A mechanism that allows for easier trade of goods and services.

Money generally serves three functions:

• Medium of Exchange
• Unit of Account
• Store of Value

Medium of Exchange - Widely accepted in exchange for goods and services

Characteristics:

• universally accepted
• the supply must be limited to keep exchange value relatively stable
• difficult to counterfeit (Gold and Silver coins were initially used because the qualities of the metal were easy to authenticate. Later replaced by paper currency as technology improved)

Unit of Account - - The function of money to provide a common measurement of the relative value of goods and services

Store of Value - The ability of money to hold value over time

Characteristics:

• Allows individuals to save current income now for purchases at a later date

• Individuals can make purchasing decisions over time through savings and spending. This is important for individuals saving for retirement or more expensive purchases.

• Traditionally U.S. currency (dollar) is a good store of purchasing power and financially many countries buy dollars as a safe investment.

• Currency or Cash
• Debit Cards
• Bitcoin

• Money does not have inherent value

• The value of money is derived from a willingness to believe it has value

• Commodity Money - Money that has market value based on the material from which it is made (Gold or Silver)

• Fiat Money - Money accepted by law and generally has no tangible value

Liquidity - the ability to convert an asset into cash quickly

• A liquid asset is one that is easily converted into cash
• An illiquid asset is one that is not easily converted into cash

Examples of liquid assets: Currency or checks (most liquid assets)

Examples of illiquid assets: Houses

Restrict ourselves to three simple classes of the money stock that build on each other:

• Currency - Coins and paper money
• M1 - Currency + checkable deposits
• M2 - M1 + savings deposits and small time deposits

M2 is slightly less liquid than M1 as savings deposits and money market mutual funds are used as a function to store the value of money.

Money Market Mutual Fund - Financial asset offered by banks that buy very short-term, Fixed interest assets like treasury bills or commercial paper. The interest earned on these short-term assets is returned to customers minus the management fee. Interest earned on money market mutual funds tends to be higher than that of savings accounts. Savings accounts are FDIC insured up to $250,000 while money market mutual funds are not insured. More risk with money market mutual fund although it tends to be low.

Most money market mutual funds allow checking or electronic transactions but the number of transactions are limited.

• Bank - A financial institution whose primary function is collecting deposits from savers and making loans to borrowers.

• Central Bank - A government agency responsible for regulating the country’s banking system and controlling monetary policy.

• Federal Reserve Bank (FED) - U.S. Central Bank consisting of 12 regional banks and a board of Governors. The Federal Reserve regulates commercial banks, processes automatic clearing house (ACH) transfers, and determines monetary policy for the U.S. The one government agency that adds revenue to the treasury.

In a traditional sense banks earn revenue by collecting interest on loans. The cost associated with banking is the interest paid on deposits. The balance sheet: - Assets - Things of value owned by households or firms for which the owner holds a legal claim. A bank’s assets are the loans made by the bank.

• Liability - Legal financial claims against firms or households. Liabilities for a bank are savings deposits.

• Net Worth - Assets - Liabilities

There is a conflict between banks and depositors, where banks have an incentive to loan a large percentage of deposits. This becomes a problem if people need to withdraw deposits quickly and the bank doesn’t have enough reserves on hand (Bank Run).

To relieve panic from depositors, regulators started a reserve banking system and insured deposits (FDIC) in savings accounts now up to $250,000.

Reserves - The amount of deposits at a financial institution that are held by the FED.

• Reserve Ratio - The ratio of a bank’s reserves to its own deposit liabilities. Example:

\[ \begin{align*} Deposits & = 1,000,000 \\ Reserves & = 200,000 \\ Reserve Ratio & = 20% \end{align*} \]

• Target Reserve Ratio - The minimum amount of reserves as a percentage of total deposits a bank needs to hold at the FED.

While banks can’t physically create money, banks can help facilitate the flow of money through the system.

• Suppose a person inherits $100,000 and deposits the money at a bank.

• The bank is required to hold a proportion of that amount with the FED as reserves (with a 10% reserve ratio = $10,000).

• The bank has $90,000 available to lend out. The loans go to help finance new capital investment and payroll and continue to cycle through the system.

“promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates”

The Federal Reserve Bank Dual Mandate:

Low Unemployment and Low Inflation

FED is designed to be insulated from political pressure.

• Current Chair of the Federal Reserve Bank - Jerome Powell

• Previous Chair of the Federal Reserve Bank - Janet Yellen

• 7 Members for the Board of Governors who are appointed to 14 year terms.

All the board members serve on the Federal Open Market Committee (FOMC) along with the five other bank presidents, which is in charge of monetary policy

Open Market Operations - The purchase and sale of government securities by the Fed.

• Treasury Bills - Mature in less than a year

• Treasury Notes - Mature in 1 - 10 years

• Treasury Bonds - Mature in more than 10 years

Most Monetary Policy involves buying and selling short term bonds to change the money supply and influence interest rates

The Fed uses monetary policy to affect interest rates. A common misconception of the FED is that the FED sets interest rates. Most of the time the FED uses open market purchases to change interest rates.

• Federal Funds Market - A market where banks lend reserves to other banks overnight to meet the reserve requirement.

• Federal Funds Rate - Interest rate charged on overnight loans of reserves from one bank to another. This is the target rate by the Fed through open market operations. The Fed does not set this rate but tries to achieve a target by buying or selling bonds.

• Discount Rate - The interest rate charged by the Fed to other banks. The discount rate is the only interest rate that is set by the Fed.

Money Supply: The supply of money in the economy. The Fed controls the money supply through open market operations.

Money Supply is assumed to be fixed and is consequently a vertical line.

Money Market

• FED buys government securities on the open market from the public (banks)

• Public receives cash from the FED from the purchase of bonds

• Open market purchase increases the money supply, which effectively lowers the federal funds rate

• Downward pressure on interest rates, which stimulates the economy

Lower interest rates, increase in GDP, and inflationary pressures

Money Market

Effects of an Open Market Sale:

• Fed sells securities on the open market to the public.

• Public pays cash to the Fed for the bonds.

• Decreases the money supply and lowers the access to money.

This puts upward pressure on interest rates, a reduction in GDP, and downward pressure on prices

Money Market

• Time Lags

• Forecasting Errors

• Time Inconsistency

Liquidity Trap: A situation where monetary policy has lost effectiveness because the federal funds rate is essentially zero.

Quantitative Easing: Unconventional monetary policy that is used when traditional policies have become ineffective.

• Credit Default Swaps

• Mortgage backed securities market fails

• Lehman Brothers Declares bankruptcy

• FED buys long-term Treasury Bonds (Operation Twist)

• FED buys mortgage backed securities