Chapter 29-30 Monetary System PDF

Chapter W 29 hen you walk...

Chapter W 29 hen you walk into a restaurant to buy a meal, you get ­something of value—a full stomach. To pay for this service, you might hand the restaurateur several worn-out pieces of greenish paper decorated with strange symbols, government ­buildings, and portraits of famous dead Americans. Or you might hand her a single piece of paper with the name of a bank and your signature. Or you might show her a plastic card and sign a paper slip. Whether you pay by cash, check, or debit card, the restaurateur is happy to work hard to satisfy your gastronomical desires in exchange The Monetary for these pieces of paper, which, in and of themselves, are worthless. Anyone who has lived in a modern economy is familiar with this social custom. Even though paper money has no intrinsic value, the System restaurateur is confident that, in the future, some third person will accept it in exchange for something that the restaurateur does value. And that third person is confident that some fourth person will accept the money, with the knowledge that yet a fifth person will accept the money... and so on. To the restaurateur and to other people in our society, your cash, check, or debit card receipt represents a claim to goods and services in the future. iStock.com/lolostock; George Rudy/Shutterstock.com Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch29_hr_589-612.indd 589has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 11:31 am  590 part X Money and Prices in the Long Run The social custom of using money for transactions is extraordinarily useful in a large, complex society. Imagine, for a moment, that an economy had no item widely accepted 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 things they need. To get your restaurant meal, for instance, you would have to offer the restau- rateur something of immediate value. You could offer to wash some dishes, mow her lawn, or give her your family’s secret recipe for meat loaf. An economy that relies on barter will have trouble allocating its scarce resources efficiently. In such an economy, trade is said to require the double coincidence of wants—the unlikely occurrence that two people each have a good or service that the other wants. The existence of money makes trade easier. The restaurateur does not care whether you can produce a valuable good or service for her. She is happy to accept your money, knowing that other people will do the same for her. Such a convention allows trade to be roundabout. The restaurateur accepts your money and uses it to pay her chef; the chef uses her paycheck to send her child to day care; the day care center uses this tuition to pay a teacher; and the teacher hires you to mow her lawn. As money flows from person to person, it facilitates production and trade, thereby allowing each person to specialize in what she does best and raising everyone’s standard of living. In this chapter, we begin to examine the role of money in an economy. We dis- cuss what money is, the various forms that money takes, how the banking system helps create money, and how the government controls the quantity of money in circulation. In the rest of this book, we devote much effort to learning how changes in the quantity of money affect various economic variables, including inflation, interest rates, production, and employment. Consistent with our long-run focus in the previous four chapters, in the next chapter we examine the long-run effects of changes in the quantity of money. The short-run effects of monetary changes are a more complex topic, which we take up later. This chapter provides the background for all of this further analysis. 29-1 The Meaning of Money What is money? This might seem like an odd question. When you read that ­billionaire Jeff Bezos has a lot of money, you know what that means: He is so rich that he can buy almost anything he wants. In this sense, the term money is used to mean wealth. money Economists, however, use the word in a more specific sense: Money is the set the set of assets in an of assets in the economy that people regularly use to buy goods and services economy that people from each other. The cash in your wallet is money because you can use it to buy regularly use to buy goods a meal at a restaurant or a shirt at a store. By contrast, the large share of Amazon and services from other that makes up much of Jeff Bezos’s wealth is not considered a form of money. people Mr. Bezos could not buy a meal or a shirt with this wealth without first obtaining some cash. According to the economist’s definition, money includes only those few types of wealth that are regularly accepted by sellers in exchange for goods and services. 29-1a The Functions of Money Money has three functions: It is a medium of exchange, a unit of account, and a store of value. These three functions together distinguish money from other assets, such as stocks, bonds, real estate, art, and even baseball cards. Let’s examine each of these functions of money. