Money is anything generally recognized as having value for the purpose of carrying out economic transactions. In the early stages of an economy, the item chosen typically has intrinsic value. In other words, it has utility and provides benefits or satisfaction if the owner chooses to keep it for his or her own personal use. If cigarettes become generally recognized as having value for economic deals in prison economies, then cigarettes become money with intrinsic value since they can be kept and smoked. Since furs were generally recognized as having value in the mid-nineteenth century, they became money with intrinsic value since they could be kept and made into a coat or a comforter.

The money we use in the American money system today has no intrinsic value. It is what is known as fiat money, that is, it is money because the government says it is and, more importantly, because we have general confidence in it. The coins and currency we use as money have no intrinsic value. They only have value because we all know that sellers of goods and services will take a $20 bill because they know that others in turn will accept it. Certainly, you wouldn't use dollar bills to start your fireplace or use them as wallpaper. Coin collectors are an exception, but in general coins and currency lack intrinsic value. If you examine a dollar bill, you'll notice the statement "This note is legal tender for all debts, public and private." This is what is meant by the term fiat money.

Note that while the U.S. Government owns gold reserves, there is no longer a direct connection between the ownership of gold reserves and the size of the money supply. That link was severed back in 1971.

If we went back far enough in history we would find no economic transactions at all. A family was a separate and independent economic unit engaged in subsistence food gathering. The next step was for two families to engage in barter, the direct exchange of one good for another. One family had taken an animal and had meat while another picked strawberries in a field. The two could get together and swap meat for strawberries.

The difficulty with barter is the matching process. If you want to swap camera equipment for scuba diving gear, you first have to find someone who has the scuba equipment. But that isn't enough. They must be interested in obtaining photographic equipment. This matching difficulty led to the need for the development of a money system. This occurs as an economy becomes more specialized and produces thousands and thousands of goods and services. It would be extremely inefficient for the modern U.S. economy to use a barter system as the major means of carrying out economic transactions.

This need for money is first satisfied by choosing an item with intrinsic value, as discussed above. The fact that the money chosen has value in and of itself provides us with psychological comfort. If something goes wrong with the money system, we can always use it for our own personal benefit. The next step is to realize that there is no need to carry around furs or cigarettes or whatever item has been chosen as money. Instead, we can use coins and paper. But to maintain some degree of psychological comfort, the government might own a certain amount of silver or gold or other precious metal. At this point in the development of a money system there will be a defined relationship between this ownership and the size of the money supply. For example, the rule could be that the U.S. Government must own an amount of gold that equals 25% of the M1 money supply, defined as all cash plus checking account money in the system. Years ago, we had in place such a requirement. Then it was determined that this was unnecessary, so we changed to a system of pure fiat money, as mentioned above. Every major country uses this type of system today. To summarize, the following progression normally occurs in the development of a money system:

Notice that these definitions are sequenced in terms of liquidity, with the most liquid or cash-like definition being M1 and the least liquid being M3. M3 is the least liquid because typically there is a three-month interest forfeiture assessed for tapping a certificate of deposit before it matures. Technically, M2 is less liquid than M1 because in the event of a banking system emergency, your access to your savings can be restricted more than your access to checking account balances.

The liquidity concept may be defined generally as the ease or difficulty with which an asset may be converted into cash without loss of fair market value. You could consider all the assets you own and rank them from most to least liquid. If you own stocks directly (as opposed to indirect ownership via a retirement plan such as a 401(k)), then you own a liquid asset because you can sell them and obtain your money within a few days. Alternatively, if you own real estate such as a house, then this is an illiquid asset since it may take several months or more to sell the property at its fair market value.

What about credit cards? They are not included in M1, M2, or M3 because they are loans or lines of credit.

One function of money has been referred to above, and that is the medium of exchange function. By using money as an intermediary, we eliminate the matching difficulty associated with barter. Now all you have to do is locate a seller who has a pair of shoes you want to buy and you can pay by cash, check, or credit card. You don't have to worry about whether the shoe seller is interested is swapping the shoes for your camera equipment. In this way money provides efficiency for the buying and selling of goods. We no longer have to waste time matching up buyers and sellers.

