“Money is whatever is generally
accepted in exchange for goods and
services — a temporary abode of
purchasing power to be used for
buying still other goods and
services.”
-- Milton Friedman
1
What is Money?

Money is …
– anything
generally acceptable to
sellers in exchange for goods and
services.
–a
liquid asset is that can easily
(i.e., quickly, cheaply,
conveniently) be exchanged for
goods and services.
2
Functions of Money

Medium of exchange

Unit of account
– Standard

of Deferred Payment
Store of value
3
Money: A Medium of Exchange
Money as a medium of exchange lowers
transactions costs.
 Trade without money, directly exchanging
goods for goods, is barter.

–
–

Barter requires a double coincidence of
wants
Barter is time-consuming and costly.
A medium of exchange must be:
–
–
–
Widely accepted for payment
Portable
Divisible
4
Money: A Unit of Account
 Money
is a common unit of
measurement.
– Allows us to compare the values of
dissimilar things.
– Makes accounting possible.
– Lowers information costs.
5
Money: A Standard of Deferred Payment
 Debt
is denominated in money terms.
– The standard for repayment is
money.
 There is a difference between money
and credit:
– Money is what you use to pay for
goods and services.
– Credit is debt, something you owe.
6
Money: A Store of Value = Wealth

Money: one possible way to carry
buying power forward into the future.
– For money to be a store of value, it
must be durable retain value over
time.
– Inflation reduces the effectiveness of
money as a store of value.
– High inflation can lead to currency
substitution
•
the use of foreign money as a substitute
for domestic money  dollarization 7
M1 Money Supply: Means of Payment
– Currency
… the bills and coins we
use.
– Demand Deposits / Other Checkable
Deposits
… can be converted into currency and
are used to settle debts.
Checks … accepted in
payment for things
– Travelers
8
9
In 2003, currency was 52% of M1.
 U.S. currency is not backed by gold

 It
is backed by the confidence and trust
of the public.
It is a fiduciary monetary system.
(“Fiducia” means “trust” in Latin.)
– Money backed by gold or silver (or
something else) is commodity money.
•
•
•
Gresham’s Law: if two coins have the same face
value but different intrinsic (commodity) values, the
cheaper coin will be used and the other coin will be
hoarded.
“Bad money drives out good.”
10
M2: A Broader Definition of Money
 M2
includes everything in M1
 Adds:
– Savings deposits
– Small denomination time deposits
(CDs)
– Retail money market mutual funds
 M2 adds to M1 less liquid assets that
can easily be converted to M1
(means of payment)
11
12
13
Financial Intermediaries That Hold Our
Money
1) Commercial banks
2) Savings and loan associations
3) Savings banks and credit
unions
4) Money market mutual funds
14
U.S. Depository Institutions
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Deposit Insurance
 Bank panic: depositors fear a bank
will fail  rush to withdraw their $$
 bank fails
 Federal Deposit Insurance
Corporation (FDIC – 1933)
– A federal agency that insures bank
deposits so that depositors do not
lose their deposits if a bank fails.
16
Bank Failures
17
International Banking

Eurocurrency market or “offshore banking
–
–

A German firm may deposit Euros in a Tokyo
bank
A U.S. firm may borrow dollars from a bank in
London.
International Banking Facilities (IBFs)
–
a division of a U.S. bank that receives deposits
from and make loans to nonresidents of the
U.S. without the restrictions that apply to
domestic U.S. banks.
18
Fractional Reserve Banking
 Banks
keep less than 100 percent of
deposits available for withdrawal.
– They lend out the rest
– An outgrowth of goldsmith
practices.
19
How Banks Create Money
Reserves: Actual and Required
– Reserve ratio: the fraction of a bank’s
total deposits that are held in reserves.
– Required reserve ratio:
• must be kept on hand or on deposit
with the Federal Reserve (the U.S.
Central Bank)
– Excess reserves are the cash reserves
beyond those required
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– Excess reserves can be loaned.
Multiple Creation of Bank Deposits  M1
21
How Banks Create Money
Deposit Expansion Multiplier =
1
Reserve Requirement (ratio)
22