Money, Banking & The Federal Reserve: Comprehensive Class Notes

Core Concepts: Money & Its Functions

• Barter (direct exchange) – swapping goods/services for other goods/services; requires a double-coincidence of wants.
• Three official functions of money
• Medium of Exchange – sell your output for money, then use money to purchase other items; removes double-coincidence problem.
• Unit of Account – common measuring stick; today >90 % exists only as computer data, not as coin/paper.
• Store of Value – asset that keeps purchasing power over time, letting us accumulate wealth (unlike eggs that spoil). Example: buying a car through 60 monthly payments.

Types of Money

• Commodity Money – intrinsic value before it was money (gold, silver, cattle, salt).
• Representative Money – no intrinsic value, but redeemable for a commodity (e.g., gold certificates backed by bullion in Fort Knox).
• Fiat Money – value comes solely from government decree; U.S. currency has been pure fiat since 1971 (“full faith and credit…”).
• Current U.S. paper notes therefore = fiat money.

Measures of the U.S. Money Supply

• $M<em>1$ – currency & coin in circulation + checkable (demand) deposits + traveler’s checks.
• $M</em>2$ = M_1 + small time deposits, savings deposits, money-market mutual funds, etc. (Items that cannot be spent immediately but can be converted fairly quickly.)

Motives / Demands for Holding Money

• Transactions Demand – keep cash on hand to pay for routine spending (e.g., lunch at Taco Bell after class).
• Asset Demand – hold money simply to have it (liquidity/precaution), especially for retirement; not intended for immediate spending.
• Speculative Demand – hold cash so you can pounce on an unexpected opportunity. Instructor stories:
• $6 000 “dog-poop-brown” 1990 Corvette purchased from elderly neighbor because cash was on hand.
• Buying a proven Jet’s Pizza franchise for $200 000 that nets $10 000 / month.
→ All three demands are inter-related but conceptually distinct.

The Federal Reserve System

Structure

• Board of Governors (BoG) – 7 members, appointed by the U.S. President, staggered 14-yr terms (1 seat normally opens every 2 yrs).
• Federal Open Market Committee (FOMC) – BoG + 5 regional-bank presidents (NY + 4 others on rotating basis); sets/executes monetary policy by controlling the growth rate of loans → money supply.
• Federal Advisory Council – private bankers who brief BoG/FOMC on ground-level banking conditions.
• 12 Regional Reserve Banks – instructor-listed cities: Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St Louis, Minneapolis, Kansas City, San Francisco, (Dallas omitted in lecture). Currency letters A–L on bills identify issuing district.

Key Functions ("What the Fed Does")

Fiduciary / Caretaker of U.S. Currency – ultimate steward of the dollar.
Hold Reserve Balances for Member Banks – interest-bearing deposits at the Fed.
Fiscal Agent for the Federal Government –
• Accounts Payable → Fed writes checks for aircraft carriers, F-47 prototypes, etc.
• Accounts Receivable → IRS collects owed funds.
Supervise & Regulate Banks – enforces Congressional regulations; can fine institutions (example: $1 000 000 for refusing a legal withdrawal request).
Bankers’ Bank – provides to banks the same services your bank provides to you (clearing, settlements, emergency liquidity, etc.).

Bank Balance-Sheet Terminology

Symbol	Definition	Location
$DD$	Demand Deposits (your checking balance)	Liability
$TR$	Total Reserves (vault cash + Fed deposit)	Asset
$rr$	Required-Reserve Ratio (decimal)	Policy parameter
$RR$	Required Reserves $= rr \times DD$	Asset
$ER$	Excess Reserves $= TR - RR$	Asset
$CS$	Capital Stock – funds raised from initial share offering	Liability

• Reserves may sit only in two places: vault cash or a deposit at the Fed (the latter earns modest interest).
• Violation anecdote: bank that denies a lawful withdrawal can be fined ≈ $1 000 000 per occurrence.

How Banks Create Money (Simplified)

• When a bank issues a loan, it credits the borrower’s deposit account – simultaneously creating a loan (asset) and a matching deposit (liability).
→ Example: $15 000 car loan adds $15 000 to money supply (appears as Loans Receivable and Cash in Dealer’s Account).
• Monetary expansion hinges on excess reserves; higher RR or lower deposits shrink lending capacity.

