Money, Banks, And The Federal Reserve

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Money, Banks, and the FederalReserve

What is Money? Money – any asset that people are generally willingto accept in exchange for goods and services or forpayment of debts. Is money simply just bills and coins? No Many items have been used by different cultures, includinggold, cattle, beads, shells, cigarettes, casino chips, deerskins,and more. Even large stones that are difficult to move havebeen used as money on the island of Yap, called fei.

Does an Economy Need Money? An economy does not need money to function, but itgreatly facilitates trade, and therefore economicgrowth. Money solves the double coincidence of wants foundin a barter economy. For example, say you have some goats, but would like a guitar.It will take you a long time to find someone who will trade youor you will have to go through numerous trades before youfinally get your guitar.An economy that uses money allows you to take your goat tothe market, sell it, and then use your funds to buy a guitar.

The Functions of Money Any asset that is used as money should fulfill thefollowing four functions: 1. Medium of Exchange 2. Unit of Account Prices are quoted in terms of money values.3. Store of Value People use money to make payments for goods, services, andfinancial assets.People can hold money for a time without losing much of itspurchasing powers for future use in exchange4. Standard of Deferred Payment People can buy goods and services today by promising to pay at alater date.

What can Serve as Money Any good currency will meet the following fivecriteria: 1. It should be accepted by most people.2. It should be of standardized quality so that any two unitsare identical.3. It should be durable and not easily spoiled.4. It should be easily transported.5. It should be divisible since different goods are valued atdifferent prices.

Commodity and Fiat Money Commodity Money – Money that is backed by atangible commodity; gold, beads, shells, stones,cigarettes. Commodity money often suffers fromGresham’s Law, particularly precious metals. Badmoney drives out good money in an economy.Historically, ridges were placed on coins in order toprevent shaving and turning good money into “badmoney”. Fiat Money – Money by decree of law. “This Note isLegal Tender: For All Debts, Public and Private.”

Do Firms Have to Accept Money? By law, fiat money has to be accepted for payment ofdebts and taxes. “There is no Federal statue mandating that a privatebusiness, a person or an organization must acceptcurrency or coins as payments for goods and/or services.For example, a bus line may prohibit payment of fares inpennies or dollar bills. In addition, movie theaters,convenience stores and gas stations may refuse to acceptlarge denomination currency (usually notes above 20)as a matter of policy.” U.S. Treasury Department.

Measuring the Amount of Money in the Economy Money is typically measured by M1, M2, and M3(discontinued in 2006), with M1 being the mostliquid and M3 being the least liquid. Also, M1 is themost narrowest definition with M3 being a widerdefinition.

Measuring the Amount of Money in the Economy M1 - focuses on money’s role as a medium ofexchange. It includes only currency, checkabledeposits, and traveler’s checks. This is money usedfor the intention of buying and selling. M2 - is equal to M1 plus near-money assets such assavings accounts, money market mutual funds, andsmall time deposits (CD’s under a 100,000). Thisincludes money for buying and selling, but alsomoney being used as a store of value. M3 – is equal to M2 plus large time deposits andother near monies.

Measuring the Amount of Money in the Economy M3 was discontinued by the Federal Reserve in 2006since: “M3 does not appear to convey any additional informationabout economic activity that is not already embodied in M2and has not played a rol withdrawtheir money, it is a bank run. Banks runs that lead tobank panics are problematic. The Central Bank or “The Fed” is the lender of the last resort.

The Federal Reserve System The Fed was created in 1913 in partial response tothe panic of the 1907. However, during the panic of1930, the Fed was not willing to act as a lender of lastresort. Some regional banks did while others didnot. Many economists believe that the Fed’s unwillingness to act asthe lender of last resort exacerbated the Great Depression.

The Functions of The Fed. The Fed conducts monetary policy, holds, bankdeposits, and performs several other functions: Function’s as a banker’s bank.Functions as lender of last resort. It offers extension of creditto financial institutions experiencing financial difficultieswhich are unable to obtain necessary funds elsewhere.Supervises banks.Conducts monetary policy.Issues currency printed by the U.S. Treasury, but the Fed putsit into circulation.Clears Check.

The Structure of the Fed The Fed has a Board of Governors (BoG), which isresponsible for the overall direction of the Fed andits policies. There are seven members on the BoGswith 14 year nonrenewable terms that are staggeredto expire every two years. Members are appointed bythe President and confirmed by the Senate One BOG member is appointed chairperson who serves a fouryear renewable term. This may be the most powerfuleconomic actor in the world. As of 2011, that person is BenBernanke who replaced Alan Greenspan in 2006.As of today, Janet Yellen is the chairperson of the Fed.

The Structure of the Fed Even though governors are assigned to 14 year non-renewable terms, their actual terms are muchshorter. Average terms for 67 Fed governors appointed beforeGreenspan: 7.2 years. Since then: 4.8 years. Last 10governors: 4.4 years. This allows the President to nominate the entire board, whichthe system was set up to protect against. It can create politicalgridlock among the parties when appointing governors.Since the recession, we have only had a full BoG 20% of thetime. ho-s-Blame-Power-Shift-Fed

The Structure of the Fed Federal Open Market Committee (FOMC), whichconducts monetary policy. It consists of twelvemembers (7 BoGs 4 rotating district bankPresidents the President of the NY District Bank).They meet every 4 – 6 weeks to discuss and conductmonetary policy. The President of the NY Bank always gets a seat since NYC isarguably the financial capital of the world. Before becoming U.S. Secretary of Treasury, Timothy Geithnerwas the President Federal Bank of New York.

The Structure of the Fed The Federal Reserve Regional Banks. There aretwelve regional bank spread out through U.S. Iowa’sregional bank is located in Chicago.

The Structure of the Fed Source:

How The Fed Manages the Money Supply The Fed conducts monetary policy to manage themoney supply and interest rates to pursuemacroeconomic objectives. The tools that the Fed has at its disposal are: Conducting Open Market Operations (OMO)Changing the discount rateChanging the reserve requirementsQuantitative EasingChanging ExpectationsMoral Suasion

Open Market Operations OMO – this is the primary tool, along with thediscount policy, used by the Fed to conduct monetarypolicy. The FOMC meets roughly 8 times a year tobuy and sell government securities, typically T-billswhich mature in a few days to a year. Selling securities will decrease bank reserves and thereforedecrease the money supply. Contractionary Monetary Policy.Buying securities will increase bank reserves and thereforeincrease the money supply. Expansionary Monetary Policy.

Changing the Discount Rate The discount rate is the Fed’s other primary took andis the rate that the Fed charges member ba

The Functions of Money Any asset that is used as money should fulfill the following four functions: 1. Medium of Exchange People use money to make payments for goods, services, and financial assets. 2. Unit of Account Prices are quoted in terms of money values. 3. Store of Value People can hold money for a time without losing much of its