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This document offers a foundational understanding of money, its functions, and the role of banks and the federal reserve in managing the money supply. it covers key concepts such as commodity money, fiat money, the money supply (m1 and m2), bank balance sheets, money creation, and the quantity theory of money. Suitable for introductory economics courses and provides a basic framework for further study.
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Money is a crucial invention. Economists define money as any asset generally accepted in exchange for goods, services, or debt repayment. This section explores the role of money, its forms, and the roles of banks and government in managing it, culminating in a model linking prices to the money supply.
Money is defined and its four functions are discussed. Before money, societies relied on barter. Commodity money, goods with intrinsic value used as money (e.g., animal skins, precious metals), emerged. Money simplifies trade and enables specialization, fostering economic development.
Money serves four key functions:
Medium of exchange: Money is widely accepted as payment for goods and services. Its liquidity, or ease of exchange, makes it particularly effective.
Commodity money possesses value independent of its use as money. Examples include:
Cowrie shells in Asia. Precious metals like gold and silver. Beaver pelts in pre-colonial America. Cigarettes in prisons.
Fiat money is authorized by a central bank or government and doesn't need to be exchanged for a commodity. Paper money, originating in 10th-century China, is an example. The Federal Reserve issues fiat money.
Fiat money offers flexibility to central banks in controlling the money supply, as they aren't bound by commodity reserves. However, its acceptance relies on public confidence in its stable value.
The definitions of the money supply used in the United States today are discussed.
M1: The narrowest definition, including currency in circulation, checking account deposits, and traveler's checks. M2: A broader definition, encompassing M1, savings account balances, small-denomination time deposits, money market deposit accounts, and non-institutional money market fund shares.
For discussion, both currency and checking account balances are considered "money." Banks are recognized as playing a key role in managing the money supply through checking accounts. Debit cards provide access to checking accounts, but the card itself is not money; the account balance is.
Banks play a critical role in the money supply. Banks create money by using deposits to make loans and buy securities. Their largest liabilities are deposit accounts.
Reserves are deposits kept as cash or with the Federal Reserve. Banks profit by lending or investing deposited money.
Banks must hold a fraction of deposits as required reserves, either as vault cash or on deposit with the Federal Reserve. The required reserve ratio (RR) is the minimum percentage of deposits banks must hold as reserves. Banks may also hold excess reserves, exceeding the legal requirement.
A T-account illustrates how a transaction changes a bank's balance sheet. Banks keep a percentage of deposits as reserves and lend out the rest, creating new checking account deposits.
The simple deposit multiplier is calculated as 1/RR.
Velocity of money is the average number of times each dollar is used to purchase goods and services included in GDP.
Velocity (V) can be calculated using the money supply (M1), the GDP deflator (P), and real GDP (Y). The quantity theory of money assumes that the velocity of money is constant.
When variables are multiplied together in an equation, we can form the same equation with their growth rates added together.
In the long run, inflation results from the money supply growing at a faster rate than real GDP.