Functions of money

• Medium of exchange - Usable for buying and selling goods and services

  • Exchange complications of barter

• Unit of account - Society uses monetary units—dollars, in the United States—as a yardstick for measuring the relative worth of a wide variety of goods, services, and resources

• Store of value - Enables people to transfer purchasing power from the present to the future

• Liquidity - The ease with which an asset can be converted quickly into the most widely accepted and easily spent form of money, cash, with little or no loss of purchasing power

  • Money has the most liquidity (perfectly liquid)

Components of money supply

• M1 - Currency (coins and paper money) in the hands of the public and all checkable deposits (all deposits in commercial banks and “thrift” or savings institutions on which checks of any size can be drawn)

• Currency (coins + paper money)

  • Federal Reserve Notes - Paper money issued by the Federal Reserve System (the U.S. central bank)

  • Token money - The face value of any piece of currency is unrelated to its intrinsic value—the value of the physical material (metal or paper and ink) out of which that piece of currency is constructed

• Checkable deposits - A way to transfer the ownership of deposits in banks and other financial institutions

  • Commercial banks - Accept the deposits of households and businesses, keep the money safe until it is demanded via checks, and in the meantime use it to make available a wide variety of loans

  • Thrift institutions - Savings and loan associations (S&Ls), mutual savings banks, and credit unions

• Near-monies - Certain highly liquid financial assets that do not function directly or fully as a medium of exchange but can be readily converted into currency or checkable deposits

  • Money market deposit account (MMDA) - An interest-bearing account containing a variety of interest-bearing short-term securities

  • Time deposits - Funds become available at their maturity

  • Money market mutual fund (MMMF) - Mutual fund companies use the combined funds of individual shareholders to buy interest-bearing short-term credit instruments such as certificates of deposit and U.S. government securities

What backs the money supply?

• “Backed” (guaranteed) by government’s ability to keep the value of money relatively stable

• Money as debt

  • Paper money is the circulating debt of the Federal Reserve Bank

  • Managing the money supply is more sensible than linking it to gold or to some other commodity whose supply might change arbitrarily and capriciously

• Value of money

  • Acceptability - Currency and checkable deposits are money because people accept them as money

  • Legal tender - Paper money is a valid and legal means of payment of any debt that was contracted in dollars

  • Relative scarcity

• Money and prices

  • The amount a dollar will buy varies inversely with the price level

  • Runaway inflation may significantly depreciate the value of money between the time it is received and the time it is spent

  • People will use money as a store of value only as long as there is no sizable deterioration in the value of that money because of inflation

• Stabilizing money’s purchasing power

  • Rapidly rising price levels (rapid inflation) and the consequent erosion of the purchasing power of money typically result from imprudent economic policies

  • US monetary authorities must maintain the purchasing power of the dollar

Federal Reserve System - Directs the activities of the 12 Federal Reserve Banks, which in turn control the lending activity of the nation’s banks and thrift institutions

• Centralization and public control are essential for an efficient banking system

• Board of Governors - Central authority of the U.S. money and banking system

• Federal Reserve Banks - Blend private and public control, collectively serving as the nation’s central bank

  • Each bank serves a district

  • Quasi-public banks

  • Not motivated by profit

  • Accepts deposits + make loans to banks + thrifts

  • Issue currency

Federal Open Market Committee (FOMC) - Aids the Board of Governors in conducting monetary policy

• Directs purchase + sale of gov’t securities

Fed functions + the money supply

• Issue currency

• Set reserve requirements + holding reserves

• Lend money

• Provide check collection

• Act as fiscal agent

• Supervise banks

• Control money supply (the Fed buying and selling government bonds)

  • Buying bonds increases the money supply, while selling bonds decreases the money supply

Federal reserve independence → Protected from political pressures

Relative decline of banks + thrifts

• Declining shares of banks + thrifts

• Channeling more savings towards other financial institutions

Convergence of services provided by financial institutions

• Financial institutions can merge + sell each other’s products

• Will encourage financial innovation

More globalization of financial markets

Electronic payments - Used to replace currency and checks to buy products, pay bills, pay income taxes, transfer bank funds, and handle recurring mortgage and utility payments