Money A medium of exchange, and the final means of payment.

A unit of account: the units the money is counted in. E.g. dollars. A unit of account measures and records economic value.

Liquidity Money provides the service of liquidity: being able to exchange the asset for goods immediately.

Commodity money Money with non-monetary value. Examples: gold, silver. Gold standard: the widespread use of gold as commodity money.

Fiat money Money not based on any commodity. Established by law, legal tender. Currency: coins and paper dollars. Demand deposits: checking accounts.

Measuring the money supply M1: currency and demand deposits. M2: M1 + savings accounts + small time deposits + personal money market accounts. M3: M2 + large time deposits + institutional money market accounts. Which best measures money?

MZM: money zero maturity MZM = M2 + institutional money market accounts - small time deposits.

The Federal Reserve Central bank: a government agency that controls the money supply, regulates banks, and acts as a lender of last resort. Fed was created in Chairman and board are appointed by the president with Senate approval.

Free banking Free-market banking: no central bank, no deposit insurance, no restrictions on branches, no reserve requirements. There is real money and money substitutes such as bank notes and demand deposits. Bank notes can be exchanged for real money at a fixed rate.

The Fed Chairman: Ben Bernanke. 12 regional Federal Reserve Banks. They are bankers’ banks. Banks may borrow from the Fed. Banks have deposits (reserves). Federal Reserve Bank of San Francisco.

Monetary policy The expansion of the money supply. The Fed targets the “federal funds rate,” interest rate on inter-bank loans. Federal Open Market Committee. Conducts “open market operations,” buying and selling bonds.

How the Fed creates money 1. Fed buys a bond, paying with a Fed check. 2. Seller deposits Fed check in his bank. 3. Bank deposits the check in its account in a Federal Reserve Bank. 4. The Fed covers the check by expanding the reserves of the bank. The Fed has created money out of nothing.

How much money? Fed’s policy problem: how much money to create? Too much: inflation. Too little: high interest rates, recession. The full effect is in the future. How can we know the optimal money supply?

The optimal money supply Taylor rule: i = 2%+  + (1/2)(y-y*)/y* + (1/2)(  -  *)  : inflation rate; y: real GDP y* GDP at natural rate of employment.  *: inflation target. But Fed does not follow it, and there is no proof it is optimal.

The Fed’s problem The optimal money supply and interest rate are unknowable. Only a free market can set a rate which balances savings and investment. Errors in the money supply create inflation, recessions, uncertainty. Free banking could let the market set them.

T Accounts Asset: something one owns. Liability: a debt that one owes. Deposit creates an asset and a liability. Fractional reserve banking: only a fraction of deposits has to be kept as required reserves.

Reserves Excess reserves: deposits beyond required reserves; can be loaned out. Every bank loan creates money. Deposits and withdrawals do not change the money supply. Loans get deposited back into the banking system, and then loaned again.

The money multiplier MM = 1/rr The eventual creation of money is 1/rr times the initial creation by the Fed. The discount rate: interest rate the fed sets when it loans money to banks. When the Fed loans money, it creates that money by raising the bank’s reserves.