L4: The Money Supply and the Federal Reserve System
13 important questions on L4: The Money Supply and the Federal Reserve System
Most people take the ability to obtain and use the money for granted. When the whole monetary system works well, as it generally does in the United States, the basic mechanics of the system are virtually invisible.
The idea that you can buy things with money is so natural and obvious that it seems absurd to mention it, but stop and ask yourself: "How is it that a store owner is willing to part with a steak and a loaf of bread that I can eat in exchange for some pieces of paper that are intrinsically worthless?
- What is money?
- It is an idea - a very powerful one.
So powerful we all believe in it and it became a social construct (institutionalized).
Money is a means of payment, a store of value, and a unit of account.
Examples of other ways of payment:
World War II prisoners of war camps used cigarettes as a monetary commodity.
Cattle used in Southern Africa.
Huge wheels of carved stone on the island of Yap in the South Pacific.
These various kinds of money are generally divided into two groups, commodity monies and fiat money.
- Define Commodity money:
- Commodity money is items used as money with an intrinsic value.
Examples: Precious metals like gold and silver, cigarettes and salt.
Various kinds of money are divided into two groups, commodity monies and fiat money.
- Define Fiat money:
- Fiat money is by government decree (no intrinsic value).
Example: United States Dollar and Euro.
Fiat means = "Let is be done" (Latin).
Finance comes from "finer" (old-French) = to settle.
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A Historical Perspective: Goldsmiths
Because they had what amounted to "extra" gold sitting around, goldsmiths gradually realized that they could lend out some of this gold without any fear of running out of gold. Why would they do this? Because instead of just keeping their gold idly in their vaults, they could earn interest on loans. Something subtle, but dramatic, happened at this point.
- What happened?
- The goldsmiths changed from mere depositories (depothouders) for gold into banklike institutions that had the power to create money.
The central bank.
ECB, Bank of England, Bank of Japan, FED all central banks.
The FED is the central Bank of the United States. Central Banks are sometimes known as bankers banks because only banks (and occasionally foreign governments) can have accounts in them. As a private citizen, you cannot go to the nearest branch of the FED and open a checking account or apply to borrow money.
- What are the central Banks responsible for?
- Print Banknotes.
- Supervision over the bigger banks.
- Targeting inflation.
- Monetary policy.
To solve the problem of multiple monies, economists have given different names to different measures of money. The two most common measures of money are M1 and M2.
- Define M1 and M2 money:
- M1 = Cash + Demand deposists (debit card).
- M2 = M1 + Near money (like your savings account.
Inflation can be moderated by the Central Bank.
- When the Central Bank wants to slow down the economy. What does the Central Bank do?
- It increases interest rates (expensive to borrow money).
- Name the three instruments of a Central Bank:
- Changing the reserve requirement (quantity of money).
- Changing the discount rate (the price of money).
- Open market operations.
- What is an Expansionary fiscal policy?
- A form of macroeconomic policy that seeks to encourage economic growth.
An expansionary policy can consist of either monetary policy or fiscal policy (or a combination of the two). It is part of the general policy prescription of Keynesian economics, to be used during economic slowdowns and recessions in order to moderate the downside of economic cycles.
- What does a contractionary policy refer to?
- Contractionary policy is a monetary measure referring either to a reduction in government spending—particularly deficit spending—or a reduction in the rate of monetary expansion by a central bank.
- What does a contractionary policy?
- It is a type of macroeconomic tool designed to combat rising inflation or other economic distortions created by central banks or government interventions.
By far the most significant of the Fed's tools for controlling the supply of money is open market operations.
- Explain the Fed's Open Market operations:
- The purchases and sale by the Fed of government securities in the open market; a tool used to expand or contract the number of reserves in the system and thus the money supply.
- What are excess reserves?
- The difference between a bank's actual reserves and its required reserves.
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