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Economists use the word "money" to refer to

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those assets regularly used to buy goods and services.

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Money is consisted of cash, which is ____ by definition, as well as other highly liquid assets.

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liquid

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Currency in circulation

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is cash held by the public (debit card- considered money).

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Checkable bank deposits

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bank accounts on which people can write checks (also considered money)

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Money supply

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the total value of financial assets in the economy that are considered money.

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The *narrowest* definition of "money supply" (M1) considers only the most liquid assets to be money (3):

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1. Currency in circulation ($1 bills, $5 bills) 2. Traveler's checks 3. Checkable/demand bank deposits

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Money plays three *roles*:

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1. Medium of exchange (3) 2. a Store of value, 3. a Unit of account.

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Medium of Exchange

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an asset that individuals use to trade for goods and services rather than for consumption

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Example of the problem of finding a "double coincidence of wants" or *medium of exchange*

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In a barter system, a cardiac surgeon and an appliance store owner could trade only if the store owner happened to want a heart operation and the surgeon happened to want a new refrigerator.

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In order to act as a medium of exchange, money must also be a:

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store of value

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Store of Value

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a means of holding purchasing power over time (a necessary but not distinctive feature of money).

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Unit of Account

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the commonly accepted measure individuals use to *set prices and make economic calculations*.

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Example of unit of account:

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during the Middle Ages, peasants typically were required to provide landowners with goods and labor rather than money. A peasant might, for example, be required to work on the lord's land one day a week and hand over one-fifth of his harvest.

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Types of Money (3):

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1. Commodity money 2. Commodity-backed money 3. Fiat money

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Commodity money

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is a *good* used as a medium of exchange that has intrinsic value in other uses (normally gold or silver).

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WW2 example of alternative uses of *commodity money*:

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cigarettes, which served as money in World War II prisoner of war camps, were also valuable because many prisoners smoked. Gold was valuable because it was used for jewelry and ornamentation, aside from the fact that it was minted into coins.

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Commodity-backed money

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is a medium of exchange with *NO intrinsic value* whose ultimate value is *guaranteed by a promise* that it can be converted into *valuable* goods.

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TRUE OR FALSE: Commodity-backed money uses resources more efficiently than simple commodity money (like gold), because it ties up fewer valuable resources.

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True

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Example of commodity-backed money:

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By 1776, the year in which the United States declared independence and Adam Smith published The Wealth of Nations, there was widespread use of paper money in addition to gold or silver coins. Unlike modern dollar bills, however, this paper money consisted of notes issued by private banks, which *promised to exchange their notes for gold or silver coins* on demand.

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In a famous passage in The Wealth of Nations, Adam Smith described *paper money* as a

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*"waggon-way through the air"* - (Smith was making an analogy between money and an imaginary highway that did not absorb valuable land beneath it).

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TRUE OR FALSE: A U.S. dollar bill isn't commodity money, and it isn't even commodity-backed.

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True (Rather, its value arises entirely from the fact that it is generally accepted as a means of payment, a role that is ultimately decreed by the U.S. government).

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Fiat Money

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money whose value derives entirely from its official status as a means of exchange (ex: paper money)

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Fiat money has two major advantages over commodity-backed money:

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1. creating it doesn't use up any real resources beyond the paper it's printed on. 2. the supply of money can be adjusted based on the needs of the economy, instead of being determined by the amount of gold and silver prospectors happen to discover.

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Risks of Fiat Money (2):

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1. Counterfeiting (imitation/fraudulent money) 2. governments that can create money whenever they feel like it will be tempted to abuse the privilege.

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Historically, money first took the form of ____ money, then of _____ money. Today the dollar is pure ___ money.

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commodity, commodity-back, fiat

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Monetary Policy

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increases/decreases the *money supply* to speed up/slow down the overall economy

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Monetary Aggregate

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an overall measure of the money supply

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The money supply is measured by two monetary aggregates (calculated by the Fed. Reserve):

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M1 and M2

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*M1* includes: (assets you can use to buy groceries:)

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1. currency 2. traveler's checks 3. checkable/demand deposits

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*M2* (the broader definition of money supply) includes:

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1. Savings accounts/deposits 2. Near-moneys: a. Time deposits (CD's, *interest-bearing deposit* held by a bank or financial institution for a *fixed term*), b. Market funds.

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Near-moneys

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financial *assets that aren't directly usable as a medium of exchange* but can be readily *converted into* cash/checkable bank deposits, such as *savings accounts*.

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TRUE OR FALSE: Because currency and checkable deposits are directly usable as a medium of exchange, M1 is the *most liquid measure of money*.

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True

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Suppose you hold a gift certificate, good for certain products at participating stores. Is this gift certificate money?

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No. Although a gift certificate can easily be used to purchase a very defined set of goods or services, it cannot be used to purchase any other goods or services. A gift certificate is therefore not money, since it cannot easily be used to purchase all goods or services.

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A *bank* uses *liquid assets* in the form of ___ ____ to finance the illiquid investments (stocks, bonds,collectibles) of borrowers.

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bank deposits

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Bank Reserves

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currency in bank vaults and bank deposits held at the Federal Reserve (not held by the public, not part of currency in circulation).

