Money Assets that people are generally willing to accept in exchange for goods and services or for payment of debts.

Asset Anything of value owned by a person or a firm.

What Is Money and Why Do We Need It?

The Functions of Money• Medium of exchange

• Unit of account/standard of deferred payment

• Store of valueWhat Can Serve as Money? Commodity Money or Fiat Money1 The good must be acceptable to most people.

2 It should be of standardized quality so that any two units are identical.

3 It should be durable so that value is not lost by spoilage.

4 It should be valuable relative to its weight … easily transported.

5 It should be divisible because different goods are valued differently.

M1: The Narrowest Definition of the Money Supply: Means of Payment

How Is Money Measured in the United States Today?

Measuring the Money Supply, May 2007 M2: A Broader Definition of Money

What about Credit Cards and Debit Cards?

Money without a Government? The Strange Case of the Iraqi Dinar

Many Iraqis continued to use currency with Saddam’s picture on it, even after he was forced from power.

How Banks Create Money

Don’t Let This Happen to YOU!Know When a Checking Account Is an Asset and When It Is a Liability

Balance Sheet for Wachovia Bank, December 31, 2006

Reserves Deposits that a bank keeps as cash in its vault or on deposit with the Federal Reserve.

Required reserves Reserves that a bank is legally required to hold, based on its checking account deposits.

Required reserve ratio The minimum fraction of deposits banks are required by law to keep as reserves.

Excess reserves Reserves that banks hold over and above the legal requirement.

How Banks Create Money in a Fractional Reserve Banking System: Using T-Accounts

How Banks Create Money

Now PNC has excess reserves and can makea loan

How Banks Create Money: The multiple creation of money and credit

BANK INCREASE IN CHECKING ACCOUNT DEPOSITS

Wachovia $1,000

PNC + 900 (= 0.9 x $1,000)

Third Bank + 810 (= 0.9 x $900)

Fourth Bank + 729 (= 0.9 x $810)

. + •

. + •

. +

Total Change in Checking Account Deposits =$10,000

Deposit multiplier The ratio of the amount of deposits created by banks to the amount of new reserves. RR

1 multiplierdeposit Simple

The Simple Deposit Multiplier versus the Real-World Deposit Multiplier: People hold currency and banks hold excess reserves, slowing multiple creation of deposits and credit

The 2001 Argenine Bank Panic

The Argentine central bank was not able to stop the bank panic of 2001.

The 2008 US Financial System Panic

The Federal Reserve was able to stop the panic of 2008 … by pumping over $1 trillion into the financial system.

Fractional reserve banking system: banks keep less than 100 % of deposits as reserves.

Bank run: depositors decide to withdraw money from a bank at same time

Bank panic: many banks experience runs at the same time.

The Federal Reserve System: Lender of Last Resort!

Federal Reserve Districts

Federal Open Market Committee (FOMC) •Governors and District Presidents meet eight times a year in DC to set monetary policy

•The 7 governors and 5 of 12 Presidents vote / FRBNY President always votes•Meet more often if necessary

The Federal Reserve SystemMonetary policy The actions the Federal Reserve takes to manage the money supply and interest rates to pursue economic objectives.

To manage the money supply, the Fed uses three monetary policy tools:

1 Open market operations

2 Discount policy

3 Reserve requirements

Objectives of monetary policy: 1.Price stability2.High employment3.Economic growth4.Stability of financial markets and institutions

The Federal Reserve System

Open Market Operations: the buying and selling of Treasury securities by the Federal Reserve in order to control the money supply. Federal Open Market Committee (FOMC) The Federal Reserve committee responsible for open market operations and managing the money supply in the United States.

Discount Policy

Discount loans Loans the Federal Reserve makes to banks. These loans provide banks with reserves.

Discount rate The interest rate the Federal Reserve charges on discount loans.

Reserve Requirements

When the Fed reduces the required reserve ratio, it converts required reserves into excess reserves.

The Federal Reserve System

Putting It All Together: Decisions of the Public, the Banks, and the Fed

Using its three tools—open market operations, the discount rate, and reserve requirements—the Fed has substantial influence over the money supply, but that influence is not absolute.

Two other actors—the nonbank public and banks—also influence the money supply.

•The public can convert its deposits to currency, thus draining reservesfrom banks and reducing their ability to lend and create money.

•Banks can hold excess reserves rather than lend and create money.

Connecting Money and Prices: Irving Fisher’s Quantity Equation

M × V = P × Y

The Quantity Theory of Money

V = Velocity of money The average number of times each dollar in the money supply is used to purchase goods and services included in GDP.

MY x PV

We can transform the quantity equation from Y x P V x M to:

Growth rate of the money supply + Growth rate of velocity

=

Growth rate of the price level (inflation rate) + Growth rate of real output

The growth rate of the price level is just the inflation rate•we can rewrite the quantity equation to help us understand the factors that determine inflation:

If velocity is constant,

Inflation rate = Growth rate of the money supply + Growth rate of velocity

− Growth rate of real output

The Quantity Theory of Money

Inflation rate = Growth rate of the money supply − Growth rate of real output

• If money supply grows at a faster rate than real GDP inflation.• If money supply grows at a slower rate than real GDP, deflation.

Very high rates of inflation—in excess of hundreds or thousands of percentage points per year—are known as hyperinflation.

Economies suffering from high inflation usually also suffer from very slow growth, if not severe recession.

K e y T e r m s

AssetBank panicBank runCommodity moneyDiscount loansDiscount rateExcess reservesFederal Open MarketCommittee (FOMC)Federal Reserve SystemFiat moneyFractional reserve banking

system

M1M2Monetary policyMoneyOpen market operationsQuantity theory of moneyRequired reserve ratioRequired reservesReservesSimple deposit multiplierVelocity of money