I. Functions of money
    A. Medium of exchange: facilitate exchange eliminating barter which requires people with mutually needs.
    B. Standard of value: allows for the pricing of heterogeneous goods.
    C. Store of value: maintains value and provides liquidity so extra spending power is available as needed.
    D. Standard of deferred payment: makes credit contracts possible so credit transactions are possible.

II. The money supply
     A. Three categories of money
          1. M1 = Currency, coins, and demand deposits (checking accounts). 
          2. M2 = M1 plus near monies such as small time deposits (savings accounts) and short-term government securities. 
          3. M3 = M2 plus large time deposits (over $100,000)
     B. What backs the dollar?
          1. It is a debt of the federal government.
          2. Backed by faith in the government's ability to control inflation.
          3. Value is determined by acceptability (it is legal tender and scarce).
          4. It's fiat (by decree of the government) money.
          5. Coins have little intrinsic value (a small % of face value) so they are called token money.
          6. Commodity money such as tobacco used as money in the Virginia colony has intrinsic value of its own.

III. Maintaining money's value requires
       A. A sound fiscal policy (a reasonable federal debt)
       B. A sound monetary policy (not using inflation to pay the federal debt)

IV. United States private banking system
      A. Two kinds of banks
          1. Commercial banks offer demand deposits (checking accounts)
          2. Savings and loan associations used to specialize in time deposits (saving accounts) and home mortgages. 
              Now, because of deregulation during the early 1980's, they are similar to commercial banks. 
     B. Federal deregulation contributed to banking difficulties in the 1980's.
     C. Visit History provided by the Federal Reserve Bank of St. Louis for a time line of the U.S. banking System. 
          Be sure to point at each date to see what happens during that period.

V. The Federal Reserve System
     A. Organization Chart

 

           1. Board of Governors oversee the Federal Reserve System
                a. Seven governors
                b. Governors are appointed by the President and confirmed by the Senate.
               c. The chair is appointed by the President for a four-year term.
                   1)  To foster independence, the term does not coincide with the President's term. 
                   2) Other board members are appointed to 14-year terms on a staggered basis to insure an experienced board.
             2. Federal Open Market Committee
                 a. Membership consists of the Board of Governors and 5 of the 12 Federal Reserve bank presidents with the 
                    N.Y. president always a member because N.Y. City is the financial center for U.S. international trade.
                 b. The Committee tries to affect interest rates by affecting the supply of money by buying and selling U.S. government 
                    bonds (See Chapter 15).
             3. Federal Advisory Council 12 prominent commercial bankers, one from each district, who advise the Board of 
                 Governors
             4. Twelve Federal Reserve Banks 
                 a. The United States is divided into 12 homogenous districts and each has its own bank
                 b. Bank for the federal government
                 c. Bank for member banks
                 d. Graphic is complements of the Board of Governors of the Federal Reserve System.

            5. Member commercial banks
            6. Nonmember commercial banks and thrifts are regulated by other government agencies
        B. Functions of the Federal Reserve
            1. Regulate the money supply
            3. Oversea the financial system
            4. Check collection and clearing
            5. Fiscal agent for the government
            6. Supervise (audit) member banks 
            7. Hold reserves (deposits) for member banks
            8. Compile economic statistics such as the Beige book, which is
                a quarterly summary of each districts' recent economic activity.
           9. Many Federal Reserve publications are free.
          10. 2008/05/Paul Volcker  on the 2007-08 financial crisis and the Federal Reserve bailout of Bear Stearns.
      C. Philadelphia Reflections: Whither, Federal Reserve? is a well done, concise history of banking in the United States.

VI. The fractional reserve system and the creation of money
      A. Commercial banks are required to keep a reserve (cash) of about 12% of their demand deposits (checking accounts)
           at their bank or on deposit with the Federal Reserve (required reserves). The remainder, (Excess Reserves) may 
           be loaned out even though they support deposits.
      B. Money is created by these loans as long as the demand deposits (DD) created by them stay within the banking system, 
           that is, the money loaned is redeposit as a DD into a bank within the system. The banks owe the demand deposits created
           by the loans to each other. These inter-brain debts  are canceled with a bookkeeping entry. It should be pointed out that the 
           demand deposits created by such loans are spent, and goods transferred, just as if the transaction involved currency.
      C. Example: Bank A has $50,000 in demand deposits. A reserve requirement of 10% would yield required reserves of 
           .10 x $50,000 = $5,000. If Bank A had $7,000 in reserve, it could loan up to $2,000 in the form of demand deposits. 
           Suppose Bank B does exactly the same with both banks' customers depositing their DD in the other bank. Banks would 
           owe cashed checks to each other, would cancel interbank debts, and money  has been created.
      D. The system works in reverse with money destroyed if reserves leave the system.
      E. Required reserves, reserves not loaned, and loans of cash (reserves) represent a leakage which eventually stops money
          supply growth.

