Chapter 10: Money, the Federal Reserve, and the Interest Rate

What Is Money?
- Money serves three primary functions:
- Means of Payment (Medium of Exchange):
  - Direct exchange of goods known as barter, which requires a double coincidence of wants (both parties must have what the other wants)
  - Medium of exchange is what sellers generally accept and buyers generally use for transactions.
- Store of Value:
  - An asset that retains purchasing power over time.
  - Liquidity: The characteristic that allows money to be easily exchanged for goods; it is readily accepted and portable.
  - Disadvantage: The value of money can decrease with inflation, affecting its effectiveness as a store of value.
- Unit of Account:
  - A standard measure or system used for quoting prices and valuing goods.

Definitions:
- Commodity Monies: Items that serve as money and have intrinsic value, e.g., gold, silver.
- Fiat Money (Token Money): Items that have no intrinsic value but are sanctioned as money by government decree.
- Legal Tender: Money that must be accepted in settlement of debts due to government regulation.
Inflation and Currency Debasement:
- Currency Debasement: Occurs when the supply of money is increased rapidly, diminishing its value.

M1: Transactions Money:
- Definition: M1 includes money that is directly usable for transactions.
- Components of M1 (as of January 2024):
- Currency held outside banks
- Demand deposits
- Traveler's checks
- Other checkable deposits
M2: Broad Money:
- Definition: M2 includes M1 plus near monies.
- Near Monies: Close substitutes for transactions money, such as savings accounts and money market accounts.
- M2 Total (as of March 2018)
- Components: M1 + Savings accounts + Money market accounts + Other near monies

Beyond M2:
- Broader definitions may include the credit card credit available as money, but the focus remains on transactions money (M1).

Historical Perspective (Goldsmiths):
- Origin of banking can be traced to goldsmiths in the 15th and 16th centuries:
- Gold deposits led to issuing receipts that effectively served as paper money.
- The over-issuance of receipts without proportional gold backing increased the money supply.
- Run on a Bank: A situation where numerous depositors withdraw their funds simultaneously, often due to fear of insolvency.
Regulatory Modern Banking:
- Banks today have a Required Reserve Ratio, a legal minimum amount of reserves they must keep relative to deposits, contrasting past practices without formal requirements.

Accounting Overview:
- Assets: What a bank owns, primarily comprised of loans made.
- Liabilities: What a bank owes, primarily from deposits.
- Net Worth: Value of the bank to its shareholders, calculated as Assets - Liabilities.
Reserves:
- Comprise amounts held at the Federal Reserve and vault cash.
- The Required Reserve Ratio stipulates what percentage of deposits must be kept as reserves.

Excess Reserves:
- Defined as the difference between a bank's actual reserves and required reserves.
- Loans create deposits, hence expanding the money supply.

A crucial concept in banking, stating that:
- The increase in bank reserves results in greater than proportional increases in the total money supply.
- Money Multiplier: Defined as the multiple of deposits attributed to an increase in reserves, expressed mathematically as:
  ext{money multiplier} = rac{1}{ ext{required reserve ratio}}

Founded in 1913, the Federal Reserve (Fed) serves as the central bank of the United States, with key milestones in the 1930s.
Board of Governors: The central decision-making body of the Fed, independent from direct political influence.
Federal Open Market Committee (FOMC): Comprises members who set monetary policy regarding money supply and interest rates.
- Open Market Desk: Location where government securities are managed by the Fed.

Roles:
- Control of the money supply.
- Clearing payments between banks.
- Providing emergency funding to banks in financial distress (lender of last resort).
- Management of foreign exchange and reserves.

The amount of money held is influenced by:
- Transaction Motives: Positively correlating with transaction size.
- Interest Rates: Negatively correlating, since higher rates represent an opportunity cost for holding money.

Interest-bearing securities are sold by entities borrowing funds, having both a face value and a fixed interest payment.
There exists an inverse relationship between interest rates and security prices: as interest rates increase, existing security prices decrease.

As of March 6, 2024:
- Assets: Total includes gold, U.S. Treasury securities, mortgage-backed securities, etc. Total assets are $7,589 billion.
- Liabilities: Include currency in circulation, reserve balances, etc. Total liabilities equal assets, reflecting balanced accounting practice.

Changed operational tools post-crisis include interest payments on reserves held by the Fed. Traditional mechanisms like open market operations have remained less effective in this new monetary environment.

The Fed's primary tool for controlling short-term interest rates has significantly evolved since 2008, moving from open market operations to managing interest on reserves.

Important terms include:
- Barter, Commodity Monies, Currency Debasement, Federal Open Market Committee (FOMC), Federal Reserve Bank (the Fed), Fiat Money (Token Money), Legal Tender, Lender of Last Resort, Liquidity, M1, M2, Medium of Exchange, Near Monies, Open Market Desk, Reserves, Run on a Bank, Store of Value, Unit of Account.
Equations:
- ext{M1} = ext{Currency held outside banks} + ext{Demand Deposits} + ext{Traveler's Checks} + ext{Other Checkable Deposits}
- ext{M2} = ext{M1} + ext{Some Savings Accounts} + ext{Some Money Market Accounts}
- ext{Assets} = ext{Liabilities} + ext{Net Worth}