What Is Money and Why Do We Need It? 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. The Functions of Money • Medium of exchange • Unit of account/standard of deferred payment • Store of value What Can Serve as Money? Commodity Money or Fiat Money 1 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.

How Is Money Measured in the United States Today? M1: The Narrowest Definition of the Money Supply: Means of Payment 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 Balance Sheet for Wachovia Bank, December 31, 2006 Don’t Let This Happen to YOU! Know When a Checking Account Is an Asset and When It Is a Liability

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 make a loan

How Banks Create Money: The multiple creation of money and credit 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. 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 2008 US Financial System Panic 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 2001 Argenine Bank Panic The 2008 US Financial System Panic The Argentine central bank was not able to stop the bank panic of 2001. The Federal Reserve was able to stop the panic of 2008 … by pumping over $1 trillion into the financial system.

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 System Monetary policy The actions the Federal Reserve takes to manage the money supply and interest rates to pursue economic objectives. Objectives of monetary policy: Price stability High employment Economic growth Stability of financial markets and institutions To manage the money supply, the Fed uses three monetary policy tools: 1 Open market operations 2 Discount policy 3 Reserve requirements

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 reserves from banks and reducing their ability to lend and create money. Banks can hold excess reserves rather than lend and create money.

The Quantity Theory of Money Connecting Money and Prices: Irving Fisher’s Quantity Equation M × V = P × Y 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. We can transform the quantity equation from 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 Quantity Theory of Money 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: Inflation rate = Growth rate of the money supply + Growth rate of velocity − Growth rate of real output If velocity is constant, 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 Asset M1 Bank panic M2 Bank run Monetary policy Commodity money Discount loans Discount rate Excess reserves Federal Open Market Committee (FOMC) Federal Reserve System Fiat money Fractional reserve banking system M1 M2 Monetary policy Money Open market operations Quantity theory of money Required reserve ratio Required reserves Reserves Simple deposit multiplier Velocity of money