Unit 9 - Functions of Money

The Functions of Money
A society without any form of money is called a
barter economy. Goods and services are traded
directly for other goods and services.
In a barter economy there must be a double
coincidence of wants for a trade to take place.
Macroeconomics
Unit 9 - Functions of Money

The Functions of Money
In a barter economy trading and
specialization are limited.
Thus, the standard
of living is lower.
Macroeconomics
Is money the root of all evil?
1.
2.
3.
4.
0 of 5
Yes
No
Not sure
Most of the time
Unit 9 - Functions of Money

An economy without any form of money
(barter) still is likely to have acts of robbery,
burglary and violence. Thus, money must not
be the root of all evil.

Money makes it
easier to commit
crimes and commit evil.
Macroeconomics
Which of the following is NOT a
recognized function of money
1.
2.
3.
4.
0 of 5
Medium of
exchange
Standard of value
Creator of wealth
Store of value
Unit 9 - Functions of Money

Medium of Exchange
Money is exchanged for products.
Macroeconomics
Unit 9 - Functions of Money

Standard of Value
Money prices make it easier to determine
how much products are worth.
Macroeconomics
Unit 9 - Functions of Money

Store of Value
Money makes it easier to accumulate wealth.
Macroeconomics
Unit 9 - Functions of Money

Money Supply Measures
Common U.S. money supply measures are:
 The Monetary Base
 M1
 M2
 M3
Macroeconomics
Unit 9 - Functions of Money

Money Supply Measures
The monetary base is:
Bank reserves + Currency in the Hands of
the Non-bank Public.
Bank reserves are funds held by banks that
can be loaned out.
Currency includes paper money and coins.
Macroeconomics
Unit 9 - Functions of Money

Money Supply Measures
M1 = Currency + Traveler’s Checks +
Demand Deposits + Other Checkable
Deposits.
M1 contains forms of money that you can
use to buy common products at groceries,
department and other stores.
Macroeconomics
Unit 9 - Functions of Money

Money Supply Measures
M2 = M1 + MMMFs + Short Term CDs + Small
Time Deposits
MMMF = money market mutual funds (a form of
savings).
CD = certificate of deposit (savings with a fixed
interest rate)
Small time deposits = money in small savings
accounts.
Macroeconomics
Unit 9 - Functions of Money

Money Supply Measures
M3 = M2 + Large Time Deposits + RPs +
Eurodollars + Institution held MMMFs
Large time deposits = money in large (corporate)
savings accounts.
RP = repurchase agreements (savings with
collateral in the form of bonds).
Eurodollars = dollar savings in foreign countries.
Macroeconomics
Unit 9 - Functions of Money

Money Supply Measures
For the latest money supply statistics, visit:
http://www.federalreserve.gov
Macroeconomics
Unit 9 - Functions of Money

The Federal Reserve System
The Federal Reserve System is the central
banking system of the United States.
It was created in 1913, and includes 12
central banks, a Federal Reserve Board,
various committees, and member banks.
Macroeconomics
Unit 9 - Functions of Money

The Federal Reserve System
The Federal Reserve acts independently from
Congress.
Federal Reserve
Building in Washington, D.C.
The Capitol in
Washington, D.C.
Macroeconomics
Unit 9 - Functions of Money

Organization of the Federal Reserve
System
Fed Board
FAC
FOMC
(7 members)
(12)
Central Banks (12)
and Central Bank
Branch Banks (25)
Bank
Bank
Bank
Bank
Bank
Macroeconomics
Unit 9 - Functions of Money

Organization of the Federal Reserve System
The FOMC is the Federal Open Market
Committee. It consists of the 7 Board
members plus 5 central bank presidents. It is
the decision-making committee.
The FAC is the Federal Advisory Committee.
Macroeconomics
Unit 9 - Functions of Money

The Federal Reserve System
Federal Reserve Functions include:
 Control of the money supply
 Supervision of banks
 Check clearing
 Statistics gathering and research
Macroeconomics
Unit 9 - Functions of Money

