Money and Banking Quiz

Chapter 25: Money, the Federal Reserve, and the Interest Rate

• This chapter examines how the money market functions within the macroeconomy, contrasting it with the goods market explored in prior chapters.

An Overview of Money

• Money functions as a means of payment, a store of value, and a unit of account.

What Is Money? (1 of 3)

• Barter: Direct exchange of goods and services for other goods and services.
• Double Coincidence of Wants: A crucial requirement for barter; both parties must want what the other has.
• Medium of Exchange (Means of Payment): Sellers accept and buyers use to pay for goods and services.

What Is Money? (2 of 3)

• Store of Value: An asset capable of storing purchasing power over time.
• Liquidity: Money's portability and ready acceptance, facilitating its exchange.
• Inflation's Impact: Money's value decreases as prices rise.

What Is Money? (3 of 3)

• Unit of Account (Standard Unit): Consistent way to quote prices.

Commodity and Fiat Monies (1 of 2)

• Commodity Money: Items with intrinsic value (e.g., red feathers, gold).
• Fiat Money: Items without intrinsic value, but designated by a government (e.g., paper currency).
• Legal Tender: Money the government requires be accepted as payment for debts.

Commodity and Fiat Monies (2 of 2)

• Currency Debasement: Value of money decreases due to rapid increase in supply.

Measuring the Supply of Money in the United States (1 of 3)

• M1 (Transactions/Currency Money): Money used for direct transactions.

• M1 = Currency outside banks + demand deposits + traveler's checks + other checkable deposits

• Stock Measure: Measured at a specific point in time, e.g., February 2015.

Measuring the Supply of Money in the United States (2 of 3)

• M2 (Broad Money): M1 plus close substitutes, like savings accounts and money market accounts.
• M2 = M1 + savings accounts + money market accounts + other near monies

Measuring the Supply of Money in the United States (3 of 3)

• Beyond M2: Available credit on cards is also part of the money supply.

How Banks Create Money (1 of 3)

• Goldsmiths: Early banks that provided safekeeping for gold.
• Receipts for stored gold evolved into early paper forms of money.

How Banks Create Money (2 of 3)

• Increased Circulation: Goldsmiths increased the amount of money without adding more gold.
• Runs on Banks: Instances where many depositors demand their gold/money simultaneously. This highlights the fragility of trusting a financial institution's safety.

How Banks Create Money (3 of 3)

• Differing Role of Today's Banks: Today's banks are subject to a specified required reserve ratio. Early goldsmiths were constrained by their fear of needing to provide gold on demand to customers.

The Modern Banking System (1 of 3)

• Accounting Basics: Assets minus liabilities equal net worth. (Assets = Liabilities + Net Worth)
• Assets of a Bank: Most significant are loans, followed by cash on hand (vault cash), and deposits with the central bank.

The Modern Banking System (2 of 3)

• Liabilities of a Bank: Most significant is customer deposits.
• Central Bank of the US: The Federal Reserve Bank

The Modern Banking System (3 of 3)

• Reserves: Deposits held by a bank at the Federal Reserve plus cash on hand.
• Required Reserve Ratio: Percentage of total deposits that a bank must hold as reserves at the Federal Reserve.

The Creation of Money

• Excess Reserves: Difference between actual reserves and required reserves.
• The expansion of money supply can be greater than 1 for 1. Excess reserves allow for further lending and deposit creation in banks.

The Money Multiplier

• Greater-than-one Increase: Expansion of the money supply exceeds the increase in reserves.
• Multiple (Multiplier): Deposits multiply based on the required reserve ratio; 1 divided by the required reserve ratio.

The Federal Reserve System (1 of 2)

• Established (1913): Founded as the central bank during significant economic reforms of the 1930s.
• Independent Agency: The Fed is separate from and independent of the President and Congress.

The Federal Reserve System (2 of 2)

• Federal Open Market Committee (FOMC): A committee of the Fed, responsible for setting monetary policy directions (including the money supply).

Functions of the Federal Reserve (1 of 2)

• Banker's Bank: Central banks are sometimes referred to as banks for other banks.
• Money Supply Control: The Fed plays a vital role in managing money supply.
• Banks' Financial Assistance: Fed provides clearing payments assistance and helps struggling banks.
• Foreign Exchange: The Fed manages exchange rates and foreign exchange reserves.

Functions of the Federal Reserve (2 of 2)

• Facilitating Funds Transfer: The Federal Reserve facilitates the transfer of money between banks by adhering to various rules and regulations.
• Lender of Last Resort: The Fed provides funds to banks in dire straits. This is a vital role for maintaining economic stability.

The Demand for Money

• Transaction Size: Positively related to the size of transactions.
• Interest Rate: Negatively related to the interest rate; opportunity cost of holding money.

Interest Rates and Security Prices

• Securities Issuance: Firms and government issue securities to borrow money; these contracts have a face value and recurring payments.
• Interest Rates and Security Prices Relationship: As interest rates rise (fall), prices of existing securities fall (rise).

How the Federal Reserve Controls the Interest Rate (1 of 2)

• Traditionally (Pre-2008): Three main tools existed: open market operations; reserve requirement ratio changes and discount rate adjustments.

How the Federal Reserve Controls the Interest Rate (2 of 2)

• Open Market Operations: Buying and selling government securities to manage money supply.
• Discount Rate: Interest rate banks pay to borrow reserves.

The Equilibrium Interest Rate

• Equilibrium Interest Rate Based on Money Supply: The interest rate depends on the chosen money supply level. Increasing the money supply will lower the interest rate.

Money Supply

• Money supply independent of interest rate; vertical money supply curve.

Expanded Fed Activities Beginning in 2008

• Large financial institution participation: The Fed became a more active player in the private banking system.
• Securities buying: The Fed bought various securities to try to improve financial conditions.

The Federal Reserve Balance Sheet

• Assets and Liabilities (April 2015): Includes holdings of gold, U.S. Treasury securities, federal agency debt securities, mortgage-backed securities, and other assets listed against liabilities.

Tools After 2008

• Paying Interest on Reserves: The Fed started paying interest on reserves held by banks; this would make prior tools less effective. This effectively increased the amount of excess reserves in banks.

Review Terms and Concepts (1 of 2)

• List of key terms for Chapter 25 concerning money supply, the Federal Reserve, and interest rates.

Review Terms and Concepts (2 of 2)

• Contains an additional list of key terms and equations. These help to summarize major formulas and concepts in the chapter.

Chapter 25 Appendix: The Various Interest Rates in the U.S. Economy

• Term Structure of Interest Rates: Relationship between interest rates and securities of varying maturities.
• Expectations Theory: 2-year interest rate is the average of the current 1-year rate and expected next year's one-year rate.
• Fed Behavior: Fed actions affect expectations of short-term rates, influencing long-term rates.

Types of Interest Rates (1 of 2)

• Treasury Bill Rate: Interest rate paid for government short-term debt (3-month maturity.)
• Government Bonds: Long-term debt securities issued by the government.
• Federal Funds Rate: Rate banks charge each other for overnight borrowing of reserves.
• Commercial Paper: Short-term debt instruments of corporations.

Types of Interest Rates (2 of 2)

• Prime Rate: Benchmark banks use to quote interest rates to clients.
• Corporate Bonds: Bonds issued by corporations with various risk ratings (AAA being the least risky.)

Test your knowledge on the functions and characteristics of money, the Federal Reserve System, and the dynamics of interest rates. This quiz covers key concepts in monetary economics, focusing on how money operates within the economy and its implications for banking. Challenge yourself to understand the critical role money plays in facilitating trade and savings.