MONEY

What is Money?

Money is anything that is generally accepted in payment for goods and services or in the repayment of debts. Money is characterized by its three functions:

1. Medium of Exchange: Facilitates transactions by being widely accepted as payment.
2. Standard of Value: Provides a consistent measure for valuing goods and services.
3. Store of Value: Allows individuals to save and retrieve their wealth over time.

Money is our first payments system, serving as the mechanism through which funds are transferred between economic agents.

What is and is Not Money?

• What is Money?

  • Currency: Physical form of money, such as bills and coins.
  • Debit Cards: Represent an asset and facilitate transactions.
  • Checks: Written orders directing a bank to pay money.

• What is Not Money?

  • Credit Cards: Represent a liability rather than an asset since they are a promise to pay at a later date.
  • Bitcoin: Not considered money because it does not meet the criteria of being generally accepted in payment or serving as a standard of value.

How is Money Measured?

U.S. money functions as a form of fiat money, which means that its intrinsic value is less than its value as money. Consequently, money is considered a stock variable, meaning it is measured at one point in time rather than across a period of time. The money supply in the U.S. is measured using monetary aggregates known as M1 and M2.

M1: The Medium of Exchange

M1 includes:

• Currency outside the Federal Reserve banks, the U.S. Treasury, and vaults of depository institutions.
• Demand deposits at all commercial banks.
• Other checkable deposits, including negotiable orders of withdrawal (NOW) and automatic transfer service accounts (ATS) in banks, thrifts, and credit unions.
• Liquid savings deposits.

As of January 2026, M1 totaled $18.173 trillion.

M2: A Store of Value

M2 includes:

• M1
• Small-denomination time deposits.
• Balances in retail money funds.

As of January 2026, M2 totaled $21.289 trillion.

The Interest Rate

The interest rate is defined as the cost of borrowing or the price paid for the rental of funds. It can also be viewed as the amount one must pay to persuade someone to postpone their consumption so that you may use their money for your own consumption or investment.

1. Interest rates are expressed as a percentage of the principal amount borrowed.
2. Changes in interest rates are frequently reported in basis points (bp), with 100 basis points equating to 1.0%.

Interest Rates and Time to Maturity

Interest rates can be categorized based on their time horizons:

• Short Rates: Maturities of one year or less.
• Long Rates: Maturities of 10 years or more.
• Intermediate Rates: Maturities between 2 to 9 years.

The Unique Case of Government Borrowing

When you lend dollars to the U.S. government, you have assurance that your principal will be returned. The credit risk, which is the probability of not receiving back your principal, is considered zero in this specific situation.

Why is this the case? The U.S. government is the only entity capable of printing dollars to meet its debt obligations, should it choose to do so.

Government Borrowing and Time

Lending to the U.S. government involves purchasing securities known as treasuries, categorized into three maturities:

• T-Bills: Maturities of one year or less.
• T-Notes: Maturities between 2 to 9 years.
• T-Bonds: Maturities between 10 to 30 years.

Short and Long Rate Signals

• Short Rates: Best exemplified by T-Bills and the central bank lending rate (Fed Funds).
• Long Rates: Measured by 30-year quality corporate bonds or 10-year treasuries. Longer rates particularly influence interest-sensitive spending, such as on consumer durables and investments, fundamentally affecting economic direction.

The Federal Reserve System

The Federal Reserve System (Fed) was established by the Federal Reserve Act of 1913. The Fed operates as follows:

1. Owned by member banks but is not a profit-making entity nor a purely not-for-profit institution.
2. Operating funds come from earnings derived from its asset holdings, with surplus earnings returned to the U.S. Treasury.
3. It is independent within the government, possessing both public and private functions.
4. Comprises 12 separate district banks forming one larger system, with local leadership selection.

Four Major Responsibilities of the Fed

1. Conducting Monetary Policy: Influences money and credit conditions in the economy.
2. Supervising and Regulating Banking Institutions: Ensures safety and soundness of the banking and financial system while protecting consumer credit rights.
3. Providing Financial Services: Offers services to the U.S. government, the public, financial institutions, and foreign official institutions, playing a major role in operating the nation's payment systems.
4. Maintaining Financial Stability: Works to contain systemic risk that may arise in financial markets.

Systemic Risk and Lender of Last Resort

Systemic risk typically involves a total breakdown of lending and liquidity (absence of available dollars). Without access to borrowing or sufficient liquidity, the economy faces the risk of collapse. The Fed acts as the lender of last resort, providing loans to banks that cannot secure other lenders, thus helping to avoid crises like bank runs.

The Goals of Fed Policy

The Federal Reserve adheres to two primary goals determined by the dual mandate:

1. Control Inflation: Maintain price stability.
2. Promote Maximum Sustainable Employment: Work towards reducing unemployment.

Conflicts often arise within this dual mandate, particularly when combating inflation during periods of high or rising unemployment.

Monetary Policy and Interest Rates

Monetary policy entails manipulating the money supply and interest rates by the Fed to influence the growth rate of Real Gross Domestic Product (RGDP) or the overall price level. This manipulation is the purview of the central bank, independent of government branches.

