Chapter 14: Money – Functions, Measurement, Banking, the Federal Reserve, and the Quantity Theory

Chapter 14: Money

14.1 What Is Money, and Why Do We Need It?

This section introduces the concept of money, its essential functions in the economy, and the characteristics that make something suitable as money.

• Definition of Money: Money is any asset that is generally accepted as payment for goods and services or repayment of debt.

The Four Primary Functions of Money

• Medium of Exchange: Money is accepted by a wide variety of parties as a form of payment for goods and services. Example: Paying $10 for lunch at a food court.

• Unit of Account: Money provides a standard measure of value, making it easier to compare prices. Example: The price of a gallon of gas is posted as $3.20.

• Store of Value: Money allows people to transfer purchasing power from the present to the future by saving. It is liquid, meaning it can be easily exchanged for goods and services. Example: Transferring 10% of your paycheck into a savings account.

• Standard of Deferred Payment: Money facilitates exchanges over time, allowing for contracts and loans. Example: Monthly payments on a car loan.

What Can Serve as Money?

For a good to serve as money, it must have the following characteristics:

1. Acceptable – Usable by most people.

2. Standardized Quality – Any two units are alike.

3. Durable – Value is not lost by wearing out.

4. Valuable Relative to Weight – Easily transported in large quantities.

5. Divisible – Usable for both low-priced and high-priced goods.

Forms of Money

• Commodity Money: Money that has value apart from its use as money (e.g., gold, silver, cattle).

• Fiat Money: Money that has no intrinsic value and is authorized by a central authority to be accepted as money (e.g., paper currency, coins).

Money Versus Wealth

• Money: All currency in circulation and demand deposits (checking and savings accounts) at banks.

• Wealth: The sum of monetary and non-monetary assets an individual has.

• Liquidity: The ease with which a non-monetary asset can be converted into money. Example: Cash is very liquid; ownership in a business is less liquid.

14.2 How Is Money Measured in the United States Today?

This section discusses the definitions and measures of the money supply used in the United States.

• Money Supply: The total quantity of money in the economy at any given time (currency in circulation and demand deposits).

The Federal Reserve's Measures of Money Supply

• M1: The narrowest definition. Includes:

  • Currency in circulation

  • All checking and savings account deposits in banks (demand deposits)

  September 2023: M1 = $18.1 trillion

• M2: A broader measure. Includes:

  • Everything in M1

  • Small denomination time deposits (CDs less than $100,000)

  • Retail (noninstitutional) money market mutual funds

  • Short-term bond investments

  September 2023: M2 = $20.8 trillion

14.3 How Do Banks Create Money?

This section explains the role of banks in the economy, focusing on how banks create money through the process of accepting deposits and making loans.

Bank Balance Sheets

• Assets: Loans made to borrowers

• Liabilities: Demand deposits (customer deposits)

• Deposits become loans, which become deposits, and so forth, expanding the money supply.

Banking System

• Financial Intermediary: An institution that amasses funds from one group and makes them available to another group.

• Bank: A financial intermediary that accepts deposits, makes loans, and offers checking accounts.

• Fractional Reserve Banking System: Banks hold only a fraction of deposits as reserves.

Banking Definitions

• Reserves: Cash on hand in the vault.

• Required Reserve Ratio (RR): The fraction of demand deposits a bank must maintain as cash in the vault.

• Required Reserves: The quantity of reserves that banks are required to hold as cash in the vault.

• Excess Reserves: Reserves in excess of the required reserves.

• Money Multiplier: $\text{Money Multiplier} = \frac{1}{\text{Required Reserve Ratio}}$

How Do Banks Create Money?

• Banks create money by making loans from excess reserves.

• In a multi-bank system, the total increase in the money supply is:

  • $\text{Increase in Money Supply} = \frac{1}{\text{RR}} \times \text{Initial Excess Reserves}$

Class Examples

• Example 1: If $1,000 is deposited and the required reserve ratio is 20%, the money multiplier is 5. The maximum increase in the money supply is $1,000 × 5 = $5,000$.

