Money, The Price Level, and Inflation

Money and Its Functions

• Definition of Money: Money is a commodity or token that is widely accepted as payment.
  • Functions of Money:
  • Medium of Exchange: Used to settle debts and facilitate trade; eliminates the difficulties of barter, which requires a double coincidence of wants.
  • Unit of Account: Provides a standard measure for pricing goods and services, simplifying comparisons.
  • Store of Value: Maintains value over time, allowing money to be saved and spent later.

Characteristics of Money

• General Acceptability: Must be widely accepted by consumers.
• Stability of Value: Should maintain its value over time.
• Transportability: Easy to carry and transfer.
• Storability: Can be stored without degrading.
• Divisibility: Can be divided into smaller units for various transactions.

Types and Measures of Money

• Currency and Deposits:
  • Currency includes notes and coins in circulation.
  • Deposits consist of checking and savings accounts that can be used to make payments.
• Official Measures:
  • M1: Comprises currency, traveler's checks, and checking deposits.
  • M2: Includes M1 plus savings deposits, money market mutual funds, and time deposits.

Banking System

• Depository Institutions: Entities that accept deposits and extend credit, such as commercial banks, thrift institutions, and money market funds.
• Functions of Banks:
  • Accept deposits and provide loans.
  • Balance profits from lending with the need to provide access to depositor funds.

The Federal Reserve System (The Fed)

• Role of the Fed: Regulates depository institutions and controls money supply; aims to manage inflation, full employment, and economic growth.
• Key Structures:
  • Board of Governors: Composed of seven members; oversees the Fed.
  • Federal Reserve Banks: 12 regional banks with local governance.
  • Federal Open Market Committee (FOMC): Key decision-making body for monetary policy.

Monetary Policy Tools

• Open Market Operations: Buying/selling government securities to influence money supply and interest rates.
• Discount Rate: The interest rate charged to commercial banks for loans from the Fed.
• Required Reserve Ratio: Centric to maintaining liquidity in the banking system; rarely changed.

Money Creation by Banks

• Process of Creating Money:
  • Banks can create deposits through loans, expanding the money supply beyond the monetary base.
  • Money Multiplier: Expresses how much money banks can create based on their reserves.
  • ext{Money Multiplier} = rac{1 + rac{C}{D}}{rac{R}{D} + rac{C}{D}}
  • Factors Affecting Money Creation:
  • Monetary base: Total currency and reserves.
  • Desired reserves: The proportion of deposits that banks choose to keep in reserve.
  • Currency drain: The amount of money held as currency rather than as bank deposits.