0. © 2007 Thomson South-Western

1. What Money Is and Why It’s Important
Without money, trade would require barter, the exchange of one good or service for another.
Every transaction would require a double coincidence of wants – the unlikely occurrence that two people each have a good the other wants.
Most people would have to spend time searching for others to trade with – a huge waste of resources.
This searching is unnecessary with money, the set of assets that people regularly use to buy g&s from other people.
As in previous chapters, “g&s” = goods & services.
“Double coincidence of wants” simply means that two people have to want each other’s stuff.
Students find the following example amusing:
I’m an economics professor, but I’m a consumer, too. Suppose I want to go out for a beer. Under a barter system, I would have to search for a bartender that was willing to give me a beer in exchange for a lecture on economics. As you might imagine, I would have to spend a LOT of time searching. (On the plus side, this would prevent me from becoming an alcoholic.)
But thanks to money, I can go directly to my favorite pub and get a cold beer; the bartender doesn’t have to want to hear my lecture, he only has to want my money.
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2. Money has three functions in the economy:
The Functions of Money
Money has three functions in the economy:
Medium of exchange
Unit of account
Store of value

3. The Functions of Money Medium of Exchange
A medium of exchange is an item that buyers give to sellers when they want to purchase goods and services.
A medium of exchange is anything that is readily acceptable as payment.

4. The Functions of Money Unit of Account Store of Value
A unit of account is the yardstick people use to post prices and record debts.
Store of Value
A store of value is an item that people can use to transfer purchasing power from the present to the future.

5. The Functions of Money
Liquidity is the ease with which an asset can be converted into the economy’s medium of exchange.

6. The 2 Kinds of Money
Commodity money: takes the form of a commodity with intrinsic value
Examples: gold coins, cigarettes in POW camps
Fiat money: money without intrinsic value, used as money because of govt decree
Example: the U.S. dollar
Intrinsic value means the commodity would have value even if it weren’t being used as money.
In the film “The Shawshank Redemption,” prisoners use cigarettes as money.
Fiat money is worthless – except as money. Yet, people are happy to accept your dollars (or euros or yen or whatever) because they know that they will be able to spend them elsewhere.
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7. Money in the U.S. Economy
Currency is the paper bills and coins in the hands of the public.
Demand deposits are balances in bank accounts that depositors can access on demand by writing a check.

8. Figure 1 Two Measures of the Money Stock for the U.S. Economy
Billions
of Dollars M2
$6,398 •
Savings deposits
Small time deposits
Money market
mutual funds
A few minor categories
($5,035 billion) M1
$1,363 •
Currency
($699 billion)
Demand deposits
Traveler ’
s checks
Other checkable deposits
($664 billion) •
Everything in M1
($1,363 billion)

9. CASE STUDY: Where Is All The Currency?
In 2004 there was $699 billion of U.S. currency outstanding.
That is $3,134 in currency per adult.
Who is holding all this currency?
Currency held abroad
Currency held by illegal entities

10. THE FEDERAL RESERVE SYSTEM
The Federal Reserve (Fed) serves as the nation’s central bank.
It is designed to oversee the banking system.
It regulates the quantity of money in the economy.

11. THE FEDERAL RESERVE SYSTEM
The Fed was created in 1913 after a series of bank failures convinced Congress that the United States needed a central bank to ensure the health of the nation’s banking system.

12. The Structure of the Fed
The Structure of the Fed
The Federal Reserve System consists of:
Board of Governors (7 members), located in Washington, DC
12 regional Fed banks, located around the U.S.
Federal Open Market Committee (FOMC), includes the Bd of Govs and presidents of some of the regional Fed banks The FOMC decides monetary policy.
Ben S. Bernanke Chair of FOMC, Feb 2006 – present
In subsequent chapters (including the chapter immediately following this one), students will learn that the Federal Reserve’s monetary policy can have huge effects on many macroeconomic variables, like inflation, interest rates, unemployment, and even stock price indexes and exchange rates.
As chair of the FOMC, Ben Bernanke is in the news quite frequently. 12

13. The Fed’s Organization
Three Primary Functions of the Fed
Regulates banks to ensure they follow federal laws intended to promote safe and sound banking practices.
Acts as a banker’s bank, making loans to banks and as a lender of last resort.
Conducts monetary policy by controlling the money supply.

14. The Federal Open Market Committee (FOMC)
Monetary policy is conducted by the Federal Open Market Committee.
The money supply refers to the quantity of money available in the economy.
Monetary policy is the setting of the money supply by policymakers in the central bank.

15. The Federal Open Market Committee
Open-Market Operations
The money supply is the quantity of money available in the economy.
The primary way in which the Fed changes the money supply is through open-market operations.
The Fed purchases and sells U.S. government bonds.

