1. WHAT IS MONEY?

Learning Objectives1. Define money and discuss its three basic functions.2. Distinguish between commodity money and fiat money, giving

examples of each.3. Define what is meant by the money supply and tell what is

included in the Federal Reserve System’s two definitions of it (M1 and M2).

• Money is anything that serves as a medium of exchange.

1.1 The Functions of Money

• A medium of exchange is anything that is widely accepted as a means of payment.

• To Barter an individual exchanges goods directly for other goods.

• A unit of account is a consistent means of measuring the value of things.

• A store of value is an item that holds value over time.

1.2 Types of Money

• Commodity money is money that has value apart from its use as money.

– E.g. Mackerel in federal prisons, gold, and silver • Fiat money is money that some authority, generally

a government, has ordered to be accepted as a medium of exchange.

– E.g. paper money and coins in the U.S. “this note is legal tender for all debts public and private”

• Currency is paper money and coins.• Checkable deposits are balances in checking

accounts.• A check is a written order to a bank to transfer

ownership of a checkable deposit.

1.3 Measuring Money

• Money supply refers to the total quantity of money in the economy at any one time.

• Liquidity is the ease with which an asset can be converted into currency.

• M1 is the narrowest of the Fed’s money supply definitions that includes currency in circulation, checkable deposits, and traveler’s checks.

• M2 is a broader measure of the money supply than M1 that includes M1 and other deposits.

The two M’s: December 2008

2. THE BANKING SYSTEMS AND MONEY CREATION

Learning Objectives1. Explain what banks are, what their balance sheets look like,

and what is meant by a fractional reserve banking system.2. Describe the process of money creation (destruction), using

the concept of the deposit multiplier.3. Describe how and why banks are regulated and insured.

2.1 Banks and Other Financial Intermediaries

• A financial intermediary is an institution that amasses funds from one group and makes them available to another.

• A bank is a financial intermediary that accepts deposits, makes loans, and offers checking accounts.

2.2 Bank Finance and a Fractional reserve System

• A balance sheet is a financial statement showing assets, liabilities, and net worth.

• Assets are anything of value.• Liabilities are obligations to other parties.• Net worth refers to assets less liabilities.• Reserves are bank assets held as cash in

vaults and in deposits with the Federal Reserve.

• A fractional reserve banking system is a system in which banks hold reserves whose value is less than the sum of claims outstanding on those reserves.

The Consolidated Balance Sheet for U.S. Commercial Banks, June 2008.

Assets Liabilities and Net Worth

Reserves $300.0 Checkable deposits $604.5

Other assets 1,357.8 Other deposits 6,306.7

Loans 6,903.4 Borrowings 2,322.1

Securities 2,466.9 Other liabilities 6,576.6

Total assets $11,928.1 Total Liabilities 9,890.9

Net worth 1,137.2

2.3 Money Creation

• Required reserves are the quantity of reserves banks are required to hold.

• The required reserve ratio is the ratio of reserves to checkable deposits a bank must maintain.

• Excess reserves are reserves in excess of the required level.

• A bank is said to be loaned up when its excess reserves equal zero.

A Balance Sheet for ACME Bank

ACME Bank

Assets Liabilities

Reserves $1,000 Deposits $10,000

Loans $9,000

A Balance Sheet for ACME Bank

A Balance Sheet for ACME Bank

2.4 The Deposit Multiplier

• A deposit multiplier is the ratio of the maximum possible change in checkable deposits (ΔD) to the change in reserves (ΔR).

EQUATION 2.1

EQUATION 2.2

EQUATION 2.3

EQUATION 2.4

EQUATION 2.5

10000,1$

000,10$

R

Dmd

rrrDR

DrrrR

DRrrr

1

dmR

D

rrr

1

2.5 The Regulation of Banks

• Deposit insurance– In the U.S. if a commercial bank fails, the

FDIC guarantees to reimburse depositors up to at least $100,000 per account.

• Regulation to Prevent Bank Failure– The FDIC audits banks to ensure they are

operating safely (i.e. not making investments deemed too risky and maintaining a minimum level of net worth as a fraction of total assets)

3. THE FEDERAL RESERVE SYSTEM

Learning Objectives1. Explain the primary functions of central banks.2. Describe how the Federal Reserve System is structured and governed.3. Identify and explain the tools of monetary policy.4. Describe how the Fed creates and destroys money when it buys and sells federal government

bonds.

• A central bank is a bank that acts as a banker to the central government, acts as a banker to banks, acts as a regulator of banks, conducts monetary policy, and supports the stability of the financial system.

3.1 Structure of the Fed

3.2 Powers of the Fed

• Reserve requirements• The discount window and other credit facilities

– The discount rate is the interest rate changed by the Fed when it lends reserves to banks.

– The federal funds market is a market in which banks lend reserves to one another.

– A federal funds rate is the interest rate charged when one bank lends reserves to another.

3.2 Powers of the Fed

• Open market operations– A bond is a promise by the issuer of the bond to pay

the owner of the bond a payment or a series of payments on a specific date or dates.

– Open market operations are the buying and selling of federal government bonds by the Fed.

3.2 Powers of the Fed

The FedThe Fed

BanksBanks

The PublicThe Public

Reserves

DepositsLoans