Money and Its Role in the Economy

Definition and Importance of Money

Money is a fundamental invention in economic history, serving as the backbone of modern economies. Economists define money as 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.

• Money facilitates trade, specialization, and economic development.

What Is Money, and Why Do We Need It?

Before the invention of money, trade was conducted through barter, which required a double coincidence of wants—both parties must want what the other offers. The emergence of commodity money (goods with intrinsic value, such as animal skins or precious metals) simplified trade and enabled economic specialization.

• Barter: Direct exchange of goods and services.

• Double coincidence of wants: Both parties must desire what the other offers.

• Commodity money: Goods used as money that have value independent of their use as money.

The Four Primary Functions of Money

Money serves four essential functions in the economy:

1. Medium of exchange: Accepted by a wide variety of parties for payment.

2. Unit of account: Provides a standard measure of value.

3. Store of value: Allows value to be saved and used in the future; money is liquid and easily exchanged.

4. Standard of deferred payment: Facilitates exchanges across time, with predictable purchasing power.

Characteristics of Money

For a good to serve as money, it should possess the following characteristics:

1. Acceptable: Usable by most people.

2. Standardized quality: Any two units are alike.

3. Durable: Value is not lost by wearing out.

4. Valuable relative to weight: Easily transported in large quantities.

5. Divisible: Usable for both low-priced and high-priced goods.

Commodity Money

Commodity money has value independent of its use as money. Examples include:

• Cowrie shells in Asia

• Precious metals (gold, silver)

• Animal pelts and skins in colonial North America

• Cigarettes in prisons and POW camps

Paper Money and Fiat Money

Paper money originated in China and spread globally, initially exchangeable for commodities like gold. In modern economies, paper money is issued by a central bank and is typically fiat money—authorized by a government but not backed by a commodity.

• Fiat money: Currency authorized by a central bank or government, not exchangeable for a commodity.

• The Federal Reserve is the central bank of the United States.

Advantages and Disadvantages of Fiat Money

• Advantage: Central banks can create money flexibly without needing commodity reserves.

• Disadvantage: Fiat money relies on public confidence; if lost, the currency loses value.

Modern Money and Payment Systems

Cashless Transactions and Legal Tender

Some businesses and countries have moved toward cashless transactions, especially accelerated by the Covid-19 pandemic. Firms are not legally obliged to accept cash for payment, though debts are a different matter.

Measuring Money in the United States

The money supply is measured using two main aggregates:

• 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.

As of September 2023:

• M1 ≈ $18.1 trillion

• M2 ≈ $20.8 trillion

• About 13% of M1 is currency; 75% of U.S. paper currency is $100 bills.

M1 versus M2

Recent changes have made M1 and M2 similar, so either can be used for most discussions. Both include checking and savings 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: Represent short-term loans; transactions are not complete until the loan is paid off. Credit cards do not represent money.

Bitcoin and E-Money

• Bitcoin: A decentralized digital currency, not issued by a government or firm.

• Not currently included in M1 or M2, as it is not widely used as a medium of exchange.

• Other forms of e-money include PayPal, Apple Pay, and Google Pay.

The Role of Banks in the Economy

Banks as Financial Intermediaries

Banks are critical to the economy, creating money and facilitating lending. They are profit-making firms, using deposits to make loans and investments.

Bank Balance Sheets

A bank's balance sheet lists assets (left side) and liabilities plus stockholders' equity (right side). The largest liabilities are deposit accounts owed to customers.

Reserves and Required Reserves

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

• Previously, banks were required to hold a fraction of deposits as required reserves (e.g., 10%), but this is no longer mandated.

Economic Importance of Bank Lending

• Banks reduce transaction costs through economies of scale and specialization.

• Banks reduce information problems (asymmetric information) by evaluating borrowers' credit risks using statistical analysis and relationship banking.

Fintech and Interest Rate Ceilings

• Fintech firms facilitate peer-to-peer lending but may increase risky loans.

• Proposals to cap credit card interest rates may make loans less accessible for some borrowers.

Money Creation and the Banking System

How Banks Create Money

Banks create money through the process of accepting deposits and making loans. This is illustrated using T-accounts:

• Depositing currency increases both reserves and deposits.

• Lending out a portion of deposits (fractional reserve banking) creates new checking account deposits.

Fractional reserve banking system: Banks keep less than 100% of deposits as reserves.

The Money Multiplier

The money multiplier is the ratio of the money supply to the monetary base (). It reflects the multiple expansion of deposits resulting from bank lending.

• The money multiplier has become unstable since 2007, limiting the Fed's control over the money supply.

Interest on Reserve Balances

• Since 2008, the Fed pays interest on reserves held by banks (Interest on Reserve Balances, IORB).

• This has led to an ample-reserves regime, with banks holding more reserves than required.

Fluctuations in the Money Multiplier

• Changes in reserves held by banks and currency held by households/firms affect the money multiplier.

• More currency held means less money available for banks to create new deposits.

The Federal Reserve System

Bank Runs and Panics

• Bank run: Many depositors withdraw funds simultaneously due to loss of confidence.

• Bank panic: Multiple banks experience runs at the same time.

• Central banks act as lenders of last resort to prevent panics.

Establishment and Structure of the Federal Reserve

• Founded in 1914 after repeated bank panics.

• Makes discount loans to banks at the discount rate.

• Divided into 12 Federal Reserve districts, overseen by the Board of Governors.

• The Federal Open Market Committee (FOMC) manages open market operations.

Deposit Insurance and Moral Hazard

• The FDIC insures deposits up to $250,000, reducing the risk of bank panics.

• Moral hazard: Insuring deposits may encourage risky behavior by banks.

The Fed, Banks, and the Money Supply

Monetary Policy

The Federal Reserve manages interest rates and the money supply to pursue macroeconomic policy objectives.

Open Market Operations

• Open market operations: Buying and selling of Treasury securities to control the money supply.

• To increase the money supply: The Fed purchases Treasury securities.

• To decrease the money supply: The Fed sells Treasury securities.

• These operations are quick and reversible.

Formula: Change in Money Supply

Summary Table: Key Terms and Definitions

Additional info: These notes expand on the original slides by providing definitions, formulas, and context for key macroeconomic concepts related to money, banking, and the Federal Reserve System.