Money and Banking

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The Functions of Money
The three functions of money are:
 Medium of exchange
 Used to buy goods and services
 Accepted in payments
 Barter system
 Convenient way of exchange: specialization
 Unit of account
 Monetary units (KD) to measure the relative worth
of goods and services
 The price of each good and services is stated in
monetary terms
 Enable buyers to compare between a verity of
goods and services
 Debt, GDP, taxes
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 Store of value
 Transfer purchasing power from the present
to the future
 Savings
 Best store of value in short terms
 Efficient liquid asset
 Liquidity: transformation of an asset into goods
and services
 Inflation

The Components
of the Money Supply
 Two definitions of the U.S. money supply are M1 and
M2.
 M1 is the narrowest definition of the money supply,
whereas M2 is a more broadly defined money supply.
Currency includes coins and paper money.
 All coins in circulation are token money.
 Paper money, issued by the Federal Reserve Banks,
are known as Federal Reserve Notes.
Money Definition: M1
M1 money = currency + checkable deposits
The U.S. money supply is guaranteed by government’s
ability to keep the value of money relatively stable.

Value of Money
Money has value because of its acceptability, legal
tender designation, and relative scarcity.
 Government has decreed currency as legal tender;
paper money is a valid and legal means of payment of
debt.
1. Acceptability
2. Legal Tender
3. Relative scarcity

Money and Prices
 The purchasing power of money is the amount of
goods and services a unit of money will buy.
 The purchasing power of the dollar varies inversely
with the price level.
 If the price level rises, the purchasing power of the
dollar falls, and vice versa.
 Inflation may also affect the purchasing power of
money and its acceptability.
 When the government prints too much money, the
purchasing power of money declines.
 Also, runaway inflation may significantly reduce the
purchasing power of the dollar and may cause it to
cease being used as a medium of exchange.

The Federal Reserve System
and The Banking System
 A key element of the U.S. banking system is the
Federal Reserve System (the “Fed”).
 The Fed consists of the Board of Governors of the
Federal Reserve and 12 regional Federal Reserve
Banks.

Board of Governors
 The seven-member group that supervises and
controls the money and banking system of the U.S..
The 12 Federal Reserve Banks
 The 12 banks chartered by the U.S. government to
control the money supply and perform other
functions.
 They collectively serve as the nation’s “central bank”
and also serve as bankers’ bank.

Federal Open Market Committee (FOMC)
 The FOMC is the 12 member Federal Reserve group
determines the purchase and sale policies of the
Federal Reserve Banks in the market for U.S.
securities.
 The Federal Reserve Bank in New York City conducts
most of the Fed’s open market operations.
Commercial Banks and Thrifts
 Of the approximately 7600 commercial banks, three-
fourths are state banks, while the remaining one-fourth
are national banks, chartered by the Federal
government to operate nationally.
 The 11,400 thrift institutions are regulated by agencies
separate and apart from the Board of Governors and
the Federal Reserve Banks.

Fed Functions and
Responsibilities
 The Fed performs the following functions.
 Issues currency
 Sets reserve requirements and holds reserves
 Lends money to banks and thrifts
 Provides the banking system with a means for
collecting checks
 Acts as a fiscal agent for the Federal government
 Supervises the operation of banks
 Controls the money supply

Fed Reserve Independence
 The Federal Reserve is an independent agency of the
government.
 This protects the Fed from political pressure so that
it could effectively control the money supply and
interest rates to foster price-level stability.
Depositing Reserves in
a Federal Reserve Bank
 All commercial banks and thrifts that provide
checkable deposits must by law keep required
reserves.
 Required reserves are an amount of funds equal to
a specified percentage of the bank’s own deposit
liabilities.
 Required reserves must be kept on deposit with the Federal
Reserve Bank or held as cash in the bank’s vault.

Depositing Reserves in
a Federal Reserve Bank
 The “specified percentage” of checkable deposit
liabilities that a commercial bank must be keep as
reserves is known as the reserve ratio.
Reserve Bank’s required reserves
ratio Bank’s checkable-deposit liabilities
=

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