What Is Money?  Serves ALL the following purposes:  Medium of exchange: accepted as payment for goods and services (and debts).  Store of value: can be held for future purchases.  Standard of value: serves as a yardstick for measuring the prices of goods and services.  Food For Thought: Are checking account balances money? Are credit cards money?

Composition of Money Supply  Some bank accounts are better substitutes for cash than others.  M1: cash and transactions accounts  Transactions accounts include checking accounts and travelers checks.  Money supply (M1): currency held by the public, plus balances in transactions accounts.  M1 permits direct payment for goods and services.

Composition of Money Supply  M2: M1 plus savings accounts, etc.  Savings account balances and money market mutual funds are almost as good a substitute for cash as transactions accounts.  Money supply (M2): M1 plus balances in most savings accounts and money market mutual funds.  M2 must be turned into M1 before it can be used to purchase goods and services.

Composition of Money Supply  Cash is about half of M1 money supply. Most of the rest are transactions account balances.  M2 is larger than M1. People hold money in M2 accounts because they can earn some interest on these deposits. Food For Thought: What percentage of your monthly bills do you pay with a)cash b) check c) credit card and d) automatic transfers? How does your use of cash compare with the composition of the money supply?

Economic Importance of Money  How much money is available (the size of the money supply) affects consumers’ ability to purchase goods and services.  This directly affects aggregate demand (AD).

Creation of Money  Cash is either printed or coined. But cash is a very small part of M2.  How is the money in transactions accounts and savings accounts created?  These bank accounts are not physical lumps of cash. They are computer data entries.  A few keystrokes can increase or decrease the money in a bank account.

Creation of Money  Banks create money by making loans.  A customer deposits $100 into his savings account.  The bank loans the $100 to a borrower, who deposits the money into his checking account.  There are now $200 in deposits: $100 in the savers’ account and $100 in the borrow’s account.  Money is “created.”  The bank’s ability to create money is limited by the Federal Reserve System (the “Fed”).  The Fed requires the bank to hold some of the deposit in reserve.  This limits the bank’s ability to create money.  Thus the Fed controls the basic money supply.

Fractional Reserves  The Fed controls a bank’s ability to create money by making loans.  Bank reserves: assets held by a bank to fulfill its deposit obligations.  Required reserves: the minimum amount of reserves a bank is required to hold.  Required reserve ratio: the ratio of a bank’s required reserves to its total deposits. Required reserves = Required reserve ratio x Total deposits

Fractional Reserves  The bank must set aside required reserves.  The bank loans its excess reserves.  Excess reserves: bank reserves in excess of required reserves.  Reserve Requirement directly limits lending possibilities. Excess reserves = Total reserves – Required reserves