Money also functions as a measuring device. In a barter system you would constantly have to gauge the fair value of the swap. True, we still do that in a money system, but you'd have to do it much more if you were reduced to barter. Is a gallon of milk worth a bushel of tomatoes? Is a used Nikon camera body worth some used scuba gear? It's much easier to use money as the measuring device. If a gallon of milk is priced at $2, then you can compare that to the price at other stores or the price you paid last time at the same store or to the price of other drinks and food products. A money system makes this measuring process much easier and more efficient.

Using a barter system, how would you purchase a new car on credit? Would the seller agree to your delivering 100 bushels of tomatoes each month for four years as your car payment? That seems bizarre. Yet this is the type of arrangement that would be needed in a barter system. The usage of credit would be extremely limited.

The modern U.S. economy relies heavily upon credit. A money system is needed in order for this to work. Dollars are used as the money standard and when someone else's money is used, the "price" for using their money can be stated as a percentage rate of interest. The purchase of a car on credit can now be defined as $350 per month for five years at an interest rate of 8%. Credit transactions can be a major part of the economy, something that is not practical under a barter system.

When you receive a paycheck for your work, most of it is used for consumption spending. A small amount is allocated for savings. But how would you save in a barter system? If you paint a house and in return the homeowner pays you by doing yard work at your house, how would you save the service you received? If you sell a car and receive 100 bushels of tomatoes, how would you save some of these bushels? Maybe you could can them, if you're really motivated to do that. But you are much better off when you are paid in dollars. You can then divide your money into consumption spending and savings quite easily. This savings process is good for you individually (e.g., providing for retirement) and it is also good for the macroeconomy since it furnishes a source for the funding of investment.

The primary demand for money is known as the transactions demand. It involves ongoing, predictable bills such as house and car payments, food, clothing, utilities, etc. We know these bills are coming due and if we're diligent, we budget for them accordingly. Traditionally this transactions demand was handled by checking account money and it still is. For most households, the transactions demand for money accounts for 90% or more of disposable income.

The next type of demand for money is called precautionary demand. This demand for money may be positive or negative. The positive, precautionary type is the more pleasant of the two and involves an unplanned expenditure that is optional. For example, you go to a nearby shopping mall and find that the expensive scuba diving gear you have wanted for a long time is on sale at a great price and so you go ahead and buy it. The money comes from a savings account you built up over time. A modern variation of this is to use a credit card (negative savings) that has a significant amount of available credit.

Precautionary demand may also be negative. This is an unplanned outlay that is required, not optional. On the way home from work you drive too fast and receive a speeding ticket. You don't budget for this each month (at least, let's hope not) but you have to pay it. Or your water heater goes out and must be replaced. You don't budget for this either, but you have to pay for a replacement. As mentioned earlier, these kinds of expenditures were typically associated with a savings account.

If you are able to handle your transactions needs and also have built up a liquid savings account of three to six months of your monthly take home pay, then you would move on to the third type of demand for money, which is known as the speculative demand. The word speculative may not be the best label for the concept, but it is the usual one that is used. It doesn't refer to a trip to a gambling casino. It means that once the transactions and precautionary demands have been met, we will want to engage in some personal financial investing and we will want to retain a certain percentage of our investment portfolio in cash. This is done to preserve flexibility so that it is unnecessary to sell one stock or bond in order to purchase another. Professional managers of retirement and mutual funds will keep perhaps 5% to 10% of their portfolio in cash to achieve liquidity and flexibility. The exact percentage will vary with each fund and with market conditions. For individual investors, they will have a base account established at a brokerage firm. These base accounts will receive interest and dividend payments. They are a source for buying stocks and bonds without having to sell off other securities in order to do so.

