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Monetary system   This is the system of money and banking, established by law and subject to the control of the central bank, the Federal Reserve.  Each nation has its own system, some quite different from the U.S. monetary system. 

Banking system  This is the system of depository institutions, consisting of commercial banks and thrifts (savings institutions and credit unions).  The term bank is sometimes used generically to refer to any financial institution that is licensed to accept deposits and issue credit money through loans.

Monetary base   Referred to here as base money, is all issued by the Fed.  Federal Reserve notes and coins comprise the largest part of the monetary base.  The Fed estimates that over half of the value of notes outstanding are used in foreign countries as transaction money and as a store of wealth where local currencies are not stable.

Notes and coins   Federal Reserve notes in various denominations up to $100 are the only form of paper money now issued.  They are printed by the Treasury and sold at cost to the Fed.  Coins are minted by the Treasury and sold at face value to the Fed.  Banks purchase notes and coins at face value from the Fed and issue them to customers in exchange for debits against their deposits.

Deposits at the Fed   In addition to its vault cash, a bank holds deposits at the Fed as a part of its required reserves.  In order to avoid overdraft penalties, its account at the Fed must be sufficient to cover the net withdrawal of funds due to the checking activities of its depositors as well as its own expenditures. 

Credit money   This is money created by a depository institution when it credits an account with a new deposit to fund a loan.  When the loan is repaid, that amount of credit money vanishes.

Fed funds rate   This is the interest rate banks charge one another on overnight loans of reserves that they hold at the Fed.  Since the Fed does not pay interest on reserves, banks with excess reserves normally seek to lend them to banks needing reserves.  This is an active market in which the interest rate varies with supply and demand. 

Commercial banks   These comprise the major part of the banking system.  They should not be confused with investment banks and finance companies.  The latter may neither accept deposits nor create them.  They can only lend their own money or borrowed money.

Lending rate   Banks lend at different interest rates depending upon the amount and duration of the loan, and the creditworthiness of the borrower.  Their lowest rate, known as the prime rate, is reserved for major companies who are regular borrowers.  The prime rate is normally based on a markup from the Fed funds rate which in turn sets the cost that banks must pay to borrow funds.

Equity  A bank's equity, also known as its capital, is the difference between what it owns and what it owes, in other words assets minus liabilities.  A bank's capital grows with retained earnings.  If its total liabilities exceed its total assets, the bank is insolvent.  Do not confuse the total market value of a bank's outstanding shares, which is sometimes referred to as its market capitalization, with the bank's capital.

Capital ratio   This is the ratio of a bank's capital to its risk-weighted assets. The Fed requires a minimum capital ratio of 4% to 8%, depending upon the type and quality of its assets.  When a bank issues a loan, its assets increase but not its capital since its liabilities increase equally by the deposit created to fund the loan. However interest earned on loans, together with fees and income from its other investments, increase both its capital and assets. 

Reserve ratio   This is the ratio of a bank's reserves to the amount of its demand deposits, i.e. its checking deposits.  The Fed sets the required minimum ratio, currently 10%.  Even with no specified minimum ratio, banks would have to maintain sufficient reserves to cover checks written by depositors and to provide cash on demand. 

Open market operations   The Open Market Desk of the New York Federal Reserve Bank has the task of controlling the reserves in the banking system as required to hold the Fed funds rate on target.  It does so mainly through repurchase agreements with authorized dealers.  The Fed buys or sells Treasury securities with a promise to reverse the transaction at a later date.  Commonly known as repos, these are basically short-term collateralized loans at a negotiated interest rate. 

Banking system reserves   This is the total reserves held by all depository institutions.  A bank must hold its reserves on deposit at the Fed and as vault cash.  Banks cannot create reserves themselves. The amount of reserves fluctuates for a number of reasons, including cash deposits or withdrawals by bank customers.  The Fed must constantly monitor and adjust reserves to keep the Fed funds rate on target. 

Target rate   The Open Market Committee of the Federal Reserve (FOMC) sets the target rate for Fed funds, its primary monetary policy tool.  That is its only effective means for controlling the demand for credit, and thus the rate of growth of the money supply.

Discount window  This is the facility through which the Fed lends short-term to healthy banks.  The rate of interest on the loan is known as the discount rate.  It is set 100 basis points above the target Fed funds rate.  Banks use the discount window sparingly because they can usually borrow at a lower rate in the money market.

Treasury securities   This refers to Treasury bills, notes, and bonds sold to the public to cover deficit spending, i.e. spending not covered by tax revenues.  The term T-bond is sometimes used generically to refer to all three types of Treasury securities. 

Monetizing the debt   The Fed occasionally purchases T-bonds outright for its own portfolio to meet the growing demand for cash and for banking system reserves.  This is done as needed to reduce the number and size of repos arising from its open market operations.  It pays for its purchases by simply crediting the seller's bank with a new deposit in its account at the Fed. 

Printing money   The Treasury only sells securities to the Fed to roll over maturing securities in the Fed's portfolio.  Otherwise it would be creating new money rather than recycling existing money with obvious inflationary implications.  That is sometimes referred to as printing money. 

Accord of 1951  Until this date, the Fed bought whatever securities the Treasury could not sell to the public at a pegged interest rate.  The Accord ended the inflationary pressure resulting from the creation of excessive banking system reserves.  Henceforth the Fed assumed full control of monetary policy, independent of the executive branch.

Money balances   The Treasury maintains accounts, i.e. money balances, with the Fed and with commercial banks.  Incoming funds are deposited in banks and transferred as needed to the Fed account from which all of its payments are made. 

National debt owed to the public   This refers to the Treasury debt on which real interest payments are made, as distinct from the total debt which includes what it owes to government trust funds.  The latter involves intra-government interest payments, an essentially meaningless bookkeeping exercise. 

Rolling over T-bonds   For the Treasury, this means selling new T-bonds to cover the principal due on the maturing T-bonds.  For bond holders, it means using the proceeds from a maturing bond to buy a new bond.

Bond owners   Less than 10 percent of the debt is held by individual U.S. owners.  Most Treasury securities are held by institutions, e.g. commercial banks, insurance companies, corporations, pension funds, mutual funds, foundations, security dealers, and state local governments, and foreign central banks.  As of 2006, about 50 percent of the bonds were owned by foreign institutions and individuals.

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