The Functions of Money: To be money a good must be all of the following.

1. Medium of Exchange

2. Unit of account (Measure of value and standard of value.)

3. Store of value.

Goods that do only some of these things are called near money.

Medium of Exchange:

Eliminates the need for the coincidence of wants,simplifies trade. Traders accept money in exchange, rather than goods "in kind."

 This technological innovation permits large trading economies to exist, since individuals do not have to wait to find someone whose wants coincide with their own.

 Unit of Account: A Measure and A Standard of Value:

Allows us to measure costs, and to standardize relative valuations. Allows us to keep financial and cost records in a "common denominator" or "numeraire", that makes comparisons of value possible.

We did this early in the course, when we used dollars as the common denominator to calculate nominal GDP in the example with wheat and coal.

 Store of Value: Money carries value over time.

If you hold money for a long period of time, it holds some or all of its value. This allows contracts to be written and allows the accumulation of wealth in the form of "liquid" assets, or assets that can be readily spent. The store of value function is destroyed in rapid and accelerating inflations, called hyperinflations.


 1. Desirability: People want to hold it for exchange of because it is desirable in itself.

 2. Divisibility : It can make be subdivided to meet any exchange, from small to large. [Making change.]

 3. Easily Stored: We don't want to waste resources storing our wealth.

 4. Portability: It is easy to carry around and transport.

 5. Stable in Value: Its value does not change radically over time, so that it stores value well.

Things used as money in various cultures: gold, silver, cattle, stones, shells, beads, paper,plastic.


  Not used up in production. Desired for what it will buy, not in itself.

  Lubricates workings of the economy; it is a

  "circulating stock", a quantity of a good that is passed from person to person in the economy.


 Coins+ and paper money = Currency in hands of the public

Our currency is "fiat" money, and is treated as debt of the Federal Reserve System. Look on any denomination of paper money. It is a Federal Reserve Note.

It is called "fiat" money because it is not backed by another commodity, but by the belief that it is worth its face value.

At other times in the USA, our paper money represented a given amount of gold or silver. These types of paper money were called gold certificates or silver certificates. It is extremely rare to find any of these in circulation.

We classify our money in the USA in decreasing levels of liquidity.

 M1 = [coins + paper money held outside the banking system]+demand deposits+ Travelers Checks + Other Checkable Deposits.

    = currency + checking deposits

In 1991, M1 = $835.9 Billion

In 1993, M1 = $1,131 Billion

M2 = M1 + savings accounts + money market accounts + other time deposits with no or limited check writing.

M2 = $3360 Billion in 1991

M2 = $3552 Billion in 1993

A Short History of Banking:

Gold and silver were hard to store and transport.

Merchants began renting space to store other merchant's wealth.

Paper receipts, and eventually, contracts, were issued to `stand for' the money "on reserve" , and traded in its place.

Eventually, those who stored money realized they could lend a large proportion of their holdings out, as long as they got it back when needed.


Net Worth = Assets - Liabilities

Typical balance sheet ($millions)

   ASSETS                            LIABILITIES

Reserves         30               Capital Accounts    32

Loans           270               Checkable deposits 213

US Securities    50                    Time Deposits 210

Other securities 80                 Other liabilities 50

other assets     75             Total Liabilities  505

Total Assets    505

We will deal in simple cases, in which the only assets are RESERVES and LOANS, and the only liabilities are CHECKABLE DEPOSITS.

Full Reserve Banking:

United Bank

                                    ASSETS                           LIABILITIES

                               Reserves 100,000               Demand Deposits 100,000

In this case, the bank has created demand deposits to just equal the cash reserve on hand. The public has put $100,000 in the bank, and received $100,000 in demand deposits, i.e., checking accounts, in return. There has been NO CHANGE in M1, since currency in the hands of the public has fallen by $100,000, and checkable deposits have risen by $100,000.

Suppose the United Bank, shown above, decides to keep only enough cash reserves to cover only 20% of its deposits. Then, it will loan out $80,000, and its balance sheet will look like:

United Bank

Required Reserves 20,000  Demand Deposits       $100,000
Excess Reserves 80,000 DD created for borrower 80,000
Loans 80,000 
TOTAL ASSETS  $180,000 TOTAL LIABILITIES      $180,000

United Bank has lent $80,000 and added this to someone's purchasing power. Thus, the $80,000 causes an increase in M1.

Suppose a person borrowed the whole $80,000, and deposits it in Merchant's Bank. Then, the balance sheet

for United Bank becomes:

United Bank

Required Reserves 20,000  Demand Deposits      $100,000
Excess Reserves        0
 Loans            80,000

The check for $80,000 deposited in Merchant's Bank is cashed, so cash reserves must be withdrawn from United Bank and placed in Merchant's Bank. The assets and liabilities of Merchant's Bank will rise by $80,000, since cash reserves are transferred from United Bank to Merchant's Bank, and since the demand deposits in Merchant's Bank have increased by the $80,000 deposit.

