Module 5: Money, Banking, and Monetary Policy

5.1 The Nature and Functions of Money

Money is a critical component of a modern economy, but its nature is often misunderstood. In early societies, as settlers expanded westward, they faced the dangers of carrying valuable possessions like gold. To protect their wealth, they began depositing their gold with blacksmiths, who would issue receipts. Over time, these receipts themselves began to be used as payment for goods and services, evolving from a simple store of value into a complex medium of exchange that facilitates all economic activity. Money is anything that is generally acceptable to sellers in exchange for goods and services.

The Three Functions of Money

For an asset to be considered money, it must perform three essential functions:

• A Medium of Exchange: Money eliminates the inefficiencies of a barter system (trading goods for goods). It provides a universally accepted item that can be used to buy and sell, making transactions much more efficient.
• A Unit of Account: Money provides a common measure of relative value. It allows us to compare the worth of a diamond ring to that of a pair of shoes without having to express one in terms of the other. It acts as a yardstick for value.
• A Store of Value: Money allows you to transfer purchasing power from the present to the future. It holds its value over time, so you can save it today and spend it tomorrow without it expiring or spoiling.

The Money Supply

The money supply is the total quantity of money available to the public. Economists measure it in several ways, based on liquidity (how easily an asset can be converted into cash).

• M1: The most liquid measure. It includes all currency (coins and paper money) in public hands, all checkable deposits, and travelers’ checks.
• M2: A broader measure that includes all of M1 plus less liquid assets like savings deposits, certificates of deposit (under $100,000), and money market mutual funds.
• M3: An even broader measure that includes all of M2 plus large-time deposits (over $100,000).

Unlike in the past, when the U.S. dollar was backed by gold, today’s money supply is “fiat money,” meaning it is not backed by a physical commodity. Its value is upheld by three key factors:

1. Acceptability: We accept it as money because we are confident others will accept it from us.
2. Government Decree: The government has declared it legal tender.
3. Scarcity: Its value is derived from its scarcity, which is managed by the central bank.

Having defined what money is, we now turn to the system that creates, manages, and regulates it: the banking system and the central bank.

5.2 The Federal Reserve and the Money Creation Process

The Federal Reserve (the Fed) is the central bank of the United States. It operates as the chief regulator of the nation’s banking system and serves as the primary agent for conducting monetary policy. Its structure and functions are designed to ensure the stability and integrity of the country’s financial system.

Structure and Functions of the Fed

The Fed’s leadership consists of the Board of Governors, seven members appointed by the President for staggered 14-year terms. The key policymaking body is the Federal Open Market Committee (FOMC), which includes the seven governors and five of the twelve regional Federal Reserve Bank presidents.

The Federal Reserve has several key functions:

• Issuing currency (paper money and coins)
• Setting reserve requirements for banks
• Lending money to banks at the “discount rate”
• Supervising and examining member banks to ensure they adhere to regulations
• Acting as the government’s bank for taxes and securities
• Controlling the money supply to stabilize the economy

The Money Creation Process

The modern banking system operates on a fractional reserve basis. This means that banks are required to hold only a fraction of their checkable deposits in reserve; the rest can be loaned out. This system is the mechanism through which new money is created in the economy.

The potential expansion of the money supply is determined by the money multiplier. The formula is: Money Multiplier = 1 / Reserve Requirement

Let’s walk through an example. Assume the reserve requirement is 20% (or 0.20).

1. An individual makes an initial deposit of $20,000 into a bank.
2. The bank must keep 20% of this deposit ($4,000) in reserve.
3. The remaining $16,000 is considered excess reserves, which the bank can lend out.
4. This 16,000 loan is then deposited by the borrower into another bank, which in turn keeps 20% (3,200) in reserve and can lend out the remaining $12,800.
5. This process continues, with each round of lending creating new checkable deposits, which are part of the money supply.

The total potential increase in the money supply is calculated by Initial Deposit × Money Multiplier. In our example, this would be $20,000 × (1 / 0.20) = $20,000 × 5 = $100,000.

Crucially, to find the amount of new money created, we must subtract the initial deposit, which was already part of the money supply. New Money Created = $100,000 (Total) – $20,000 (Initial Deposit) = $80,000

We now turn to the specific tools the Federal Reserve uses to execute its most important function: controlling the nation’s money supply.

5.3 Monetary Policy: Tools and Application

Monetary policy consists of the actions undertaken by a central bank to manage the money supply and credit conditions in an economy. The Federal Reserve’s primary goal in conducting monetary policy is to help stabilize the business cycle by controlling inflation, promoting full employment, and ensuring sustainable economic growth.

The Tools of Monetary Policy

The Fed uses three primary tools to adjust the money supply. Each can be used in an expansionary (“easy” or “loose”) capacity to fight a recession, or in a contractionary (“tight”) capacity to fight inflation.

1. Reserve Requirement: This is the fraction of checkable deposits that banks are required to hold in reserve and not lend out.
   • Expansionary: Lowering the reserve requirement frees up excess reserves, allowing banks to lend more and expand the money supply.
   • Contractionary: Raising the reserve requirement forces banks to hold more in reserve, restricting their ability to lend and contracting the money supply.
2. Discount Rate: This is the interest rate that the Federal Reserve charges on short-term loans to commercial banks.
   • Expansionary: Lowering the discount rate makes it cheaper for banks to borrow from the Fed, encouraging them to lend more and increasing the money supply.
   • Contractionary: Raising the discount rate discourages banks from borrowing from the Fed, thereby restricting the money supply.
3. Open Market Operations: This is the buying and selling of U.S. government bonds (securities) by the Fed. It is the most effective and commonly used monetary policy tool. A helpful acronym is “Buying Gives, Selling Takes”:
   • Expansionary: The Fed buys government bonds from banks. This gives banks more money in their reserves, increasing their ability to lend and expanding the money supply.
   • Contractionary: The Fed sells government bonds to banks. This takes money out of the banks’ reserves in exchange for the bonds, reducing their lending capacity and contracting the money supply.

Perspectives on Monetary Policy

Different economic schools of thought have varying views on how monetary policy affects the economy.

• Classical and Monetarist View: Changes in the money supply have a direct effect on the price level and aggregate demand. Monetarists argue the Fed should focus on keeping the growth of the money supply steady and predictable.
• Keynesian View: Changes in the money supply primarily affect the economy by first changing interest rates. These changes in interest rates then influence investment and consumption, which in turn affects aggregate demand.

The Phillips Curve

The Phillips Curve is a model used to analyze the relationship between inflation and unemployment.

• The short-run Phillips Curve illustrates a trade-off: lower unemployment is often associated with higher inflation, and vice versa.
• The long-run Phillips Curve is vertical at the natural rate of unemployment. This indicates that in the long run, there is no trade-off between inflation and unemployment.

Strengths and Problems of Monetary Policy

• Strengths: Monetary policy is valued for its speed and flexibility compared to fiscal policy. Because the Fed is politically independent, it can act quickly without getting bogged down in legislative debates.
• Problems and Limitations: Monetary policy can be less effective during a severe recession. While the Fed can increase bank reserves (the “easy money” policy), it cannot force businesses and consumers to borrow and spend. As the saying goes, “you can lead a horse to water, but you can’t make it drink.” Another limitation is the Fed’s inability to control the velocity of money—how quickly money is spent by consumers.

Having completed our overview of the macroeconomic “big picture,” we will now return to the microeconomic analysis of the foundational units of the economy: individual firms and consumers.