Money & Banking

Question: What is money (what is the economic definition of money)? Answer: Economists define money as anything generally accepted in exchange for commodities and in repayment of debt. For this reason, economists call money a ‘medium of exchange.’

Three Functions of Money 1.Medium of Exchange – asset individuals acquire for the purpose of trading goods and services rather than for consumption 2.Store of Value – means of holding value over time 3.Unit of Account – used to place a value on a good or service

Types of Money commodity money – good used as a medium of exchange that has intrinsic value in other uses commodity-backed money – good used as a medium of exchange that has no value in other uses fiat money – an official medium of exchange, usually declared by the government

Question: It is fair to ask, how can something with no intrinsic value be an asset? Answer: Fiat money has value simply by virtue of the fact that people believe it has value! Fiat money maintains its value only so long as people believe that other people will accept it in exchange for commodities. In other words, the value of money is a self-fulfilling prophecy (that is, a social phenomenon that occurs because people believe it will occur).

Measuring Money (the Money Supply) Measuring money usually occurs with a money aggregate. There exist different money aggregates – each vary in their definition of money (usually via liquidity) Common Money Aggregates – M1 Money Supply – M2 Money Supply – M3 Money Supply* *M3 is not commonly used – in 2006, the US Federal Reserve Bank determined measuring M3 was no longer useful

August, 2008

“Inflation is always and everywhere a monetary phenomenon.” – Milton Friedman

The Federal Reserve System (U.S. Central Bank) Created in 1913 It is a private institution (not apart of the government) Consists of two main parts – Board of Governors 7 members (appointed by the President & confirmed by the Senate) each serving 14 year terms. The chair is appointed for 4 year terms. – 12 Regional Federal Reserve Banks

Board of Governors The seven members of the Board of Governors of the Federal Reserve System are nominated by the President and confirmed by the Senate. A full term is fourteen years. One term begins every two years, on February 1 of even- numbered years. A member who serves a full term may not be reappointed. A member who completes an unexpired portion of a term may be reappointed. All terms end on their statutory date regardless of the date on which the member is sworn into office. The Chairman and the Vice Chairman of the Board are named by the President from among the members and are confirmed by the Senate. They serve a term of four years. A member's term on the Board is not affected by his or her status as Chairman or Vice Chairman.

The Federal Reserve System

The Federal Reserve System (U.S. Central Bank) Acts as a lender of last resort Audits private sector banks to ensure “financial health” Provides check clearing services The Federal Reserve Bank of New York carries out open-market operations and its president is always on the Board of Governors The Fed conducts the nations monetary policy

The Federal Reserve System (U.S. Central Bank) The fed pays close attention to interest rates and attempts to set them prime rate – Interest rate banks charge their ‘best customers’ discount rate – Interest rate the Fed charges the banks federal funds rate – Interest rate banks charge each other (think of it as an overnight loan) Click for Current Rates

Question: How well does the Fed target the Federal Funds Rate?

Economic Tools of the Fed Question: How does the Fed control interest rates? Required Reserve Ratio (RRR) – Amount required to keep on hand The Discount Rate – Discount rate vs. federal funds rate (usually 1 percent higher than FFR) Open-Market Operations – Buying and selling of bonds Reserve Ratio Interest Rate (RR Interest Rate) – Interest on Required Reserve balances and Excess Reserve balances

Economic Tools of the Fed Increasing the Money Supply ↓ RRR ↓ Discount Rate Buy Bonds ↓ RR Interest Rate Decreasing the Money Supply ↑ RRR ↑ Discount Rate Sell Bonds ↑ RR Interest Rate

Money Demand (the opportunity cost of holding money) Shifts in the Money Demand Curve – Changes in the price level If prices are higher, you need more cash to make the same purchases – Changes in Real GDP If GDP increases, the number of goods and services bought and sold increases, thus you need more cash on your person to make the new purchases – Changes in Technology ATMs & online banking – Changes in Institutions In the past, some bank accounts weren’t legally allowed to pay interest