Paper MONEY International Group

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Describe money and functions of money using real life examples andfurther describe how banks, central banks control money-supply,money multiplication and its pros and cons. Explain all processes

banks, consumers and governments follow in about sequences.

Group work by, Gohar BadalyanCaridad Morente Cadenas de Llano

Merve Nasr

David Babayan

Teresa Picerno

15.11.2011
http://www.facebook.com/profile.php?id=605856627http://www.facebook.com/profile.php?id=605856627http://www.facebook.com/profile.php?id=605856627


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Outline

Introduction

Money Functions of money Measuring money supply The circulation of money

Banking

Banks and money supply Money multiplication

Central Banks and Monetary Policy Central Bank and its Functions Central Banks and Monetary Policy Control of money supply


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Introduction

What is money and why everyone wants to have money? Why you can change money for somecommodity? An answer to this and other questions related to money is possible to find in thispaper. There were clearly described money as a universal mean, its functions and a circulation of

it. Banks and banking, how central banks control the money supply and how the monetary policyworks. Together with definitive and systematic explanations there were brought a real lifeexamples related to this, which help reader to understand it more clearly.

Money

In economics the meaning of the term money is different from its everyday meaning. Peopleoften say money when they mean income or wealth, however in economics money refersspecifically to assets that are widely used and accepted as payment. Historically, the forms ofmoney have ranged candy bars, cigarettes (in World War II prisoner-of-war camps), huge wheelsof carved stone (on the island of Yap in the South Pacific), cowrie shells (in West Africa), beads

(among North American Indians), cattle (in southern Africa) to gold and silver. In moderneconomies the most familiar forms of money are coins and paper money, or currency. Anothercommon form of money is checkable deposits; assets that can be used in making payments, suchas cash and checking accounts, or bank accounts on which checks can be written for makingpayments. One reason that money is important is that most prices are expressed in units ofmoney, such as dollars, yen, and euros. Money is generally divided into two groups, commoditymoney and fiat money.Commodity money is for example, prisoners of war made purchases withcigarettes (seeAppendix1), quoted prices in terms of cigarettes, and held their wealth in the formof accumulated cigarettes. Of course, cigarettes could also be smoked, so they had an alternativeuse. Gold represents another form of commodity money. But, today money almost in over theWorld is mostly fiat money. Fiat money, sometimes called token money, is money that is

basically worthless. Why would anyone accept worthless paper instead of something that hassome value?It is not because the paper money is exchanged by gold or silver. There was a time when dollarbills were convertible directly into gold. If the price of gold were $35 per ounce, for example, thegovernment agreed to sell 1 ounce of gold for 35 dollar bills. However, it is no longer like this.They are exchangeable only for dimes, nickels, pennies, other dollars, and so on.The public accepts paper money as a means of payment and a store of value because thegovernment has ensured that its money is accepted. The government declares its paper money tobe legal tender; the government declares that its money must be accepted in settlement of debts.Functions of money: Money serves four basic functions: It is a medium of exchange, a unit ofaccount, a store of value, and a standard of deferred payment. Not all monies serve all of these

functions equally well. But to be money, an item must perform enough of these functions tomake people to use it.Medium of Exchange: Money is a medium of exchange; it is given in exchange for goods andservices. Sellers willingly accept money as payment for the products and services that theyproduce. Without money, we would have to resort to barter, the direct exchange of goods andservices for other goods and services.Unit of Account: Money is a unit of account: Goods and services are priced in terms of money.This common unit of measurement allows us to compare relative values easily. If whole-wheat


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bread sells for a dollar a loaf and white bread sells for 50 cents, we know that whole-wheat breadis twice as expensive as white bread. Using money as a unit of account is efficient. It reduces thecosts of gathering information on what things are worth.Store of Value:Money functions as a store of value or purchasing power. If you are paid today,you do not have to hurry out to spend your money. Or for example you buy a painting of Picasso

you can store it and after some years you will store value and you will sell it much expensive.But in this case inflation plays a major role in determining the effectiveness of money as a storeof value. Higher the inflation rate, lower your money purchasing power.Standard of Deferred Payment: Finally, money is a standard of deferred payment. Debtobligations are written in terms of money values. If you have a credit card bill that is due in 30days, the value you owe is stated in monetary unitsfor example, dollars in the United Statesand yen in Japan. We use money values to state amounts of debt, and we use money to pay ourdebts.Measuring money supply: Changes in the money supply affect interest rates, inflation, andother indicators of economic wellbeing. When economists measure the money supply, theymeasure spendable assets. As we know, many different assets have performed this role over the

