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

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

Money is a fundamental economic invention that facilitates trade, specialization, and economic development. Before money, societies relied on barter, which required a double coincidence of wants and was inefficient. The introduction of money allowed for easier transactions and greater economic specialization.

• Definition of Money: Any asset that people are generally willing to accept in exchange for goods and services or for payment of debts.

• Asset: Anything of value owned by a person or a firm.

• Barter: Direct exchange of goods and services without using money.

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.

• Store of Value: Money can be saved and used for future purchases; it is liquid and easily exchanged.

• Standard of Deferred Payment: Money enables transactions across time, with predictable value.

Characteristics of Acceptable Money:

• Acceptable to most people

• Standardized quality

• Durable

• Valuable relative to weight

• Divisible

Commodity Money: Has value independent of its use as money (e.g., gold, cowrie shells, animal pelts).

Fiat Money: Money authorized by a central bank or government, not exchangeable for commodities like gold.

Advantages: Flexibility for central banks.

Disadvantages: Relies on public confidence; loss of confidence can render fiat money useless.

Apply the Concept: Your Money Is No Good Here!

Some businesses, such as Dig Inn, have chosen not to accept cash, preferring mobile payments to speed up service and reduce robbery risk. Legally, firms are not required to accept currency for purchases, though debts are treated differently.

Many stores refuse large-denomination bills, and some countries are nearly cashless. The Covid-19 pandemic accelerated the shift toward contactless payments.

14.2 How Is Money Measured in the United States Today?

Money supply is measured using two main aggregates: M1 and M2. The distinction is important for understanding monetary policy and economic activity.

• M1: Currency in circulation, checking account deposits, and savings account deposits.

• M2: Includes M1 plus small-denomination time deposits and noninstitutional money market fund shares.

Money Supply Statistics (September 2023):

• M1: $18.1 trillion

• M2: $20.8 trillion

• 75% of U.S. paper currency is $100 bills

U.S. currency is widely held, sometimes in other countries due to lack of confidence in local currencies or to facilitate underground economies.

Debit and Credit Cards: Debit cards access checking accounts but are not money themselves. Credit cards provide short-term loans and are not counted as money.

Apply the Concept: Is Bitcoin Money?

Digital currencies and e-money (e.g., PayPal, Apple Pay) are increasingly trusted by consumers. Bitcoin is a decentralized digital currency, traded for other currencies and accepted by some merchants. Currently, Bitcoin is not included in official measures of the money supply, but this may change with increased adoption.

14.3 The Role of Banks in the Economy

Banks are profit-making firms that play a critical role in the economy by creating money and facilitating lending. They operate under a fractional reserve system, keeping less than 100% of deposits as reserves.

• Reserves: Deposits kept as cash in vaults or with the Federal Reserve.

• Fractional Reserve Banking: Banks lend out most deposits, keeping only a fraction as reserves.

Economic Importance of Bank Lending:

• Banks reduce transaction costs through economies of scale.

• Banks reduce information problems, especially asymmetric information, by evaluating borrower risk.

Fintech and Interest Rate Ceilings: New fintech firms facilitate peer-to-peer lending but may increase risky loans. Proposals to cap credit card interest rates aim to help borrowers but may restrict access to credit for some.

Do Banks Create Money?

Banks create money through the process of lending. When a deposit is made, banks lend out a portion, creating new deposits and expanding the money supply. This process is known as the money multiplier.

• Money Multiplier: Ratio of money supply to monetary base ().

• Instability in the money multiplier since 2007 has limited the Fed's control over the money supply.

Interest on Reserve Balances: Since 2008, the Fed pays interest on reserves, leading banks to hold more reserves.

Fluctuations in the Money Multiplier: Caused by changes in bank reserves and currency held by households and firms.

14.4 The Federal Reserve System

The Federal Reserve (Fed) is the central bank of the United States, established to prevent bank panics and manage the money supply. It acts as a lender of last resort and insures deposits through the FDIC.

• Board of Governors: Oversees the Federal Reserve System; seven members appointed by the president.

• Federal Open Market Committee (FOMC): Manages open market operations and the money supply.

Open Market Operations: The Fed buys and sells Treasury securities to control the money supply. Purchases increase reserves and the money supply; sales decrease them.

Bank Regulation: Banks are regulated by the Fed, FDIC, and other agencies to ensure stability and liquidity.

Moral Hazard: Protecting depositors can encourage risky behavior by banks. The FDIC resolves failed banks to minimize costs and discourage moral hazard.

Shadow Banking System: Nonbank financial firms (investment banks, money market funds, hedge funds) provide credit but are less regulated and more leveraged, increasing systemic risk.

Securitization: The process of transforming loans into securities that can be traded.

14.5 The Quantity Theory of Money

The quantity theory of money connects the money supply to the price level and inflation. Historically, increases in the money supply have led to higher prices.

• Quantity Equation:

• Variables: M = Money supply, V = Velocity of money, P = Price level, Y = Real output

• Growth Rate Equation: Growth rate of money supply + Growth rate of velocity = Inflation rate + Growth rate of real output

• Quantity Theory of Money: Assumes velocity is constant; predicts inflation when money supply grows faster than real GDP.

Hyperinflation: Extremely high inflation rates (over 50% per month), often caused by excessive money supply growth. Examples include Zimbabwe and Venezuela.

German Hyperinflation (1920s): Massive expansion of the money supply led to the collapse of the German mark's value.

Key Formulas

• Quantity Equation:

• Money Multiplier:

• Growth Rate Equation:

Summary Table: Types of Money

Summary Table: Money Supply Measures

Additional info: Academic context was added to clarify the role of banks, the Fed, and the money multiplier, as well as to provide historical examples and formulas for exam preparation.