These are my notes on the monetary system in economics.
Money has three key roles: serving as a medium of exchange, a store of value, and a unit of account.
The quantity theory of money describes the relationships among the money supply, velocity, prices, and real GDP.
The Federal Reserve, the US central bank, has a dual mandate-low inflation and maximum employment.
The federal reserve holds the reserves of private banks.
The Federal Reserve’s management of private bank reserves enables the Fed to do three things: set a key short term interest rate, influence the money supply and the interest rate, and influence the long term real interest rate.
Money is the asset that people use to make and receive payments when buying and selling goods and services.
A medium of exchange is an asset that can be traded for goods and services.
A store of value is an asset that enables people to transfer purchasing power into the future.
A unit of account is a universal yardstick that is used for expressing the worth of different goods and services.
Fiat money refers to something that is used as legal tender by government decree and is not backed by a physical commodity like gold or silver.
The money supply adds together currency in circulation, checking accounts, saving accounts, travelers’ checks, and money market accounts. It is sometimes referred to as M2.
The quantity theory of money assumes that the growth rate of the money supply and the growth rate of the nominal GDP are the same over the long run.
The deflation rate is the rate of decrease of a price index.
Government revenue obtained from printing currency is called seigniorage.
The real wage is the nominal wage divided by a price index, like the consumer price index.
The central bank is the government institution that monitors financial institutions, controls key interest rates, and indirectly controls the money supply. The activities constitute monetary policy.
The Federal Reserve bank is the name of the central bank in the US.
Liquidity refers to funds available for immediate repayment. To express the same concept in a slightly different way, funds are liquid if they are immediately available for payment.
The federal funds market refers to the market where banks obtain overnight loans of reserves from one another.
The federal funds rate is the interest rate that banks charge each other for overnight loans in the federal funds market. The funds being lent are reserves at the Federal Reserve Bank.
Private banks that hold reserves at the Federal Reserve, including reserves that they have borrowed, are paid interest on those hold reserves. This is called interest on reserves, and this interest rate is set by the Federal Reserve.
The point where the supply and demand curves cross in the federal funds market is the federal funds market equilibrium.
If the Federal Reserve wishes to increase the level of reserves that private banks hold, it offers to buy government bonds from the private banks, and in return it gives the private banks more electronic reserves. If the Federal Reserve wishes to decrease the level of reserves, it offers to sell government bonds to the private banks and in return the private banks give back some of their reserves. By buying or selling government bonds, the Federal Reserve shifts the vertical supply curve in the federal funds market and thereby controls the level of reserves. These transactions are referred to as open market transactions.
The long term real interest rate is the long term nominal interest rate minus the long term inflation rate.
The realized real interest rate is the nominal interest rate minus the realized rate of inflation.
The expected real interest rate is the nominal interest rate minus the expected rate of inflation.
Economic agents’ inflation expectations are their beliefs about future inflation rates.
Money plays a vital role in our lives. It makes a range of economic transactions possible, simultaneously serving as a medium of exchange that can be traded for goods and services, a store of value that enables us to save and transfer purchasing power into the future, and a common unit of account that expresses the price of different goods and services.
The money supply is the quantity of money that individuals can immediately use in transactions. The money supply is defined as the sum of currency in circulation and the balances of most bank accounts at private banks. This measure of the money supply is referred to as M2. This measure excludes all forms of bank reserves. Specifically, the money supply excludes bank reserves of private banks on deposit at the Federal Reserve.
The quantity theory of money links the money supply to nominal GDP, which is the value of total output in the economy measured at current prices. The quantity theory of money implies that the long term inflation rate equals the long run growth rate of the money supply minus the long run growth rate of real GDP.
At a fixed growth rate of real GDP, faster growth of the money supply leads to inflation and hyperinflation. Inflationary growth in the money supply generates social costs that firms incur as they make frequent price changes and price controls that create supply disruptions, shortages, and inefficient queuing. Moderate growth in the money supply generates certain benefits for society including seigniorage. Moderate inflation also enables employers to lower real wages without cutting nominal wages. Moderate inflation also makes it easier for the Federal Reserve to lower the real interest rate. Lower real wages and lower real interest rates stimulate growth of real GDP.
Central banks, such as the Federal Reserve bank in the US, attempt to keep inflation at a low and stable level and also try to maximize the sustainable level of employment.
The Federal Reserve regulates banks, implements interbank payments, and attempts to influence macroeconomic fluctuations.
The Federal Reserve holds the reserve of private banks. The management of these private bank reserves is one of the most important roles that the Federal Reserve plays. It’s management of private bank reserves enables it to influence interest rates, the inflation rate, and the level of employment.
The Federal Reserve has many policy levers that enable it to influence the market for bank reserves, the federal funds rate, including shifting the quantity of reserves supplied, which is referred to as open market operations and changing the interest on reserves which shifts the demand curve for reserves.