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Money & Banking
Question: What is money (what is the economic
definition of money)?
Answer: Economists define money as anything
generally accepted in exchange for
commodities and in repayment of debt. For
this reason, economists call money a ‘medium
of exchange.’
Three Functions of Money
1. Medium of Exchange
– asset individuals acquire for the purpose of
trading goods and services rather than for
consumption
2. Store of Value
– means of holding value over time
3. Unit of Account
– used to place a value on a good or service
Types of Money
• commodity money
– good used as a medium of exchange that has
intrinsic value in other uses
• commodity-backed money
– good used as a medium of exchange that has no
value in other uses
• fiat money
– an official medium of exchange, usually declared
by the government
Question: It is fair to ask, how can something
with no intrinsic value be an asset?
Answer: Fiat money has value simply by virtue of
the fact that people believe it has value! Fiat
money maintains its value only so long as
people believe that other people will accept it
in exchange for commodities. In other words,
the value of money is a self-fulfilling prophecy
(that is, a social phenomenon that occurs
because people believe it will occur).
Measuring Money
(the Money Supply)
• Measuring money usually occurs with a
money aggregate.
• There exist different money aggregates – each
vary in their definition of money (usually via
liquidity)
• Common Money Aggregates
– M1 Money Supply
– M2 Money Supply
– M3 Money Supply*
*M3 is not commonly used – in 2006, the US Federal Reserve
Bank determined measuring M3 was no longer useful
August, 2008
“Inflation is always and everywhere a
monetary phenomenon.”
– Milton Friedman
The Federal Reserve System
(U.S. Central Bank)
• Created in 1913
• It is a private institution (not apart of the
government)
• Consists of two main parts
– Board of Governors
• 7 members (appointed by the President & confirmed by
the Senate) each serving 14 year terms. The chair is
appointed for 4 year terms.
– 12 Regional Federal Reserve Banks
Board of Governors
• The seven members of the Board of Governors of the
Federal Reserve System are nominated by the President
and confirmed by the Senate. A full term is fourteen years.
One term begins every two years, on February 1 of evennumbered years. A member who serves a full term may not
be reappointed. A member who completes an unexpired
portion of a term may be reappointed. All terms end on
their statutory date regardless of the date on which the
member is sworn into office.
• The Chairman and the Vice Chairman of the Board are
named by the President from among the members and are
confirmed by the Senate. They serve a term of four years. A
member's term on the Board is not affected by his or her
status as Chairman or Vice Chairman.
The Federal Reserve System
The Federal Reserve System
(U.S. Central Bank)
• Acts as a lender of last resort
• Audits private sector banks to ensure
“financial health”
• Provides check clearing services
• The Federal Reserve Bank of New York carries
out open-market operations and its president
is always on the Board of Governors
• The Fed conducts the nations monetary policy
The Federal Reserve System
(U.S. Central Bank)
• The fed pays close attention to interest rates
and attempts to set them
• prime rate
– Interest rate banks charge their ‘best customers’
• discount rate
– Interest rate the Fed charges the banks
• federal funds rate
– Interest rate banks charge each other (think of it
as an overnight loan)
Click for Current Rates
Question: How well does the Fed target the
Federal Funds Rate?
Economic Tools of the Fed
Question: How does the Fed control interest rates?
• Required Reserve Ratio (RRR)
– Amount required to keep on hand
• The Discount Rate
– Discount rate vs. federal funds rate (usually 1
percent higher than FFR)
• Open-Market Operations
– Buying and selling of bonds
• Reserve Ratio Interest Rate (RR Interest Rate)
– Interest on Required Reserve balances and Excess
Reserve balances
Economic Tools of the Fed
Increasing the Money Supply
• ↓ RRR
• ↓ Discount Rate
• Buy Bonds
• ↓ RR Interest Rate
Decreasing the Money Supply
• ↑ RRR
• ↑ Discount Rate
• Sell Bonds
• ↑ RR Interest Rate
Money Demand
(the opportunity cost of holding money)
• Shifts in the Money Demand Curve
– Changes in the price level
• If prices are higher, you need more cash to make the same
purchases
– Changes in Real GDP
• If GDP increases, the number of goods and services bought
and sold increases, thus you need more cash on your person
to make the new purchases
– Changes in Technology
• ATMs & online banking
– Changes in Institutions
• In the past, some bank accounts weren’t legally allowed to
pay interest