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Although we commonly think of “money” as
being paper bills and metal coins, these are by
no means the only items that can act as
“money.”
Money must fulfill three functions:
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Medium of exchange
Store of value
Unit of account
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Problem with barter system: “Coincidence of
wants.”
In a barter system, both people must have exactly what
the other person wants, exactly when and where it’s
wanted.
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Medium of exchange eliminates this problem.
Definition: Anything used to facilitate trade
and avoid a straight barter system.
Anything can serve as money so long as people
are willing to accept it.
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US dollars are what is called fiat money: They
have no intrinsic value. Rather, their value is a
function of the US government saying they
have value.
This is true for most nations’ currencies: They
are backed only by the faith and credit of the
given country’s government.
“This note is legal tender for all debts, public
and private.”
Money need not be convertible into something
with intrinsic value (e.g., gold).
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Standard unit of measurement of the
value/cost of goods, services, or assets.
Analogy: you go to WeShop and pay $5 for a
gallon of milk.
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Gallon : size :: dollar : price
Take away the price units: A gallon of milk simply
costs “5.” 5 what?
Another example: “GM incurred losses of 700
million in the second quarter.”
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The dollar sign lends meaning to the phrase.
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Yap (island in the Pacific Ocean) uses stones
ranging from 1.4 inches to 10 feet in diameter
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Ithaca, NY, has its own currency, the Ithaca
HOUR.
One Ithaca HOUR is valued at $10
 Ithaca HOURs cannot be converted to US dollars
 Businesses that receive HOURs must spend them on
local goods and services
 Ithaca inspired similar systems in Madison, WI, and
Corvallis, OR
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Here is the Swedish 10-daler coin ca. 1720,
which was made of copper and weighed 43
pounds (and facilitated the introduction of
paper money)
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And last but not least, the currently available
Canadian $1 million gold coin, which weighs
100kg and has a diameter of 50 cm.
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Needed for transactions
transactions demand: Money demand in its most
simple form
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Asset-holding motives:
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Precautionary demand (i.e., money people want in
case of emergency or if they are worried how long
they will live)
Speculative demand (need for cash to take
advantage of investment opportunities that may
arise in the future)
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M1, M2
M1: Physical currency + demand deposits (i.e.,
checking accounts)
M2: M1 + savings accounts + money market
accounts + small-denomination time deposits
(CDs under $100,000)
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A balance sheet indicates a bank’s assets and
liabilities.
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Assets = reserves + loans
Liabilities = deposits + capital (stockholders’ equity)
The two sides of the balance sheet must be
equal!
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The accounting identity was developed in the 15th
century as a means for identifying accounting errors
Sometimes the right side (Liabilities) is broken into
liabilities (=deposits) & net worth (=equity/capital)
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Banks are required to keep a certain percentage of
their deposits in reserve.
The percentage they must keep is called the reserve ratio
(rr) and is set by the Fed.
 Banks can choose to keep additional reserves beyond the
requirement.
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Banks are free to lend out the rest of their deposits.
These loans make their way to other banks, which
in turn loan them out, and so on.
Fractional banking can lead to damaging “bank
runs,” such as what partially precipitated the Great
Depression (remember in Mary Poppins?)
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This cycle shows how banks can create money.
The money multiplier (mm) describes the total
increase in money resulting from a $1 initial
increase in reserves.
mm = 1/rr
So, for example, if rr = 20%, a $1 initial increase
will increase the money supply in total by $5.
Note that the effect of the money multiplier is
diminished if individuals increase their cash
holdings.
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Policymakers at the Fed determine the US
money supply.
The Fed has three tools to change Ms:
Reserve ratio
 Discount rate (interest rate charged to banks that
borrow from the Fed)
 Open-market operations (buying and selling bonds)
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When the Fed wishes to lower the money
supply, it sells bonds (government securities)
to the public. The money it receives from these
transactions is retired (removed from
circulation), so the net effect is to lower Ms.
Similarly, when the Fed wants to increase the
money supply, it buys bonds from the public.
The money multiplier acts to further increase
Ms as well. (Money multiplier also works
backwards when Fed sells bonds.)
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Let’s bring money supply and money demand
together on one graph
Why is Md downward-sloping?
Think of interest rate as the cost of holding money
 Money sitting in your wallet does not earn interest;
the higher the interest rate, the more interest is
foregone by holding onto money—so the
opportunity cost of holding money is higher.
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As output (Y) increases, Md shifts/increases
(more money demanded for transactions)