Key Concepts in Money and Monetary Policy

Money

Any asset that is widely accepted as a means of payment for goods and services, repayment of debts, and a unit of account.

Fiat Money

A type of money that has no intrinsic value and is not backed by a physical commodity like gold. Instead, it derives value from government regulation and public trust (e.g., US dollars, euros).

Barter

A system of exchange where goods and services are traded directly without using money. It requires a 'double coincidence of wants,' meaning both parties must have what the other wants.

Medium of Exchange

One of the key functions of money, allowing people to trade goods and services without the inefficiencies of barter.

Unit of Account

Money serves as a standard measure for pricing goods and services, making value comparisons easier.

Store of Value

Money can retain value over time, allowing individuals to save purchasing power for future use. However, inflation can erode this function.

Liquidity

The ease with which an asset can be converted into cash without losing value. Cash is the most liquid asset, while real estate is less liquid.

M1

A narrow measure of the money supply, including the most liquid assets like cash, checking accounts, and traveler's checks.

M2

A broader measure of the money supply, including M1 plus savings accounts, small time deposits, and money market mutual funds.

Financial System

The network of institutions, markets, and instruments that facilitate the flow of funds between savers and borrowers.

Financial Intermediaries

Institutions like banks, credit unions, and investment firms that channel funds from savers to borrowers.

Return on Investment (ROI)

A metric used to evaluate the profitability of an investment, calculated as: Higher ROI indicates better investment performance.

Tradeoff Between Lower Risk and Higher Returns

The concept that safer investments (e.g., government bonds) offer lower returns, while riskier investments (e.g., stocks) provide higher potential returns but with greater uncertainty.

Teaser Rates

Initially low-interest rates offered on loans or credit cards to attract customers, which increase after an introductory period.

Compounding Effect

The process where earnings on an investment generate additional earnings over time. It is a key driver of wealth accumulation.

Vesting Period

The time an employee must work before gaining full ownership of employer-provided benefits like stock options or retirement contributions.

Pensions

Retirement plans that provide periodic payments to retirees, typically funded by employers, employees, or governments.

Reserve Ratio

The fraction of customer deposits that banks must keep in reserve rather than lend out.

Reserve Requirement

The minimum amount of reserves that a bank must hold as mandated by the central bank.

Fractional Reserve Banking System

A banking system where banks hold only a fraction of their deposits in reserve and lend out the rest, creating money through credit expansion.

Excess Reserves

Bank reserves held above the required minimum, which can be used for additional lending.

Money Multiplier

A measure of how much the money supply increases with each dollar of central bank reserves.

Monetary Base

The total amount of money created by the central bank, including currency in circulation and bank reserves.

Insolvent

A financial state where an entity's liabilities exceed its assets, meaning it cannot meet its debt obligations.

Federal Reserve System

The central banking system of the United States, responsible for regulating banks, conducting monetary policy, and maintaining financial stability.

Federal Open Market Committee (FOMC)

The policy-making body of the Federal Reserve that sets interest rates and controls money supply through monetary policy decisions.

Federal Funds Rate

The interest rate at which banks lend excess reserves to each other overnight, influencing overall borrowing costs in the economy.

Open Market Operations (OMO)

The buying and selling of government securities by the Federal Reserve to influence money supply and interest rates.

Arbitrage

The practice of profiting from price differences in different markets by buying low in one and selling high in another.

Discount Rate

The interest rate the Federal Reserve charges banks for short-term loans, influencing overall liquidity and interest rates.

Expansionary Monetary Policy

A policy used to stimulate economic growth by lowering interest rates, increasing money supply, and encouraging borrowing and spending.

Contractionary Monetary Policy

A policy used to reduce inflation by raising interest rates and decreasing money supply, slowing down economic activity.

Equation of Exchange

A formula that represents the relationship between money supply, velocity, price level, and output: MV=PQ where M = money supply, V = velocity of money, P = price level, and Q = quantity of goods/services.

Money Illusion

The tendency of people to think in nominal terms rather than real terms, meaning they overlook inflation when assessing income or prices.

Liquidity Trap

A situation where interest rates are near zero, making monetary policy ineffective as people prefer to hold cash rather than spend or invest.

Monetary Rule

A policy framework where the central bank follows a fixed rule to control money supply growth, instead of adjusting policy discretionarily.

Inflation Targeting

A monetary policy strategy where the central bank aims for a specific inflation rate (e.g., 2%) to maintain price stability.

Taylor Rule

A guideline for setting interest rates based on inflation and economic output.

Monetary Hawk

A policymaker or economist who prioritizes controlling inflation and favors higher interest rates, even at the cost of slower economic growth.

Monetary Dove

A policymaker or economist who prioritizes economic growth and job creation, favoring lower interest rates and looser monetary policy.