Sorry.  I forgot to write the chapter numbers.  I will add those in the morning.  It is just the Fed chapter and the MS chapter.

I.    The Meaning of Money

A.   Definition of money:

B.   The Functions of Money

1.   Money serves three functions in our economy.

a.   Definition of medium of exchange:

b.   Definition of unit of account:

c.    Definition of store of value:

2.   Definition of liquidity:

C.   The Kinds of Money

   Definition of commodity money:

   Definition of bank notes:

   Definition of fiat money:

D.   Money in the U.S. Economy

1.   The quantity of money circulating in the United States is sometimes called the money stock.

2.   Included in the measure of the money supply are currency, demand deposits, and other monetary assets.

a.   Definition of currency:

b.   Definition of demand deposits:

3.   M1 and M2......

II.   The Federal Reserve System

A.   Definition of Federal Reserve (Fed):

B.   Definition of central bank:

C.   The Fed’s Organization

1.   The Fed was created in 1913 after a series of bank failures.

2.   The Fed is run by a Board of Governors with 7 members who serve 14-year terms.

a.   The Board of Governors has a chairman who is appointed for a four-year term.

3.   The Federal Reserve System is made up of 12 regional Federal Reserve Banks located in major cities around the country.

4.   One job performed by the Fed is the regulation of banks to ensure the health of the nation’s banking system.

a.   The Fed monitors each bank's financial condition and facilitates bank transactions by clearing checks.

b.   The Fed also makes loans to banks when they want (or need) to borrow.

5.   The second job of the Fed is to control the quantity of money available in the economy.

a.   Definition of money supply:

b.   Definition of monetary policy:

D.   The Federal Open Market Committee

1.   The Federal Open Market Committee (FOMC) consists of the 7 members of the Board of Governors and 5 of the 12 regional Federal Reserve District Bank presidents.

2.   The primary way in which the Fed increases or decreases the supply of money is through open market operations (which involve the purchase or sale of U.S. government bonds).

III. Banks and the Money Supply

   The financial position of the bank can be described with a T-account:

   Money Creation with Fractional-Reserve Banking

1.   Definition of fractional-reserve banking:

2.   Definition of reserve ratio:

5.   When the bank makes these loans, the money supply changes.

a.   Before the bank made any loans, the money supply was equal to the $100 worth of deposits.

b.   Now, after the loans, deposits are still equal to $100, but borrowers now also hold $90 worth of currency from the loans.

c.    Therefore, when banks hold only a fraction of deposits in reserve, banks create money.

6.   Note that, while new money has been created, so has debt. There is no new wealth created by this process.

C.   The Money Multiplier

1.   The creation of money does not stop at this point.

2.   Borrowers usually borrow money to purchase something and then the money likely becomes redeposited at a bank.

3.   Suppose a person borrowed the $90 to purchase something and the funds then get redeposited in Second National Bank. Here is this bank’s T-account (assuming that it also sets its reserve ratio to 10%):

4.   If the $81 in loans becomes redeposited in another bank, this process will go on and on.

5.   Each time the money is deposited and a bank loan is created, more money is created.

6.   Definition of money multiplier 204 style: the amount of money the banking system generates with each dollar of reserves.

D.   The Fed’s Tools of Monetary Control

1.   Definition of open market operations:

2.   Definition of reserve requirements:

3.   Definition of discount rate:

E.   Problems in Controlling the Money Supply

1.   The Fed does not control the amount of money that consumers choose to deposit in banks.

a.   The more money that households deposit, the more reserves the banks have, and the more money the banking system can create.

b.   The less money that households deposit, the smaller the amount of reserves banks have, and the less money the banking system can create.

2.   The Fed does not control the amount that bankers choose to lend.

a.   The amount of money created by the banking system depends on loans being made.

b.   If banks choose to hold onto a greater level of reserves than required by the Fed (called excess reserves), the money supply will fall.

3.   Therefore, in a system of fractional-reserve banking, the amount of money in the economy depends in part on the behavior of depositors and bankers.

4.   Because the Fed cannot control or perfectly predict this behavior, it cannot perfectly control the money supply.

I. The Fed and the Monetary Base

      A.  Another way the Fed manages the nation’s money supply is by controlling the monetary base (320 style), which is comprised of all currency in circulation and reserves held by banks.

      B.   The Fed’s principal liabilities are currency in circulation and reserves.

                   1.   The Fed’s currency outstanding includes currency in circulation, which is currency held by the nonbank public, and vault cash, which is currency held by depository financial institutions.

