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

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

Money is a fundamental concept in macroeconomics, serving as the backbone of modern economies. It facilitates exchange, specialization, and economic growth by providing a universally accepted medium for transactions.

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

• Functions of Money:

  1. Medium of Exchange: Accepted by sellers in exchange for goods and services.

  2. Unit of Account: Provides a common measure for valuing goods and services.

  3. Store of Value: Retains value over time, allowing individuals to transfer purchasing power into the future.

  4. Standard of Deferred Payment: Facilitates transactions over time, such as loans and credit.

• Barter and Double Coincidence of Wants: In barter economies, trade requires each party to want what the other offers, making transactions inefficient.

• Commodity Money: A good used as money that also has intrinsic value (e.g., gold, animal skins).

• Fiat Money: Money authorized by a central authority (e.g., paper currency) with no intrinsic value but accepted by decree.

• Criteria for Good Money:

  • Acceptable to most people

  • Standardized quality

  • Durable

  • Valuable relative to its weight

  • Divisible

Example: In 18th-century New York, beaver skins served as commodity money, meeting most criteria for money and acting as a unit of account.

14.2 How Is Money Measured in the United States Today?

The money supply is measured using two main aggregates: M1 and M2. These measures help economists and policymakers track liquidity in the economy.

• M1 (Narrow Money): Currency in circulation, checking account deposits, and savings account deposits.

• M2 (Broad Money): Includes M1 plus small-denomination time deposits and noninstitutional money market mutual fund shares.

• Key Points:

  • Banks play a crucial role in the money supply by managing deposits and loans.

  • Credit cards are not money; they represent loans. Debit cards access money but are not money themselves.

• Seigniorage: The profit made by the government from issuing fiat money, calculated as the difference between the face value and production cost.

Example: The U.S. government sometimes spends more to produce pennies than their face value, leading to debates about eliminating low-denomination coins.

14.3 The Role of Banks in the Economy

Banks are financial intermediaries that accept deposits and make loans, playing a central role in the creation of money and the functioning of the economy.

• Bank Balance Sheets:

  • Assets: Reserves, loans, securities

  • Liabilities: Deposits (checking, savings, certificates of deposit)

• Fractional Reserve Banking: Banks keep less than 100% of deposits as reserves, lending out the rest.

• Reducing Transaction Costs and Asymmetric Information: Banks use economies of scale and credit assessment expertise to efficiently allocate funds.

• Money Creation: Through lending, banks create new deposits, expanding the money supply.

• Money Multiplier: The ratio of the money supply to the monetary base.

Formula:

where is the money supply and is the monetary base (currency in circulation + bank reserves).

Example: If a $1,000 deposit is made and the bank lends out $900, the money supply increases as the loan is spent and redeposited, continuing the cycle.

14.4 The Federal Reserve System

The Federal Reserve (Fed) is the central bank of the United States, responsible for monetary policy and financial system stability.

• Bank Runs and Panics: Occur when many depositors withdraw funds simultaneously, potentially destabilizing banks.

• Lender of Last Resort: The Fed can provide emergency loans to banks to prevent panics.

• Structure of the Fed:

  • 12 Federal Reserve Districts

  • Board of Governors (7 members, 14-year terms)

  • Federal Open Market Committee (FOMC): 12 members (7 Governors, NY Fed President, 4 other Reserve Bank Presidents)

• Monetary Policy Tools:

  • Traditional: Open market operations, discount rate, reserve requirements

  • Modern: Interest on reserves (IOR), reverse repurchase agreements

• Regulation: Banks are regulated to ensure stability (e.g., Liquidity Coverage Ratio, stress tests).

• Moral Hazard: Deposit insurance can reduce depositor vigilance, potentially encouraging risky bank behavior.

• Shadow Banking System: Nonbank financial firms (investment banks, money market funds, hedge funds) provide credit but are less regulated and more leveraged, making them vulnerable to runs (as seen in the 2007–2009 crisis).

Example: The 2023 collapse of Silicon Valley Bank (SVB) highlighted the fragility of banks and the importance of regulatory intervention to prevent systemic crises.

14.5 The Quantity Theory of Money

The quantity theory of money connects the money supply to the price level and inflation, providing a framework for understanding long-run price changes.

• Quantity Equation:

  • = Money supply

  • = Velocity of money (average number of times each dollar is used in transactions)

  • = Price level

  • = Real output (real GDP)

• Velocity of Money:

• Quantity Theory of Money: Assumes velocity is constant; thus, changes in the money supply directly affect the price level.

• Inflation Equation (in growth rates):

  • If velocity is constant, inflation equals money supply growth minus real output growth.

• Predictions:

  • If money supply grows faster than real GDP, inflation occurs.

  • If money supply grows slower than real GDP, deflation occurs.

  • If money supply grows at the same rate as real GDP, price level is stable.

• Hyperinflation: Extremely high inflation, usually caused by rapid money supply growth far exceeding real GDP growth.

Example Calculation: If money supply grows by 20%, velocity by 5%, and real GDP by 1%, then:

Key Terms Table

Summary Table: M1 vs. M2

Additional info:

• Recent changes in monetary policy focus more on interest rates than on the money supply due to instability in the money multiplier.

• The shadow banking system played a significant role in the 2007–2009 financial crisis due to its lack of regulation and high leverage.

• Hyperinflation is rare in developed economies but can devastate economies where central banks finance large government deficits by printing money.