The types of demand for money are summarized in the following table:

When you deposit your paycheck into a bank, only a small percentage of it is kept by the bank in its vault or on account with the Federal Reserve System. Most of your deposit is available for your bank to loan out. The amount kept on hand by your bank is known as the required reserve amount and is roughly 10% of your deposit. The rest of it, about 90%, is referred to as excess reserves. This is the source for lending to consumers and business firms.

Money creation in our banking system occurs because we have thousands of banks and money that is deposited into one bank may be loaned out and then redeposited into another bank. This process, known as the deposit-loan sequence, results in money creation or expansion of the money supply.

Suppose you deposit $1,000 into Bank 1. $100 is kept on hand as the required reserve amount. The other $900 is loaned to Borrower, who wants to buy an antique grandfather's clock. Borrower applies for a loan, his credit is checked and found to be good, and Bank One then adds $900 to Borrower's checking account. He then writes a check for $900 to the antiques dealer. The dealer then deposits this check into Bank Two. $90 is kept on hand as the required reserve amount and $810 is available to be loaned out. Debtor then applies for a loan so that he can buy a used motorcycle. He qualifies for credit, the loan is made, and the motorcycle dealer is paid $810. This amount is then deposited into Bank Three, and the process continues. The initial deposit of $1,000 could support an expansion of the money supply that is much more than the original $1,000 deposit.

A shortcut is available to summarize the maximum possible expansion of the money supply that could result from an initial deposit of, say, $1,000. A multiplying factor, known as the bank multiplier, is first calculated. Just take the number one and divide by the reserve requirement. In our example, 1/.10 equals 10. Now take this factor of 10 and multiply it by the amount of the initial deposit. Since the initial deposit was $1,000, the answer is $10,000. Note that this is the maximum possible expansion that can result from the deposit-loan sequence. Banks might choose to not make all possible loans up to the legal limit due to a lack of qualified borrowers or for other reasons. Also, at various stages in the deposit-loan sequence, there might not be a complete redeposit into the next bank. Instead, cash leakage could occur. That is, the payments to the antiques dealer and the motorcycle dealer in the examples above might be cashed, in whole or in part. To the extent this occurs, the maximum possible expansion through the loan-deposit sequence is diminished. In fact, studies by the Federal Reserve System indicate that the real world bank multiplier is closer to 3 than 10. That's a big difference, although for some banks the reserve requirement is .12 instead of the .10 used in the above example. A reserve requirement of .12 would yield a bank multiplier of 8.33. Still, that's a large difference. The exact percentage reserve requirement for a particular bank depends on the total amount of deposits in that bank.

The Fed has many different responsibilities, including auditing banks for sound practices, providing banking services for the federal government, research and publishing, and overseeing monetary policy. The Fed's management of monetary policy is its most important function. Monetary policy deals with the adjustment of interest rates, particularly the Fed Funds Rate, so as to either increase or decrease the growth rate of GDP. A change in the Fed Funds rate (or the Discount Rate, which is not as important these days) will lead to a change in the growth rate of the money supply, which in turn will lead to a change in the GDP growth rate.

As an organization, the Fed is headed by the Board of Governors and the Federal Open Market Committee. The seven-member Board of Governors is headed by the Fed Chairman. There is also a vice-chairman. Both of these individuals serve four-year terms. They are appointed (and reappointed) by the President, subject to approval by the Senate. The other five members serve fourteen-year terms. They also are appointed by the President and confirmed by the Senate. These terms are staggered so that they won't all come open at one time.

The Board of Governors sets the Discount Rate, which is the interest rate the Fed charges to banks that borrow from the Fed, as well as the Reserve Requirement, which has already been discussed. All seven members of the Board of Governors are also part of the Federal Open Market Committee. The FOMC also includes the president of the New York Fed (one of the twelve Fed district banks) because the NY Fed handles the Open Market Operations that will be discussed shortly. Four of the other eleven Fed district bank presidents serve one year terms a rotating basis. So the total number of voting members on the FOMC is twelve. However, the non-voting Fed district bank presidents normally attend and participate in the FOMC meetings, even if they don't vote.