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch29_hr_589-612.indd 590has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 11:31 am  CHAPTER 29 The Monetary System 591 A medium of exchange is an item that buyers give to sellers when they purchase medium of exchange goods and services. When you go to a store to buy a shirt, the store gives you the an item that buyers give shirt and you give the store your money. This transfer of money from buyer to seller to sellers when they want allows the transaction to take place. When you walk into a store, you are confident to purchase goods and that the store will accept your money for the items it is selling because money is services the commonly accepted medium of exchange. A unit of account is the yardstick people use to post prices and record unit of account debts. When you go shopping, you might observe that a shirt costs $50 and a the yardstick people use ­hamburger costs $5. Even though it would be accurate to say that a shirt costs to post prices and record 10 hamburgers and a hamburger costs 1 10 of a shirt, prices are never quoted in debts this way. Similarly, if you take out a loan from a bank, the size of your future loan repayments will be measured in dollars, not in a quantity of goods and services. When we want to measure and record economic value, we use money as the unit of account. A store of value is an item that people can use to transfer purchasing power store of value from the present to the future. When a seller accepts money today in exchange for a an item that people can good or service, that seller can hold the money and become a buyer of another good use to transfer purchasing or ­service at another time. Money is not the only store of value in the ­economy: power from the present to A ­person can also transfer purchasing power from the present to the future by the future ­holding nonmonetary assets such as stocks and bonds. The term wealth is used to refer to the total of all stores of value, including both money and nonmonetary assets. Economists use the term liquidity to describe the ease with which an asset liquidity can be converted into the economy’s medium of exchange. Because money is the the ease with which an economy’s medium of exchange, it is the most liquid asset available. Other assets asset can be converted vary widely in their liquidity. Most stocks and bonds can be sold easily with low into the economy’s cost, so they are relatively liquid assets. By contrast, selling a house, a Rembrandt medium of exchange painting, or a 1948 Joe DiMaggio baseball card requires more time and effort, so these assets are less liquid. When people decide how to allocate their wealth, they have to balance the liquidity of each possible asset against the asset’s usefulness as a store of value. Money is the most liquid asset, but it is far from perfect as a store of value. When prices rise, the value of money falls. In other words, when goods and services become more expensive, each dollar in your wallet can buy less. This link between the price level and the value of money is key to understanding how money affects the economy, a topic we start to explore in the next chapter. 29-1b The Kinds of Money When money takes the form of a commodity with intrinsic value, it is called ­commodity money. The term intrinsic value means that the item would have commodity money value even if it were not used as money. One example of commodity money is money that takes the gold. Gold has intrinsic value because it is used in industry and in the making form of a commodity with of jewelry. Although today we no longer use gold as money, historically gold intrinsic value was a c­ ommon form of money because it is relatively easy to carry, measure, and verify for ­impurities. When an economy uses gold as money (or uses paper money that is convertible into gold on demand), it is said to be operating under a gold standard. Another example of commodity money is cigarettes. In prisoner-of-war camps during World War II, prisoners traded goods and services with one another using cigarettes as the store of value, unit of account, and medium of exchange. Similarly, as the Soviet Union was breaking up in the late 1980s, cigarettes started replacing Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch29_hr_589-612.indd 591has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 11:31 am  592 part X Money and Prices in the Long Run the ruble as the preferred currency in Moscow. In both cases, even nonsmokers were happy to accept cigarettes in an exchange, knowing that they could use the cigarettes to buy other goods and services. fiat money Money without intrinsic value is called fiat money. A fiat is an order or decree, money without intrinsic and fiat money is established as money by government decree. For example, com- value that is used as pare the paper dollars in your wallet (printed by the U.S. government) with the money by government paper dollars from a game of Monopoly (printed by the Parker Brothers game decree company). Why can you use the first to pay your bill at a