 Merchant's Bank

Reserves +$80,000  Demand Deposits +$80,000

But, Merchant's Bank can also lend out 80% of this new deposit,changing its balance sheet

 Merchant's Bank

Required Reserves $16,000 Demand Deposits         $80,000
Excess Reserves    64,000 DD created for borrower $64,000
Loans              64,000
TOTAL ASSETS     $144,000 TOTAL LIABILITIES     $144,000


If the Demand Deposit created by the $64,000 loan is withdrawn and deposited in a third bank, then the balance sheet for Merchant's Bank becomes:

 Merchant's Bank

Required Reserves $16,000 Demand Deposits         $80,000
Excess Reserves         0
Loans              64,000
TOTAL ASSETS      $80,000 TOTAL LIABILITIES        $80,000

This expansion will continue, bank by bank, until 20% of the increase in deposits is very small.

 Change in M1 = $100,000 (initial deposits)+$80,000(Created by United bank)+ $64,000(Created by Merchant's Bank) +.....

              = $100,000 +(0.8)$100,000 + (0.8)2$100,000 +...

              = $100,000 (1 + (0.8) + (0.8)2 + ...

              = $100,000 (1/(1-0.8))

              = $100,000 (1/0.2)

              = $100,000*(5)

              = $500,000

Thus, we have a bank credit multiplier. The change in the money supply will equal the change in the monetary base (money injected into the banking system from outside it) times the reciprocal of the reserve ratio.

Change in M1 = Change in Monetary Base x 1/[reserve ratio]

Balance Sheet of Banking System as a Whole, after the expansion has taken place:

Banking System
Required Reserves $100,000 Demand Deposits      $500,000
Excess Reserves          0
Loans              400,000 
TOTAL ASSETS      $500,000 TOTAL LIABILITIES    $500,000


Monopoly Bank: If we had only one bank in the USA, with many branches all over the country, its response to an injection of high powered money would be summarized like the balance sheet given above.

For a Monopoly Bank: If the reserve requirement was 20%, then a monopoly bank would know that it could expand an initial injection of $100,000 in new deposits into a total of $500,000 of deposits, by making $400,000 in loans, i.e., the Monopoly Bank, if it wanted to expand the money supply as far as it could, would immediately try to loan out $400,000.

There are four agents that must cooperate in if the expansion is to have its maximum effect:

1. The Public: Individuals must put their money into the banking system, and not hide it in their mattresses or bury it in their back yards.

2. Banks: Banks must use the fractional reserve system to its fullest extent, and not keep excess reserves.

3. Borrowers: Borrowers must be willing to borrow when the banks are willing to make loans.

4. Federal Reserve: The Fed must use its policy tools to allow the expansion to continue.

Any leakage from the banking system will dampen the expansion.


[Central Bank] ===> Private Banking System===> change in M1

In the USA, the central bank is called the Federal Reserve System. In Germany, it is called the Bundesbank; in Japan, the Bank of Nippon; in the United Kingdom, the Bank of England.

In the USA, we have 12 regional Federal Reserve Banks.

 New York           Dallas              Boston

St. Louis           San Francisco       Kansas City

Cleveland           Richmond            Atlanta

Philadelphia        Chicago             Minneapolis

The FED was formed in 1913. It was opposed initially by commercial banks, who had to pay a mandatory fee to join the system, as if they were buying stock in a corporation.

A Board of Governors, appointed by the President, runs the system.

Each Governor has a 14 year term. A Chair with a 4 year term is appointed to run the Board, and is responsible for policy decisions. The current Chair is Alan Greenspan, who was renominated by President Clinton a few years ago.

The Fed Open Market Committee, or FOMC, is made up of the Board of Governors and 5 representatives of the Federal Reserve Regional Banks. The FOMC is the main policy arm of the FED. It operates out of the New York Federal Reserve Bank

Responsibilities of the FED

Handle all transactions of the Federal Government

Coordinate the operation of the private banking system, and regulate private commercial banks.

Control the supply of money, and make credit available to the economy as needed.

Control the value of the dollar with respect to foreign currencies.

The FED is answerable to Congress, but the Chair is appointed by the President and confirmed by the Senate. The Chair can only be removed by impeachment, and is often considered the second most powerful person in the USA, second only to the President, in controlling the economy.


The FED has three major tools it uses to control the supply of money.

1. Open Market Operations

2. The discount rate

3. The reserve requirement

Open Market Operations: [OMO]

The FED buys and sells federal government securities on the open market. When it buys bonds and other securities, the Resreve Base or Monetary Base is increased in the banking system, and the money supply expands. When it sells bonds and other securities, the Monetary Base is reduced, and the money supply contracts.