VII. The monetary multiplier
        A. An infusion of reserves into the system by the Treasury as directed by the Federal Reserve can be loaned a number of times
             by the commercial banking system. For example, the Federal Reserve may buy a $100 Treasury bond from Ms. A who  
             deposits the Federal Reserve check (reserves) into Bank A.
        B. Bank A's new DD of $100 requires them to keep $10 (10%) in reserve leaving $90 excess to loan to Mr. B who 
            deposits it in Bank B.
        C. Bank B needs to keep only $9 ($90 x .1) in reserve and may loan out $81. 
        D. This process continues and as long as the demand deposits being created by the loans stay within the commercial 
             banking system, interbank debts are canceled and money has been created
        E. Monetary multiplier (M) sets the upper limit of the expansion
           1. R = reserve requirement = 10% = .1
           2. M = 1/R = 1/.1 = 10
        F. In the above example the total amount of DD created beginning with Bank A's $90 in excess reserves would equal 
            Excess Reserves x M = $90 x 10 = $900. If the $100 infusion by the Federal Reserve is included, the increase is 
           10 x 100 = $1,000.
        G. For more Information visit The Banking System and the Money Multiplier from Jay Kaplan of the University of Colorado at Boulder.

VIII. The quantity theory of money
         A. Represents the basic theory behind macroeconomics prior to the Keynesian Revolution
         B. Believed that changes in the money supply would only affect price and not economic activity.
         C. The equation of exchange
                                                                                       MV = PT
                    Money Supply X Velocity of Money  = Average Price Level X Number of Transactions

             1. Velocity of money is how often the money supply is spent.
             2. Number of transactions is real economic activity
             3. The equation is an identity
                 a. Dollars spent = dollars received
                 b. MV = Aggregate Demand and PT = Nominal GDP = C + I + G + X_N = GDP
             4. Classical theory stated that V was basically stable and that there existed some natural level of growth for T. 
                  a. This natural level was a function of individual and business interaction. 
                  b. V and T were essentially unalterable which meant changes in M would change P and not the natural level of T. 
                  c. Government should therefore refrain from interfering with market activity by adjusting the money supply.
         D. Came into disfavor in the 1930's with the popularity of Keynesian economics which stated that real output could
              be changed by affecting aggregate demand.

IX. Monetarism
       A. Monetarists believe that changes in the money supply are both a necessary and sufficient condition to cause inflation.
       B. If AD was low, increasing the money supply would only increase short-run economic activity. 
           1.Eventually short-term expansion stops and increasing M only adds to inflation. 
           2. Public anticipation stops the process from being repeated. 
           3. Monetarists believe that government involvement in the economy, especially monetary intervention, increases 
               the magnitude of the business cycle.
      C. Keynes believed changing the money supply would affect interest rates which would affect investment which in turn
           would affect Real GDP
      D. To some degree monetarism is an extension of classical economics. Its advocates believe that a competitive market,
           free from government interference, results in economic stability and a reasonable growth rate.
      E. For more on Monetarism visit  Monetarism from The Concise Encyclopedia Of Economics and Monetarism from 
          The History of Economic Thought Website.

X. New classical economists 
     A. Lead by Milton Friedman, these economists revived the quantity theory of money. 
     B. They rely on market forces and not government manipulation of aggregate demand and the money supply to control
          economic activity. 
     C. This economic school of thought has much in common with those who believe in rational expectations. 
          1. This recently formed school does not assume market participants have perfect knowledge. 
          2. Instead, it assumes market participants will learn from experience and use current information to predict and
              adjust to the expected future. 
          3. The result is not the disequilibrium of Keynesian economics with its inflationary and deflationary gaps but a constant
              equilibrium with economic behavior adjusting to be compatible with different levels of economic activity. 
          4. As with the classical school, the new classical school, monetarist, and those believing in rationalist expectation feel 
              government involvement in economic activity is not beneficial.
      D. For more on New Classical Economics visit New Classical Macroeconomics, by Robert King: The Concise

XI. Supply-side Economists
      A. Slow economic growth and high inflation of the 1970's caused some economists to emphasize increasing Aggregate Supply.
      B. Known as Supply-Side Economics, this theory is discussed in chapter 16.

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