restaurant but not the second? The answer is that the U.S. government has decreed its dollars to be valid money. Each paper dollar in your wallet reads: “This note is legal tender for all debts, public and private.” Although the government is central to establishing and regulating a system of fiat money (by prosecuting counterfeiters, for example), other factors are also required for the success of such a monetary system. To a large extent, the ­acceptance of fiat money depends as much on expectations and social convention as on government decree. The Soviet government in the 1980s never abandoned the ruble as the official currency. Yet the people of Moscow preferred to accept cigarettes (or even American dollars) in exchange for goods and services because they were more confident that these alternative monies would be accepted by others in the future. Cryptocurrencies: A Fad or the Future? I n recent years, the world has seen a proliferation of a new kind of money, called cryptocurrencies. These currencies use the tools of cryptography to create a medium of exchange that exists only in electronic form. They in illicit transactions such as the drug trade and benefit from the ano­ nymity that bitcoin transactions offer. During bitcoin’s brief history, its dollar value has fluctuated wildly. In rely on a technology called blockchain to maintain a decentralized, public 2010, the price of a bitcoin ranged between 5 cents to 39 cents. The price ledger that records transactions. rose above $1 in 2011 and above $1,000 in 2013 before falling below The first of these cryptocurrencies, introduced in 2009, was ­bitcoin. $500 in 2014. Over the following few years, the dollar value of a bitcoin It was conceived by a computer expert called Satoshi Nakamoto. skyrocketed, reaching more than $19,000 in 2017. But by early 2019, it Nakamoto authored and circulated a white paper establishing the ­bitcoin had fallen back to $3,500. Meanwhile, a variety of other cryptocurrencies protocol, but Nakamoto’s identity is otherwise unknown. According to were introduced, such as Ethereum, Litecoin, Ripple, and Zcash, providing the protocol, people create bitcoins by using computers to solve complex competition for bitcoin. These other cryptocurrencies differ from bitcoin mathe­matical problems. The number of bitcoins that can be “mined” in in the details of their protocols, but like bitcoin, they have all exhibited this way is supposedly limited to 21 million units. Once created, bitcoins large price swings. can be used in exchange. They can be bought and sold for U.S. dollars The long-term success of cryptocurrencies depends on whether they on organized bitcoin exchanges, where supply and demand determine succeed in performing the functions of money: a store of value, a unit the dollar price of a bitcoin. People can hold bitcoins as a store of value, of account, and a medium of exchange. Many economists are skeptical. and they can use bitcoins to buy things from any vendor who is willing The great volatility of the dollar prices of cryptocurrencies makes them to accept them. a risky way to hold wealth and an inconvenient measure in which to Bitcoins are neither commodity money nor fiat money. Unlike com­ post prices. Few retailers accept them in exchange, at least so far. As modity money, they have no intrinsic value. You can’t use bitcoins for a result, cryptocurrencies are excluded from standard measures of the anything other than exchange. Unlike fiat money, they are not created quantity of money. by government decree. Fans of bitcoin embrace this new form of money Cryptocurrencies may be the money of the future, or they may be a because it exists apart from government. Some bitcoin users are engaged passing fad. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch29_hr_589-612.indd 592has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 11:31 am  CHAPTER 29 The Monetary System 593 29-1c Money in the U.S. Economy As we will see, the quantity of money circulating in the economy, called the money stock, has a powerful influence on many economic variables. But before we consider why that is true, we need to ask a preliminary question: What is the quantity of money? In particular, suppose you were given the task of m ­ easuring how much money there is in the U.S. economy. What would you include in your measure? The most obvious asset to include is currency—the paper bills and coins in currency the hands of the public. Currency is clearly the most widely accepted medium of the paper bills and coins exchange in our economy. There is no doubt that it is part of the money stock. in the hands of the public Yet currency is not the only asset that you can use to buy goods and services. Many stores also accept personal checks. Wealth held in your checking account is almost as convenient for buying things as wealth held in your wallet. To measure the money stock, therefore, you might want to include demand deposits—balances demand deposits in bank accounts that depositors can access on demand simply by writing a check balances in bank or