• Our nation’s central bank, the Federal Reserve, is responsible for controlling the money supply.

13.1 What is Money?

• Money: Any items that are regularly used in economic transactions or exchanges and accepted by buyers and sellers.

• Economic exchange: One party hands over currency and the other party hands over goods and services.

• Currency is money and checks also function as money because they are used to pay suppliers.

Three Properties of Money

• Medium of Exchange: Any item that buyers give to sellers when they purchase goods and services.

• Barter: The exchange of one good or service for another.

• Double Coincidence of Wants: The problem in a system of barter is that one person may not have what the other desires.

• Principle of Voluntary Exchange: A voluntary exchange between two people makes both people better off.

• Without money, we would be left with a barter system, and most transactions that make both people better off would not be possible.

• Unit of Account: a standard unit in which we can state prices and compare the value of foods and services.

• In our economy, money is the unit of account because we quote all prices in terms of money.

• Store of value: the property of money that holds that money preserves value until it is used in an exchange.

• Money is actually a somewhat imperfect store of value because of inflation.

• Commodity Money: A monetary system in which the actual money is a commodity, such as gold or silver.

• Gold standard: A monetary system in which gold backs up paper money.

• Fiat money: A monetary system in which money has no intrinsic value but is backed by the government.

Measuring Money in the U.S. Economy

• M1: The sum of currency in the hands of the public, demand deposits, other checkable deposits, and traveler’s checks.

• The first part of M1 is currency held by the public, that is, all currency held outside bank vaults.

• The second component is deposited in checking accounts, called demand deposits.

• The third component, other checkable deposits, was introduced in the early 1980s and did pay interest.

• M2: M1 plus other assets, including deposits in savings and loans accounts and money market mutual funds.

13.2 How Banks Create Money

A Bank’s Balance Sheet: Where the Money Comes From and Where It Goes

• Balance sheet: An account statement for a bank that shows the sources of its funds (liabilities), as well as the uses of its funds (assets).

• Liabilities: The sources of funds for a bank, including deposits and owners’ equity.

• Assets: The uses of the funds of a bank, including loans and reserves.

• Owners’ equity: The funds provided to a bank by its owners.

• Reserves: The portion of banks’ deposits set aside in either vault cash or as deposits at the Federal Reserve.

• Required reserves: The specific fraction of their deposits that banks are required by law to hold as reserves.

• Excess reserves: Any additional reserves that a bank holds above-required reserves.

How Banks Create Money

• Reserve ratio: The ratio of reserves to deposits.

How the Money Multiplier Works

• The total increase in checking account balance throughout all banks = (initial cash deposit) x 1/(reserve ratio)

• Money Multiplier: The ratio of the increase in total checking account deposits to an initial cash deposit.

How the Money Multiplier Works in Reverse

• The expansions and contractions offset each other when private citizens and firms write checks to one another.

13.3 A Banker’s Bank: The Federal Reserve

• Central bank: A banker’s bank-an an official bank that controls the supply of money in a country.

• Lender of last resort: A central bank is the lender of last resort, the last place, all others have failed, from which banks in emergency situations can obtain loans.

Functions of the Federal Reserve

• The Fed supplies currency to the economy

• The Fed provides a system of check collection and clearing

• The Fed holds reserves from banks and other depository institutions and regulates banks.

• The Fed conducts monetary policy

• Monetary Policy: The range of actions taken by the Federal Reserve to influence the level of GDP or inflation.

The Structure of the Federal Reserve

• Federal Reserve Bank: One of 12 regional banks that are an official part of the Federal Reserve System.

• Board of Governors of the Federal Reserve: The seven-person governing body of the Federal Reserve System in Washington, D.C.

• Federal Open Market Committee (FOMC): The group that decides on monetary policy. It consists of the seven members of the Board of Governors plus five of 12 regional bank presidents on a rotating basis.