Ch.13
Money and Banking
Functions of Money
http://www.youtube.com/watch?v=VQpc0QfBaMc
• Medium of exchange: Money can be exchanged for goods and services.
• Unit of account: Prices are quoted in dollars and cents.
• Store of value:
 allows us to transfer purchasing power from present to future
 the most liquid of all assets
 a convenient way to store wealth
Supply of Money
M1: M1 is the most narrow definition of U.S. money supply
 M1 consists of currency and checkable deposits
Currency: coins + bills; so-called “token” money; issued by the Federal Reserve.
Checkable deposits: deposits in financial institutions on which checks can be drawn.
Currency and checkable deposits held by the federal government, Federal Reserve, or
other financial institutions are not included in M1.
Definition of M2: M1 + some “near-monies”:
• Savings deposits and money market deposit accounts.
• Certificates of deposit less than $100,000
• Money market mutual fund balances
Definition of M3: M2 + large certificates of deposit $100,000 or more
M1 M2 or M3???
M1 is assumed for analysis in this course (unless otherwise noted). However, …
M2 and M3 are important:
• M2 is watched closely by the Federal Reserve in determining monetary policy.
• M2 and M3 are fairly liquid; they influence spending.
Note that the ease of shifting between M1, M2, and M3 complicates the task of
controlling the spendable money supply.
Note: Credit cards are not money (they constitute short-term loans).
 the convenience of credit allows lower M1 balances
Why is money worth anything? What “backs” the money supply?
Government’s ability to keep its value stable provides the backing.
 government action to avoid times of excessive inflation/deflation
Value arises not from its intrinsic value, but its value in trade.
 Currency is “legal tender” (or fiat money)…must be accepted by law.
 Checks are not legal tender (but are generally acceptable in trade)
Money’s relative scarcity (relative to goods and services) helps it retain purchasing power.
Maintaining the value of money
The government tries to maintain the value of money with both fiscal and monetary
policy:
• Fiscal policy can impact the velocity of money and the money supply
• Monetary policy (enacted by the Federal Reserve) tries to keep money relatively
scarce to maintain its purchasing power, while expanding enough to allow the
economy to grow.
The Money Market
The Federal Reserve can shift supply,
which affects interest rates,
which in turn affect
investment and consumption
(and aggregate demand)
and ultimately
output, employment, and prices.
Rate of interest, i (percent)
The Demand for Money
• Transactions demand
 money kept for purchases
• Asset demand
 money kept as a store of value for later use
Sm
10
7.5
5
2.5
ie
Dm
0
Amount of money demanded
(billions of dollars)
THE FEDERAL RESERVE
http://www.youtube.com/watch?v=RHivYY1ruKM&feature=player_embedded
Board of Governors of the Federal Reserve:
• selected by the U.S. president with
the confirmation of the Senate.
• seven board members
• 14 year terms — staggered so that one
member is replaced every 2 years.
• U.S. President selects the chairperson
and vice-chairperson of the board
• Chairperson and vice-chairperson serve 4-year terms and can be
re-appointed.
Several groups help the Board of Governors determine banking
and monetary policy, including:
• The Federal Open Market Committee
 Votes on the Fed’s monetary policy
 directs the purchase or sale of government securities.
 A rotation of presidents of the 12 Federal Reserve Banks
have voting rights
 annual rotation of voting rights among the 12 banks
(president of the NY Fed is permanent)
THE FEDERAL RESERVE (cont.)
• The 12 Federal Reserve Banks are “central” banks whose policies are coordinated by the
Board of Governors.
• They are quasi-public banks, meaning that they are a blend of private ownership and public
control.
• They are also banker’s banks in that they perform essentially the same functions for banks
and thrifts as those institutions perform for the public.
The Federal Reserve performs 7 basic functions:
1. The Fed issues Federal Reserve Notes, the paper currency used in the U.S. monetary system.
2. The Fed sets reserve requirements and holds the mandated reserves that are not held as
vault cash.
3. The Fed lends money to banks and thrifts.
4. The Fed provides for check collection and the oversight of debit card transactions.
5. The Fed acts as fiscal agent for the Federal government.
6. The Fed supervises the operation of commercial banks.
7. The Fed has responsibility for regulating the supply of money, and this in turn enables it to
affect interest rates.
The Monetery Equation of Exchange
the Velocity of Money
Equation of Exchange:
MV = PQ
M = M1; the nominal amount of money in circulation
V = the income velocity of money
 the number of times $1 is spent on goods and services over a given time period
P = the price level of the goods and services making up GDP; the “GDP deflator”
Q = Real GDP
Historically, the velocity of money has been relatively stable due to structured pay
periods, standardized payment terms, etc.
However, the expanded use of technology (credit/debit cards, on-line bill pay, etc.) has
increased the velocity of money in recent decades.
Macro W/B Activity 36
What is money?
http://www.youtube.com/watch?v=DjTs-rjVkB8&feature=relmfu
How is money created?
http://www.youtube.com/watch?v=pZRvja7Mvrw&feature=relmfu
What is The Fed?
http://www.youtube.com/watch?v=aMg3vrQ6keE&feature=relmfu
13-5
What “backs” the money supply in the United States?
Nothing; there is no concrete backing to the money supply in the United States.
What determines the value (domestic purchasing power) of money?
• Paper money has little intrinsic value.
• Paper money has value only because people are willing to accept it.
• Checks and debit card transactions constitute money (but are not legal tender);
people accept them willingly from people believed trustworthy.
How does the value of money relate to the price level?
The value or purchasing power of money is inversely related to the price level.
Who in the U.S. is responsible for maintaining money’s value? Why is it important to be able to
alter the money supply?
The Board of Governors of the Federal Reserve System (the Fed) is responsible for
managing the United States’ money supply so that money retains its value.
13-6. Suppose the price level and value of the dollar in year 1 are 1.0 and $1.00, respectively. If the price
level rises to 1.25 in year 2, what is the new value of the dollar? If instead the price level had fallen to .50,
what would have been the value of the dollar? What generalization can you draw from your answer?
Use the formula 𝐷 =
1
𝑃
where D is the value of the dollar and P is the price level.
If the price level rises to 1.25, the value of the dollar (in year 2, relative to year 1) is $0.80 (= 1/1.25).
If the price level falls to 0.50, the value is $2.00 (= 1/.50).
Generalization: The price level and the value of the dollar are inversely related.
13-15. Over the years the Federal Reserve Banks have printed many billions of dollars more in currency than
American households, businesses, and financial institutions now hold. Where is this “missing” money? Why
is it there?
This missing money is outside of the country:
• It left the country to pay for imports of goods and services purchased by Americans from
producers abroad.
• It is in circulation outside the country, especially in countries whose currencies are not stable.
• For example, it is estimated that Russians hold about $40 billion worth of U.S. dollars.
• The same is true in other countries with high rates of inflation.
• The dollar is also used in international transactions, both legal and illegal, where it is
acceptable because of its stability.