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Macroeconomics: Money, Banking, and the Federal Reserve

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  • What is money according to economists?

    Money is any asset generally accepted in exchange for goods, services, or payment of debts.

  • What are the four primary functions of money?
    • Medium of exchange
    • Unit of account
    • Store of value
    • Standard of deferred payment
  • What characteristics must a good have to serve as money?
    • Acceptable to most people
    • Standardized quality
    • Durable
    • Valuable relative to weight
    • Divisible
  • What is commodity money?

    Money that has value independent of its use as money, e.g., gold, silver, cowrie shells, animal pelts.

  • What is fiat money?

    Money authorized by a central bank or government that is not backed by a commodity and has value by government decree.

  • What is the main advantage and risk of fiat money?

    Advantage: Central banks can create money flexibly. Risk: It depends on public confidence; loss of trust makes it worthless.

  • What are M1 and M2 money supply measures?

    M1 includes currency and checking deposits; M2 includes M1 plus savings deposits, small time deposits, and money market funds.

  • Are debit and credit cards considered money?

    Debit cards access checking accounts (money), but credit cards are short-term loans and not money.

  • How do banks create money?

    By lending out a portion of deposits (fractional reserve banking), banks create new checking deposits, expanding the money supply.

  • What is the money multiplier?

    The ratio of the money supply to the monetary base, showing how deposits multiply through the banking system.

  • Why has the money multiplier become unstable since 2007?

    Due to changes in banks' reserve holdings and currency preferences, reducing the Fed's control over the money supply.

  • What role does the Federal Reserve play in preventing bank panics?

    The Fed acts as a lender of last resort, providing loans to banks to pay depositors and stop bank runs.

  • What is a bank run and a bank panic?

    A bank run is when many depositors withdraw funds simultaneously; a bank panic is when many banks experience runs at once.

  • What is the Federal Deposit Insurance Corporation (FDIC)?

    A government agency that insures bank deposits up to \$250,000 to limit bank panics.

  • What is moral hazard in banking?

    When banks take excessive risks because they expect government bailouts if they fail.

  • What is securitization in banking?

    The process of transforming loans into tradable securities, allowing banks to sell loans and raise funds.

  • What is the shadow banking system?

    Nonbank financial firms like investment banks, hedge funds, and money market funds that provide credit outside traditional banks.

  • What is the quantity theory of money?

    A theory linking money supply, velocity, price level, and real output via the equation \(M \times V = P \times Y\).

  • What does the quantity theory say about inflation?

    Inflation rate equals money supply growth minus real output growth, assuming constant velocity.

  • What causes hyperinflation according to the quantity theory?

    Very high inflation occurs when the money supply grows much faster than real GDP, often due to government financing deficits by money creation.

  • Give an example of historical hyperinflation.

    Germany in the early 1920s experienced hyperinflation when the government expanded money supply to pay war reparations, making the mark worthless.