Money Is a Lubricant For, More Than the Fuel Of, Economic Activity

Chapter 21

The Monetary System

Introduction

§  Let's talk a little bit about money. So far we have managed to talk about the economy without mentioning money. That's an indication that in economics money, per se, is not that important.

§  Money is a lubricant for, more than the fuel of, economic activity.

§  It has taken many different forms through time and in different societies. We are going to learn what happens when money loses its value, that is, when there is inflation.

§  The real economy (unemployment, real output...) usually goes its own separate way from the financial sector (stock and bonds market, finance) but of course they are related and we have to talk about the later sector too.

§  The financial industry is regulated and controlled by the monetary authority, a central bank called the Federal Reserve System, the Fed. It also implements the monetary policy.

§  This chapter and the next one should be seen as an introduction to a “Money and Banking” course and for our purposes it will be the basis for the future discussion of monetary policy.

The Meaning of Money

§  First of all we have to clarify a general confusion between money as income ("making a lot of money") and money as wealth ("having a lot of money").

§  Money is a flow and a stock at the same time and that can be sometimes misleading.

§  Secondly, we have to stress that we can properly call money any other assets, besides just bills and coins, as long as those assets serve simultaneously as:

-  Medium of exchange; used to pay for goods and services. Money is better than barter because it saves time (reduces transaction costs) and is more efficient for purchases.

-  Without money we need a double coincidence of wants in order to have an exchange.

-  Unit of account; it can be used as a yardstick to measure the value of goods, to put a price.

-  Store of value; a way of accumulating wealth that can be spent in the future.

§  The ease with which an asset can be converted into the economy’s medium of exchange is called liquidity and naturally currency is the most liquid of all assets.

§  Money has taken different forms through time:

-  Ancient societies used coins made out of gold as money because those assets had intrinsic value (had value on their own as precious metals that could be used to make jewelry). We call this commodity money.

-  For practical reasons paper bills were issued as mediums of exchange for certain amounts of gold. Those bills were redeemable at the country’s central bank. Silver was also employed.

-  These days paper money is just fiat money, a legal convention enforced by the government through laws but without any redeemable value in terms of gold or silver.

§  Why credit cards are not considered money?

§  In the US economy many different assets are highly liquid so when measuring how much money is in circulation we need to account for more than just bills and coins.

§  Actually we will employ the classification of monetary aggregates used by the Fed:

-  The different types of money are classified from the most liquid to the least liquid.

-  Like Russian dolls, each category encompasses the previous one.

-  Whenever the Fed compares the total amount of money printed by the Mint ($580 billion) with the actual amount of cash circulating in the US (around $145 billion) they find a huge difference. Where is the missing money? In the underground economy and overseas.

The Federal Reserve System

§  Central banks are the monetary authorities in every country. The US central bank has a federal structure as a result of previously failed attempts at creating a European-style central bank.

§  The duties of the Fed include: regulating and supervising commercial banks, to ensure that they are financially sound, and controlling the money supply, (i.e. setting monetary policy.)

§  The decision-making power within the Fed is shared among state and federal institutions, the private sector and the government, bankers, business people and the public.

§  Federal Reserve Banks

-  The US is divided into 12 Federal Reserve Districts. Each has a Federal Reserve Bank that is partly controlled and financed by the member commercial banks.

-  They control the supply of currency in the region, examine (regulate) commercial banks, set the discount rate and participate in the FOMC.

§  The Board of Governors

-  Appointed by the President and confirmed by the Senate. Each serves for 14 years but one governor's term expires every other January.

-  The Chairperson is appointed for 4 years (renewable.)

-  They participate in the FOMC, set reserve requirements and the discount rate.

§  The Federal Open Market Committee (FOMC)

-  An open market operation is a sale or a purchase of Treasury Bills by the Fed that in turn reduces or increases the nationwide level of money supply.

-  These OMOs are the most powerful tools of monetary policy.

-  Reserve requirements and the discount rate are determined here "de facto" even though officially are the responsibilities of other parts of the Fed.

Banks and the Money Supply

§  Banks can create money by the process of multiple deposit creation. We can explain that process following these 7 steps:

1.  Households and firms maintain part of their wealth in cash for transaction purposes, another fraction of that wealth is kept in the form of bank deposits.

2.  The business of banks is to accept deposits and make loans with the money deposited. A fraction of those deposits (the required reserve ratio) must be kept in the banks reserves.

3.  Banks make loans with the available funds.

4.  More money is made available in the economy.

5.  The borrowers that obtain the loans increase their money holdings.

6.  A fraction of those holdings is spent. The rest is deposited in bank accounts.

7.  Banks satisfy the required reserve ratio on those deposits and ... We move back to n. 3.

§  Note: The required reserve ratio (RRR) was instituted by the Fed to guarantee that depositors could always withdraw part of their deposits and so bank runs could be avoided.

§  How many times will we repeat this circle? As many times as it takes for the initial amount of deposits to be converted into required reserves kept with the Fed district bank.

§  How much money is created in this way? The money multiplier tells us that.

D in Total Deposits = ( 1 / Required Reserve Ratio) x D in Initial Deposits

For example: if the required reserve ratio is 10% and initial deposits increase by $100, total deposits increase by $1,000.

Tools of Monetary Policy

§  The Fed can change the total amount of money in circulation in the economy (in order to affect the level of activity) by affecting the process of money creation performed by banks.

§  To do so, it has three tools of monetary policy:

Open Market Operations (OMOs)

§  Purchases or sales of federal securities from or to banks and the general public.

-  PURCHASE: the Fed exchanges money for bonds that banks or the public holds. This increases the amount of money in the hands of the public so deposits increase.

-  SALE: the Fed exchanges bonds it holds for money from banks or the public. This decreases the amount of money in the hands of the public so deposits decrease.

Discount Rate (DR)

§  Changes in the interest rate that the Fed charges for loans made to commercial banks.

-  RAISING the DISCOUNT RATE: the Fed reduces the money available to banks to satisfy their required reserves. Less money is available for commercial loans.

-  LOWERING the DISCOUNT RATE: the Fed makes more money available to banks to satisfy their required reserves. More money is available for commercial loans.

Required Reserve Ratio (RRR)

§  The RRR has very powerful and direct effects on the money multiplier.

-  RAISING the RRR: required reserves increase so banks have less money to make loans.

-  LOWERING the RRR: required reserves decrease so banks have more money to make loans.

§  What monetary policy tool is more frequently employed?

-  Changing the RRR has very powerful effect in changing the money supply but that prevents its use for fine tuning adjustments and can cause important liquidity problems for banks.

-  Changing the DR is effective as long as banks increase or decrease their borrowing from the Fed accordingly -and that is beyond the Fed control.

-  The most powerful tools are the OMOs. These are easy to implement, their effect on bank reserves is immediate and are easy to reverse or reinforce. They are the most frequently used.