• Barter: the exchange of one good or service for another to obtain the things they need

• Double coincidence of wants: the unlikely occurrence that two people each have a good or service that the other wants

• The existence of money makes trade easier

29-1 The Meaning of Money

• Money: the set of assets in an economy that people regularly use to buy goods and services from other people

• Money is related to wealth

The Functions of Money

• Money serves as a

  • Medium of exchange: an item that buyers give to sellers when they want to purchase goods and services

  • Unit of account: the yardstick people use to post prices and record debts

  • Store of value: an item that people can use to transfer purchasing power from the present to the future

• Liquidity: the ease with which an asset can be converted into the economy’s medium of exchange

  • Since money is the designated medium of exchange, it is the most liquid

  • When allocating wealth, the liquidity of each asset has to be balanced

The Kinds of Money

• Commodity money: money that takes the form of a commodity with intrinsic value

• Intrinsic value means an item would have value even if it were not used as money

  • Ex: Gold, because it is used in the industry. When an economy uses gold as money, it operates under a gold standard

• Fiat money: money without intrinsic value that is used as money by government decree

  • Ex: The US dollar

Money in the US Economy

• Money stock: the quantity of money circulating in the economy

• Currency: the paper bills and coins in the hands of the public

• Demand deposits: balances in bank accounts that depositors can access on demand by writing a check

29-2 The Federal Reserve System

• Federal Reserve (Fed): the central bank of the United States

• Central bank: an institution designed to oversee the banking system and regulate the quantity of money in the economy

The Fed’s Organization

• Lender of last resort: a lender to those who cannot borrow anywhere else. This is in reference to the Fed

• Money supply: the quantity of money available in the economy

• Monetary policy: the setting of the money supply by policymakers in the central bank

The Federal Open Market Committee

• The Federal Open Market Committee makes decisions. Through this, the Fed has the power to increase or decrease the number of dollars in the economy

• Open-market operation: the purchase and sale of US government bonds. This is the Fed’s primary tool to change the money apply

• Prices rise when the government prints too much money. The Fed determines the inflation in the long run

29-3 Banks and the Money Supply

The Simple Case of 100-Percent-Reserve Banking

• Reserves: deposits that banks have received but have not loaned out

• A 100-percent-reserve-banking is an imaginary economy where all deposits are held as reserves

• A balance sheet is an accounting statement where the assets and liabilities are equivalent

• If banks hold all deposits in reserve, banks do not influence the supply of money

Money Creation with Fractional-Reserve Banking

• Fractional-reserve banking: a banking system in which banks hold only a fraction of deposits as reserves

• Reserve ratio: the fraction of deposits that banks hold as reserves

• The Fed sets a minimum amount of reserves that banks must hold. This is called a reserve requirement

• Banks can hold above the reserve requirement, called excess reserves

• When banks hold only a fraction of deposits in reserve, the banking system creates money

The Money Multiplier

• Money multiplier: the amount of money the banking system generates with each dollar of reserves

• The money multiplier is the reciprocal of the reserve ratio

• The higher the reserve ratio, the less of each deposit bank loan out, and the smaller the money multiplier

Bank Capital, Leverage, and the Financial Crisis of 2008-2009

• Bank capital: the resources a bank’s owners have put into the institution

• Leverage: the use of borrowed money to supplement existing funds for purposes of investment

• Leverage ratio: the ratio of assets to bank capital

• A bank is insolvent when it is unable to pay off its debt in full since its assets fell below its liabilities

• Capital requirement: a government regulation specifying a minimum amount of bank capital

• A credit crunch is a shortage of capital that induces banks to reduce lending

29-4 The Fed’s Tools of Monetary Control

How the Fed Influences the Quantity of Reserves

• Open-Market Operations

• Open-Market Operations: the purchase and sale of US government bonds by the Fed.

  • To reduce the money supply, the Fed sells government bonds to the public. The public affords this with currency and bank deposits, which reduces the money in circulation

• Fed Lending to Banks:

  • Typically, banks borrow from the Fed’s discount window and pay interest on that loan

  • Discount rate: the interest rate on the loans that the Fed makes to banks

  • Term Action Facility: the quantity of funds the Feds wanted to lend to banks, where banks bid on those funds. ran from 2007-2010

  • The Fed lends to banks to help financial institutions **

How the Fed Influences the Reserve Ratio

• Reserve Requirements

  • Reserve requirements: regulations on the minimum amount of reserves that banks must hold against deposits

  • An increase of reserve requirements raises the reserve ratio, lowers the money multiplier, and decreases the money supply

  • When the Fed changes its requirements, it affects banks.

• Paying Interest on Reserves

  • When a bank holds reserves at the Fed, the Fed now pays the bank interest on those deposits

Problems in Controlling the Money Supply

• The Fed’s control of the money supply is not precise, so problems can still arise

• The Fed does not control the amount of money that households choose to hold as deposits in banks

• The Fed does not control the amount that bankers choose to lend, therefore the Fed cannot be sure of how much money the banking system will create

The Federal Funds Rate

• Federal funds rate: the interest rate at which banks make overnight loans to one another

• The discount rate is an interest rate paid to borrow directly from the Fed. The federal funds rate consists of borrowing reserves from another bank rather than from the Fed

• Interest rates of different loans are strongly correlated with one another, so the federal funds rate has an impact on the economy

• Open-market purchases lower the federal funds rate. Open-market sales raise the federal funds rate