Money

• Has three principle uses
  1. Medium of exchange
  2. Unit of account
  3. Store of value
• Without money we’d have to barter, or trade directly
• M1: the sum of current held outside of banks, traveler’s/cashier’s checks, money orders, and checking account balances (by businesses and individuals)
• M2: M1 plus assets that are useable in making payments but at a greater cost, like savings deposits

Cards

Checks, credit cards, debit cards are not themselves money, but rather a form of ID. The actual bank deposits they pull from is the actual money.

Virtual Commercial Bank Example

• Government issues $1M
• All people must deposit all money into the commercial bank
  • Deposits of liability for the bank
  • The dollars are an asset
  • They are also the bank’s reserves
  • Reserves aren’t part of the money supply, but deposits are
• Initially all $1M is deposited and held by bank, 100% reserve banking
• Assume then only 10% required RD ratio
  • Bank can lend out $900,000 as loans
  • Keeps only $100,000 in reserves
  • All $900,000 lent out must be deposited back into the bank
  • So there is $1.9M in total deposits, $1M in new reserves, $900k in loans which are assets
• This continues on and on until eventually the series is exhausted and we’ve reached the actual RD ratio
• This will be 1/0.1 = 10x money multiplier on the amount of physical money

Commercial Banks and Creation of Money

• Bank reserves: cash help by banks for purpose of meeting depositor withdrawals and payments
• 100% reserve banking: when bank holds 100% of their deposits as liabilities
• Reserve-deposit ratio: reserves/deposits
• Fractional reserve system: banks hold only a fraction of of deposits as reserves, loan out the rest
• Money multiplier: the amount by the which the physical currency is multiplied to reach the money supply $$\frac{1}{\text{Reserve-deposit ratio}}$$
• Money supply: total value of money available in an economy at a point in time; equals currency held + bank deposits
  • Note that money supply can only expand under banks due to the idea that not everyone must have their money set aside for them at all times. This lag allows the money supply to rise as banks lend out their money back into the economy as available funds, but they’re still responsible for allowing that individual access to their funds whenever they might want to withdraw. So should all individuals demand their money back at a given point in time, the money supply would come down to the supply of physical cash.

Federal Reserve

• The Fed is the central bank of the US
• Responsibilities:
  • Conduct monetary policy
  • Oversight and regulation of financial markets
• Began operations in 1914
  • Don’t attempt to maximize profit
  • Promote public goals like econ growth, low inflation, smooth market function
• Motivation was to stabilize financial markets and economy
• Helps to prevent bank panics (people rushing to take out their money) by
  • Supervising and regulating banks
  • Loaning funds to banks when needed
• Bank panics of 1930-1933
  • Money supply decreased, severity of Great Depression increased
  • No federal deposit insurance so people held cash
  • Banks respond by increasing RD ratio due to bankruptcy fears, further decreasing money supply

FDIC

• Congress created the Federal Deposit Insurance Corporation (FDIC) in 1934
• Ensures deposits of $250,000 or less will be repaid even if bank closes
• Helps prevent bank panics, but means depositors don’t care as much about what banks are doing with their money since it’s insured

Controlling the Money Supply with Open Market Purchase

• Increasing:
  • The Fed purchases gov. bonds from public, giving the people cash
  • People deposit this money into banks
  • This increase bank reserves
  • The money supply increases, as it’s a multiple of the reserves
• Decreasing:
  • Fed sells bonds to public
  • The Fed receives checks for these bonds (or can think of it as cash from the bond buyers)
  • When these checks clear (or if thinking of it as cash, the money has already been withdrawn), money leaves bank accounts
  • Money supply falls due to lower reserves

Money and Prices

• In the long run, inflation is almost always caused by too much money chasing too few goods
• In long run, money supply is directly proportional to prices
• Velocity: the speed at which money circulates, number of times typical dollar changes hands in a year $$\text{Velocity} = \frac{\text{Value of transactions}}{\text{Money stock}} = \frac{\text{Nominal GDP}}{\text{Money stock}} = \frac{P \text{(price level)} \times Y \text{(real GDP)}}{M \text{(money supply)}}$$