Banks and Interest Rates

Banks retain a fraction of their deposits as reserves for meeting depositor or bank liquidity needs and unforeseen events. The remainder of the deposited money can be lent out dollar-for-dollar. Banks generate revenue by lending these reserves at interest rates higher than those at which they acquire the funds they lend.

Banks Hold Some Reserves at the Fed

Banks have the option to hold some reserves at the Fed, referred to as Federal Funds or Fed Funds. The Fed permits banks to use these funds to lend to other banks in need or directly loan them to the Fed.

To Whom Can Banks Lend?

The options banks have for lending include three avenues:

• Lending to individuals and businesses.
• Lending to other banks.
• Lending to the Fed directly.

Banks Lending to the Fed

Banks can earn interest by depositing Fed Funds at the Fed or through direct loans called Reverse Repurchase Agreements (RePo). In both situations, banks earn a return.

Why Does This Fed Interaction Matter?

Before considering options like loans to individuals or other banks, a bank assesses potential earnings from the Fed. If, for example, the Fed is offering 4% interest, another bank must offer the lending bank more than 4% to secure a loan, influencing overall lending rates.

This Fed Interaction Sets a Floor for Rates

By adjusting the interest it pays on Fed Funds or through RePou, the Fed establishes a minimum short interest rate, referred to as the Fed Funds Target Range, typically a 25 basis point range within which it operates its deposit and loan interest rates.

When Banks Borrow from Other Banks

When banks borrow Fed Funds from one another, they negotiate an interest rate termed the effective Fed Funds rate. This effective rate is aligned with or slightly higher than the Fed Funds Target (Range), showcasing the Fed's influence on short-term rates.

What Goes into a Market Rate of Interest We Pay?

As a lender, several risks are associated with a transaction:

1. The borrower may default on part of the loan or the entire amount, known as credit risk.
2. The repayment may not retain its purchasing power if inflation rises, leading to a reduction in the money's value over time.
3. Conversely, if there is deflation, the repayment amount is worth more in purchasing terms.

A Couple More Details

To ascertain the true cost of borrowing, additional factors must be considered:

• The lender's cost to secure funds, represented by the Federal Funds Effective Rate.
• Expectations for return on investment throughout the term of the loan.

The “Real” Rate of Interest

Lenders predict a return they expect to achieve, adjusted for factors such as inflation, credit risk, and the cost of funds. This is referred to as the “real rate of interest”. Historically, this rate is approximately equivalent to the long-term growth rate of real GDP.

Notation for All These Factors

We can use specific notation for these variables:

• i = market rate of interest as stated in the contract.
• r = real rate of interest.
• ffer = cost of money, or Federal Funds Effective Rate.
• π = the rate of inflation.
• Πe = expected rate of inflation.

Market Rates of Interest

The market rate of interest on a security that has zero credit risk is derived by summing the desired real rate of interest (r), the premium for expected inflation (Πe), and the cost of the borrowed capital (ffer):
$i = r + Π_e + ffer$

What We Do and Don’t Know

When signing a loan contract, the market rate of interest is known and stated on the contract. However, the real rate remains uncertain due to unpredictability of inflation rates, which can complicate lending and borrowing for many parties involved.

Monetary Policy and the Economy

The relationship between monetary policy and the economy can be modeled using the transmission mechanism:
$∆ Policy → ∆ i → ∆ C ext{ and/or } I → ∆ GDP$

Despite the chain of influence, each link is less reliable, indicating that monetary policy can be seen as both an art and a science.

The Fed’s Power to Manipulate the Economy is Limited

While the Fed can effectively slow an overheating economy, its ability to stimulate a recessionary economy is often constrained. In scenarios where the Fed can influence spending effectively, economic growth should respond in kind.

Interest Rates and Policy Lags

There is a 24-month lag for the full effects of interest rate changes to manifest in the economy:

• First 6 months: Approx. 40% of effect felt.
• Months 7-18: Additional 40% effect.
• Months 19-24: Remaining 20% effect.

Monetary policy aims at future economic conditions rather than addressing past or present circumstances.

A Simple Model of Interest Rates

Interest rates are determined by the dynamics of demand and supply, similar to wages, exchange rates, and rents. The money supply is a stock concept, fixed at any single point in time. In graphical representation with interest rate (i) on the vertical axis against quantity of money (M), the supply curve is represented as a vertical line:

$Ms$

The total money supply is approximated at $18.6 trillion.

Money Demand

Assuming control over resources termed income, individuals must decide how to allocate their income between saving and liquid cash holdings. The desire to retain liquidity is represented in the demand for money model. Given savings returns interest, this return presents alternatives to holding liquid cash.

Money Demand is Downsloping

At any level of income, individuals assess that choice between liquidity and returns. When returns rise, the willingness to keep liquid cash decreases; conversely, if interest rates fall, individuals become more inclined toward liquidity due to reduced opportunity costs. Hence, money demand exhibits a downsloping trend.

Interest Rate Determined by Money Supply and Demand

The equilibrium interest rate is determined at the intersection of money supply (Ms) and money demand (Md):

$i = ¡e$

Where an estimated money supply is approximately $18.4 trillion.