Money and Its Role in the Economy

What Is Money?

Money is a fundamental invention in economic history, serving as a medium that facilitates exchange, measures value, stores wealth, and enables deferred payments. 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.

• Before money, economies relied on barter, which required a double coincidence of wants—both parties needing what the other offered.

• The use of money allows for specialization and more efficient trade.

The Four Primary Functions of Money

1. Medium of Exchange: Money is widely accepted as payment for goods and services.

2. Unit of Account: Money provides a standard measure of value.

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

4. Standard of Deferred Payment: Money is used to settle debts payable in the future, assuming its purchasing power remains stable.

What Can Serve as Money?

To function effectively as money, a good should have the following characteristics:

• Acceptability: Usable by most people.

• Standardized Quality: Any two units are alike.

• Durability: Not easily destroyed or worn out.

• Valuable Relative to Weight: Easily transported, even in large amounts.

• Divisibility: Can be used for both small and large transactions.

Types of Money

• Commodity Money: Has intrinsic value (e.g., gold, silver, cowrie shells, animal pelts, cigarettes in prisons).

• Paper Money: Originated as banknotes exchangeable for commodities (e.g., gold).

• Fiat Money: Money authorized by a central authority, not backed by a physical commodity. Its value depends on public confidence.

Advantages of Fiat Money: Flexibility for central banks; no need to hold commodity reserves. Disadvantages: Relies on trust; if confidence is lost, fiat money can become worthless.

Modern Money and Payment Systems

• Not all businesses are required to accept cash; some are cashless for efficiency or security.

• Digital payments and e-money (e.g., PayPal, Apple Pay) are increasingly common.

• Bitcoin and Cryptocurrencies: Not currently counted as money (M1 or M2) due to limited use as a medium of exchange.

Measuring the Money Supply

Definitions of Money Supply

• M1: The narrowest measure; includes currency in circulation, checking account deposits, and savings account deposits.

• M2: A broader measure; 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 in $100 bills.

Recent changes have made M1 and M2 more similar, so either can be used for most discussions.

What Is Not Money?

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

• Credit Cards: Provide short-term loans; not considered money until the loan is paid off using funds from a deposit account.

The Role of Banks in the Economy

Bank Functions and Balance Sheets

• Banks accept deposits and make loans, creating money in the process.

• They are profit-seeking firms, with their largest liabilities being deposit accounts.

Reserves and Fractional Reserve Banking

• Reserves: Deposits held as cash in the bank or at the Federal Reserve.

• Banks keep only a fraction of deposits as reserves (fractional reserve banking), lending out the rest to earn profit.

• Reserve requirements were eliminated in March 2020; banks now hold reserves for other regulatory and operational reasons.

Economic Importance of Bank Lending

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

• Banks reduce information problems (asymmetric information) by evaluating borrowers' creditworthiness.

Fintech and Interest Rate Ceilings

• Fintech firms offer peer-to-peer lending, earning fees but not bearing loan risk.

• Proposals to cap credit card interest rates may make loans less accessible to high-risk borrowers.

How Banks Create Money

The Money Creation Process

• When a deposit is made, banks keep a portion as reserves and lend out the rest, creating new deposits in the process.

• This process is illustrated using T-accounts to show changes in assets and liabilities.

Example: Deposit $1,000 in currency at Bank of America:

• Reserves increase by $1,000; deposits increase by $1,000.

• If the bank lends out $900 (keeping 10% as reserves), new deposits are created elsewhere in the banking system.

This is the basis of the money multiplier:

The process continues as loans are deposited and re-lent, expanding the money supply.

Instability of the Money Multiplier

• The money multiplier can fluctuate due to changes in reserve holdings and currency preferences.

• Since 2007, instability has led the Fed to focus more on interest rates than direct money supply control.

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.

The Federal Reserve System and Monetary Policy

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.

• The Fed acts as lender of last resort to prevent panics by providing emergency loans.

Establishment and Structure of the Federal Reserve

• Created in 1914 after a series of bank panics.

• Composed of the Board of Governors (7 members, 14-year terms) and 12 regional Federal Reserve districts.

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

Deposit Insurance and the FDIC

• Established in 1934 to insure deposits up to $250,000 per account, reducing the risk of bank runs.

Monetary Policy Tools

• Monetary policy: Actions by the Fed to manage interest rates and pursue macroeconomic objectives.

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

To increase the money supply: The Fed buys Treasury securities (open market purchase), increasing bank reserves. To decrease the money supply: The Fed sells Treasury securities (open market sale), reducing bank reserves.

Bank Regulation and Financial Stability

Bank Regulation

• Banks are regulated by the Fed, FDIC, state agencies, and the Office of the Comptroller of the Currency.

• Regulations include liquidity coverage ratios and other requirements to ensure stability.

Moral Hazard and Systemic Risk

• Moral hazard: When deposit insurance or bailouts encourage banks to take excessive risks.

• FDIC resolves failed banks by selling assets and paying creditors, but large depositors may still face losses.

• In systemic crises, the FDIC may reimburse all depositors to prevent wider panic, increasing moral hazard risk.

The Shadow Banking System and Financial Crises

• Nonbank financial firms (investment banks, money market funds, hedge funds) play a major role in credit markets.

• These firms are less regulated and more leveraged, making them vulnerable to runs and crises (e.g., 2007-2009).

• Securitization: The process of transforming loans into tradable securities, increasing complexity and risk.

The Quantity Theory of Money and Inflation

The Quantity Theory of Money

• Links the money supply to the price level and inflation.

• Velocity of money: The average number of times each dollar is used to purchase goods and services in GDP.

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

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

• If both grow at the same rate, the price level is stable.

Hyperinflation

• Extremely high inflation (over 50% per month), usually caused by rapid money supply growth far exceeding real output growth.

• Recent examples: Zimbabwe (2000s), Venezuela (2019).

• Hyperinflation is often associated with severe economic disruption and loss of confidence in money.

Summary Table: Types of Money and Their Characteristics

Key Formulas

• Money Multiplier:

• Quantity Theory of Money (simplified):