Lecture 17 Notes: Money, Banks, and the Federal Reserve System
Econ 201 Lecture Notes: Chapter 14 - Money, Banks, and the Federal Reserve System
What Is Money and Why Do We Need It?
Definition of Money: Money serves multiple roles in the economy, enabling trading and value storage.
Functions of Money:
Medium of Exchange:
Money serves as a medium where sellers accept it in exchange for goods or services.
Unit of Account:
In a barter system, every good has multiple prices making transactions complicated.
Money simplifies this by providing a common denominator for pricing goods and services.
Store of Value:
Money allows individuals to store value for future purchases.
Accumulated money can be saved rather than spent immediately, preserving purchasing power over time.
Standard of Deferred Payment:
Money facilitates borrowing and lending by serving as a standard for obligations to pay in the future.
What Can Serve as Money?
Criteria for a Suitable Medium of Exchange:
Acceptability: Must be usable by most people.
Standardized Quality: All units need to be identical (uniform quality).
Durability: Must maintain value over time; should not spoil or deteriorate.
Portability: Needs to be valuable relative to its weight to facilitate transportation for trade.
Divisibility: Should be divisible into smaller units to accommodate different values of goods and services.
The 2 Kinds of Money
Commodity Money:
Takes the form of a commodity with intrinsic value.
Examples: Gold coins, cigarettes (in POW camps).
Fiat Money:
Has no intrinsic value and is established as money by government decree.
Example: U.S. dollar.
How Is Money Measured in the United States Today?
M1:
The narrowest definition of the money supply, consisting of:
Currency in circulation (not held by banks or government).
Checking account deposits in banks.
Traveler's checks (not significant, approximately $5 billion as of July 2009).
M2:
A broader definition of the money supply:
Includes all elements of M1, plus:
Savings account balances.
Small-denomination time deposits.
Balances in money market deposit accounts in banks.
Noninstitutional money market fund shares.
Key Points About the Money Supply:
Money supply consists of both currency and checking account deposits.
Banks play a vital role in the money supply's increase and decrease due to checking account deposits.
Credit Cards and Debit Cards
Credit Cards:
Although used for transactions, credit cards are not considered part of the money supply.
Definitions of M1 and M2
Impact of Withdrawal:
If $5,000 is withdrawn from a checking account to buy a bank certificate of deposit (CD), M1 decreases while M2 remains unchanged.
Bank Balance Sheets
Importance of Bank Balance Sheets:
Essential items include:
Reserves: Cash that banks keep in vaults or with the Federal Reserve.
Loans: Money lent to individuals or businesses.
Deposits: Money deposited by customers.
Total assets equal total liabilities + stockholders' equity (net worth).
How Do Banks Create Money?
**Reserves:
Types of Reserves:**
Required Reserves: Legally mandated amount a bank must hold, based on checking account deposits.
Excess Reserves: Any reserves beyond what is legally required.
T-Accounts and Money Creation Process:
When a deposit is made (e.g., $1,000) into a checking account:
Increases both assets (reserves) and liabilities (deposits) by the same amount ($1,000).
If the bank loans out $900 (from excess reserves):
Assets show Reserves +$1,000, Loans +$900.
Liabilities show Deposits +$1,000 and creates new money supply by $900.
When the loaned $900 check clears:
Affect on reserves and deposits between banks (Wachovia and PNC) facilitates the movement and creation of money across the banking system.
The Simple Deposit Multiplier:
Definition:
Ratio of deposits created by banks to the amount of new reserves.
Effects of Reserve Changes on Money Supply:
When banks gain reserves, they create new loans, causing the money supply to expand.
Conversely, when banks lose reserves, they cut back on loans, contracting the money supply.