Banks, Money, and the Federal Reserve System: Study Notes

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Chapter 14: Banks, Money, and the Federal Reserve System

14.1 What Is Money, and Why Do We Need It?

Money is a foundational concept in macroeconomics, serving as a medium for exchange and enabling economic specialization. Before the invention of money, trade relied on barter, which required a double coincidence of wants—both parties needing what the other offered. The development of money greatly facilitated trade and economic growth.

Definition of Money: Any asset generally accepted in exchange for goods, services, or payment of debts.
Asset: Anything of value owned by a person or firm.

The Four Primary Functions of Money

Medium of Exchange: Money is widely accepted as payment for goods and services.
Unit of Account: Money provides a standard measure of value, making price comparisons possible.
Store of Value: Money allows value to be stored and deferred for future consumption; it is liquid and easily exchanged.
Standard of Deferred Payment: Money enables transactions across time, with predictable purchasing power.

What Can Serve as Money?

For a good to function as money, it must possess certain characteristics:

Acceptability: Usable by most people.
Standardized Quality: All units are alike.
Durability: Value is not lost by wearing out.
Valuable Relative to Weight: Easily transported in large quantities.
Divisibility: Usable for both small and large purchases.

Commodity Money

Has value independent of its use as money.
Examples: Cowrie shells (Asia), precious metals (gold, silver), animal pelts (colonial North America), cigarettes (prisons).

Paper Money to Fiat Money

Paper Money: Originally exchangeable for commodities (e.g., gold).
Fiat Money: Authorized by a central bank or government, not backed by a commodity.
The Federal Reserve issues fiat money in the U.S.

Fiat Money—Advantages and Disadvantages

Advantage: Flexibility for central banks; not tied to commodity reserves.
Disadvantage: Relies on public confidence; if trust erodes, money loses value.

Examples and Applications

Some businesses (e.g., Dig Inn) do not accept cash, preferring digital payments for efficiency and security.
Covid-19 accelerated the shift toward cashless, contactless payments.

14.2 How Is Money Measured in the United States Today?

Measuring the money supply is essential for understanding monetary policy and economic activity. The U.S. uses two main definitions:

M1: Currency in circulation + checking account deposits + savings account deposits.
M2: M1 + small-denomination time deposits + noninstitutional money market fund shares.

How Big Is the Money Supply?

As of September 2023: M1 ≈ $18.1 trillion; M2 ≈ $20.8 trillion.
About 13% of M1 is currency; most U.S. currency is in $100 bills.
High U.S. currency holdings are partly due to global use and underground economies.

M1 versus M2: Which One Should We Use?

Recent changes have made M1 and M2 similar; both include checking and savings balances.
Banks play a key role in managing these balances and thus the money supply.

Debit and Credit Cards

Debit Cards: Access checking accounts directly; the card itself is not money.
Credit Cards: Represent short-term loans; not considered money until paid off.

Bitcoin and Digital Money

Bitcoins and other digital currencies are not currently included in official measures of the money supply.
If their use becomes widespread, they may be considered in the future.

14.3 The Role of Banks in the Economy

Banks are central to the creation and management of money in the economy. They operate as profit-seeking firms and facilitate the flow of funds between savers and borrowers.

Money held in checking accounts exceeds actual currency in circulation, indicating banks create money.
Banks use deposits to make loans and investments.

Bank Balance Sheet

Assets (in billions)	Liabilities & Stockholders' Equity (in billions)
Reserves: $135	Deposits: $1,000
Loans: $900	Short-term borrowing: $400
Securities: $700	Long-term debt: $360
Buildings & equipment: $15	Other liabilities: $275
Other assets: $550	Stockholders' equity: $265
Total assets: $2,300	Total liabilities & equity: $2,300

Reserves

Deposits kept as cash in vaults or at the Federal Reserve.
Previously, banks were required to hold a fraction of deposits as reserves; this requirement was eliminated in March 2020.

The Economic Importance of Bank Lending

Reducing Transactions Costs: Banks use economies of scale and specialization to lower costs for borrowers and lenders.
Reducing Information Problems: Banks address asymmetric information through statistical analysis and relationship banking.

Fintech and Interest Rate Ceilings

Fintech firms facilitate peer-to-peer lending online, charging fees for loan facilitation and payment collection.
Proposals to cap credit card interest rates may limit access to credit for some borrowers.

Do Banks Create Money?

When a deposit is made, the bank's reserves and deposits increase equally.
In a fractional reserve system, banks lend out a portion of deposits, creating new money through the expansion of checking account balances.

Additional info:

Further details on the money multiplier, the Federal Reserve System, and the quantity theory of money are covered in subsequent slides and textbook sections.