centuries, ranging from gold to paper currency to checking accounts.For example, money market mutual funds (MMMFs). MMMFs are organizations that sell sharesto the public and invest the proceeds in short-term government and corporate debt. MMMFsmake every effort to earn a high return for their shareholders. They allow their shareholders towrite a small number of checks each month. Thus, although MMMF shares can be used to makepayments, they are not as convenient as cash or regular checking accounts for this purpose. Butthere is no definitive answer MMMF shares should be considered as money or not.To measure money, we need a precise definition that tells exactly what assets should beincluded. For this reason, in most countries economists and policymakers use several differentmeasures of the money stock. These official measures are known as monetary aggregates. TodayMonetary aggregates are called M1, M2 and M3 (see Table 1inAppendix 2).M1 Money Supply: The narrowest and most liquid measure of the money supply is the M1money supply, or financial assets that are immediately available for spending. This definitionemphasizes the use of money as a medium of exchange. The M1 money supply consists ofcurrency held by the nonbank public, travelers checks, demand deposits, and other checkabledeposits. Demand deposits and other checkable deposits are transactions accounts; they can beused to make direct payments to a third party. The components of the M1 money supply are usedfor about 74 percent of family purchases. This is one reason why the M1 money supply may be auseful variable in formulating macroeconomic policy.M2 Money Supply: The M2 money supply is a broader definition of the money supply thatincludes assets in somewhat less liquid forms. The M2 money supply includes the M1moneysupply plus savings deposits, small-denomination time deposits, and balances in retail moneymarket mutual funds.M3 Money Supply: The M3 monetary aggregate adds to M2 somewhat less liquid assets such aslarge denomination time deposits, repurchase agreements, Eurodollars and institutional moneymarket mutual fund shares.The circulation of money: Money circulates all the time. It circulates from the central banks togovernment to industries than to individuals and back to all. So this is very complicated systemand understanding of this we will put a diagram where is shown the circulation of money (seeAppendix 3).


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Banking

Commercial banks are financial institutions that offer deposits on which checks can be written.In most of all countries, commercial banks are privately owned. Thrift institutions are financialinstitutions. Savings and loan associations, credit unions, and mutual savings banks are all thrift

institutions. Both commercial banks and thrift institutions are financial intermediaries,middlemen between savers and borrowers. Banks accept deposits from individuals and firmsthen use those deposits to make loans to individuals and firms. A bank is willing to serve as anintermediary because it hopes to earn a profit from this activity. It pays a lower interest rate ondeposits than it charges on loans; the difference is a source of profit for the bank. Islamic banksare prohibited by holy law from charging interest on loans; thus, they use a different system formaking a profit. According to Muslim holy book, the Koran, Islamic law prohibits interestcharges on loan. Infect profit-sharing deposits; Islamic banks typically offer checking accounts,travelers checks, and trade-related services on a fee basis. Islamic banks have been lendingmoney to traditional banks to fund investments that satisfy the moral and commercial needs ofboth, such as lending to private firms. These funds cannot be used to invest in interest-bearing

securities or in firms that deal with alcohol, pork, gambling, or arms. The most popularinstrument for financing Islamic investments is murabaha. This is essentially cost-plusfinancing, where the financial institution purchases goods or services for a client and then, overtime, is repaid an amount that equals the original cost plus an additional amount of profit (seefull caseAppendix 4).

Banks and money supply

Banks create money by lending money. They take deposits, and then lend a portion of thosedeposits in order to earn interest income. The portion of their deposits that banks keep on hand isa reserve to meet the demand for withdrawals. In a fractional1 reserve banking system, banks

keep less than 100 percent of their deposits as reserves. If all banks hold 10 percent of theirdeposits as a reserve, for example, then 90 percent of their deposits are available for loans. Whenthey loan these deposits, money is created.Money multiplier: The money multiplier is the multiple by which deposits can increase forevery dollar increase in reserves. The deposit expansion multiplier equals the reciprocal of thereserve requirement. It also tells us how much the monetary base expands to create the moneysupply, because Money Supply = monetary base * money multiplierMoney multiplier deposit expansion multiplier = 1/required reserve ratioRequired reserve ratio= reserves at bank/total depositsMoney multiplier < deposit expansion multiplier, it is only if public holds currency and bankshold excess reserves.

