This is “Review and Practice”, section 24.4 from the book Economics Principles (v. 1.0).
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In this chapter we investigated the money supply and looked at how it is determined. Money is anything that serves as a medium of exchange. Whatever serves as money also functions as a unit of account and as a store of value. Money may or may not have intrinsic value. In the United States, the total of currency in circulation, traveler’s checks, and checkable deposits equals M1. A broader measure of the money supply is M2, which includes M1 plus assets that are highly liquid, but less liquid than those in M1.
Banks create money when they issue loans. The ability of banks to issue loans is controlled by their reserves. Reserves consist of cash in bank vaults and bank deposits with the Fed. Banks operate in a fractional reserve system; that is, they maintain reserves equal to only a small fraction of their deposit liabilities. Banks are heavily regulated to protect individual depositors and to prevent crises of confidence. Deposit insurance protects individual depositors.
A central bank serves as a bank for banks, a regulator of banks, a manager of the money supply, a bank for a nation’s government, and a supporter of financial markets generally. In the financial crisis that rocked the United States and much of the world in 2008, the Fed played a central role in keeping bank and nonbank institutions afloat and in keeping credit available. The Federal Reserve System (Fed) is the central bank for the United States. The Fed is governed by a Board of Governors whose members are appointed by the president of the United States, subject to confirmation by the Senate.
The Fed can lend to banks and other institutions through the discount window and other credit facilities, change reserve requirements, and engage in purchases and sales of federal government bonds in the open market. Decisions to buy or sell bonds are made by the Federal Open Market Committee (FOMC); the Fed’s open-market operations represent its primary tool for influencing the money supply. Purchases of bonds by the Fed initially increase the reserves of banks. With excess reserves on hand, banks will attempt to increase their loans, and in the process the money supply will change by an amount less than or equal to the deposit multiplier times the change in reserves. Similarly, the Fed can reduce the money supply by selling bonds.
A smart card, also known as an electronic purse, is a plastic card that can be loaded with a monetary value. Its developers argue that, once widely accepted, it could replace the use of currency in vending machines, parking meters, and elsewhere. Suppose smart cards came into widespread use. Present your views on the following issues:
Which of the following items is part of M1? M2?
Consider the following example of bartering:
1 10-ounce T-bone steak can be traded for 5 soft drinks.
1 soft drink can be traded for 10 apples.
100 apples can be traded for a T-shirt.
5 T-shirts can be exchanged for 1 textbook.
It takes 4 textbooks to get 1 VCR.
Suppose the Fed sells $5 million worth of bonds to Econobank.
Suppose a bank with a 10% reserve requirement has $10 million in reserves and $100 million in checkable deposits, and a major corporation makes a deposit of $1 million.
Suppose a bank with a 25% reserve requirement has $50 million in reserves and $200 million in checkable deposits, and one of the bank’s depositors, a major corporation, writes a check to another corporation for $5 million. The check is deposited in another bank.
Now consider an economy in which the central bank has just purchased $8 billion worth of government bonds from banks in the economy. What would be the effect of this purchase on the money supply in the country, assuming reserve requirements of:
Now consider the same economy, and the central bank sells $8 billion worth of government bonds to local banks. State the likely effects on the money supply under reserve requirements of: