Content: Money and Banking

➢ Money, Functions of money

➢ Defining money supply

➢ Functions of Central bank/ FED

➢ Tools to control money supply.

 Money
money is any good that is widely accepted for purposes of exchange (payment for goods and services) and in
the repayment of debts.
Three Functions of Money
Money has three major functions. It functions as a
1. medium of exchange,
2. unit of account, and
3. store of value.
Barter
Exchanging goods and services for other goods and services without the use of money.
Medium of Exchange Anything that is generally acceptable in exchange for goods and services. A function
of money.
Unit of Account
A common measure in which relative values are expressed. A function of money.
Store of Value
The ability of an item to hold value over time. A function of money.
 The Functions of the Fed
The Fed has eight major responsibilities or functions.
1. Control the money supply. A full explanation of how the Fed does this comes later in this chapter. Monetary
policy refers to changes in the money supply. More specifically, expansionary monetary policy refers to an
increase in the money supply, and contractionary monetary policy refers to a decrease in the money supply.

2. Supply the economy with paper money (Federal Reserve notes). The Federal Reserve Banks have Federal
Reserve notes on hand to meet the demands of the banks and the public. During the Christmas season, for
example, more people withdraw larger-than-usual amounts of $1, $5, $20, $50, and $100 notes from banks.
Banks need to replenish their vault cash, so they turn to their Federal Reserve

3. Provide check-clearing services. When someone in San Diego writes a check to a person in Los Angeles,
what happens to the check? The process by which funds change hands when checks are written is called the
check-clearing process.
 The Functions of the Fed

4. Hold depository institutions’ reserves. As noted in the last chapter, banks are required to
keep reserves against customer deposits either in their vaults or in reserve accounts at the Fed.
These accounts are maintained by the 12 Federal Reserve Banks for member banks in their
respective districts.

5. Supervise member banks. Without warning, the Fed can examine the books of member
commercial banks to see the nature of the loans the banks have made, monitor compliance
with bank regulations, check the accuracy of bank records, and so on. If the Fed finds that a
bank has not been maintaining established banking standards, it can pressure it to do so.
 The Functions of the Fed

6. Serve as the government’s banker. The federal government collects and spends large sums of
money. As a result, it needs a checking account for many of the same reasons an individual does.
Its primary checking account is with the Fed.The Fed is the government’s banker.

7. Serve as the lender of last resort. A traditional function of a central bank is to serve as the lender
of last resort for banks suffering cash management, or liquidity, problems.

8. Serve as a fiscal agent for the Treasury. The U.S. Treasury often issues (auctions) Treasury bills,
notes, and bonds. These U.S. Treasury securities are sold to raise funds to pay the government’s
bills.The Federal Reserve District Banks receive the bids for these securities and process them in
time for weekly auctions.
Fiscal policy and monetary policy
 Fed Tools for Controlling the Money Supply

1. open market operations

2. the required reserve ratio
3. the discount rate

Open Market Operations

OPEN MARKET PURCHASES The buying of government securities by the Fed.

➢ When the Fed buys securities, someone has to sell securities. Suppose bank ABC in Denver is the seller.
In other words, suppose the Fed buys $5 million worth of government securities from bank ABC.
➢ The Fed pays for the government securities by increasing the balance in bank ABC’s reserve account. In
other words, if before bank ABC sold the securities to the Fed, it had $0 on deposit with the Fed, then
after it sells the securities to the Fed, it has $5 million on deposit with the Fed.
OPEN MARKET PURCHASES
OPEN MARKET SALES Sometimes, the Fed sells government securities to banks and others. Suppose the Fed
sells $5 million worth of government securities to bank XYZ in Atlanta. The Fed surrenders the securities to
bank XYZ and is paid with $5 million previously deposited in bank XYZ’s reserve account at the Fed. In
other words, the Fed simply reduces the balance in bank XYZ’s reserve account by $5 million.
The Required Reserve Ratio
 Discount Rate

Federal Funds Market

A market where banks lend reserves to one another, usually for short periods.
Federal Funds Rate
The interest rate in the federal funds market; the interest rate banks charge one another to borrow reserves.
Discount Rate The interest rate the Fed charges depository institutions that borrow reserves from it.

Let us suppose, though, that the discount rate was lowered so that it is below the federal funds rate. What
would happen? Banks would go to the Fed for loans instead of going to each other. Let’s suppose bank
ABC gets a loan from the Fed.
 Discount Rate

➢ When bank ABC borrows from the Fed, its reserves increase while the reserves of no other bank
decrease. The result is increased reserves for the banking system as a whole, so the money supply
increases. In summary: When a bank borrows at the Fed’s discount window, the money supply
increases.
➢ When the discount rate is raised above the federal funds rate, banks will not borrow from the Fed.
However, as the banks pay back their Fed loans previously taken out, reserves fall, and ultimately, the
money supply declines.
Government Budget