Prepared by:
Fernando & Yvonn Quijano
© 2007 Worth Publishers Essentials of Economics Krugman • Wells • Olney
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The FOMC’s decision about interest rates is anxiously
watched by traders like these, and by investors
around the world.
What you will learn in
this chapter:
➤ The various roles money plays and
the many forms it takes in the
economy
➤ How the actions of private banks and
the Federal Reserve determine the
money supply
➤ How the Federal Reserve uses openmarket operations to change interest
rates
➤ How monetary policy affects aggregate
output in the short run
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The Meaning of Money
A household’s wealth is the value of its
accumulated savings.
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The Meaning of Money
What Is Money?
Money is any asset that can easily be
used to purchase goods and services.
An asset is liquid if it can be quickly converted
into cash without much loss of value.
Currency in circulation is cash held by the
public.
Checkable bank deposits are bank
accounts on which people can write checks.
The money supply is the total value of
financial assets in the economy that are
considered money.
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The Meaning of Money
Roles of Money
Medium of Exchange
A medium of exchange is an asset that
individuals acquire for the purpose of
trading rather than for their own
consumption.
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The Meaning of Money
Roles of Money
Store of Value
A store of value is a means of holding
purchasing power over time.
Unit of Account
A unit of account is a measure used
to set prices and make economic
calculations.
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The Meaning of Money
Types of Money
Commodity money is a good used as a
medium of exchange that has other uses.
A commodity-backed money is a
medium of exchange with no intrinsic
value whose ultimate value is guaranteed
by a promise that it can be converted into
valuable goods.
Fiat money is a medium of exchange
whose value derives entirely from its
official status as a means of payment.
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The Meaning of Money
Measuring the Money Supply
A monetary aggregate is an overall
measure of the money supply.
Near-moneys are financial assets that
can’t be directly used as a medium of
exchange but can be readily converted
into cash or checkable bank deposits.
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The Meaning of Money
Measuring the Money Supply
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The Monetary Role of Banks
What Banks Do
A bank is a financial intermediary that provides liquid
assets in the form of bank deposits to lenders and
uses those funds to finance the illiquid investments or
investment spending needs of borrowers.
A financial intermediary is an institution that
transforms the funds it gathers from many individuals
into financial assets.
A bank deposit is a claim on a bank that obliges the
bank to give the depositor his or her cash when
demanded.
Bank reserves are the currency banks hold in their
vaults plus their deposits at the Federal Reserve.
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The Monetary Role of Banks
What Banks Do
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The Monetary Role of Banks
What Banks Do
An asset is a claim that provides
income in the future.
A liability is a requirement to pay
in the future.
The reserve ratio is the fraction of bank
deposits that a bank holds as reserves.
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The Monetary Role of Banks
The Problem of Bank Runs
A bank run is a phenomenon in which
many of a bank’s depositors try to
withdraw their funds due to fears of a
bank failure.
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The Monetary Role of Banks
Bank Regulation
Deposit Insurance
Deposit insurance guarantees that a
bank’s depositors will be paid even if the
bank can’t come up with the funds, up to
a maximum amount per account.
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The Monetary Role of Banks
Bank Regulation
Capital Requirements
To reduce the incentive for excessive
risk taking, regulators require that the
owners of banks hold substantially more
assets than the value of bank deposits.
Reserve Requirements
Reserve requirements are rules set by
the Federal Reserve that determine the
minimum reserve ratio for a bank.
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The Monetary Role of Banks
How Banks Create Money
Excess reserves are a bank’s reserves
over and above its required reserves.
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The Federal Reserve System
The Fed: America’s Central Bank
A central bank is an institution that
oversees and regulates the banking
system and controls the monetary base.
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The Federal Reserve System
The Fed: America’s Central Bank
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The Federal Reserve System
What the Fed Does: Reserve Requirements and the
Discount Rate
The federal funds market allows
banks that fall short of the reserve
requirement to borrow funds from banks
with excess reserves.
The federal funds rate is the interest
rate determined in the federal funds
market.
The discount rate is the rate of interest
the Fed charges on loans to banks.
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The Federal Reserve System
Open-Market Operations
An open-market operation is a
purchase or sale of government debt by
the Fed.
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Monetary Policy and Aggregate Demand
Expansionary and Contractionary Monetary Policy
The target federal funds rate is the
Federal Reserve’s desired federal funds
rate.
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Monetary Policy and Aggregate Demand
Expansionary and Contractionary Monetary Policy
Expansionary monetary policy is monetary policy
that increases aggregate demand.
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Monetary Policy and Aggregate Demand
Expansionary and Contractionary Monetary Policy
Contractionary monetary policy is monetary policy
that reduces aggregate demand.
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Monetary Policy and Aggregate Demand
Monetary Policy and the Multiplier
(18-1)
Y  I x
1
1  MPC
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economics in action
The Fed and the Output Gap, 1985–2004
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KEY TERMS
Money
Currency in circulation
Checkable bank deposits
Money supply
Medium of exchange
Store of value
Unit of account
Commodity money
Commodity-backed money
Fiat money
Monetary aggregate
Near-moneys
Bank
Financial intermediary
Bank deposit
Bank reserves
Asset
Liability
Reserve ratio
Bank run
Deposit insurance
Reserve requirements
Excess reserves
Central bank
Federal funds market
Federal funds rate
Discount rate
Open-market operation
Target federal funds rate
Expansionary monetary policy
Contractionary monetary policy
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