Chapter 14: Money and Its Functions

Definition of Money in Economics

Money is any asset that is generally accepted as a medium of exchange for goods and services. In modern economies, money serves several critical roles that facilitate economic activity.

• Medium of Exchange: Money is used to buy and sell goods and services, eliminating the need for barter.

• Unit of Account: Money provides a common measure for valuing goods and services.

• Store of Value: Money can be saved and used for future purchases, retaining value over time.

• Standard of Deferred Payment: Money is used to settle debts payable in the future.

Example: U.S. dollar bills are used to purchase groceries, pay rent, and settle debts, illustrating all functions of money.

Liquidity and the Most Liquid Asset

Liquidity refers to how quickly and easily an asset can be converted into cash without significant loss of value. The most liquid asset is currency (cash) itself, followed by funds in checking accounts.

• Cash: Most liquid, immediately spendable.

• Checking Accounts: Very liquid, can be accessed via checks or debit cards.

• Other Assets: Savings accounts, stocks, and bonds are less liquid.

Why Do People Hold Money?

• Transaction Motive: To make everyday purchases.

• Precautionary Motive: To cover unexpected expenses.

• Speculative Motive: To take advantage of future investment opportunities.

Dollar Bills in the Modern Economy

In the modern economy, dollar bills serve as fiat money—money that has value because the government declares it to be legal tender, not because it is backed by a physical commodity like gold.

Functions of Money

• Medium of Exchange

• Unit of Account

• Store of Value

• Standard of Deferred Payment

Chapter 15: Monetary Policy and the Federal Reserve

What is Monetary Policy?

Monetary policy refers to the actions taken by a country's central bank (in the U.S., the Federal Reserve) to manage the money supply and interest rates to achieve macroeconomic objectives.

• Tools: Open market operations, discount rate, reserve requirements.

• Objectives: Control inflation, manage employment, stabilize the financial system.

Four Monetary Policy Goals of the Federal Reserve

• Price Stability: Keeping inflation low and stable.

• High Employment: Striving for the natural rate of unemployment.

• Stability of Financial Markets and Institutions: Ensuring the financial system operates smoothly.

• Economic Growth: Promoting sustainable increases in real GDP.

Main Policy Goal and Purpose of the Federal Reserve in 1913

When established in 1913, the main goal of the Federal Reserve was to provide the nation with a safer, more flexible, and more stable monetary and financial system, primarily by acting as a lender of last resort to prevent banking panics.

Federal Reserve's Goal During the 2007-2008 Subprime Mortgage Crisis

During the financial turmoil of 2007-2008, the Federal Reserve's main goal was to stabilize the financial system and prevent a collapse of major financial institutions, using tools such as emergency lending and asset purchases.

Federal Reserve Actions to Manage Monetary Policy

• Open Market Operations: Buying and selling government securities to influence the money supply.

• Discount Rate: Changing the interest rate charged to commercial banks for borrowing from the Fed.

• Reserve Requirements: Adjusting the amount of funds banks must hold in reserve.

Chapter 16: Fiscal Policy

Discretionary Fiscal Policy

Discretionary fiscal policy involves deliberate changes in government spending and taxation to influence economic activity, typically enacted by Congress and the President.

• Examples: Stimulus packages, tax cuts, increased infrastructure spending.

Contractionary Fiscal Policy

Contractionary fiscal policy is used to slow down economic growth, often to combat inflation. It involves decreasing government spending or increasing taxes.

• Example: Raising income taxes to reduce consumer spending.

Fed Policy vs. Fiscal Policy

• Fed Policy (Monetary Policy): Managed by the Federal Reserve, focuses on money supply and interest rates.

• Fiscal Policy: Managed by the government (Congress and President), focuses on government spending and taxation.

Fiscal Policy: Objective and Classification

• Objective: To influence aggregate demand, stabilize the economy, and promote growth and employment.

• Classified as: Expansionary (increase spending or cut taxes) or contractionary (decrease spending or raise taxes).

Automatic Stabilizers

Automatic stabilizers are government programs that automatically increase or decrease with the business cycle, helping to stabilize disposable income and consumption without new legislation.

• Examples: Unemployment insurance, progressive income taxes.

Largest Sources of Federal Government Revenue (2022 and Forward)

Order of Expenditures (2022):

Government Transfer Payments

Transfer payments are payments made by the government to individuals without any goods or services being received in return. Examples include Social Security, unemployment benefits, and welfare.

Social Security

• Purpose: To provide income support to retirees, disabled individuals, and survivors of deceased workers.

• Type of System: Pay-as-you-go system, where current workers' taxes fund current beneficiaries.

• Problems Facing Social Security: Aging population, longer life expectancies, and a declining worker-to-beneficiary ratio threaten long-term sustainability.

Additional info: The 2025 Fiscal Statement likely highlights the need for reform to ensure future solvency.

Medicaid and Medicare

• Medicaid: Joint federal and state program providing health coverage to low-income individuals and families.

• Medicare: Federal program providing health insurance to people aged 65 and older, and some younger people with disabilities.

Fiscal Policy Actions: Tax Cuts and Increases

• Tax Cuts (Expansionary): Designed to stimulate spending and economic growth during a recession by increasing disposable income.

• Tax Increases (Contractionary): Used to slow economic growth and reduce inflation by decreasing disposable income.

Example: The American Recovery and Reinvestment Act of 2009 included tax cuts to boost spending during the Great Recession.

Key Formulas

• Money Multiplier:

• Government Spending Multiplier:

• Tax Multiplier:

Where MPC is the marginal propensity to consume.