OMO are a powerful tool, operating quickly, secretly, and with major impact when necessary. By the time traders realize an OMO is in progress, it is over and the system has adjusted to it. When the FED conducts a transaction, it does it "under cover", through un-named accounts. No one knows it is the FED doing the trading.

Usually, it is harder for the FED to apply counter-cyclical policy during a downturn--individuals may not want to sell bonds so readily if interest rates keep falling, since their portfolios will be gaining in value.

Discount Rate: The rate of interest bankers pay to the FED for loans or for exchanging loan certificates for cash.

 When the economy is booming, the FED will raise the discount rate to make it harder for banks to borrow from the FED and make loans to the private sector.

 When the economy is in recession, the FED may lower the discount rate to encourage a monetary expansion.

 We do not use discount rate policy very often in the USA:

1. Discount rate adjustments have a long lead-time.

2. Banks may not react to the change in the discount rate as expected.

3. The FED uses the discount rate to keep an eye on the stability of banks--if the amount of discounts for a member bank is very high, the FED may warn the bank, or audit the bank. To avoid this, banks may borrow from other banks when they are in a pinch, to avoid FED scrutiny.

4. The discount rate is sometimes used to correct overshooting of some OMO: If and OMO cuts M1 and causes interest rates to rise, the FED may raise the discount rate to discourage banks from expanding their loans too much.

Change in the Reserve Requirement or Required Reserve Ratio:

The Reserve Requirement is the percentage of deposits that must be held by banks on reserve, i.e., as available cash. The FED can change this requirement, and change the monetary base.

This policy is seldom used. It has strong announcement effects, and can affect the money supply suddenly and powerfully. It can be disruptive if not used carefully.

In a monopoly bank model, suppose we have the following. The reserve requirement is 20%, and there are no excess reserves in the system:

 Monopoly Bank
Required Reserves $10,000 Demand Deposits      $50,000
Excess Reserves         0
Loans              40,000 
TOTAL ASSETS      $50,000 TOTAL LIABILITIES    $50,000

Suppose the reserve requirement drops from 20% to 10%. The monopoly bank can adjust by realizing that the $10,000 on reserve can now support 100,000 in demand deposits, instead of only 50,000.

The new balance sheet, after all adjustment, will be:

Monopoly Bank
Required Reserves  $10,000 Demand Deposits      $100,000
Excess Reserves          0
Loans               90,000 
TOTAL ASSETS      $100,000 TOTAL LIABILITIES    $100,000


We have a sudden expansion, if loan opportunities are available, and if banks loan out to the legal limit.


Early theories of the demand for money were built on the proposition that individuals do not desire money for itself, but for what it will buy. It was assumed that money's primary function was as a medium of exchange, and that no one would hold it as a way to store wealth.

Irving Fisher's Quantity Theory:


Where    M - supply of money

         V - transactions velocity of money

         P - price index

         T - Volume of transactions in the economy

V or Transactions Velocity is defined as the number of times the money stock circulates, per year, to support a given level of total sales

We can re-write Fisher's equation as:

V = PT/M

PT = nominal value of transactions

The quantity equation, MV = PT, in words, is:

Number of dollars x Number of times the = Total Nominal in the economy money supply circulates Value of Transactions

To Fisher: " an increase in the quantity of money is an exactly proportional increase in the general level of prices."

Determinants of V, Velocity of Transactions: Velocity is institutionally determined.

V does not change when the money supply changes. Its level depends on:

1. Habits of Payment, e.g., are workers paid monthly, weekly, etc. How often bills are due, etc.

The more frequently we pay wages and salaries, the smaller the money supply needed to support any

given level of nominal sales.

2. Availability and use of credit. If credit is easily available,

a smaller money supply is needed to support any given level of nominal sales.

3. Sophistication of transportation and communications systems. The faster we can send and receive

goods and information, the smaller the money supply needed for any given level of

nominal sales.

Determinants of T, the Volume of Transactions: The volume of

transactions is determined by resource availability and the

level of technological development. It does not change as

the money supply changes.

1. Natural Resource Availability: The more productive resources,

available, the higher the volume of transactions.

2. Technology for production and distribution of goods:

The more advanced production and distribution methods, the

higher the volume of transactions. The level of output, here represented by the volume of transactions,

depends on long run parameters, and not on the supply of money.

In Fisher's Quantity Theory, if the money supply changes, the price

level must change by the same percentage. This is so because

V and T are fixed, with respect to the money supply.

MV = PT where V and T are constant means that

       [Change in P]/P = [Change in M]/M

In this model, changes in the money supply have no effect on the volume of

transactions or velocity. In fact, changes in the money supply have no effect on anything except the price level.

Increasing the money supply can only cause higher prices.

Fishers variable T, which does not change in the short run, is represented in modern economics by "natural" or potential real GDP.