Lecture 10: The Monetary System: Understanding Money, Its Creation, and Impact
Introduction to the Monetary System
The Ironic Question: What is Money? While seemingly obvious, the concept of money is far more complex than a simple definition of physical currency. It involves understanding its functions, forms, and the institutions that govern its creation and flow, which often challenges common assumptions.
Money's Complexity and Evolution: The definition and use of money are not static; they are dramatically changing due to technological advancements (e.g., digital payment systems, cryptocurrencies), global financial integration, and evolving economic theories. This evolution profoundly impacts the economy, financial markets, and daily lives, making its study increasingly relevant. The course will explore why money is becoming more complicated, moving beyond traditional physical forms.
Money Supply and Demand:
Similar to the concepts of supply and demand applied to GDP and labor markets, but with crucial distinctions.
The supply of money is unique because it is not produced by private firms in a competitive market. Instead, it is primarily controlled by a government monopolist: the central bank (e.g., the Federal Reserve in the U.S.).
The Federal Reserve determines the money supply not purely based on market forces of profit and loss, but based on what it believes is best for achieving macroeconomic goals such as price stability and maximum sustainable employment. This objective-driven approach makes the money market less aligned with traditional free-market capitalist principles.
Influence on the Macro Economy:
Demo Macro Markets Review: Recall the essential division into real markets (which focus on real quantities like GDP, employment, and capital) and nominal markets (which primarily deal with dollar-denominated values such as money, interest rates, and other financial assets). These two sides of the economy interact in distinct ways.
Long Run (Chapter 17): In the long run, nominal economic variables (like the quantity of money or general price levels) do not directly affect real economic variables (like real GDP and employment). This concept is often referred to as monetary neutrality, suggesting that money only affects prices over the long haul.
Short Run (Chapters 20-23, latter half of semester): In contrast to the long run, money and asset markets can significantly impact real GDP and employment during shorter periods. Changes in the money supply or interest rates can influence investment, consumption, and aggregate demand, thereby affecting output and job creation. Understanding this short-run dynamic is crucial for analyzing business cycles and the effectiveness of monetary policy.
Defining Money
Course Objectives (Chapter Focus):
Identify assets that qualify as money: This involves understanding the characteristics an asset must possess to serve as money, such as general acceptability and divisibility.
Understand the basic functions of money: Money serves three primary purposes: $1.$ Medium of Exchange: It facilitates transactions, avoiding the inefficiencies of barter. $2.$ Unit of Account: It provides a common measure of value for goods and services. $3.$ Store of Value: It allows purchasing power to be transferred from the present to the future, though its effectiveness as a store of value can vary with inflation.
Differentiate between types of money: The course will distinguish between commodity money (money that has intrinsic value, like gold or silver) and fiat money (money that has no intrinsic value but is accepted as legal tender by government decree and trust in the issuing authority, such as the U.S. dollar).
The Federal Reserve and Money Creation
Role of the Federal Reserve: The U.S. Central Bank is unique globally due to its decentralized structure and specific mandates. The course will explore its organizational structure (Board of Governors, Federal Open Market Committee (FOMC), 12 Federal Reserve Banks), its primary functions (conducting monetary policy, supervising banks, maintaining financial stability, providing financial services), and its dual mandate to achieve maximum employment and stable prices.
How Money is Created by Banks: Money is predominantly created through the process of fractional reserve banking. When commercial banks receive deposits, they are only required to hold a fraction of these deposits in reserve, lending out the remainder. This lending process creates new deposits in other banks, which are then partially lent out again, leading to a multiplier effect on the money supply. This cycle, represented by the money multiplier formula , illustrates how a relatively small initial deposit can lead to a much larger increase in the overall money supply. The Federal Reserve influences this process by setting reserve requirements and controlling the monetary base.