Banks that are in need of additional reserves usually borrow these reserves from other banks in the federal funds market. The federal funds market interest rate, the federal funds rate, is determined by supply and demand. The Fed typically sets the discount rate above the federal funds rate to discourage bank borrowing from the Fed. Normally the discount rate is set one percentage point above the federal funds rate, but starting in the fall of 2007 the Fed, in response to the financial crisis, reduced the spread between the discount rate and the federal funds rate. • Open-market operations are the Fed's most important monetary policy tool. The Fed possesses both assets and liabilities: its liabilities consist of bank reserves, both deposited at the Fed and in bank vaults, and currency in circulation. In other words, the Fed's liabilities are equal to the monetary base. • When the FOMC directs the Federal Reserve Bank of New York to purchase Treasury bills, it effectively increases the amount of reserves in the banking system by crediting the commercial banks that sell the Treasury bills with additional reserves. These additional reserves start the money multiplier process, which leads these additional reserves to support a higher level of bank deposits. The money supply increases. • When the FOMC directs the Federal Reserve Bank of New York to sell Treasury bills, it effectively decreases the amount of reserves in the banking system: commercial banks that purchase these Treasury bills pay for them when the Fed debits their reserve accounts at the Fed. This reduction in reserves starts the money multiplier process, which results in these reduced reserves supporting a lower level of bank deposits. The money supply decreases. • The Fed can create the funds it needs to purchase Treasury bills. Thus, the Fed can create monetary base at its own discretion. In addition, the Fed earns interest from the Treasury bills its holds: this interest is returned to the Treasury and provides a source of revenue to the Treasury.

There are many different central banks in the world today. The European Central Bank is the central bank for the members of the European Union. Like the Federal Reserve its organization is answerable to voters while protected from short-term political pressures.

Financial crises over the course of U.S. history have resulted in legislation as well as awareness of policy issues with regard to financial markets and institutions. • After the financial crisis of 1907, legislation was passed creating the Federal Reserve. The Fed was given responsibility for centralizing the holding of reserves, inspecting banks, and providing a sufficiently elastic money supply in response to changing economic conditions. • During the Great Depression in the early 1930s, bank runs were a problem and legislation was passed creating federal deposit insurance to help eliminate these bank runs. In addition, during this time period the federal government recapitalized banks by lending to them and purchasing shares of banks. In 1933, banks were separated into two classes of banks: commercial banks and investment banks. • In the 1980s, the S&L Crisis revealed tendencies for banking institutions to engage in overly speculative transactions and pointed out the need not only for federal deposit insurance, but also regulation with regard to capital requirements and reserve requirements. • In the 1990s, some firms—using huge amounts of leverage—speculated in global markets, and this speculation led to financial crises in Asia and Russia. During this crises there were particular problems associated with deleveraging where large firms (in particular LTCM) sold their assets to cover their losses and this selling of assets created balance sheet problems for other firms around the world. These problems led to the failure of various credit markets and required intervention by the New York Fed to get these world credit markets functioning. • In the mid-2000s, the housing bubble in the United States—accompanied by the securitization of subprime lending—led to massive losses by banks and other nonbank financial institutions once the housing bubble burst. This financial crisis required intervention by the U.S. government to expand its lending to bank and nonbank institutions as well as the provision of bank capital through government purchase of bank shares. By 2008, it was clear that this latest financial crisis would result in the creation of a wider safety net and broader regulation of the financial sector.

any asset that can easily be used to purchase goods and services.

actual cash held by the public.

bank accounts on which people can write checks.

the total value of financial assets in the economy that are considered money.

an asset that individuals acquire for the purpose of trading for goods and services rather than for their own consumption. store of value an asset that is a means of holding purchasing power over time.

a measure used to set prices and make economic calculations.

a medium of exchange that is a good, normally gold or silver, that has intrinsic value in other uses.

a medium of exchange that has no intrinsic value whose ultimate value is guaranteed by a promise that it can be converted into valuable goods on demand.

a medium of exchange whose value derives entirely from its official status as a means of payment.

an overall measure of the money supply. The most common monetary aggregates in the United States are M1, which includes currency in circulation, travelers' checks, and checkable bank deposits, and M2, which includes M1 as well as near-monies.

a financial asset that cannot be directly used as a medium of exchange but can be readily converted into cash or checkable bank deposits.

currency held by banks in their vaults plus their deposits at the Federal Reserve.

a simple tool that summarizes a business's financial position by showing, in a single table, the business's assets and liabilities, with assets on the left and liabilities on the right.

the fraction of bank deposits that a bank holds as reserves. In the United States, the minimum required reserve ratio is set by the Federal Reserve.

a phenomenon in which many of a bank's depositors try to withdraw their funds due to fears of a bank failure.

a guarantee that a bank's depositors will be paid even if the bank can't come up with the funds, up to a maximum amount per account.

rules set by the Federal Reserve that set the minimum reserve ratio for banks. For checkable bank deposits in the United States, the minimum reserve ratio is set at 10%.

a protection against bank runs in which the Federal Reserve stands ready to lend money to banks in trouble.

a bank's reserves over and above the reserves required by law or regulation.

the sum of currency in circulation and bank reserves. money multiplier the ratio of the money supply to the monetary base. central bank an institution that oversees and regulates the banking system and controls the monetary base.

the financial market that allows banks that fall short of reserve requirements to borrow funds from banks with excess reserves.

the interest rate at which funds are borrowed and lent in the federal funds market.

the rate of interest the Federal Reserve charges on loans to banks that fall short of reserve requirements.

a purchase or sale of U.S. Treasury bills by the Federal Reserve, normally through a transaction with a commercial bank.

a bank that accepts deposits and is covered by deposit insurance.

a bank that trades in financial assets and is not covered by deposit insurance.

It is important to understand the definition and the distinction between the monetary base, the money supply, and reserves. The money supply is the value of financial assets in the economy that are considered money: this would include cash in the hands of the public, checkable bank deposits, and traveler's checks, using the narrow definition of the money supply given by the monetary aggregate M1. Bank reserves are composed of the currency banks hold in their vaults plus their deposits at the Federal Reserve. The monetary base is the sum of currency in circulation and bank reserves. The monetary base is not equal to the money supply: the money supply is larger than the monetary base.

It is important to understand the distinction between assets and liabilities. Make sure you clearly understand what an asset and a liability are and then recognize that any financial instrument represents both an asset and a liability. For example, a mortgage represents a liability for the borrower and an asset for the lender; a checking account deposit represents a liability for the bank providing the check service and an asset to the individual depositing the funds.

For any T-account, clearly identify whose perspective is represented in the T-account. T-accounts represent the assets and liabilities of an institution or an individual. When making a T-account, consider whose T-account it represents: this will help you more clearly identify whether the financial instruments you include are assets or liabilities. For example, bank reserves are a liability in the Fed's T-account and an asset in a bank's T-account.

deposit-taking banks, usually specialized in issuing home loans.

the degree to which a financial institution is financing its investments with borrowed funds.

the reduction in a firm's net worth from falling asset prices.

the sequence of events that takes place when a firm's asset sales to cover losses produce negative balance sheet effects on other firms and force creditors to call in their loans, forcing sales of more assets and causing further declines in asset prices.

lending to home buyers who don't meet the usual criteria for borrowing.

the pooling of loans and mortgages made by a financial institution and the sale of shares in such a pool to other investors.