In the United States, the required reserve ratio varies depending on the size of the bank and thetype of deposit. For large banks the ratio is currently 10 percent, the money multiplier will be1/.10 = 10. This means that an increase in reserves of $1 could cause an increase in deposits of$10.Money multiplier is derived under the assumption that banks hold no excess reserves. Forexample, when Bank 1 gets the deposit of $100, it loans out the maximum that it can, namely

1a system in which banks keep less than 100 percent of their deposits available for withdrawal


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$100 times 1 minus the reserve requirement ratio. If instead Bank 1 held the $100 as excessreserves, the increase in the money supply would just be the initial $100 in deposits.The deposit expansion multiplier indicates the maximum possible change in total deposits whena new deposit is made. If banks hold more reserves than the minimum required, they lend asmaller fraction of any new deposits, and this reduces the effect of the deposit expansion

multiplier. For instance, if the reserve requirement is 10 percent, then the deposit expansionmultiplier is 10. If a bank chooses to hold 20 percent of its deposits on reserve, the depositexpansion multiplier is only 5 (1/.20).If money (currency and coin) is withdrawn from the banking system and kept as cash, depositsand bank reserves are smaller, and there is less money to loan out. The removal of moneyreduces the deposit expansion multiplier.The money multiplier usually is relatively stable, but not always. For example during 1930-1933,in the early part of the Great Depression, the money multiplier fell sharply and it created seriousproblems for monetary policy (seeAppendix 5).The disadvantage of money multiplier is that it could lead to financial crisis.

Central Banks and Monetary Policy

Central Bank and its Functions: Central banks are sometimes known as bankers banksbecause only banks (and occasionally foreign governments) can have accounts in them. Privatecitizens cannot go to the Central Bank and open a checking account or to borrow money.Examples of central banks are Federal Reserve System (FED) is the central bank of UnitedStates, European Central Bank (ECB) is the central bank of euro-area countries. Decisions,concerning monetary policy (for instance, choosing target(s)) in US, are the responsibility of theFederal Open Market Committee (FOMC).Although from a macroeconomic point of view the Central Banks the most important role is to

control the money supply, but they are also perform several important functions for banks. Thesefunctions include clearing interbank payments, regulating the banking system, and assistingbanks in a difficult financial position. Beside this they are also responsible for managingexchange rates and the nations foreign exchange reserves.Clearing interbank payments works as follows. Suppose, for example in Armenia one companywrite a 100 AMD check drawn on Ameria Bank to pay to another company, which bank`saccount is in ProCredit bank. The process, how the money from Ameria Bank (firts account) getto ProCredit Bank (second account), is implemented by Central Bank of Armenia. WhenCompany 2 receives the check and deposits it at ProCredit Bank, the bank submits the check tothe Central Bank, asking it to collect the funds from Ameria Bank. The Central Bank presents thecheck to America bank and then debit Ameria bank`s account for 100AMD and credit theaccount of ProCredit Bank. Accounts at the Central Bank stand as reserves. The two banks tradeownerships of their deposits at the Central Bank and the total volume of reserves has notchanged.Central Banks are responsible for many regulations governing banking practices and standards.For example, the Federal Reserve System has the authority to control mergers among banks, andit is responsible for examining banks to ensure that they are financially stable. Also CentralBanks sets reserve requirements for all financial institutions.Another important responsibility of Central Banks is to act as the lender of last resort for

banking system. It provides funds to troubled banks, which are not able to find any other sourcesof funds.


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As it was writhen above the most important function of Central Banks is to control the moneysupply. For example every year during the Christmas season, the demand for currency risesbecause people carry more money to buy gifts. During the holiday season, the Federal ReserveSystem increases the supply of money. After the holiday season, the demand for money declinesand public begin to deposit cash in banks. Then the banks return the cash to the Federal Reserve

System.Monetary policy: Monetary policy is the government's decisions about how much money tosupply. It is an important tool to affect macroeconomic behavior. Changes in the money supplywill affect nominal variables such as the price level and the nominal exchange rate. Monetarypolicy also affects real variables such as real GDP, the real interest rate, and the unemploymentrate.In almost all countries the central bank is the government institution responsible for monetarypolicy2.The ultimate goal of monetary policy is the economic growth with stable prices.Economic growth means greater output; stable prices mean a low, steady rate of inflation.Central banks do not control gross domestic product or the price level directly. Instead, theycontrol the money supply, which in turn affects GDP and the level of prices. The money supply,