The responsibility of the FOMC is to set the Federal Funds Rate, which is the interest rate banks pay each other on short-term, overnight loans. The FOMC also provides guidance to the open-market operations that are executed by the NY Fed. When the Fed lowers the Fed Funds Rate (or the Discount Rate), other interest rates in the system, such as home mortgage loans or car loans, normally decrease also. The effect of this is to stimulate more economic activity as goods become more affordable. This will increase the GDP growth rate. On the other hand, if the Fed raises the Fed Funds or Discount Rate, other interest rates will tend to rise also, making goods less affordable, thereby slowing down the GDP growth rate.

Both the Fed Funds Rate and the Discount Rate may be though of as wholesale interest rates. When wholesale rates go up, we expect retail interest rates to rise. This will slow the GDP growth rate. When wholesale rates drop, retail interest rates will decrease also and the GDP growth rate will increase. In fact, some retail lenders link their interest rates directly to the Fed Funds rate. For instance, a lender who finances cars could use the Fed Funds rate plus four percentage points as its retail interest rate. If the Fed Funds rate were 5%, the retail-lending rate would be 9%. Banks that issue credit cards often tie their interest rate to the federal funds rate or anther interest rate that is linked to the federal funds rate.

The Fed Funds rate is actually a market determined rate but it is heavily influenced by the Fed's open market operations, so the effect is that the Fed can set a target for the Fed Funds rate and come close to hitting the target by using its open market operations. Open market operations involve the buying and selling of government securities by the Fed. These securities are sold by the U.S. Treasury at auction to licensed bond dealers and are used to finance the accumulated U.S. Government's deficit. After these securities are sold to dealers, who then resell to their own customers, the Fed participates in the secondary market for these securities. Some of the securities are short-term, such as a 90 day Treasury bill, and others are long term, such as a 30 year U.S. Government bond. There are many securities that are in between these two extremes in their maturity dates. All of the securities may be bought and sold freely in the marketplace at any time.

Suppose the Fed wants to slow down the GDP growth rate to stop possible inflation. The Fed will raise federal funds target rate. To achieve the target rate, the Fed will sell government securities. As the Fed is paid for these securities, bank reserves drop. As bank reserves decrease, the pool of excess reserves for loans also decreases. The supply of money for loans is diminished and interest rates rise. The GDP growth rate will fall.

Now suppose the Fed wants to stimulate the economy and increase the GDP growth rate so as to create more jobs and reduce unemployment. It would reduce the federal funds rate target. To hit the new target, the Fed would buy government securities. The Fed would have to pay for these securities and the result would be an increase in bank reserves, including excess reserves. As the supply of reserves available for loans increases, interest rates will decrease. The GDP growth rate will rise.

The Fed could also stimulate the GDP growth rate by reducing the required reserve amount (although the Fed rarely takes this action because it is difficult for banks to adjust to this type of change). The effect would be to increase the excess reserve amount, thereby stimulating the lending process and increasing the GDP growth rate.

To slow the GDP growth rate, the Fed could raise the required reserve amount. This would reduce the amount of excess reserves and drive up interest rates. Fewer loans would be made as goods become less affordable. The economy would slow down.

When the Fed decides to increase the GDP growth rate by reducing interest rates, we refer to the Fed as moving toward ease or pursuing an easy money policy. When the Fed decides to decrease the GDP growth rate by increasing interest rates, the Fed is said to be tightening or pursuing a tighter money policy. Under some conditions, the Fed may be doing neither. It may just be in a neutral position. Sometimes, when the Fed is in neutral, it will give an indication that it's next move is likely to be toward ease or tightness. These indications are subject to change, however.