Start-Up Bank Case Study (fictional but numerically detailed)

Initial Capitalization
• 30 investors contribute $25 \times 90\,000 = 2.25\text{ million}$
• Lead instructor contributes $0.75\text{ million}$
• $CS = 3\text{ million}$ (posts to liabilities)
• Asset side: $3\text{ million}$ cash.
Branch Network: 6 high-visibility mall branches; build-out $= 300\,000$ (capital equipment).
Opening-month Deposits: $DD = 10\text{ million}$ gathered from public.
Reserve Requirement (assume $rr = 12\%$ ):
• $RR = 1.2\text{ million}$ ; choose ½ in vault, ½ at Fed.
• $ER = 8.8\text{ million}$ available for lending/investment.
Loan Portfolio (Month 1)
• Auto loans 2 M @ 4.8 % (≈ $4/k-mo → $8 000/mo interest).
• Stafford student loans 2 M @ 6 % (≈ $5/k-mo → $10 000/mo; gov’t pays while student enrolled).
• Small-business & personal loans 4.8 M @ 7.2 % (≈ $6/k-mo → $28 800/mo).
• Fed deposit interest: 600 k @ 1.2 % annual ≈ $600/mo.
• Invest bank’s own 2.7 M in conservative MFS Corporate Bond fund @ 0.3 %/mo → $8 100/mo.
→ Total month-1 revenue ≈ $55 500.
Interest Paid on Deposits – offer competitive 0.72 % annual (≈ 0.06 %/mo): $10\text{ M} \times 0.0006 = 6\,000$ .
Net Month-1 Profit ≈ $49 500. If 3 % is distributed as cash dividend per investor share: $49\,500 \times 0.03 = 1\,485$ /investor for the first month (≈ $17 820 annualized).
Expansion Strategy – partner every branch with a nearby auto dealer for first-time-buyer loans, plus franchise/start-up loans; continuous reinvestment of growing ER magnifies earnings.

Indirect (Interest-Rate) “Crowding-Out” Effect

• When the Fed (or market forces) raise interest rates: borrowing costs rise → some firms cancel planned plants/stores/distribution centers → private investment spending “crowded out.”

Illustrative Anecdotes & Classroom References

• $30 bounced-check fee in Flint story.
• “Mork from Ork” mnemonic: $R \rightarrow RR \rightarrow RRR$ (said with Mork’s laugh: “na-nu na-nu!”).
• Cookie tradition on the instructor’s birthday; extra-credit index cards due Monday (small: 1 pt; big: 2 pts; two cards = 2 pts; bringing extras earns classmates’ gratitude).

Equations & Quick Reference

• Required reserves: $RR = rr \times DD$
• Excess reserves: $ER = TR - RR$
• Simple money multiplier (implicit): $\text{MM} = \dfrac{1}{rr}$ (not deeply discussed but good to recall).
• Monthly interest approximation:
– 4.8 % yr ≈ $4 per $1 000 per year? (instructor uses shortcut $4/k per month for class arithmetic).
– 6 % yr ≈ $5/k-mo; 7.2 % yr ≈ $6/k-mo.

Practical Take-Aways for the Exam

• Know definitions & examples of barter, medium of exchange, unit of account, store of value.
• Distinguish commodity vs. representative vs. fiat money; identify current U.S. money.
• Memorize components of $M<em>1$ and $M</em>2$ .
• Be able to label/compute transactions, asset, and speculative money demands.
• Recall Fed structure (7 BoG, 14-yr terms, FOMC role, 12 districts) and its five core functions.
• Work reserve-requirement problems: given $DD$ and $rr$ calculate $RR, ER,$ and lending capacity.
• Understand how loans simultaneously expand deposits and the money supply.
• Explain how higher interest rates can discourage investment (crowding-out).
• Familiarize yourself with real-world stories (brown Corvette, franchise purchase) to illustrate speculative demand.

Good luck reviewing — these notes are designed to replace the entire lecture if needed!