“Money is whatever is generally accepted in exchange for goods and services — a temporary abode of purchasing power to be used for buying still other goods and services.”

-- Milton Friedman-- Milton Friedman

Money: a liquid asset is that can easily (i.e., quickly, cheaply, conveniently) be exchanged for goods and services.

Functions of Money

• Medium of exchange

• Unit of account

–Standard of Deferred Payment

• Store of value

Money: A Standard of Deferred Payment

• Debt is denominated in money terms.

–The standard for repayment is money.

• There is a difference between money and credit:

–Money is what you use to pay for goods and services.

–Credit is debt, something you owe.

Money: A Store of Value = Wealth

• Money: one possible way to carry buying power forward into the future.–For money to be a store of value, it

must be durable retain value over time.

– Inflation reduces the effectiveness of money as a store of value.

M1 Money Supply: Means of Payment– Currency … the bills and coins we use.

• In 2003, currency was 52% of M1.• U.S. currency is not backed by gold • It is backed by the confidence and trustconfidence and trust of the

public. – Money backed by gold or silver (or something else) is

commodity money.

– Demand Deposits / Other Checkable Deposits … can be converted into currency and are

used to settle debts.

– Travelers Checks … accepted in payment for things

M2: A Broader Definition of Money

M2 includes everything in M1 … plus

– Savings deposits

– Small denomination time deposits (CDs)

– Retail money market mutual funds

• M2 adds to M1 less liquid assets that can easily be converted to M1 (means of payment)

Financial Intermediaries That Hold Our Money

1) Commercial banks2) Savings and loan associations3) Savings banks and credit unions4) Money market mutual funds

Fractional Reserve Banking

• Banks keep less than 100 percent of deposits available for withdrawal.

–They lend out the rest

–An outgrowth of goldsmith practices.

–Deposit insurance few bank runs

How Banks Create Money

Reserves: Actual and Required

– Reserve ratio: the fraction of a bank’s total deposits that are held in reserves.

– Required reserve ratio:

• must be kept on hand or on deposit with the Federal Reserve (the U.S. Central Bank)

– Excess reserves: reserves beyond those required

• Excess reserves can be loaned.

Multiple Creation of Bank Deposits M1

How Banks Create Money

Deposit Expansion Multiplier =1

Reserve Requirement (ratio)

The Deposit Expansion Multiplier andThe Autonomous Spending Multiplier

• The deposit expansion multiplier is analogous to the spending multiplier– The deposit expansion multiplier is not the same thing

as the spending multiplier

• The magnitudes of both multipliers are reduced by leakages– Bank reserves are not relent and hence not recycled

through the banking system• Money held as currency and not deposited in banks is another

leakage that reduces the deposit expansion multiplier

– Household saving is not recycled thru the spending system

• Income siphoned off as taxes and income spent on imports are other leakages from the spending stream that reduce the spending multiplier

The Federal Reserve System• The Federal Reserve System (“the Fed”) is the

central bank of the United States.• Central bank functions:

– Bankers’ bank: • accepts deposits from banks• makes loans to banks.

– Banker for the government.– It controls the money supply.– Regulates banks– Clears checks

Structure of the Federal Reserve System

The Board of Governors Ben Bernanke, Chair

6 other governors

12 Regional Federal Reserve District Banks (FRBs)

Federal Open Market Committee (FOMC) The Board of Governors (7)

5 of 12 District Presidents (in Rotation)

The Federal Reserve System

The Board of Governors

• Seven members appointed by the President and confirmed by the Senate

• 14-year term

• Terms are staggered:

– one comes vacant every two years

• President appoints Chairman to serve a four-year term

Functions of the Fed Banking Services and Supervision

– Supplies currency to banks through its 12 district federal reserve banks.

– Holds reserves of banks in the district bank of each bank.

• These are commercial bank deposits at the Fed– Processes and routes checks to banks through its

district banks and processing centers.– Makes loans to banks—it is the “lender of last resort”,

the “banker’s bank”.– It supervises and regulate banks, ensuring that they

operate in a sound and prudent manner.– Banker for the U.S. government. – Manages sales of government securities for the U.S.

Treasury.

Functions of the Fed

• Controlling the Money Supply– Vary money supply to meet seasonal

fluctuations in the demand for money. • Helps keep interest rates steady.• Example: 4th quarter holiday season

creates an increased demand for money to buy gifts.

–Adjust federal funds rate to meet policy goals of the FOMC.