The following table summarizes the basic tools available to the Fed for increasing or decreasing the GDP growth rate:

You already know the difference between a liquid and an illiquid asset. You can think of the Fed as altering the liquidity of the overall money and banking system by taking easy or tight money policy actions. When the Fed pursues an easy money policy, it is making the system more liquid and the result is more lending activity, more deposit-loan money supply expansion, and an increase in the GDP growth rate. An analogy might be a situation in which you are walking around a shopping mall with $1,000 stuffed into your wallet or purse. You are more likely to buy goods because you are quite liquid. The opposite situation would be walking around a mall with only $10 in your pocket. You are much less liquid and less likely to purchase as much. Note that in both cases your overall net worth (assets minus liabilities) might be the same. Let's say they are in fact the same. In other words, this is just a change in liquidity, not overall net worth. The same is true for the Fed. The immediate result of a tighter or easier money policy is a change in liquidity in the money and banking system, not net worth.

The velocity of money, or annual turnover rate of the "average" dollar, is a potential wild card for the Fed. If we consider the dollars in our money system, we realize that some may be turning over quite slowly. This is true for coins or bills that you stuff into a piggy bank. On the other hand, some dollars are spent and respent rapidly. We need a more specific definition for the velocity of money. It is defined as the GDP divided by the money supply. Either M1, M2, or M3 may be used as the money supply. For historical comparison purposes, M1 is usually chosen. So Velocity = GDP/M1. If the current U.S. GDP = $7.5 trillion and the current M1 = $1 trillion, then velocity = 7.5.

If we take the formula velocity = GDP/M1 and cross-multiply it, then we have Velocity x M1 = GDP. Now suppose the Fed wishes to pursue an easy money policy and boosts the growth rate of M1. The intention is to increase the growth rate of the GDP. Could this intent be foiled by a perverse drop in the velocity of money? Or suppose the Fed wanted to pursue a tight money policy to slow the economy down and therefore raised interest rates to cut the money supply. Could this intent also be foiled by an unwelcome increase in velocity? In theory, it could be. In practice, velocity is found to be relatively stable for the short-run. This notion of the short run is ambiguous, but in this context it is about twleve to eighteen months. Anything more than that is long-run. Velocity is less stable over the long-run.

If velocity is relatively stable over the short run, then a boost in the money supply growth rate (i.e., easy money policy) should result in a rise in the GDP growth rate. A decrease in the money supply growth rate (i.e., tight money policy) should lead to a decrease in the GDP growth rate. But this raises a question: When the GDP growth rate rises or falls, are we talking about nominal or real GDP? Take the above equation Velocity x M1 = GDP and restate it as follows: Velocity x M1 = P x Q, where P stands for the average price level and Q stand for the actual production of goods and services in the economy. In this version, we're just substituting P x Q for GDP and you already know that GDP may be though of as P x Q for each and every new good or service produced.

The equation in this form is known as the Equation of Exchange.

Suppose the economy is in a recessionary state. There is a lot of slack in the economy. In other words, the factors of production are not fully utilized. The Fed would pursue an easy money policy to stimulate the economy and reduce unemployment. The left side of the equation would increase and so the right side would have to increase also. The hope is that the Q (the actual production of goods and services) would increase, not the price level. When the price level goes up, that's just inflation, which doesn't improve the economy's performance. What's needed is an increase in the Q and it's very likely that this will happen because the factors of production are plentiful. In this situation it should be possible to take some of the slack out of the economy without increasing the rate of inflation.

However, if the Fed tried this when the economy was already at full employment, then there would be no room for the Q to grow and the result would be inflation.

Consider again the Velocity x M1 = P x Q Equation of Exchange. Now assume the economy is overheating with too much inflation. The Fed would use a tight money policy to try to reduce the inflation. The growth rate of the money supply would be cut and the left side of the equation would decrease. This would force the right side down also. But this time the Fed would hope to reduce the P (the price level or amount of inflation) to cut the inflation rate. In reality, there would be some reduction in the Q as well.

This Equation of Exchange in an alternative way of viewing the macroeconomy, just as supply-side and demand-side economics are different approaches to the economy.

You are now ready to work on the Problems and Exercises for Unit Four, Assignment One.