or the growth of the money supply (monetary aggregates) or interest rates (long term and shortterm) are the intermediate targets, an objective that helps the Central bank.Some countries have moved away from pursuing intermediate targets like money growth ratesand have instead focused on an Inflation Targeting. These countries realize that the publicgenerally likes to see policies supporting faster economic growth, like lower interest rates,whereas fighting inflation may mean unpopular higher interest rates and slower growth. Forexample, in case of European Central Bank (ECB) (seeAppendix 6). Inflation targeting has beenadopted in several countries, including New Zealand, Canada, the U.K., Australia, Switzerland,Chile, Korea, South Africa, and Europe (by the European Central Bank).Central Bank of the Republic of Armenia (CBA) proposed the adoption of an inflation targetingstrategy to achieve the legally-prescribed goal of price stability, replacing the strategy ofmonetary targeting, which was adopted as the method of monetary regulation since 1994.Control of money supply (tools of monetary policy): The Central Banks controls the moneysupply and interest rates by changing bank reserves. There are four ways that explain this; it iswritten for Federal Reserve System of USA

1. Required reserve rate trend down: The Fed can lower required reserve which raises themultiplier effect of high powered money (cash). The cash remains in the bank and eachdollar can support more loans/demand deposit.

2. Discount interest rate decreases: The Fed can lower the discount rate and lower costs ofbanks holding low excess reserves which will lower the excess reserve rate. If the Fedlower the discount rate, or fixes a lower federal funds aim, this can be done if the Fedinjects funds into the system which will drive down the price of those funds interestrates. To know how it could increase the level of the cash system, we can turn to openmarket operations.

3. Publics holding of cash changes: The Fed can raise confidence in banking system whichwill lower publics desire for holding cash. If you look at the high-powered money theFed can inject into the system, a dollar in the hands of an individual is simply a dollar of

2Most industrialized countries established central banks in the nineteenth century or early twentieth century. Prior to the establishment of central

banks, national treasury departments often were responsible for currency issue and other matters pertaining to the money supply.


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money supply. A dollar reserves at the banks, however, can support some multipleexpansion of checking accounts.

4. Open market purchases: this is the Feds primary tool of monetary policy. The Fed canbuy or sell government securities (bonds). When the Fed wants to increase the moneysupply it will buy government securities (bonds), while if it wants to decrease the money

supply it will sell government securities (bonds).Recently for example the same happenedconcerning current debt crisis of Greece (International Monetary Fund provided a loan toGreece of around $ 4.3 billion).The central banks of euro-area countries increased moneysupply by selling governmental bonds to support Greece to avoid default.


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References

1. U.S. Treasury Dept., The Use and Counterfeiting of U.S. Currency Abroad, Part 3, Section1.3, 2006.http://www.federalreserve.gov/boarddocs/ rptcongress/counterfeit/counterfeit2006.pdf.

2.www.federalreserve.gov/Releases/h33.www.federalreserve.gov/pf/pf.htm4.www.cba.am5. W. Boyes, M. Melvin; Macroeconomics; 2011; ISBN 13: 978-1-4390-3907-66. A.B. Abel, B.Bernanke; Macroeconomics; 2008; ISBN 13: 978-0-321-41554-77. http://fragments.awedge.net/?p=3698. http://www.wisegeek.com/what-is-money-circulation.htm9. http://www.investmentsandincome.com/10. http://www.uri.edu/

11. P. Dalziel; Money, Credit and Price Stability; 2001; ISBN 0-415-24056-512. F. S. Mishkin;The Economics of Money, Banking and Financial Markets; 2004; ISBN 0-321-12235-6
http://www.federalreserve.gov/http://www.federalreserve.gov/http://www.federalreserve.gov/http://www.federalreserve.gov/http://www.federalreserve.gov/http://www.federalreserve.gov/http://www.federalreserve.gov/pfhttp://www.federalreserve.gov/pfhttp://www.federalreserve.gov/pfhttp://www.cba.am/http://www.cba.am/http://www.cba.am/http://fragments.awedge.net/?p=369http://fragments.awedge.net/?p=369http://www.wisegeek.com/what-is-money-circulation.htmhttp://www.wisegeek.com/what-is-money-circulation.htmhttp://www.investmentsandincome.com/http://www.investmentsandincome.com/http://www.uri.edu/http://www.uri.edu/http://www.uri.edu/http://www.investmentsandincome.com/http://www.wisegeek.com/what-is-money-circulation.htmhttp://fragments.awedge.net/?p=369http://www.cba.am/http://www.federalreserve.gov/pfhttp://www.federalreserve.gov/http://www.federalreserve.gov/


