1. Money is whatever performs the three basic functions of money: it is a medium of exchange for buying and selling goods and services. It serves as a unit of account for measuring the monetary cost of goods and services. It is a store of value so people can transfer purchasing power from the present to the future. A key advantage of money, especially in its cash form, is that it is widely accepted and easy to use for transactions. Other assets, such as real estate, stocks, or bonds, must be converted to money before they can be used to make purchases. Ease with which such assets can be converted to money without losing purchasing power is a measure of the liquidity of an asset.
2. Money is a stock of items rather than a flow such as income. Any item that is widely accepted as a medium of exchange can serve as money, and many types of such items have done so throughout history.
a. The narrowly defined money supply is called M1 and has two principal components.
(1) One component is currency: it consists of coins that are token money, which means the value of the metal in the coin is less than the face value of the coin. It also consists of paper money in the form of Federal Reserve Notes.
(2) The second component is checkable deposits. They allow a person to transfer ownership of deposits to others by the writing of checks; these checks are generally accepted as a medium of exchange.
(3) The two major types of financial institutions offering checkable deposits are commercial banks and thrift institutions.
(4) There also is currency and checkable deposits owned by the Federal government, commercial banks and thrift institutions, and the Federal Reserve Banks. They are excluded from the calculation of M1 or in the other definitions of the money supply.
b. M2 is a broader definition of money and includes not only the currency and checkable deposits in M1 but also near-monies that do not function directly or fully as a medium of exchange, but which can be easily converted to currency or checkable deposits. M2 includes:
(1) M1 (currency and checkable deposits); plus
(2) savings deposits, which include money in savings accounts and also money market deposit accounts (MMDAs), interest-bearing accounts with short-term securities; plus
(3) small time deposits of less than $100,000, such as “certificates of deposit” (CDs); plus
(4) money market mutual funds (MMMFs) held by individuals
3. The money supply gets its “backing” from the ability of the government to keep the purchasing power of money stable.
a. Money is debt or the promise of a commercial bank, a thrift institution, or a Federal Reserve Bank to pay, but these debts cannot be redeemed for anything tangible
b. Money has value only because:
(1) It is acceptable for the exchange of desirable goods and services
(2) It is legal tender (legally acceptable for payment of debts)
(3) It is relatively scarce because its value depends on supply and demand conditions
c. Money is backed by the confidence the public has that the purchasing power of money will remain stable. U.S. monetary authorities (the Federal Reserve) are responsible for using monetary policy to maintain price-level stability and the purchasing power of money. The actions of the U.S. government are also important because sound fiscal policy supports price-level stability.
4. The monetary and financial sector of the economy is significantly influence by the Federal Reserve System (the Fed) and the nation’s banks and thrift institutions.
a. The banking system remains centralized and regulated by government because historical problems in the U.S. economy led to different kinds of money and the mismanagement of the money supply. The U.S. Congress passed the Federal Reserve Act of 1913 to establish the Fed as the nation’s central bank to be responsible for issuing currency and controlling the nation’s money supply.
b. The Board of Governors of the Fed exercises control over the supply of money and the banking system. The U.S. president appoints the seven members of the Board of Governors, who serve for 14 years. The president also selects the board chair and vice chair, who serve 4-year terms.
c. The 12 Federal Reserve Banks of the Fed have three main functions.
(1) They serve as the nation’s central bank to implement the policies set by the Board of Governors.
(2) They are quasi-public banks that blend private ownership of each Federal Reserve Ban with public control of each bank through the Board of Governors.
(3) They are “bankers’ banks” that perform banking services for the member banks in their regions.
d. The Federal Open Market Committee (FOMC) is responsible for acting on the monetary policy set by the Board of Governors. The FOMC includes the seven members of the Board of Governors, the president of the New York Federal Reserve Bank, plus 4 other presidents of Federal Reserve bans (who serve on a rotating basis). The FOMC conducts open market operations to buy and sell government securities to control the nation’s money supply and influence interest rates.
e. The Fed performs seven functions: issuing currency, setting reserve requirements and holding reserves, lending money to banks and thrifts, collecting and processing checks, serving as the fiscal agent for the Federal government, supervising banks, and controlling the money supply. The last function is the most important.
f. The Federal Reserve is an independent agency of government with control of the money supply and influence over interest rates. This independence helps insulate it from political pressure from the U.S. Congress or the U.S. president when the Fed decides to adopt a necessary, but possibly unpopular, monetary policy such as raising interest rates to combat inflation.
5. Recent developments have affected money and banking in the U.S. economy.
a. The U.S. financial services industry consists not only of banks and thrifts, but also of insurance companies, mutual fund companies, pension funds and securities firms. Over the past 25 years, the amount of financial assets managed by banks and thrifts fell from nearly 60 percent to about 24 percent as households shifted financial assets to these other types of financial services firms.
b. The number of banks and thrift institutions has declined, partly as a result of bank and thrift mergers. These mergers enable banks and thrifts to compete more effectively within the financial services industry on a national or regional basis.
c. There has also been a convergence and growing similarity in the types of financial services offered by different financial institutions such as banks, thrifts, insurance companies, mutual funds, pension funds, and securities firms.
d. Financial markets are now more integrated and operate worldwide because of advances in communications technologies and greater competition for financial capital assets around the globe.
e. The character of money has changed with the shift to the widespread use of electronic payments to make purchases and settle debts and greater use of electronic forms of money.
f. A large amount of U.S. currency is circulating abroad for use by residents of other nations. The “global greenback” is demanded because the dollar does a better job of holding its purchasing power relative to domestic currencies, especially in those nations that have experience high inflation, wars, and political turmoil. The dollar in these nations serves an effective and reliable medium of exchange, store of value, and unit of account compare with domestic currencies.
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