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T-account

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a tool for analyzing a business's financial position by showing. *Bank Assets*: reserves and loans. *Bank Liabilities*: deposits *Customer Assets*: deposits. *Customer liabilities*: loans

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TRUE OR FALSE: banks are required by law to maintain assets larger by a specific percentage than their liabilities.

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True (ex: First Street Bank holds reserves equal to 10% of its customers' bank deposits).

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Reserve Ration (rr)

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the fraction of bank deposits that a bank holds as reserves

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The Federal Reserve does (3):

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1. serve as a bank regulator 2. conduct monetary policy 3. act as a lender of last resort

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To understand why banks are regulates, let's consider a problem banks can face:

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bank runs

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Banks convert most of their depositors' funds into ____ made to borrowers.

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Loans- that's how banks earn revenue: by charging interest on loans. (illiquid)

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Bank run

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a phenomenon in which many of a bank's depositors try to withdraw their funds due to fears of a bank failure (ex: in the movie "What a Wonderful Life", the scene where everyone is at the bank demanding their money)

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Bank Regulation- A system designed to protect depositors and the economy against bank runs, has four main features:

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1. deposit insurance 2. capital requirements 3. reserve requirements 4. the discount window

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Deposit insurance

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guarantees that a bank's depositors will be paid even if the bank can't come up with the funds, up to a maximum amount per account.

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Capital Requirements

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To reduce the incentive for excessive risk taking, regulators require that the owners of banks hold substantially more assets than the value of bank deposits. (ex: gold/silver)

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Reserve Requirements

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rules set by the Federal Reserve that specify the minimum reserve ratio for banks. (ex: in the US, the minimum reserve ratio for checkable bank deposits is 10%)

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the Discount Window

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is an arrangement in which the Federal Reserve stands ready to lend money to banks in trouble (*Fed act as a lender of last resort*)

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Excess reserves

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are a bank's reserves over and above its required reserves

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The Federal Reserve controls the *sum* of bank reserves and currency in circulation, called the

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monetary base

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Money Multiplier

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is equal to the money supply divided by the monetary base.

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If the reserve ratio is 10 percent, the money multiplier is

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10 1/0.1= 10

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The Federal Reserve is a *central bank*:

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an institution that oversees and regulates the banking system and controls the monetary base.

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If the central bank in some country lowered the reserve requirement, then the money multiplier for that country would

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increase.

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The Federal Reserve system consists of two parts:

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1. the Board of Governors (7) 2. the regional Federal Reserve Banks (12)

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The Board of Governors is constituted like a government agency: its 7 members are appointed by the president and must be approved by the Senate (14-year terms)

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***

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The 12 Federal Reserve Banks each serve a region of the country, proving various banking/supervisory services. One of their jobs, is to audit the books of private-sector banks to ensure their financial health. Each regional bank is run by a board of directors chosen from the local banking and business community.

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***

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The Federal Reserve Bank of New York plays a special role: it carries out

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Open-market operations (usually the main tool of monetary policy).

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Decisions about *monetary policy* are made by which group within the Federal Reserve System?

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the FOMC (the Federal Open Market Committee)

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FOMC consists of:

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the Board of Governors plus five of the regional bank presidents.

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The Fed has three main policy tools at its disposal:

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1. reserve requirements 2. the discount rate 3. open-market operations (most important)

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the Federal Funds Market

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allows banks that fall short of the reserve requirement to borrow funds/reserves from banks with excess reserves.

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the Federal Funds Rate

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the interest rate determined in the federal funds market (plays a key role in modern monetary policy)

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interest rate

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the price of borrowing money

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Discount Rate

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is the rate of interest the Fed charges on loans to banks (banks can borrow from the Fed)

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To increase the money supply, the Fed could

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decrease the discount rate (or decrease the reserve requirements)

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The Federal Reserve holds its *asset* mostly in short-term government bonds called

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U.S. Treasury bills (left side of T-account)

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The Fed liabilities are the

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monetary base- currency in circulation + bank reserves (right side of T-account)

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when the Fed buys or sells short term government bonds, Treasury Bills (normally through a transaction with commercial banks)

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open market operations

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an Open-Market Operation

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is a purchase or sale of government debt by the Fed.

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An open-market purchase

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*increases* the number of *dollars* in the hands of the public and *decreases* the number of *bonds* in the hands of the public.

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Feds open-market purchase implies?

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an *increase in money supply* and *fall of interest rate*

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The Glass-Steagall Act of 1933 separated banks into two categories:

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1. Commercial banks 2. Investment banks

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commercial banks

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accepts deposits and is covered by deposit insurance.

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investment bank

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trades in financial assets and is not covered by deposit insurance.

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a Savings and Loan (thrift)

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is another type of deposit-taking bank, usually specialized in issuing home loans.

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In the _______(thrift) crisis of the 1970s and 1980s, insufficiently regulated S&Ls incurred huge losses from risky speculation.

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savings and loan (S&L) crisis

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During the mid-1990s, the hedge fund LTCM used huge amounts of ______ to speculate in global markets, incurred massive losses, and collapsed.

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leverage

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