• Example 2: If George deposits $1,000,000 and the required reserve ratio is 25%, the money multiplier is 4. Fred's Bank can loan out $750,000 (excess reserves), and the banking system can increase the money supply by $1,000,000 × 4 = $4,000,000$.

14.4 The Federal Reserve System

This section describes the structure and functions of the Federal Reserve System, the central bank of the United States.

Financial Markets

• Markets where funds accumulated by one group are made available to another group.

• Savings: Money placed in savings accounts, bonds, stocks, or certificates of deposit.

• Investment: Money taken out in the form of a loan.

Savings and Investment in National Accounts

• National income identity: $Y = C + I + G$

• Rearranged: $Y - C - G = I$

• Private and public savings: $(Y - C - T) + (T - G) = I$

Bond Market

• Bond: Certificate of indebtedness; the seller agrees to pay back the bond at a future date with interest.

• Face Value: Amount paid when the bond matures.

• Maturity Date: Date when the bond comes due.

• Interest Rate: Payment for the use of money, expressed as a percentage of the amount borrowed.

• Bond Prices and Interest Rates: Inverse relationship – as interest rates increase, bond prices decrease, and vice versa.

Money Market

• Money Demand: How much wealth individuals want to hold in its most liquid form (money).

• Money Supply: Currency in circulation and demand deposits at banks (M1), or savings accounts and money market mutual funds (M2).

Shifts in Money Demand

Increase in Demand for Money	Decrease in Demand for Money
Incomes increase Demand to hold more wealth as money Interest rates rise Bond prices fall Less bonds are issued Less investment, lower economic growth	Incomes fall Demand to hold less wealth as money Interest rates fall Bond prices rise More bonds are issued More investment, higher economic growth

Establishment and Structure of the Federal Reserve

• Bank Runs: The Fed acts as a lender of last resort, providing discount loans to banks in need of reserves.

• Discount Rate: The interest rate the Fed charges banks for discount loans.

• Mandate: Achieve maximum employment, create stable prices, and moderate long-term interest rates.

• Central Bank: Acts as a banker to the central government and other banks, regulates banks, sets monetary policy, and supports financial system health.

• Structure: 12 districts, Federal Open Market Committee (FOMC) with 12 voting members (7 Board of Governors, President of NY Fed, 4 rotating district presidents), 8 meetings per year.

The Fed and Money

• The Fed manages the money supply through open market operations, influencing reserves in member banks and the public's deposits and loans.

Open Market Operations

• Decrease Money Supply: Sell U.S. Treasury securities (bonds) to banks.

• Increase Money Supply: Buy U.S. Treasury securities (bonds) from banks.

14.5 The Quantity Theory of Money

This section explains the quantity theory of money and its implications for inflation.

• Quantity Theory of Money: The theory that the quantity of money available determines the price level and that the growth rate in the quantity of money determines the inflation rate.

• Equation: $MV = PY$

  • $M$ = Money supply

  • $V$ = Velocity of money (rate at which money changes hands, assumed constant in the long run)

  • $P$ = Price level

  • $Y$ = Real GDP

• If the money supply grows faster than real GDP, there will be inflation.

• Hyperinflation: Very high rates of inflation, often caused when governments finance deficits by forcing the central bank to buy bonds.

Practice Problems

• Calculating Velocity: $V = \frac{PY}{M}$

• Example: If $M = 4,000$ billion, $V = 2.5$, then $PY = 10,000$ billion. If $M$ increases to $5,000$ billion and $V$ falls to $2$,$PY$remains $10,000$ billion.

• Inflation Expectations: If the Fed announces a doubling of the money supply, people may expect inflation, increasing the velocity of money. If real GDP is constant, the price level will rise proportionally to the increase in $MV$.

Additional info: The notes include diagrams and tables for the structure of the Federal Reserve and the relationship between money demand, interest rates, and investment. Students should be familiar with the mechanics of open market operations and the implications of the quantity theory for inflation and monetary policy.