The Fed and the Money Supply
The Fed controls the money supply
through
1. Open Market Operations
2. Reserve Requirement Policy
3. Discount Rate Policy
Macroeconomics
Unit 9 - Functions of Money

The Fed and the Money Supply
Open market operations: the Fed buys and
sells government bonds in the open market.
Government bonds are formal agreements
between the government and businesses or
individuals who loan the government money
in exchange for interest and re-payment of
principal.
Macroeconomics
Unit 9 - Functions of Money

The Fed and the Money Supply
When the Fed buys bonds, the public receives
money in exchange for bonds. The Fed prints
money to pay for the bonds. This increases
the money supply.
When the Fed sells bonds, the money supply
decreases.
Macroeconomics
Unit 9 - Functions of Money
United
States
Treasury
Treasury
securities
Payment for securities
(public loans
money to the
U.S. government)
The Public
Payment for
securities
(Fed buys securities
in the open market)
Treasury
Securities
Federal
Reserve
Unit 9 - Functions of Money

The Fed and the Money Supply
Reserve Requirement Policy
When businesses or individuals deposit
money in a bank, the bank must keep a
percentage of the deposited amount (the
reserve requirement). The bank can loan
out the rest.
Macroeconomics
Unit 9 - Functions of Money

The Fed and the Money Supply
Reserve Requirement Policy
For most checking accounts, the reserve
requirement percentage is 10%. When the reserve
requirement percentage is lowered, banks can
loan more money and money in circulation
increases.
When the Fed raises the percentage, money in
circulation decreases.
Macroeconomics
Unit 9 - Functions of Money

The Fed and the Money Supply
Discount Rate Policy
The discount rate is the interest rate on
loans from the Fed to individual banks.
When the Fed raises the rate, money in
circulation decreases.
When the Fed lowers the rate, money in
circulation increases.
Macroeconomics
Unit 9 - Functions of Money

Fractional Reserve Banking
Banks can loan out a percentage (fraction) of the
money deposited by customers (and capital kept
by the bank). Let’s say someone deposits $1,000:
Bank A
Assets
$1,000 Cash
Liabilities
$1,000 Deposits
Macroeconomics
Unit 9 - Functions of Money

Fractional Reserve Banking
Assume that the reserve requirement is
10%, and bank A loans out 90% of the
deposited money:
Bank A
Assets
$100 Cash
$900 Loans
Liabilities
$1,000 Deposits
Macroeconomics
Unit 9 - Functions of Money

Fractional Reserve Banking
The person who borrows the $900 spends it.
The recipient of the $900 deposits it into:
Bank B
Bank B
A
L
$900 Cash $900 Deposits
A
L
$90 Cash
$900 Deposits
$810 Loans
Macroeconomics
Unit 9 - Functions of Money

Fractional Reserve Banking
This process of money creation continues
with Bank C, bank D, etc.
Bank C
A
$810 Cash
L
$810 Deposit
Macroeconomics
Unit 9 - Functions of Money

Fractional Reserve Banking
The total increase in deposits equals
$1,000 + $900 + $810 + $... = $10,000.
Macroeconomics
Unit 9 - Functions of Money

Fractional Reserve Banking
$10,000 = 10 x $1,000
In general:
The total increase in the nation’s money supply =
the money multiplier x the initial deposit.
The money multiplier is 1/reserve requirement.
Macroeconomics
Unit 9 - Functions of Money

Velocity of Money
Velocity is speed.
Velocity of money is how fast the same
quantity of money turns over to buy
products (GDP) in one period of time
(usually one year).
Macroeconomics
Unit 9 - Functions of Money

Velocity of Money
Velocity is defined as V = GDP/M
If GDP = $12,000 billion and M = 2,000
billion, then
V = $12,000/2,000
or: V = 6.
Macroeconomics
Unit 9 - Functions of Money

Velocity of Money
If V = GDP/M
Then, after cross-multiplying,
V = P x Q/M
or P x Q = M x V
The Quantity Theory of Money:
As M increases, so does P. There is a direct, (but
not always proportional) relationship between M
and P.
Macroeconomics