swiping a debit card at a store. accounts that depositors Once you start to consider balances in checking accounts as part of the money can access on demand by stock, you are led to consider the large variety of other accounts that people hold writing a check at banks and other financial institutions. Bank depositors usually cannot write checks against the balances in their savings accounts, but they can easily transfer funds from savings into checking accounts. In addition, depositors in money mar- ket mutual funds can often write checks against their balances. Thus, these other accounts should plausibly be counted as part of the U.S. money stock. In a complex economy such as ours, it is not easy to draw a line between assets that can be called “money” and assets that cannot. The coins in your pocket clearly are part of the money stock, and the Empire State Building clearly is not. But there are many assets in between these extremes for which the choice is less clear. Because different analysts can reasonably disagree about where to draw the dividing line between mon- etary and nonmonetary assets, various measures of the money stock are available for the U.S. economy. Figure 1 shows the two most commonly used, designated M1 and M2. M2 includes more assets in its measure of money than does M1. Billions Figure 1 of Dollars M2 Two Measures of the Money Stock $14,467 for the U.S. Economy Savings deposits The two most widely followed Small time deposits measures of the money stock are Money market mutual funds M1 and M2. This figure shows the A few minor categories size of each measure in January 2019. Source: Federal Reserve. M1 $3,737 Currency Everything in M1 ($3,737 billion) Demand deposits Traveler’s checks Other checkable deposits Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch29_hr_589-612.indd 593has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 11:31 am  594 part X Money and Prices in the Long Run Why Credit Cards Aren’t Money I t might seem natural to include credit cards as part of the ­economy’s stock of money. After all, people use credit cards to make many of their purchases. Aren’t credit cards, therefore, a medium of Notice that credit cards are different from debit cards, which auto­ matically withdraw funds from a bank account to pay for items bought. Rather than allowing the user to postpone payment for a purchase, a debit exchange? card gives the user immediate access to deposits in a bank account. In At first this argument may seem persuasive, but credit cards this sense, a debit card is more similar to a check than to a credit card. are excluded from all measures of the quantity of money. The reason The account balances that lie behind debit cards are included in measures is that credit cards are not really a method of payment but rather of the quantity of money. a method of deferring payment. When you buy a meal with a credit Even though credit cards are not considered a form of money, they card, the bank that issued the card pays the restaurant what it is are nonetheless important for analyzing the monetary system. People who due. At a later date, you will have to repay the bank (perhaps with have credit cards can pay many of their bills together at the end of the interest). When the time comes to pay your credit card bill, you will month, rather than sporadically as they make purchases. As a result, probably do so by writing a check against your checking account. people with credit cards probably hold less money on average than people The balance in this checking account is part of the economy’s stock without credit cards. Thus, the wide availability of credit cards may reduce of money. the amount of money that people choose to hold. For our purposes in this book, we need not dwell on the differences between the various measures of money. None of our discussions will hinge on the dis- tinction between M1 and M2. The important point is that the money stock for the U.S. ­economy includes not only currency but also deposits in banks and other ­financial institutions that can be readily accessed and used to buy goods and services. Where Is All the Currency? Case One puzzle about the money stock of the U.S. economy concerns Study the amount of currency. In January 2019, there was $1.7 trillion of currency outstanding. To put this number in perspective, we can divide it by 258 million, the number of adults (age 16 and older) in the United States. This calculation implies that there is more than $6,500 of currency per adult. Most people are surprised by this figure because they carry far less in their wallets. Who is holding all this currency? No one knows for sure, but there are two plausible explanations. The first explanation is that much of the currency is held abroad. In foreign countries without a stable monetary system, people often prefer U.S. dollars to domestic assets. Estimates suggest that over half of U.S. dollars circulate outside the United States. The second explanation is that much of the currency is held by drug dealers, tax evaders, and other criminals. For most people in the U.S. economy, currency is not a particularly good way to hold wealth: Not only can currency be lost or stolen but it also does not earn interest, whereas a bank deposit does. Thus, most people hold only small amounts of currency. By contrast, criminals find currency more appealing. They may avoid putting their money in banks, for instance, because a bank deposit gives police a paper trail that they can use to trace illegal activities. For criminals, currency may be the best store of value available. