“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
Money: a liquid asset is that can easily (i.e., quickly,
cheaply, conveniently) be exchanged for goods and
services.
Functions of Money
•
Medium of exchange
•
Unit of account
–Standard of Deferred Payment
•
Store of value
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.
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.
M1 Money Supply: Means of Payment
– Currency … the bills and coins we use.
• 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.
– Money backed by gold or silver (or something else) is
commodity money.
– Demand Deposits / Other Checkable
Deposits
… can be converted into currency and are
used to settle debts.
– Travelers Checks … accepted in payment
for things
M2: A Broader Definition of Money
M2 includes everything in M1 … plus
– 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)
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
Fractional Reserve Banking
• Banks keep less than 100 percent of
deposits available for withdrawal.
–They lend out the rest
–An outgrowth of goldsmith practices.
–Deposit insurance  few bank runs
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: reserves beyond those
required
• Excess reserves can be loaned.
Multiple Creation of Bank Deposits  M1
How Banks Create Money
Deposit Expansion Multiplier =
1
Reserve Requirement (ratio)
The Deposit Expansion Multiplier and
The Autonomous Spending Multiplier
• The deposit expansion multiplier is analogous to
the spending multiplier
– The deposit expansion multiplier is not the same thing
as the spending multiplier
• The magnitudes of both multipliers are reduced by
leakages
– Bank reserves are not relent and hence not recycled
through the banking system
• Money held as currency and not deposited in banks is another
leakage that reduces the deposit expansion multiplier
– Household saving is not recycled thru the spending
system
• Income siphoned off as taxes and income spent on imports are
other leakages from the spending stream that reduce the
spending multiplier
The Federal Reserve System
• The Federal Reserve System (“the Fed”) is the
central bank of the United States.
• Central bank functions:
– Bankers’ bank:
• accepts deposits from banks
• makes loans to banks.
– Banker for the government.
– It controls the money supply.
– Regulates banks
– Clears checks
Structure of the
Federal Reserve System
The Board of Governors
 Ben Bernanke, Chair
 6 other governors
12 Regional Federal Reserve District Banks
(FRBs)
Federal Open Market Committee (FOMC)
 The Board of Governors (7)
 5 of 12 District Presidents (in Rotation)
The Federal Reserve System
The Board of Governors
• Seven members appointed by the
President and confirmed by the Senate
• 14-year term
• Terms are staggered:
– one comes vacant every two years
• President appoints Chairman to serve a
four-year term
Functions of the Fed
Banking Services and Supervision
– Supplies currency to banks through its 12 district
federal reserve banks.
– Holds reserves of banks in the district bank of each
bank.
• These are commercial bank deposits at the Fed
– Processes and routes checks to banks through its
district banks and processing centers.
– Makes loans to banks—it is the “lender of last resort”,
the “banker’s bank”.
– It supervises and regulate banks, ensuring that they
operate in a sound and prudent manner.
– Banker for the U.S. government.
– Manages sales of government securities for the U.S.
Treasury.
Functions of the Fed
• Controlling the Money Supply
– Vary money supply to meet seasonal
fluctuations in the demand for money.
• Helps keep interest rates steady.
• Example: 4th quarter holiday season
creates an increased demand for money
to buy gifts.
–Adjust federal funds rate to meet
policy goals of the FOMC.