                   2.   Bank reserves equal vault cash in banks plus deposits by commercial banks and savings institutions with the Fed.

      C.   The Fed’s principal assets are government securities and discount loans.

                   1.   The Fed’s portfolio of government securities consists principally of holdings of U.S. Treasury securities.

                   2.   When the Fed lends to depository institutions, the loans are called discount loans and the interest rate on the loans is called the discount rate.

      D.  The Fed increases or decreases the monetary base by manipulating the levels of its assets.

                    1.   The most direct method the Fed uses to change the monetary base is open market operations, which is buying or selling U.S. government securities.

                           a.   In an open market purchase the Fed buys government securities.

                           b.   An open market purchase increases either bank reserves or currency in circulation; therefore it increases the monetary base, which is the sum of reserves plus currency (B = C + R).

                           c.   The Fed can reduce the monetary base by an open market sale of government securities.

                   2.   The Fed can also increase or decrease reserves—and, therefore, the base—by making discount loans to depository institutions.

                   3.   Although open market operations and discount loans both change the monetary base, the Fed has greater control over open market operations than over discount loans.

                           a.   The monetary base can be thought of as having two components: the nonborrowed base, B_non, and borrowed reserves, BR.

                            b.   We can express the monetary base as B = B_non + BR.

II. The Simple 204 style Deposit Multiplier

      A.  The money multiplier links changes in the monetary base to changes in the money supply.

      B.   When the Fed purchases T-bills from a bank it creates excess reserves in the bank.

      C.   When a bank has excess reserves it typically loans them out or buys securities with them, thereby creating checkable deposits.

      D.  When businesses or individuals receive funds from a bank as a result of a loan from the bank or a security sale to the bank, they write checks using these funds, which end up being deposited in other banks in a process known as multiple deposit expansion.

      E.   Multiple deposit expansion extends the monetary base and increases the money supply.

      F.   The ultimate change in checkable deposits as a result of a change in reserves is given by the simple deposit multiplier: DD = DR(1/( ); where D = deposits, R = reserves, and ( ) = the required reserve ratio.

      G.  If the Fed engages in an open market sale, it will set off a process of multiple deposit contraction.

III. The Money Multiplier and Decisions of the Nonbank Public

      A.  The simple deposit multiplier story contains the incorrect assumptions that individuals and businesses hold all their money as checkable deposits and that all excess reserves are loaned out.

      B.   The Fed acts to set the monetary base, but the behavior of the nonbank public and banks also influence the money supply.

      C.   The proportion of cash to checkable deposits is called the currency-deposit ratio, (C/D).

                  1.   Because currency is a necessity asset, as the economy grows and national wealth increases, the currency-deposit ratio declines.

                  2.   A decrease in interest rates paid on checkable deposits increases C/D.

                  3.   During a banking panic when there is an increase in the riskiness of checkable deposits relative to currency, C/D increases.

                   4.   Currency has an anonymity premium because it has higher value than checkable deposits in carrying out illegal activities.

                               a.   Economic activity and income earned but not reported to taxing authorities is referred to as the underground economy.

                               b.   Increases in activity in the underground economy or increases in illegal activity such as drug dealing will increase C/D.

IV. Bank Behavior: Excess Reserves and Discount Loans

      A.  Banks sometimes hold excess reserves, reducing the size of the money multiplier, and their decisions to incur discount loans also affect the amount of the monetary base that the Fed controls.

      B.   Banks generally hold small levels of excess reserves, but the amount of excess reserves fluctuates over time.

               1.   Holdings of excess reserves by banks are inversely related to the market interest rate.

               2.   Holdings of excess reserves are positively related to the expected level or variability of deposit flows.

      C.   The Fed makes discount loans available to banks, but the level of loans is determined by the banks themselves.

               1.   Economists have documented that when the spread between the rates on three-month T-bills and discount loans increases, so does the volume of discount lending.

                2.   The Fed generally discourages routine discount borrowing, but on occasion it has strongly encouraged banks to borrow from it, as it did during the October 1987 stock market crash.

V. Deriving the 320 Money Multiplier and Money Supply

      A.  The expression that converts the monetary base to the money supply, taking into account the behavior of banks and the nonbank public, is called the money multiplier.

      B.   The money supply equals the money multiplier times the monetary base, or

M = (1 + (C/D))/[(C/D + ( ) + ER/D)](B).

      C.   The derivation of the money multiplier allows for a complete description of the money supply process.

               1.   The money supply equals the monetary base times the money multiplier.

             2.   The monetary base comprises the nonborrowed base, determined primarily by the Fed through open market operations, and discount loans, determined jointly by banks and the Fed.

                3.   The money multiplier depends on the required reserve ratio (determined by the Fed), excess reserves relative to deposits (determined by banks), and the currency-deposit ratio (determined by the nonbank public).