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Appendix 1

Money in Prisoner-of-War Camp

Among the Allied soldiers liberated from German prisoner- of-war (POW) camps at the end of

World War II was a young man named R. A. Radford. Radford had been trained in economics,and shortly after his return home he published an article entitled "The Economic Organization ofa POW Camp.'" This article, a minor classic in the economics literature, is a fascinating accountof the daily lives of soldiers in several POW camps. It focuses particularly on the primitive"economies" that grew up spontaneously in the camps. The scope for economic behavior in aPOW camp might seem severely limited, and to a degree that's so. There was little production ofgoods within the camps, although there was some trade in services, such as laundry or tailoringservices and even portraiture. However, prisoners were allowed to move around freely within thecompound, and they actively traded goods obtained from the Red Cross, the Germans, and othersources. Among the commodities exchanged were tinned milk, jam, butter, biscuits, andchocolate, sugar, clothing, and toilet articles. In one particular camp, which at various times had

up to fifty thousand prisoners of many nationalities, active trading centers were run entirely bythe prisoners. A key practical issue was how to organize the trading. At first, the campeconomies used barter, but it proved to be slow and inefficient. Then the prisoners hit on the ideaof using cigarettes as money. Soon prices of all goods were quoted in terms of cigarettes, andcigarettes were accepted as payment for any good or service. Even nonsmoking prisoners wouldhappily accept cigarettes as payment, because they knew that they could easily trade thecigarettes for other things they wanted. The use of cigarette money greatly simplified theproblem of making trades and helped the camp economy function much more smoothly.Why were cigarettes, rather than some other commodity, used as money by the POWs?Cigarettes satisfied a number of criteria for good money: A cigarette is a fairly standardizedcommodity whose value was easy for both buyers and sellers to ascertain. An individual

cigarette is low enough in value that making "change" wasn't a problem. Cigarettes are portable,are easily passed from hand to hand, and don't spoil quickly. A drawback was that, as acommodity money (a form of money with an alternative use), cigarette money had a resourcecost: Cigarettes that were being used as money could not simultaneously be smoked. In the sameway, the traditional use of gold and silver as money was costly in that it diverted these metalsfrom alternative uses. The use of cigarettes as money isn't restricted to POW camps. Just beforethe collapse of communism in Eastern Europe, cigarette money reportedly was used in Romaniaand other countries instead of the nearly worthless official money.

Source: ECOIlOl1lica, November 1945, pp. 189-201.

Appendix 2


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Appendix 3


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Appendix 4

Islamic Banking

According to the Muslim holy book, the Koran, Islamic law prohibits interest charges on loans.

Banks that operate under Islamic law still act as intermediaries between borrowers and lenders.However, they do not charge interest on loans or pay interest on deposits. Instead, they take apredetermined percentage of the borrowing firms profits until the loan is repaid, then sharethose profits with depositors. Since the mid-1970s, over a hundred Islamic banks have opened,most of them in Arab nations. Deposits in these banks have grown rapidly. In fact, in somebanks, deposits have grown faster than good loan opportunities, forcing the banks to refuse newdeposits until their loan portfolio could grow to match the available deposits. One bank inBahrain claimed that over 60 percent of deposits during its first two years in operation weremade by people who had never made a bank deposit before. In addition to profit-sharingdeposits, Islamic banks typically offer checking accounts, travelers checks, and trade-relatedservices on a fee basis. Because the growth of deposits has usually exceeded the growth of local

investment opportunities, Islamic banks have been lending money to traditional banks to fundinvestments that satisfy the moral and commercial needs of both, such as lending to privatefirms. These funds cannot be used to invest in interest-bearing securities or in firms that deal inalcohol, pork, gambling, or arms. The growth of mutually profitable investment opportunitiessuggests that Islamic banks are meeting both the dictates of Muslim depositors and theprofitability requirements of modern banking. The potential for expansion and profitability ofIslamic financial services has led major banks to create units dedicated to providing Islamicbanking services. In addition, there are stock mutual funds that screen firms for compliance withIslamic law before buying their stock. For instance, since most financial institutions earn and paylarge amounts of interest, such firms would tend to be excluded from an Islamic mutual fund.The most popular instrument for financing Islamic investments is murabaha. This is essentially

cost-plus financing, where the financial institution purchases goods or services for a client andthen, over time, is repaid an amount that equals the original cost plus an additional amount ofprofit. Such an arrangement is even used for financing mortgages on property in the UnitedStates. A financial institution will buy a property and then charge a client rent until the rentpayments equal the purchase price plus some profit. After the full payment is received, the titleto the property is passed to the client.

