Chapter 14 Money Banks and the Federal Reserve System Money assets 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 Barter and the Invention of Money Barter economies economies where goods and services are traded directly for other goods and services Shortcoming Each person must want what the other one has double coincidence of wants Commodity money a good used as money that also has value independent of its use as money Trading goods and services is much easier when money becomes available People become much more productive specializing because they can pursue their comparative advantage By making exchange easier money allows people to specialize and become more productive The Functions of Money Medium of exchange o When sellers are willing to accept money in exchange for goods or o People can sell goods and services for money and use the money to o An economy is more efficient when a single good is recognized as a services buy what they want medium of exchange Unit of account o In a barter system each good has many prices o Once a single good is used as money each good has a single price rather than many prices o This function of money gives buyers and sellers a unit of account A way of measuring value in the economy in terms of money Store of value o Money allows value to be stored easily If you do not use all your dollars to buy goods and services today you can hold the rest to use in the future o Financial assets stocks bonds etc offer an important benefit relative to holding money Pay a higher rate of interest or may increase in value in the o Money is the most liquid asset Ease with which an asset can be converted into the medium of future exchange Standard of deferred payment o Money can facilitate exchange at a given point in time by providing a medium of exchange and a unit of account o Money can facilitate exchange over time by providing a store of value and a standard of deferred payment o Value of money depends on its purchasing power What can serve as money Medium of exchange helps to make transactions easier allowing the economy to work more efficiently 5 criteria make a good suitable for use as a medium of exchange o The good must be acceptable to most people o It should be of standardized quality so that any two units are identical o It should be durable so that value is not lost by spoilage o It should be valuable relative to its weight so that amounts large enough to be useful in trade can be easily transported o The medium of exchange should be divisible because different goods are valued differently Commodity money s value depends on its purity Fiat money money such as paper currency that is authorized by a central bank or governmental body and that does not have to be exchanged by the central bank for gold or some other commodity money o Paper currency is issued by a central bank o Federal Reserve the central bank of the US Legal tender which means they require that it be accepted in payment of debts and that cash or checks denominated in dollars be used in payment of taxes o Households and firms have confidence that if they accept paper dollars in exchange for goods and services the dollars will not lose much value during the time they hold them How is money measured in the US today M1 the narrowest definition of the money supply the sum of currency in circulation checking account deposits in banks and holdings of traveler s checks Currency has a larger value than checking account deposits but checking account deposits are used much more often than currency to make payments Foreign banks and foreign government hold some dollars outside the US o Most are held by households and firms in countries where there is not much confidence in the local currency If enough people are willing to accept dollars as domestic currency dollars become a second currency for the country M2 a broader definition of the money supply it includes M1 plus savings account balances small denomination time deposits balances in money market deposit account in banks and non institutional money market fund shares o Vanguard s Treasury Money Market Fund and Fidelity s Cash Reserves Fund are money market mutual funds Invest in very short term bonds Money supply o Consists of both currency and checking account deposits o Because balances in checking account deposits are included in the money supply banks play an important role in the way the money supply increases and decreases Credit Cards and Debit Cards Not included in definitions of money supply When you buy something with a credit card you are in effect taking out a loan from the bank that issued the credit card Cards themselves do not represent money How do banks create money Most important component of the money supply is checking accounts in banks Banks are profit making private businesses o Role in the economy is to accept deposits and make loans by creating checking account deposits Bank balance sheet o A firm s assets are listed on the left and its liabilities and stockholders equity are listed on the right o Key assets are its reserves loans and holdings of securities US Treasury bills Reserves deposits that a bank keeps as cash in its vault or on deposit with the Federal Reserve Required reserves reserves that a bank is legally required to hold based on its checking account deposits Required reserve ratio the minimum fraction of deposits banks are required by law to keep as reserves Excess reserves reserves that banks hold over and above the o Banks make consumer loans to households and commercial loans to legal requirement businesses A loan is an asset to a bank because it represents a promise by the person taking out the loan to make certain specified payments to the bank Banks largest liability is its deposits Deposits checking accounts savings accounts and certificates of deposit Owed to the households or firms that have deposited the funds Using T accounts to show how a bank can create money A T account is a stripped down version of a balance sheet that shows only how a transaction changes a bank s balance sheet Total value of all the entries on the right side must always be equal to the total value of all the entries on the left side Banks are required to keep 10 of deposits as reserves Simple Deposit Multiplier the ratio of the amount of deposits created by banks to the amount of new reserves Each bank in the process