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch29_hr_589-612.indd 594has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 11:31 am  CHAPTER 29 The Monetary System 595 QuickQuiz 1. Fiat money is 2. The money stock includes all of the following EXCEPT a. a type of money with intrinsic value. a. metal coins. b. a type of money set by government decree. b. paper currency. c. any asset used as the medium of exchange. c. lines of credit accessible with credit cards. d. any asset used as the unit of account. d. bank balances accessible with debit cards. Answers at end of chapter. 29-2 The Federal Reserve System Whenever an economy uses a system of fiat money, as the U.S. economy does, some agency must be responsible for regulating the system. In the United States, that agency is the Federal Reserve, often simply called the Fed. If you look at the Federal Reserve (Fed) top of a dollar bill, you will see that it is called a “Federal Reserve Note.” The Fed the central bank of the is an example of a central bank—an institution designed to oversee the banking United States system and regulate the quantity of money. Other major central banks around central bank the world include the Bank of England, the Bank of Japan, and the European an institution designed Central Bank. to oversee the banking 29-2a The Fed’s Organization system and regulate the quantity of money in the The Federal Reserve was created in 1913 after a series of bank failures in 1907 economy convinced Congress that the United States needed a central bank to ensure the health of the nation’s banking system. Today, the Fed is run by its Board of Governors, which has up to seven members appointed by the president and confirmed by the Senate. The governors have 14-year terms. Just as federal judges are given lifetime appointments to insulate them from politics, Fed governors are given long terms to give them independence from short-term political pressures when they formulate monetary policy. Among the members of the Board of Governors, the most important is the chair. The chair directs the Fed staff, presides over board meetings, and testifies regularly about Fed policy in front of congressional committees. The president appoints the chair to a 4-year term. As this book was going to press, the chair of the Fed was Jerome Powell, who was nominated to the job by President Donald Trump in 2017. The Federal Reserve System consists of the Federal Reserve Board in Washington, D.C., and 12 regional Federal Reserve Banks located in major cities around the country. The presidents of the regional banks are chosen by each bank’s board of directors, whose members are typically drawn from the region’s banking and business community. The Fed has two related jobs. The first is to regulate banks and ensure the health of the banking system. In particular, the Fed monitors each bank’s financial condition and facilitates bank transactions by clearing checks. It also acts as a money supply bank’s bank. That is, the Fed makes loans to banks when banks themselves want the quantity of money to borrow. When financially troubled banks find themselves short of cash, the Fed available in the economy acts as a lender of last resort—a lender to those who cannot borrow anywhere else— to maintain stability in the overall banking system. monetary policy The Fed’s second job is to control the quantity of money that is made available the setting of the money in the economy, called the money supply. Decisions by policymakers concerning supply by policymakers in the money supply constitute monetary policy. At the Federal Reserve, monetary the central bank Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch29_hr_589-612.indd 595has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 11:31 am  596 part X Money and Prices in the Long Run policy is made by the Federal Open Market Committee (FOMC). The FOMC meets about every six weeks in Washington, D.C., to discuss the condition of the economy and consider changes in monetary policy. 