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Three functions of money:
- 1. medium of exchange
- 2. unit of account
- 3. store of value
paper currency + checkable deposits
What is the largest part of the M1 money supply?
Two main types of financial institutions:
Commercial banks and thrift institutions (including S&Ls, credit unions)
M1 + savings deposits, market deposit accounts (MMDAs), small time deposits, and money market mutual funds (MMMFs).
M2 + large time deposits
Why are credit cards not considered money?
They act as a short loan, but have no value.
Money is a debt of what?
the Federal Reserve Banks
What three reasons give money its value?
- 1. acceptability
- 2. legal tender ("designated currency")
- 3. relative scarcity
What is the relationship between price levels and the purchasing power of the dollar?
What two factors stabilize the value of money?
- 1. appropriate fiscal policy
- 2. intelligent management of the money supply
What are the three types of demand for money?
- 1. transactions demand
- 2. asset demand
- 3. total money demand
the need of money to pay for things
the need to hold stocks, bonds, etc.
Total Money Demand
the inverse relationship between interest rate and amount of money people want to hold
the demand for money versus the supply of money
What is the relationship between interest rates and bond prices?
Federal Reserve System
controls the lending activity of the nation's banks
Federal Open Market Committee
sets the Fed's monetary policy and directs purchases/sales of govt securities
Federal Reserve Banks
collectively serve as the nation's central bank ("banker's bank")
What are the seven functions of the Federal Reserve?
- 1. issue currency
- 2. set reserve requirements/hold reserves
- 3. lend money to banks
- 4. provide for check collection
- 5. act as fiscal agent
- 6. supervise banks
- 7. control money supply
Balance Sheet of a Commercial Bank
a statement of assets and claims on assets that summarizes the financial position of the bank at a certain time (assets = liability + net worth)
Fractional Reserve System
a fraction of the total money supply is held in reserves as currency
What are two characteristics of a fractional reserve banking system?
- 1. money creation and reserves
- 2. bank panics and regulation
Eight Steps in the Creation of a Single Commercial Bank
- 1. acquire a charter; sell equity shares
- 2. acquiring property and equipment
- 3. accepting deposits
- 4. depositing reserves in a Fed Reserve Bank
- 5. clearing a check drawn
- 6. granting a loan
- 7. repaying a loan
- 8. buying govt securities
amount of funds equal to a specified percentage of the banks own deposit liabilities
reserve ratio = commercial bank's required reserves/commercial bank's checkable deposit liabilities
actual reserves - required reserves
What do required reserves help the Fed to control?
The lending ability of commercial banks; facilitating of the collection/clearing of checks
How does giving a loan and paying back a loan create and destroy money?
- Makes: by considering an IOU a form of payment
- Destroys: when the loan is paid back the IOU is returned because real money has been deposited in its place
magnifies a change in initial spending into a larger change in GDP (1/req reserve ratio)
The balance sheet of the Fed Banks is made up of these fives things:
- 1. securities
- 2. loans to commercial banks
- 3. reserves of commercial banks
- 4. Treasury deposits
- 5. outstanding Fed Reserve Notes
Open Market Operations
the buying/selling of bonds from/to commercial banks and general public
When the Fed banks buys securities in the open market, commercial banks' reserves increase
When the Fed banks sell securities in the open market, commercial banks' reserves decrease
the interest rate charged by Fed banks to commercial banks
Easy Monetary Policy
- Increase: excess reserves, money supply, investment spending, aggregate demand, and real GDP
- Decrease: reserve ratio, discount rate, and interest rate
Tight Money Policy
- Increase: reserve ratio, discount rate, and interest rate
- Decrease: excess revenue, money supply, investment spending, aggregate demand, and inflation
Two strengths of monetary policy:
- 1. speed and flexibility
- 2. isolation from political pressure
Three weaknesses of monetary policy:
- 1. less control?
- 2. change in the velocity of money
- 3. cyclical assymetry
Velocity of money
the number of times per year the average dollar is spent on goods/services
the unreliability of monetary policy to push an economy from a recession
Fed Funds Rate
the interest rate that banks charge one another on overnight loans of reserves
Prime Interest Rate
interest rate banks charge their most credit worthy customers
Monetary Net Export Effect
Easy: decreased interest rate = decreased foreign demand for the dollar; thus the dollar depreciates and net exports increase
Tight: increased interest rate = increased foreign demand for the dollar; thus the dollar appreciates and net exports decrease
What three things does an easy money policy do?
- 1. alleviates unemployment
- 2. alleviates sluggish growth
- 3. corrects balance of trade deficit
What two things does a tight money policy do?
- 1. alleviates inflation conflicts
- 2. corrects balance of trade deficits