Money Supply and the Federal Reserve System Notes

The Money Supply and the Federal Reserve System

The chapter explores money markets in the macroeconomy, building upon the previous discussions on consumer, firm, and government interactions in the goods market.
It covers the definition and role of money, the factors determining the money supply, how banks create money, and the functions of the Federal Reserve (the Fed).
Microeconomics focuses on real quantities and relative prices, largely independent of money, whereas macroeconomics heavily relies on understanding money.

Discusses what money is - a means of payment, a store of value, and a unit of account.
Barter System: Direct exchange of goods/services without money.
- Requires a double coincidence of wants.
- Inefficient in complex societies.
Monetary System: Money is exchanged for goods/services, eliminating the double-coincidence problem.
Money acts as a lubricant in a market economy.

Money serves as a store of value, allowing the transport of purchasing power across time.
Alternatives include antique paintings, baseball cards, or diamonds.
Advantages of money:
- Convenient denominations and portability.
- Easy exchange for goods.
- These two factors compose the liquidity property of money.
Disadvantage: Value decreases with rising prices.

Money functions as a unit of account, providing a consistent way of quoting prices.
Prices are quoted in monetary units (e.g., dollars) rather than in other goods.

Commodity Monies: Items with intrinsic value used as money (e.g., cigarettes in POW camps, gold).
Example: Prisoners of war made purchases with cigarettes, quoted prices in terms of cigarettes, and held their wealth in the form of accumulated cigarettes.
Gold represents another form of commodity money. For hundreds of years gold could be used directly to buy things, but it also had other uses, ranging from jewelry to dental fillings.
Fiat Money: Intrinsically worthless items designated as money (e.g., U.S. dollar bills).
Fiat money is accepted because the government declares it as legal tender and controls its supply to prevent debasement.
Why would anyone accept worthless scraps of paper as money instead of something that has some value, such as gold, cigarettes, or cattle? If your answer is "because the paper money is backed by gold or silver," you are wrong.
Legal Tender: Money that a government requires to be accepted for debt settlement.
Currency Debasement: Reduction in money value due to rapid supply increase.
Governments may resort to printing money to finance expenditures, potentially leading to inflation.
Example: In 2007, faced with a need to improve the public water system, Zimbabwe's president, Robert Mugabe, said "Where money for projects cannot be found, we will print it".

Money is a means of payment, a store of value, and a unit of account and characteristics apply to a broad range of assets in the U.S. economy in addition to dollar bills.
Economists use different measures to define money due to the broad range of applicable assets.

Includes coins, currency, and checking accounts (demand deposits).
Debit cards allow easy access to checking account funds.
Definition: Currency held outside banks + Demand deposits + Traveler's checks + Other checkable deposits.
- M1 = \text{Currency} + \text{Demand Deposits} + \text{Traveler's Checks} + \text{Other Checkable Deposits}
M1 is a stock measure at a point in time.

Includes M1 plus savings accounts, money market accounts, and other near monies.
Near Monies: Close substitutes for transactions money.
Definition: M1 + Savings accounts + Money market accounts + Other near monies.
- M2 = M1 + \text{Savings Accounts} + \text{Money Market Accounts} + \text{Other Near Monies}
M2 can be more stable than M1 due to shifts between account types.

Some economists suggest including almost all financial instruments, like available credit on credit cards, in the money supply.
For simplicity, "money" will refer to M1, comprising currency in circulation and deposits.

Most of the money in the United States today is "bank money" of one sort or another.
Financial Intermediaries: Institutions (e.g., commercial banks) that link lenders and borrowers.
They receive funds and loan them out.
Types: Commercial banks, savings and loan associations, life insurance companies, and pension funds.
The Depository Institutions Deregulation and Monetary Control Act (1980) removed many restrictions on financial institutions.