16. The Federal Open Market Committee
Open-Market Operations
To increase the money supply, the Fed buys government bonds from the public.
To decrease the money supply, the Fed sells government bonds to the public.

17. BANKS AND THE MONEY SUPPLY
Banks can influence the quantity of demand deposits in the economy and the money supply.

18. BANKS AND THE MONEY SUPPLY
Reserves are deposits that banks have received but have not loaned out.
In a fractional-reserve banking system, banks hold a fraction of the money deposited as reserves and lend out the rest.

19. BANKS AND THE MONEY SUPPLY
The reserve ratio is the fraction of deposits that banks hold as reserves.

20. Money Creation with Fractional-Reserve Banking
When a bank makes a loan from its reserves, the money supply increases.
The money supply is affected by the amount deposited in banks and the amount that banks loan.
Deposits into a bank are recorded as both assets and liabilities.
The fraction of total deposits that a bank has to keep as reserves is called the reserve ratio.
Loans become an asset to the bank.

21. Banking Money Creation with Fractional-Reserve
This T-Account shows a bank that…
accepts deposits,
keeps a portion as reserves,
and lends out the rest.
It assumes a reserve ratio of 10%.
Assets
Liabilities
First National Bank
Reserves
$10.00
Loans
$90.00
Deposits
$100.00
Total Assets
Total Liabilities

22. Money Creation with Fractional-Reserve Banking
When one bank loans money, that money is generally deposited into another bank.
This creates more deposits and more reserves to be lent out.
When a bank makes a loan from its reserves, the money supply increases.

23. The Money Multiplier
How much money is eventually created by the new deposit in this economy?

24. The Money Multiplier
The money multiplier is the amount of money the banking system generates with each dollar of reserves.

25. Increase in the Money Supply = $190.00!
The Money Multiplier
Increase in the Money Supply = $190.00!
Assets
Liabilities
First National Bank
Reserves
$10.00
Loans
$90.00
Deposits
$100.00
Total Assets
Total Liabilities
Second National Bank
$9.00
$81.00

26. The Money Multiplier
Original deposit = $100.00
1st Natl. Lending = (=.9 x $100.00)
2nd Natl. Lending = (=.9 x $ )
3rd Natl. Lending = (=.9 x $ )
… and on until there are just pennies left to lend!
Total money created by this $ deposit is $ (= 1/.1 x $100.00)

27. The money multiplier is the reciprocal of the reserve ratio: M = 1/R
Example:
With a reserve requirement, R = 20% or .2:
The money multiplier is 1/.2 = 5.

28. The Fed’s Tools of Monetary Control
The Fed has three tools in its monetary toolbox:
Open-market operations
Changing the reserve requirement
Changing the discount rate

29. The Fed’s 3 Tools of Monetary Control
1. Open-Market Operations (OMOs): the purchase and sale of U.S. government bonds by the Fed.
To increase money supply, Fed buys govt bonds, paying with new dollars.
…which are deposited in banks, increasing reserves
…which banks use to make loans, causing the money supply to expand.
To reduce money supply, Fed sells govt bonds, taking dollars out of circulation, and the process works in reverse.
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30. The Fed’s 3 Tools of Monetary Control
1. Open-Market Operations (OMOs): the purchase and sale of U.S. government bonds by the Fed.
OMOs are easy to conduct, and are the Fed’s monetary policy tool of choice.
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31. The Fed’s 3 Tools of Monetary Control
2. Reserve Requirements (RR): affect how much money banks can create by making loans.
To increase money supply, Fed reduces RR.
Banks make more loans from each dollar of reserves, which increases money multiplier and money supply.
To reduce money supply, Fed raises RR, and the process works in reverse.
Fed rarely uses reserve requirements to control money supply: Frequent changes would disrupt banking.
Reserve requirements were introduced & defined on the slide titled “Bank Reserves,” immediately following “The Structure of the Fed.”
Reserve requirements are not a good tool for monetary policy:
To make the money supply grow over time, the Fed would have to continually reduce reserve requirements. This is neither possible – they cannot be reduced below 0 – nor desirable – if reserves are too low, then banks will have liquidity problems, and bank runs (discussed later in the chapter) might become fashionable again.
To reduce the money supply using reserve requirements, banks wouldn’t be able to make as many loans, which would make the banking industry less profitable and could cause it to contract.
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32. The Fed’s 3 Tools of Monetary Control
3. The Discount Rate: the interest rate on loans the Fed makes to banks
When banks are running low on reserves, they may borrow reserves from the Fed.
To increase money supply, Fed can lower discount rate, which encourages banks to borrow more reserves from Fed.
Banks can then make more loans, which increases the money supply.
To reduce money supply, Fed can raise discount rate.
Why might banks run low on reserves? On any given day, it might turn out that depositors make higher-than-expected withdrawals, or the bank makes more loans than expected.
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33. The Fed’s 3 Tools of Monetary Control
3. The Discount Rate: the interest rate on loans the Fed makes to banks
The Fed uses discount lending to provide extra liquidity when financial institutions are in trouble, e.g. after the Oct stock market crash.
If no crisis, Fed rarely uses discount lending – Fed is a “lender of last resort.”
Indeed, the Fed is a “lender of last resort” and usually doesn’t make discount loans to banks on demand. The Fed is not in the business of giving banks cheap money to subsidize their profits.
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34. The Federal Funds Rate
On any given day, banks with insufficient reserves can borrow from banks with excess reserves.
The interest rate on these loans is the federal funds rate.
The FOMC uses OMOs to target the fed funds rate.
Many interest rates are highly correlated, so changes in the fed funds rate cause changes in other rates and have a big impact in the economy.
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35. The Fed Funds Rate and Other Rates, 1970-2008
prime
3-month Tbill 15
mortgage
(%) 10
The prime rate (the rate banks charge on loans to their best customers) and the 3-month Treasury Bill rate are very highly correlated with the Fed Funds rate.
The mortgage rate shown is the 30-year fixed rate. It is less correlated with the Federal Funds rate, but this is to be expected: Fed Funds are overnight loans between banks, while mortgages are 30-year loans to consumers.
source: FRED database 5
1970
1975
1980
1985
1990
1995
2000
2005 35