29-2b The Federal Open Market Committee The Federal Open Market Committee consists of the members of the Board of Governors and 5 of the 12 regional bank presidents. All 12 regional presidents attend each FOMC meeting, but only five get to vote. Voting rights rotate among the 12 regional presidents over time. The president of the New York Fed always gets a vote, however, because New York is the traditional financial center of the U.S. economy and because all Fed purchases and sales of government bonds are conducted at the New York Fed’s trading desk. Through the decisions of the FOMC, the Fed has the power to increase or decrease the number of dollars in the economy. In simple metaphorical terms, you can imagine the Fed printing dollar bills and dropping them around the country by helicopter. Similarly, you can imagine the Fed using a giant vacuum cleaner to suck dollar bills out of people’s wallets. In reality, the Fed’s methods for changing the money supply are more complex and subtle than this, but the helicopter-vacuum metaphor is a good first step to understanding the meaning of monetary policy. Later in this chapter, we discuss how the Fed actually changes the money supply, but it is worth noting here that the Fed’s primary tool is the open-market operation— the purchase and sale of U.S. government bonds. (Recall that a U.S. government bond is a certificate of indebtedness of the federal government.) If the FOMC decides to increase the money supply, the Fed creates dollars and uses them to buy government bonds from the public in the nation’s bond markets. After the pur- chase, these dollars are in the hands of the public. Thus, an open-market purchase of bonds by the Fed increases the money supply. Conversely, if the FOMC decides to decrease the money supply, the Fed sells government bonds from its portfolio to the public in the nation’s bond markets. After the sale, the dollars the Fed receives for the bonds are out of the hands of the public. Thus, an open-market sale of bonds by the Fed decreases the money supply. Central banks are important institutions because changes in the money supply can profoundly affect the economy. One of the Ten Principles of Economics in Chapter 1 is that prices rise when the government prints too much money. Another of the Ten Principles of Economics is that society faces a short-run trade-off between inflation and unemployment. The power of the Fed rests on these principles. For reasons we discuss more fully in the coming chapters, the Fed’s policy decisions are key determinants of inflation in the long run and employment and production in the short run. Indeed, the Fed chair has been called the second most powerful person in the United States. QuickQuiz 3. Which of the following is NOT true about the Federal 4. If the Fed wants to increase the money supply, it can Reserve? a. raise income tax rates. a. It was established by the U.S. Constitution. b. reduce income tax rates. b. It regulates the banking system. c. buy bonds in open-market operations. c. It lends to banks. d. sell bonds in open-market operations. d. It conducts open-market operations. Answers at end of chapter. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch29_hr_589-612.indd 596has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 11:31 am  CHAPTER 29 The Monetary System 597 29-3 Banks and the Money Supply Collection/www.cartoonbank.com So far, we have introduced the concept of “money” and discussed how the Fed controls the supply of money by buying and selling government bonds in open- Mick Stevens/The New Yorker market operations. This explanation of the money supply is correct, but it is not complete. In particular, it omits the key role that banks play in the monetary system. Recall that the amount of money you hold includes both currency (the bills in your wallet and coins in your pocket) and demand deposits (the ­balance in your checking account). Because demand deposits are held in banks, the “I’ve heard a lot about behavior of banks can influence the quantity of demand deposits and, therefore, money, and now I’d like the money supply. This section examines how banks affect the money supply to try some.” and, in doing so, how they complicate the Fed’s job of controlling the money supply. 29-3a The Simple Case of 100-Percent-Reserve Banking To see how banks influence the money supply, let’s first imagine a world without any banks at all. In this simple world, currency is the only form of money. To be concrete, let’s suppose that the total quantity of currency is $100. The supply of money is, therefore, $100. Now suppose that someone opens a bank, appropriately called First National Bank. First National Bank is only a depository institution—that is, it accepts ­deposits but does not make loans. The purpose of the bank is to give depositors a safe place to keep their money. Whenever a person deposits some money, the bank keeps the money in its vault until the depositor withdraws it, writes a check, or uses a debit card to access her balance. Deposits that banks have received but have not loaned out are called reserves. In this imaginary economy, reserves all deposits are held as reserves, so this system is called 100-percent-reserve deposits that banks have banking. received but have not We can express the financial position of First National Bank with a T-account, loaned out which is a simplified accounting statement that shows changes in a bank’s assets and liabilities. Here is the T-account for First National Bank if the economy’s entire $100 of money is deposited in the bank: First National Bank Assets