Appendix 5

The Money Multiplier during the Great Depression

The money multiplier usually is relatively stable, but not always. During 1930-1933, in the earlypart of the Great Depression, the money multiplier fell sharply, creating serious problems formonetary policy.The source of the instability in the money multiplier, as discussed in detail by Milton Friedmanand Anna Schwartz in their Monetary History of the United States, 1867-1960, was a series ofsevere banking panics. A banking panic is an episode in which many banks suffer runs bydepositors, with some banks being forced to close. The US panics resulted from both financialweaknesses in the banking system and the arrival of bad economic and financial news. Among


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the causes of banking panics emphasized by Friedman and Schwartz were: (1) the effects offalling agricultural prices on the economies of farm states in the autumn of 1930; (2) the failurein December 1930 of a large New York bank called the Bank of United States (a private bank,despite its name); (3) the failure in May 1931 of Austria's largest bank, which led to a Europeanfinancial crisis; and (4) Great Britain's abandonment of the gold standard in September 1931.

The most severe banking panic began in January 1933 and was halted only when the newlyinaugurated President Franklin D. Roosevelt proclaimed a "bank holiday" that closed all thebanks in March 1933. By that time more than one-third of the banks in the United States hadfailed or 'Princeton, been taken over by other banks. Banking reforms that were passed as part ofRoosevelt's New Deal legislation restored confidence in the banking system and halted bank runsafter March 1933. The banking panics affected the money multiplier in two ways. (See Fig.1)First, people became very distrustful of banks, fearing that their banks might suddenly fail andnot be able to pay them the full amounts of their deposits. (These events occurred before depositswere insured by the Federal government, as they are today.) Instead of holding bank deposits,people felt safer holding currency, perhaps under the mattress or in coffee cans buried in thebackyard. Conversion of deposits into currency caused the currency-deposit ratio to rise, as

shown in Fig.1, with a spectacular rise in the first quarter of 1933. Second, in anticipation ofpossible runs, banks began to hold more reserves (including vault cash) to back their deposits, asshown in Fig.1 by the behavior of the reserve-deposit ratio. Banks hoped to convince depositorsthat there was enough cash in the banks' vaults to satisfy withdrawals so that the depositorswould not be tempted to start a run.Increases in either the currency-deposit ratio or the reserve-deposit ratio cause the moneymultiplier to fall. As shown in Fig. 2(a), as a result of the banking panics, the money multiplierfell sharply, from 6.6 in March 1930 to 3.6 by the bank holiday in March 1933. Thus, eventhough the monetary base grew by 20% during that three-year period, the money multiplier fellby so much that the money supply fell by 35%, as shown in Fig. 2(b).

Princeton, N.J.: Princeton University Press for NBER, 1963.


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There is some controversy about whether the drop in the money supply was a primary cause of

the decline in output during 1930-1933 (Friedman and Schwartz argue that it was), but there isgeneral agreement that the drastic decline in the price level (by about one-third) in this periodwas the result of the plunge in the money supply.


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Appendix 6

The European Central Bank

The European Central Bank (ECB) began operations on June 1, 1998, in Frankfurt, Germany,

and now conducts monetary policy for the euro-area countries. The national central banks likethe Bank of Italy and the German Bundesbank are still operating and perform many of thefunctions that they had prior to the ECB, such as bank regulation and supervision and facilitatingpayments systems in each nation. In some sense, they are like the regional banks of the FederalReserve System in the United States. Monetary policy for the euro area is conducted by the ECBin Frankfurt, just as monetary policy for the United States is conducted by the Federal Reserve inWashington, D.C. Yet the national central banks of the euro area play an important role in theirrespective countries. The entire network of national central banks and the ECB is called theEuropean System of Central Banks. Monetary policy for the euro area is determined by theGoverning Council of the ECB. This council is composed of the heads of the national centralbanks of the euro-area countries plus the members of the ECB Executive Board. The board is

made up of the ECB president and vice president and four others chosen by the heads of thegovernments of the euro-area nations.The ECB pursues a primary goal of price stability, defined as an inflation rate of less than 2percent per year. Subject to the achievement of this primary goal, additional issues, such aseconomic growth, may be addressed. A benefit of a stated policy goal is that people can moreeasily form expectations of future ECB policy. This builds public confidence in the central bankand allows for greater stability than if the public were always trying guessing what the centralbank really cares about and how policy will be changed as market conditions change.

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