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 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.

• 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.

What Can Serve as Money?

For a good to serve as money, it must be acceptable, standardized, durable, valuable relative to its weight, and divisible. Historically, commodity money (such as gold, silver, cowrie shells, and even cigarettes) had value independent of its use as money.

Paper Money and Fiat Money

Modern economies use fiat money, which is currency authorized by a central bank and not exchangeable for commodities like gold. The Federal Reserve issues fiat money in the United States.

• Fiat Money: Paper currency not backed by a commodity, but by government decree.

• Advantages: Flexibility for central banks.

• Disadvantages: Relies on public confidence; loss of confidence can render it worthless.

Apply the Concept: Cashless Payments

Some businesses, such as Dig Inn, have moved to cashless payments for efficiency and security. Legally, firms are not required to accept cash for purchases, though debts are treated differently.

Cashless Societies and Large-Denomination Bills

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

14.2 How Is Money Measured in the United States Today?

The money supply is measured using two main aggregates: M1 and M2. M1 includes currency in circulation and checking/savings account deposits. M2 includes M1 plus small-denomination time deposits and money market fund shares.

• M1: Currency + checking account deposits + savings account deposits.

• M2: M1 + small-denomination time deposits + noninstitutional money market fund shares.

As of September 2023, M1 was about $18.1 trillion and M2 about $20.8 trillion. U.S. currency holdings are high, partly due to use in other countries and underground economies.

M1 vs. M2

Recent changes have made M1 and M2 similar, so either can be used to discuss the money supply. Both include currency and account balances, and banks play a key role in managing these funds.

Debit and Credit Cards

• Debit Cards: Access checking accounts directly, but the card itself is not money.

• Credit Cards: Provide short-term loans; transactions are not complete until the loan is paid off.

Apply the Concept: Is Bitcoin Money?

Bitcoin and other digital currencies are not currently included in the money supply, though they are used for transactions and can be traded for other currencies. Their inclusion may change if they become more widely accepted.

14.3 How Do Banks Create Money?

Banks play a critical role in the economy by creating money through lending. Most money is held in checking accounts, not as physical currency. Banks are profit-making firms that use deposits to make loans and investments.

Bank Balance Sheets

Banks list assets (loans, securities, reserves) on one side and liabilities (deposits, debts) and equity on the other. Deposits are the largest liability.

Reserves

Reserves are cash held by banks or deposited with the Federal Reserve. Banks no longer have a required reserve ratio for checking deposits, allowing more flexibility in lending.

The Economic Importance of Bank Lending

• Transaction Costs: Banks reduce costs by specializing in loan evaluation and processing.

• Information Problems: Banks address asymmetric information by assessing borrower risk through statistical analysis and relationship banking.

14.4 The Federal Reserve System

The Federal Reserve (the 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 oversees monetary policy.

Structure of the Federal Reserve

• Board of Governors: Seven members appointed for 14-year terms; one serves as chair.

• Federal Open Market Committee (FOMC): Twelve members, including the Board of Governors and district bank presidents, responsible for open market operations.

Open Market Operations

The Fed buys and sells Treasury securities to control the money supply. Purchases increase reserves and the monetary base, while sales decrease them. The money supply changes by the monetary base multiplied by the money multiplier.

14.5 The Quantity Theory of Money

The quantity theory of money connects the money supply to the price level and inflation. Irving Fisher formalized this relationship with the quantity equation:

• Quantity Equation:

• M: Money supply

• V: Velocity of money

• P: Price level

• Y: Real output

Growth rates can be related as:

If velocity is constant, inflation occurs when the money supply grows faster than real GDP. Hyperinflation results from excessive money supply growth, often due to government spending beyond tax revenues.

Recent Examples of Hyperinflation

• Zimbabwe (2000s): Prices increased by more than 10,000% per year.

• Venezuela (2019): Inflation rates over 2 million percent.

• Germany (1922–1923): Price index rose dramatically, making currency worthless.

Summary Table: Functions and Types of Money