Money
A medium of exchange,
and
the final means of
payment.
A unit of account:
the units the money is counted in.
E.g. dollars.
A unit of account measures and
records economic value.
Liquidity
Money provides the service of
liquidity:
being able to exchange the asset
for goods immediately.
Commodity money
• Money with non-monetary value.
• Examples: gold, silver.
• Gold standard: the widespread use
of gold as commodity money.
Fiat money
• Money not based on any
commodity.
• Established by law, legal tender.
• Currency: coins and paper dollars.
• Demand deposits: checking
accounts.
Measuring the money supply
• M1: currency and demand deposits.
• M2: M1 + savings accounts + small
time deposits + personal money market
accounts.
• M3: M2 + large time deposits +
institutional money market accounts.
• Which best measures money?
MZM: money zero maturity
• MZM = M2
+ institutional money market
accounts
- small time deposits.
The Federal Reserve
• Central bank: a government agency
that controls the money supply,
regulates banks, and acts as a lender of
last resort.
• Fed was created in 1913.
• Chairman and board are appointed by
the president with Senate approval.
Free banking
• Free-market banking: no central bank, no
deposit insurance, no restrictions on
branches, no reserve requirements.
• There is real money and money substitutes
such as bank notes and demand deposits.
• Bank notes can be exchanged for real
money at a fixed rate.
The Fed
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Chairman: Ben Bernanke.
12 regional Federal Reserve Banks.
They are bankers’ banks.
Banks may borrow from the Fed.
Banks have deposits (reserves).
Federal Reserve Bank of San
Francisco.
Monetary policy
• The expansion of the money supply.
• The Fed targets the “federal funds
rate,” interest rate on inter-bank loans.
• Federal Open Market Committee.
• Conducts “open market operations,”
• buying and selling bonds.
How the Fed creates money
1. Fed buys a bond, paying with a Fed check.
2. Seller deposits Fed check in his bank.
3. Bank deposits the check in its account in a
Federal Reserve Bank.
4. The Fed covers the check by expanding the
reserves of the bank.
• The Fed has created money out of nothing.
How much money?
• Fed’s policy problem: how much money to
create?
• Too much: inflation.
• Too little: high interest rates, recession.
• The full effect is in the future.
• How can we know the optimal money
supply?
The optimal money supply
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Taylor rule:
i = 2%+  + (1/2)(y-y*)/y* + (1/2)(- *)
: inflation rate; y: real GDP
y* GDP at natural rate of employment.
*: inflation target.
But Fed does not follow it, and there is no
proof it is optimal.
The Fed’s problem
• The optimal money supply and interest rate
are unknowable.
• Only a free market can set a rate which
balances savings and investment.
• Errors in the money supply create inflation,
recessions, uncertainty.
• Free banking could let the market set them.
T Accounts
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Asset: something one owns.
Liability: a debt that one owes.
Deposit creates an asset and a liability.
Fractional reserve banking:
only a fraction of deposits has to be
kept as required reserves.
Reserves
• Excess reserves: deposits beyond required
reserves; can be loaned out.
• Every bank loan creates money.
• Deposits and withdrawals do not change the
money supply.
• Loans get deposited back into the banking
system, and then loaned again.
The money multiplier
• MM = 1/rr
• The eventual creation of money is 1/rr times
the initial creation by the Fed.
• The discount rate: interest rate the fed sets
when it loans money to banks.
• When the Fed loans money, it creates that
money by raising the bank’s reserves.