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Money, Banking, and Monetary
Policy
Money, Banks, and the Federal Reserve
System
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.
What Is Money, and Why Do We Need It?
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.
The Functions of Money
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.
What Can Serve as Money?
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—Advantages and Disadvantages
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.
How Is Money Measured in the United States Today?
The definitions of the money supply used in the United States today are discussed.
U.S. Money Supply
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.
How Do Banks Create Money?
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.
Bank Balance Sheets
Reserves are deposits kept as cash or with the Federal Reserve. Banks profit by lending or investing deposited money.
Required and Excess Reserves
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.
Money Creation at Bank of America
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.
General Form for the Simple Deposit Multiplier
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.
Calculating the Velocity of Money
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.
The Quantity Theory Explanation of Inflation
When variables are multiplied together in an equation, we can form the same equation with their growth rates added together.
The Inflation Rate According to the Quantity Theory
In the long run, inflation results from the money supply growing at a faster rate than real GDP.
