Money and its Functions

• Money is the set of assets in an economy regularly used to purchase goods and services.

The Functions of Money

• Money has three functions in the economy:
  • Medium of exchange
  • Unit of account
  • Store of value
• A medium of exchange is an item buyers give sellers when they want to purchase goods and services
• A medium of exchange is anything readily acceptable as payment.
• A unit of account is the yardstick people use to post prices and record debts.
• A store of value is an item people can use to transfer purchasing power from the present to the future.
• Liquidity is the ease with which an asset can be converted into the economy's medium of exchange.

Types of Money

• Commodity money takes the form of a commodity with intrinsic value, with examples such as gold, silver and cigarettes.
• Fiat money is used as money because of government decree.
  • It does not have intrinsic value, with examples such as coins, currency and check deposits.
• The quantity of money available in an economy is called the money supply.
• Monetary policy is the government's control over the money supply.
  • In most countries, monetary policy is delegated to a partially independent institution called the central bank.
• The main way the central bank controls the supply of money is through open-market operations
  • Open-market operations are the purchase and sale of government bonds.
  • When the CB wants to increase the money supply, it uses some of its dollars to buy government bonds from the public.
  • Conversely, when the CB wants to decrease the money supply, it sells some government bonds from its own portfolio.

Measuring the Quantity of Money

• Currency is the paper bills and coins in the hands of the public.
• Demand deposits are balances in bank accounts that depositors can access on demand by writing a check.

Measures of Money

• C (Currency) = $1,486 billion in July 2017
• M1 = Currency plus demand deposits, traveler's checks, and other checkable deposits = $3,528 billion in July 2017
• M2 = M1 plus retail money market mutual fund balances, saving deposits (including money market deposit accounts), and small time deposits = $13,602 billion in July 2017

Role of Central Bank

• The three primary functions are:
  • Regulates banks to ensure they follow federal laws intended to promote safe and sound banking practices.
  • Acts as a banker's bank, making loans to banks and as a lender of last resort.
  • Conducts monetary policy by controlling the money supply.
• Monetary policy is conducted by the Central Bank.
  • The money supply refers to the quantity of money available in the economy.
  • Monetary policy is the setting of the money supply by policymakers in the central bank.

Open market operations

• The money supply is the quantity of money available in the economy.
• The primary way the Fed changes the money supply is through open-market operations.
  • The CB purchases and sells government bonds.

Banks and Money Supply

• Banks can influence the quantity of demand deposits in the economy and the money supply.
• Reserves are deposits that banks have received but have not loaned out.
• In a fractional-reserve banking system, banks hold a fraction of money deposited as reserves and lend out the rest.
• The reserve ratio is the fraction of deposits that banks hold as reserves.

Money Creation

• Occurs with fractional-reserve banking
• When a bank makes a loan from its reserves, the money supply increases.
• The money supply is affected by the amount deposited in banks and the amount banks loan.
  • Deposits into a bank are recorded as both assets and liabilities.
  • The fraction of total deposits that a bank has to keep as reserves is called the reserve ratio.
  • Loans become an asset to the bank.
• When one bank loans money, that money is generally deposited into another bank.
• This process creates more deposits and more reserves to be lent out.

The Money Multiplier

• The money multiplier is the amount of money banking system generates with each dollar of reserves.
• Original deposit = $100.00
  • 1st National Lending = 90.00 (=.9 x $100.00)
  • 2nd National Lending = 81.00 (=.9 x $90.00)
  • 3rd National Lending = 72.90 (=.9 x $81.00)
  • ...and on until there are just pennies left to lend!
• Total money created by $100.00 deposit = $1000.00. (= 1/.1 x $100.00)
• The money multiplier is the reciprocal of the reserve ratio: M = 1/R
  • With a reserve requirement, R = 20% or .2:
  • The money multiplier is 1/.2 = 5.

The Fed’s Tools of Monetary Control

• The Fed has three tools in its monetary toolbox:
  • Open-market operations
  • Changing the reserve requirement
  • Changing the discount rate (interest rate applies to the loans provided to banks)

Open-Market Operations

• The Fed conducts open-market operations when it buys government bonds from or sells government bonds to the public:
  • When the Fed sells government bonds, the money supply decreases.
  • When the Fed buys government bonds, the money supply increases.

Reserve Requirements

• The Fed also influences the money supply with reserve requirements.
  • Reserve requirements are regulations on the minimum amount of reserves that banks must hold against deposits.
• Changing the Reserve Requirement:
  • The reserve requirement is the amount (%) of a bank's total reserves that may not be loaned out.
  • Increasing the reserve requirement decreases the money supply.
  • Decreasing the reserve requirement increases the money supply.

Changing the Discount Rate

• The discount rate is the interest rate the Fed charges banks for loans.
  • Increasing the discount rate decreases the money supply.
  • Decreasing the discount rate increases the money supply.

Problems Controlling Money Supply

• The Fed's control of the money supply is not precise.
• The Fed must wrestle with two problems that arise due to fractional-reserve banking.
  • The Fed does not control the amount of money that households choose to hold as deposits in banks.
  • The Fed does not control the amount of money that bankers choose to lend.

Summary

• Money refers to assets that people regularly use to buy goods and services.
• Money serves three functions in an economy: as a medium of exchange, a unit of account, and a store of value.
• Commodity money is money that has intrinsic value.
• Fiat money is money without intrinsic value.
• The Federal Reserve, the central bank of the United States, regulates the U.S. monetary system.
• It controls the money supply through open-market operations or by changing reserve requirements or the discount rate.
• When banks loan out their deposits, they increase the quantity of money in the economy.
• Because the Fed cannot control the amount bankers choose to lend or the amount households choose to deposit in banks, the Fed's control of the money supply is imperfect.