This chapter discusses the monetary system. Why do people trust in the value of paper money even though it has no intrinsic value? Without money or currency people would have to barter, the exchange of one good or service for another. In such an economy, trade requires the double coincidence of wants, the unlikely occurrence that two people each have a good or service that the other wants. Thus, learning about the monetary system, especially in the long term, is very important in complex societies like ours.
What is money? Money is wealth, but economists define money as the set of assets in the economy that people regularly use to buy goods or services from other people. It has 3 functions: medium of exchange (item that buyers give sellers for a transaction), unit of account (measurement of prices and debts), and store of value (transferring purchasing power from present to the future). Liquidity of an asset describes how easily it can be changed into a medium of exchange (money is most liquid, unlike a house which takes effort to sell).
When money takes the form of a commodity with intrinsic value, it is called commodity money. An economy using gold as money (gold has intrinsic value on its own too) is operating under the gold standard. Cigarettes were used as commodity money in the Soviet Union and prisons. Money without intrinsic value is fiat money. A fiat is a decree or order. For example, paper money is fiat money. Fiat money requires the government to establish and regulate the system by prosecuting counterfeiters, and keeping expectations and social convention.
The quantity of money circulating in the economy is known as money stock. One major asset to include in the quantity is currency, the paper bills and coins in the hands of the public. It is the most widely accepted medium of exchange in the economy. Demand deposits, the balances in bank accounts that depositors can access by writing checks, must be included too. Other funds of other financial institutions must be included as well. Sometimes the line between money and assets cannot be easily drawn. Economists identify M1 as demand deposits + checks + other deposits + currency (~1.36 mil), and M2 as M1 + saving deposits + small time deposits + money market mutual funds + other minor categories (~6.3 billion).
Money outstanding could be held in foreign countries as a medium of exchange elsewhere because of its trustworthiness or by criminals. These factors are not included in domestic money stock.
The Federal Reserve System (Fed) is the system that regulates the fiat money of the U.S. It is an example of a central bank, an institution that oversees the entire banking system and regulates the money stock. It has 2 jobs: to regulate banks and ensure the health of the banking system, and to control the money supply (quantity of money mad available in the economy). Policies made are called monetary policy, in the U.S, the policymakers are the FOMC. These policies will be explained soon.
Now we talk about the banks and the money supply. Deposits that banks receive but don't loan are called reserves. 100-percent-reserve banking is when banks don't loan, they just hold the money. A T-account is a statement that shows a bank's change in assets vs liabilities. Analyzing a 100-percent-reserve bank is easy because these banks cannot influence the supply of money.
Banks can create money using fractional-reserve banking, when banks only keep a fraction of their deposits as reserves. This fraction is known as the reserve ratio. The Fed usually sets a reserve requirement, for banks to have some extra money. Some banks even carry excess reserves to be more confident. When a bank holds only a fraction of deposits in reserve, they create money when they loan since the depositor isn't using the money but still belongs to them and at the same time the borrower can use that money. They don't create wealth since the the borrower still has to pay back eventually, but they do increase the money supply. The money supply increases by the money multiplier = reciprocal of the reserve ratio. For example, a 10% reserve ratio yields 1/0.1 = 10 money multiplier. Thus, such a bank can make the supply given to them multiply by ten times. It turns out the higher the reserve ratio, the less of each deposit banks can loan out, the smaller the money multiplier.
The Fed uses 3 tools to control money supply. There's open-market operations, when selling or buying government bonds. By buying bonds, the Fed increases money supply by giving the public money in exchange for the purchased bonds. By selling bonds, the Fed reduces money supply by taking the public's money and giving them bonds. The Fed uses this most often since it can make small or large changes frequently without major changes in laws or bank regulations relatively easily. There's also changing reserve requirements. The Fed can tell banks the minimum amount of deposits banks must hold to change money multiplier and the money supply. A higher reserve requirement lowers the money supply, and vice versa for a lower reserve requirement. This tool is less used since it is inconvenient for banks. The discount rate is the interest rate on loans that the Fed makes to other banks. Banks borrow from the Fed if their reserves are too low whether from too many loans or withdrawals. A high discount rate discourages borrowing from the Fed and reduces money supply, and vice versa for a lower discount rate.
There are some problems in controlling the money supply. The Fed can't tell people how much to deposit in banks. The less people deposit, the less banks can use to loan and the less the money supply. The Fed also can't tell bankers how much excess reserve they can keep. If bankers became more cautious and kept excess reserves, less loans would be made and the money supply would decrease.
Bank runs are when depositors fear bankruptcy in a bank and rush to withdraw their deposits. Since banks loan out some of their deposits, they cannot have enough cash to repay all depositors. The bank is then forced to close its doors until some bank loans are repaid or a lender comes to help (like the Fed). Nowadays, bank runs are not a major problem. The FDIC ensures deposit safety.
As ABBA would say, "Money, money, money; Must be funny!"
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