Liabilities Reserves $100.00 Deposits $100.00 On the left side of the T-account are the bank’s assets of $100 (the reserves it holds in its vaults). On the right side are the bank’s liabilities of $100 (the amount it owes to its depositors). Because the assets and liabilities exactly balance, this accounting statement is called a balance sheet. Now consider the money supply in this imaginary economy. Before First National Bank opens, the money supply is the $100 of currency that people are holding. After the bank opens and people deposit their currency, the money supply is the $100 of demand deposits. (There is no longer any currency outstanding, since it is all in the bank vault.) Each deposit in the bank reduces currency and raises demand deposits by exactly the same amount, leaving the money supply unchanged. Thus, if banks hold all deposits in reserve, banks do not influence the supply of money. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch29_hr_589-612.indd 597has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 11:31 am  598 part X Money and Prices in the Long Run 29-3b Money Creation with Fractional-Reserve Banking Eventually, the bankers at First National Bank may start to reconsider their policy of 100-percent-reserve banking. Leaving all that money idle in their vaults seems unnecessary. Why not lend some of it out and earn a profit by charging interest on the loans? Families buying houses, firms building new factories, and students paying for college would all be happy to pay interest to borrow some of that money for a while. First National Bank has to keep some reserves so that currency is available if depositors want to make withdrawals. But if the flow of new deposits is roughly the same as the flow of withdrawals, First National needs to keep only a fraction of its deposits in reserve. Thus, First National adopts a system fractional-reserve banking called fractional-reserve banking. a banking system in The fraction of total deposits that a bank holds as reserves is called the reserve which banks hold only ratio. This ratio is influenced by both government regulation and bank policy. a fraction of deposits as As we discuss more fully later in the chapter, the Fed sets a minimum amount reserves of reserves that banks must hold, called a reserve requirement. In addition, banks may hold reserves above the legal minimum, called excess reserves, so they can reserve ratio be more confident that they will not run short of cash. For our purpose here, the fraction of deposits we take the reserve ratio as given to examine how fractional-reserve banking that banks hold as ­influences the money supply. reserves Let’s suppose that First National has a reserve ratio of 1/10, or 10 percent. This means that it keeps 10 percent of its deposits in reserve and loans out the rest. Now let’s look again at the bank’s T-account: First National Bank Assets Liabilities Reserves $10.00 Deposits $100.00 Loans 90.00 First National still has $100 in liabilities because making the loans did not alter the bank’s obligation to its depositors. But now the bank has two kinds of assets: It has $10 of reserves in its vault, and it has loans of $90. (These loans are liabilities of the people borrowing from First National, but they are assets of the bank because the bor­rowers will later repay the loans.) In total, First National’s assets still equal its liabilities. Once again consider the economy’s supply of money. Before First National makes any loans, the money supply is the $100 of deposits. Yet when First National lends out some of these deposits, the money supply increases. The depositors still have demand deposits totaling $100, but now the borrowers hold $90 in currency. The money supply (which equals currency plus demand deposits) equals $190. Thus, when banks hold only a fraction of deposits in reserve, the banking system creates money. At first, this creation of money by fractional-reserve banking may seem too good to be true: It appears that the bank has created money out of thin air. To make this feat seem less miraculous, note that when First National Bank loans out some of its reserves and creates money, it does not create any wealth. Loans from First National give the borrowers some currency and thus the ability to buy goods and services. Yet the borrowers are also taking on debts, so the loans do not make them any richer. In other words, as a bank creates the asset of money, it also creates a corresponding liability for those who borrowed the created money. At the end of this process of money creation, the economy is more liquid in the sense that there is more of the medium of exchange, but the economy is no wealthier than before. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch29_hr_589-612.indd 598has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 11:31 am  CHAPTER 29 The Monetary System 599 29-3c The Money Multiplier The creation of money does not stop with First National Bank. Suppose the bor- rower from First National uses the $90 to buy something from someone who then deposits the currency in Second National Bank. Here is the T-account for Second National Bank: Second National Bank Assets Liabilities Reserves $ 9.00 Deposits $90.00 Loans 81.00 After the deposit, Second National has liabilities of $90. If Second National also has a reserve ratio of 10 percent, it keeps assets of $9 in reserve and makes $81 in loans. In this way, Second National creates an additional $81 of money. If this $81 is eventually deposited in Third National Bank, which also has a reserve ratio of 10 percent, Third National keeps $8.10 in reserve and makes $72.90 in loans. Here is the T-account for Third National Bank: Third National Bank Assets Liabilities Reserves $ 8.10 Deposits $81.00 Loans 72.90 The process goes on and on. Each time that money is deposited and a bank loan is made, more money is created. How much money is eventually created in this economy? Let’s add it up: Original deposit 5 $100.00 First National lending 5 $ 90.00 (5.9 3 $100.00) Second National lending 5 $ 81.00 (5.9 3 $90.00) Third National lending 5 $ 72.90 (5.9 3 $81.00) Total money supply 5 $1,000.00 It turns out that even though this process of money creation can continue forever, it does not create an infinite amount of money. If you laboriously add the infinite sequence of numbers in the preceding example, you find that the $100 of reserves generates $1,000 of money. The amount of money the banking system generates with each dollar of reserves is called the money multiplier. In this imaginary econ- money multiplier omy, where the $100 of reserves generates $1,000 of money, the money multiplier the amount of money the is 10. banking system generates What determines the size of the money multiplier? It turns out that the answer is with each dollar of simple: The money multiplier is the reciprocal of the reserve ratio. If R is the reserve ratio reserves for all banks in the economy, then each dollar of reserves generates 1/R dollars of money. In our example, R 5 1 10, so the money multiplier is 10. This reciprocal formula for the money multiplier makes sense. If a bank holds $1,000 in deposits, then a reserve ratio of 1/10 (10 percent) means that the bank Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch29_hr_589-612.indd 599has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 11:31 am  600 part X Money and Prices in the Long Run must hold $100 in reserves. The money multiplier just turns this idea around: If the banking system as a whole holds a total of $100 in reserves, it can have only $1,000 in deposits. In other words, if R is the ratio of reserves to deposits at each bank (that is, the reserve ratio), then the ratio of deposits to reserves in the banking system (that is, the money multiplier) must be 1/R. This formula shows how the amount of money banks create depends on the reserve ratio. If the reserve ratio were only 1/20 (5 percent), then the banking sys- tem would have 20 times as much in deposits as in reserves, implying a money multiplier of 20. Each dollar of reserves would generate $20 of money. Similarly, if the reserve ratio were 1/4 (25 percent), deposits would be 4 times reserves, the money multiplier would be 4, and each dollar of reserves would generate $4 of money. Thus, the higher the reserve ratio, the less of each deposit banks loan out, and the smaller the money multiplier. In the special case of 100-percent-reserve banking, the reserve ratio is 1, the money multiplier is 1, and banks do not make loans or create money. 29-3d Bank Capital, Leverage, and the Financial Crisis of 2008–2009 In the previous sections, we have seen a simplified explanation of how banks work. But the reality of modern banking is a bit more complex, and this complexity played a key role in the financial crisis of 2008 and 2009. Before looking at that crisis, we need to learn a bit more about how banks actually function. In each of the bank balance sheets we have seen so far, a bank accepts depos- its and either uses those deposits to make loans or holds them as reserves. More realistically, a bank gets financial resources not only from accepting deposits but also, like other companies, from issuing equity and debt. The resources that a bank bank capital obtains from issuing equity to its owners are called bank capital. A bank uses these the resources a bank’s financial resources in various ways to generate profit for its owners. It not only owners have put into the makes loans and holds reserves but also buys financial securities, such as stocks institution and bonds. Here is a more realistic example of a bank’s balance sheet: More Realistic National Bank Assets Liabilities and Owners’ Equity Reserves $200 Deposits $800 Loans 700 Debt 150 Securities 100 Capital (owners’ equity) 50 On the right side of this balance sheet are the bank’s liabilities and capital (also called owners’ equity). This bank obtained $50 of resources from its owners. It also took in $800 of deposits and issued $150 of debt. The total of $1,000 was put to use in three ways, listed on the left side of the balance sheet, which shows the bank’s