36. Monetary Policy and the Fed Funds Rate
The Federal Funds market
To raise fed funds rate, Fed sells govt bonds (OMO).
This removes reserves from the banking system, reduces supply of federal funds,
causes rf to rise. rf F
Federal funds rate S2 S1 D1
3.75% F2 F1
3.50%
This graph is not in the textbook, so it is not supported with material in the study guide or test bank. Therefore, you may wish to omit this slide from your presentation. But I hope you will consider keeping it. It is uses a simple supply-demand diagram to illustrate something described verbally in the text: how the Federal Reserve targets the federal funds rate.
The demand for federal funds comes from banks that find themselves with insufficient reserves, perhaps because they made too many loans or had higher-than-expected withdrawals.
The supply of federal funds comes from banks that find themselves with more reserves than they want, perhaps because they had lower-than-expected withdrawals or because few customers took out loans.
The federal funds rate adjusts to balance the supply of and demand for federal funds.
The Federal Reserve can use OMOs to target the fed funds rate. Whenever the rate starts to fall below the Fed’s target, the Fed sells government bonds in the open market in order to pull reserves out of the banking system, which raises the rate as shown in this diagram. If the rate rises above the Fed’s target, the Fed buys govt bonds in the open market, injecting reserves into the banking system, and pushing the rate down.
For the Fed, OMOs are quick, easy, and effective, so the Fed can keep the fed funds rate very close to the target.
Quantity of federal funds
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37. Problems Controlling the Money Supply
If households hold more of their money as currency, banks have fewer reserves, make fewer loans, and money supply falls.
If banks hold more reserves than required, they make fewer loans, and money supply falls.
Yet, Fed can compensate for household and bank behavior to retain fairly precise control over the money supply.
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38. Bank Runs and the Money Supply
A run on banks: When people suspect their banks are in trouble, they may “run” to the bank to withdraw their funds, holding more currency and less deposits.
Under fractional-reserve banking, banks don’t have enough reserves to pay off ALL depositors, hence banks may have to close.
Also, banks may make fewer loans and hold more reserves to satisfy depositors.
These events increase R, reverse the process of money creation, cause money supply to fall.
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39. Bank Runs and the Money Supply
During , a wave of bank runs and bank closings caused money supply to fall 28%.
Many economists believe this contributed to the severity of the Great Depression.
Since then, federal deposit insurance has helped prevent bank runs in the U.S.
In the U.K., though, Northern Rock bank experienced a classic bank run in 2007 and was eventually taken over by the British govt.
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40. The term money refers to assets that people regularly use to buy goods and services.
Money serves three functions in an economy: as a medium of exchange, a unit of account, and a store of value.
Commodity money is money that has intrinsic value.
Fiat money is money without intrinsic value.

41. The Federal Reserve, the central bank of the United States, regulates the U.S. monetary system.
It controls the money supply through open-market operations or by changing reserve requirements or the discount rate.

42. When banks loan out their deposits, they increase the quantity of money in the economy.
Because the Fed cannot control the amount bankers choose to lend or the amount households choose to deposit in banks, the Fed’s control of the money supply is imperfect.