ECO 2013
Topic 4
Money - is the set of assets in the economy that people regularly use to buy
goods and services from other people.
Functions of Money
Money has three functions
1. Medium of exchange is an item that buyers give
to sellers when they want to purchase goods
and services. It also society to escape the
complications of barter.
2. Unit of Account - the yardstick people use to
post prices and record debts.
3.
Store of value - an item that people can use to
transfer purchasing power from the present to
the future. When a seller accepts money today
in exchange for a good or service, that seller
can hold the money and become a buyer of
another good or service at another time.
A person can also transfer purchasing power
from the present to the future by holding
stocks, bonds, real estate, etc. The term
wealth is used to refer to the total of all
stores of value.
Liquidity to describe the ease with which an
asset can be converted into the economy’s
medium of exchange.
The Supply of Money
 Money Definitions
o M1 – it consists of currency and checkable
deposits
o M2 – M1 + savings deposits + money market
deposits + small time deposits(less than
$100,000) + money market mutual funds
 Called near money
o M3 – M2+ large time deposits
Created by: Prof. M. Mari
Fall, 1999
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ECO 2013
Topic 4
Kinds of Money
Commodity money - money that takes the form of a
commodity with intrinsic value.
Gold Standard - when an economy uses gold as money.
Fiat money - money without intrinsic value that is used as
money because of government decree.
Government is central to establishing and regulating a
system of fiat money.
The acceptance of fiat money depends as much on
expectations and social convention as on government
decree.
Value of Money
Our money has value because:
 Acceptability
 Legal tender
 Relative scarcity
Demand for Money
 Transactions Demand
o Medium of exchange function
o Main determinant of the amount of money
demanded for transactions is the level of nominal
GDP.
 Asset Demand
o Store of value function
o Holding of financial assets
o Depends on bond interest rate
 Total Demand
o Sum of the above
Created by: Prof. M. Mari
Fall, 1999
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ECO 2013
Topic 4
The Federal Reserve
Board of Governors
 Directs the activities of the 12 Federal
Reserve Banks
 Seven members appointed by the president
and confirmed by the Senate.
 Terms of 14 years and staggered
 Officers serve 4-year terms
 Chairman is Alan Greenspan
Federal Open Market Committee - is made up of seven members of
the Board of Governors and 5 of the 12 regional bank presidents
meets every six weeks in Washington, DC to discuss the
condition of the economy and consider changes in monetary
policy
Power to increase or decrease the number of dollars in the
economy.
If the FOMC decides to increase the money supply, the Fed
creates dollars and uses them to buy government bonds from
the public in the nation’s bond markets.
If the FOMC decides to decrease the money supply, the Fed
sells government bonds from its portfolio to the public in the
nation’s bond markets.
Three Advisory Councils:
1. Federal Advisory Council
2. Thrift Institution Council
3. Consumer Advisory Council
Federal Reserve Banks
 12 district banks
 serves as central banks
 called banker’s bank
 owned by local commercial banks in its district
Created by: Prof. M. Mari
Fall, 1999
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ECO 2013
Topic 4
 Performs the same functions for banks and thrifts as
those institutions perform for the public.
 Functions
i. Issuing currency
ii. Setting reserve requirements and holding reserves
iii. Lending money to banks and thrifts
iv. Providing for check collection
v. Acting as fiscal agent for the government
vi. Supervising banks
vii. Controlling the money supply
viii. Independent agency
Banks and the Money Supply
Reserves - deposits that banks have received but have
not loaned out.
Fractional-reserves banking - a banking system in
which banks hold only a fraction of deposits as reserves.
Reserve ratio - the fraction of deposits that banks hold
as reserves.
When banks hold only a fraction of deposits in reserve,
banks create money.
Money Multiplier - the amount of money the banking
system generates with each dollar of reserves.
Reciprocal of the reserve ratio
The Fed.’s Tools of Monetary Control
 Open Market Operations
The purchase and sale of US government bonds by the
Fed
Increase the money supply - buy bonds
Decrease the money supply - sell bonds
Created by: Prof. M. Mari
Fall, 1999
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ECO 2013
Topic 4
 Reserve Requirements
Also influences the money supply with reserve
requirements which are regulations on the minimum
amount of reserves that bank must hold against deposits.
 Increase in reserve requirements means that banks
must hold more reserves and can loan out less of
each dollars that is deposited.
 Decrease in reserve requirement lowers the reserve
ratio, raises the money multiplier and increases the
money supply.
Used infrequently because it would disrupt the business
of banking.
 Discount rate
The interest rate on the loans that the Fed makes to banks
 Increase the discount rate discourages banks from
borrowing reserves from the Fed.
 Decrease the discount rate encourages banks to
borrow from the Fed.
Easy Money Policy
Increasing the money supply
 Buy securities
 Lower the reserve requirements
 Lower the discount rate
 Called expansionary monetary policy
Tight Money Policy
Decreasing the money supply
 Sell securities
 Raise the reserve requirements
 Raise the discount rate
 Called restrictive monetary policy
Created by: Prof. M. Mari
Fall, 1999
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