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Chapter 2 The United States Monetary System © 2000 John Wiley & Sons, Inc. Chapter Outcomes Describe the three ways in which money is transferred from savers and investors Explain why depository institutions are an important part of the monetary system Describe the functions of money Give a brief review of the development of money in the United States 2 Chapter Outcomes (Continued) Define the M1 money supply Briefly explain the M2, M3, and L definitions of the money supply Explain possible relationships between money supply and economic activity Comment on developments in the international monetary system 3 Savings-Investment Process Direct Transfers: Money Savers Business Firm Securities Indirect Transfers: Savers Money Securities Savers Money Intermed’s Securities Investment Banking Firm Financial Intermediary Money Securities Money Firm’s Securities Business Firm Business Firm 4 Participants in the U.S. Monetary System CENTRAL BANK: Defines and Regulates Money Supply Facilitates the Transferring of Money BANKING SYSTEM: Creates Money Transfers Money Provides Financial Intermediation Processes/Clears Checks 5 The U.S. Monetary System Central Bank Federal Reserve System Board of Governors Federal Reserve Banks Facilitates transfer of money through check processing/clearing Defines and regulates money supply Banking System: 1. Creates money 2. Transfers money 3. Provides financial intermediation 4. Processes/clears checks First Bank Other Banks Last Bank 6 U.S. Central Bank Federal Reserve System [often referred to as the “Fed”] Board of Governors Federal Reserve Banks 7 Central Bank Activities Defines and regulates money supply Facilitates the transferring of money through check processing and clearing 8 Some Basic Definitions MONEY: Anything that is generally accepted as payment BARTER: Exchange of goods or services without using money LIQUIDITY: How easily an asset can be exchanged for money 9 Functions of Money MEDIUM OF EXCHANGE: The basic function of money STORE OF VALUE: Money can be held for some period of time, without losing its value, before it is spent STANDARD OF VALUE: Exists when prices and debts are stated in terms of the monetary unit 10 Historical Types of U.S. Coins FULL-BODIED MONEY: Coins that contain the same value in metal as their face value TOKEN COINS: Coins containing metal of less value than their stated value 11 Historical Types of U.S. Paper Currency REPRESENTATIVE FULL-BODIED MONEY: Paper money fully backed by a precious metal FIAT MONEY: Legal tender proclaimed to be money by law (i.e., not backed by a precious metal) 12 Deposit Money in the U.S. CREDIT MONEY: Money worth more than what it is made of. It is backed by the “creditworthiness” of the issuer DEPOSIT MONEY: A special type of credit money backed by the depository institution that issued the deposit 13 Alternatives to “Paper Checks” AUTOMATIC TRANSFER SERVICE (ATS) ACCOUNTS: Provide for direct deposits to, and payments from, checkable deposit accounts DEBIT CARDS: Provide for immediate direct transfer of deposit amounts 14 Components of the M1 Definition of the Money Supply Currency Travelers Checks Demand Deposits at Banks Other Checkable Deposits at Depository Institutions 15 Components of the M2 Definition of the Money Supply M1 Money Supply Savings Accounts at Depository Institutions Small-Denomination Time Deposits Retail Money Market Mutual Funds 16 Components of the M3 Definition of the Money Supply M2 Money Supply Large-Denomination Time Deposits Institutional Money Market Mutual Funds Repurchase Agreements (Overnight and Term) Eurodollars (Overnight and Term) Held by U.S. Residents 17 Money Supply and Economic Activity Relationships MONETARISTS’ VIEW: The amount of money in circulation determines the level of economic activity KEYNESIANS’ VIEW: Change in the money supply first causes a change in interest rates which, in turn, alters the demand for goods and services 18 Monetarists’ View BASIC EQUATION: GDP = MS x VM GROSS DOMESTIC PRODUCT (GDP): Measures the output of goods and services in an economy MONEY SUPPLY (MS): Usually defined in terms of M1 or M2 VELOCITY OF MONEY (VM): The rate of circulation of the money 19 supply International Monetary System Historically: Tied to the gold standard Bretton Woods System (1944): Agreement to use fixed or pegged exchange rates tied to the U.S. dollar or gold Early 1970s: Development of a flexible or floating exchange rate system 20