What Is Money and Why Do We Need It?

1. What Is Money and Why Do We Need It? Money Assets that people are generally willing to accept in exchange for goods and services or for payment of debts. Asset Anything of value owned by a person or a firm. The Functions of Money • • Medium of exchange: buy stuff with money • No need to barter • • Unit of account: post prices/keep books in money terms • • Standard of deferred payment: need money to pay debts • Store of value • Hold money on chance prices of other assets fall

2. What Can Serve as Money? Criteria for an asset to be a medium of exchange: 1 It must be acceptable to most people. 2 It should be of standardized quality. 3 It should be durable. 4 It should be valuable relative to its weight. 5 It should be divisible. Currency is fine… “fiat money” Checking account balances are just as good. Electronic “money” is even better. Precious metals serve when confidence falters. Commodity money.

3. Money without a Government? The Strange Case of the Iraqi Dinar Many Iraqis continued to use currency with Saddam’s picture on it, even after he was forced from power.

4. How Is Money Measured in the United States Today? M1: The Narrowest Definition of the Money Supply M1 includes means of payment: • Currency: paper money and coins in circulation. • “in circulation” means not held by banks or the government • 2 The value of all checking account deposits at banks • 3 The value of traveler’s checks 1 Because balances in checking accounts are in the money supply, banks play an important role in the way money supply increases and decreases. What about Credit Cards and Debit Cards? You haven’t paid until you write a check to your bank.

5. How Is Money Measured in the United States Today? M2: A Broader Definition of the Money Supply M1: The Narrowest Definition of the Money Supply

6. How Do Banks Create Money in a Fractional Reserve Banking System? • Reserves Deposits that a bank keeps as cash in its vault or on deposit with the Federal Reserve. • Required reserves Reserves that a bank is legally required to hold, based on its checking account deposits. • Required reserve ratio The minimum fraction of deposits banks are required by law to keep as reserves. • Excess reserves Reserves that banks hold over and above the legal requirement. • Banks buy interest yielding assets with deposits they don’t keep in reserves: • Gov’t securities, loans to households and firms

7. How Do Banks Create Money?

8. How Do Banks Create Money?

9. How Do Banks Create Money?

10. How Do Banks Create Money?

11. How Do Banks Create Money? Simple deposit multiplier The ratio of the amount of deposits created by banks to the amount of new reserves. Change in bank reserves RR x Change in deposits = • The Simple Deposit Multiplier versus the Real-World Deposit Multiplier: • Not everything that one bank lends gets deposited in other banks. • Much leaks out as currency holdings rather than deposits. • And banks may not lend to full extent the can…they hold excess reserves. Real world deposit multiplier is less than the simple multiplier.

12. The Federal Reserve System The Organization of the Federal Reserve System Federal Reserve Districts

13. How the Federal Reserve Manages the Money Supply Monetary policy The actions the Federal Reserve takes to manage the money supply and interest rates to pursue economic objectives. To manage the money supply, the Fed uses three monetary policy tools: 1 Open market operations: Fed buys and sells gov’t securities Federal Open Market Committee (FOMC) sets target federal funds rate. “Federal funds” are reserves that banks borrow and lend to each other. Fed buys bonds to increase the supply of reserves and lower the fed funds rate. 2 Discount policy: Fed lends to banks @ discount rate  injects reserves into banking system directly 3 Reserve requirements: lowering reserve requirement converts required reserves to excess reserves Two other actors—the nonbank public and banks— also influence the money supply.

14. The Quantity Theory of Money Connecting Money and Prices: The Quantity Equation M × V = P × Y Velocity of money The average number of times each dollar in the money supply is used to purchase goods and services included in GDP.

15. The Quantity Theory Explanation of Inflation We can transform the quantity equation from: to: Growth rate of the money supply + Growth rate of velocity = Growth rate of the price level (or inflation rate) + Growth rate of real output or Inflation rate = Growth rate of the money supply + Growth rate of velocity − Growth rate of real output If velocity is constant, then the growth rate of velocity is zero. This allows us to rewrite the equation one last time: Inflation rate = Growth rate of the money supply − Growth rate of real output

16. High Rates of Inflation Very high rates of inflation—in excess of hundreds or thousands of percentage points per year—are known as hyperinflation. Economies suffering from high inflation usually also suffer from very slow growth, if not severe recession.

17. The Quantity Theory of Money High Inflation in Argentina Money Growth and Inflation in Argentina

18. MakingtheConnection • The German Hyperinflation of the Early 1920s During the hyperinflation of the 1920s, people in Germany used paper currency to light their stoves.

19. K e y T e r m s M1 M2 Monetary policy Money Open market operations Quantity theory of money Required reserve ratio Required reserves Reserves Simple deposit multiplier Velocity of money Asset Bank panic Bank run Commodity money Discount loans Discount rate Excess reserves Federal Open Market Committee (FOMC) Federal Reserve System Fiat money Fractional reserve banking system