I. The Meaning of Money

A. Definition of Money: the set of assets in an economy that people regularly use to buy goods and services from other people.

B. The Functions of Money

1. Money serves three functions in our economy.

a. Definition of Medium of Exchange: an item that buyers give to sellers when they want to purchase goods and services.

b. Definition of Unit of Account: the yardstick people use to post prices and record debts.

c. Definition of Store of Value: an item that people can use to transfer purchasing power from the present to the future.

2. Definition of Liquidity: the ease with which an asset can be converted into the economy’s medium of exchange.

a. Money is the most liquid asset available.

b. Other assets (such as stocks, bonds, and real estate) vary in their liquidity.

C. The Kinds of Money

1. Definition of Commodity Money: money that takes the form of a commodity with intrinsic value.

2.  Definition of Bank Notes:  money that is backed by a commodity with intrinsic value.

3. Definition of Fiat Money: money without intrinsic value that is used as money because of government decree.

D. Money in the U.S. Economy

1. The quantity of money circulating in the United States is sometimes called the money supply.

2. Included in the measure of the money stock are currency, demand deposits and other monetary assets.

a. Definition of Currency: the paper bills and coins in the hands of the public.

b. Definition of Demand Deposits or Checkable Deposits: balances in bank accounts that depositors can access on demand by writing a check.

II. The Federal Reserve System

A. Definition of Federal Reserve (Fed): the central bank of the United States.

B. Definition of Central Bank: An institution designed to oversee the banking system and regulate the quantity of money in the economy.

C. The Fed’s Organization

1. The Fed was created in 1914 after a series of bank failures.

2. The Fed has a Board of Governors with seven members who serve 14-year terms.

a. The Board of Governors has a chairman who is appointed for a four-year term.

b. The current chairman is Ben Bernanke.

3. The Federal Reserve System is made up of 12 regional Federal Reserve Banks located in major cities around the country.

4. One job that the Fed does is the regulation of banks to ensure the health of the nation’s banking system.

5. The second job of the Fed is to control the quantity of money available in the economy.

a. Definition of Money Supply: the quantity of money available in the economy.

b. Definition of Monetary Policy: the setting of the money supply by policymakers in the central bank.

D. The Federal Open Market Committee

1. The Federal Open Market Committee (FOMC) consists of the 7 members of the Board of Governors and 5 of the 12 regional Federal Reserve District Banks.

2. The FOMC meets about every six weeks in order to discuss the condition of the economy and consider changes in monetary policy.

3. The primary way in which the Fed increases or decreases the supply of money is through open market operations (which involve the purchase or sale of government bonds).

a. If the Fed wants to increase the supply of money, it creates dollars and uses them to purchase government bonds from the public.

b. If the Fed wants to lower the supply of money, it sells government bonds from its portfolio to the public. Money is then taken out of the hands of the public and the supply of money falls.

B. Money Creation with Fractional-Reserve Banking

1. Definition of Fractional-Reserve Banking: a banking system in which banks hold only a fraction of deposits as reserves.

2. Definition of Required Reserve Ratio: the fraction of deposits that banks hold as reserves.

C. The Money Multiplier

1. The creation of the money does not stop at the first bank.

2. Borrowers usually borrow money to purchase something and then the money likely becomes redeposited elsewhere.

3. Suppose a person borrowed the $90 to purchase something and the funds then get redeposited in Second National Bank. Here is this bank’s T-account (assuming that it also sets its reserve ratio to 10%):

4. If the $81 in loans becomes redeposited in another bank, this process will go on and on.

5. Each time the money is deposited and a bank loan is created, more money is created.

D. The Fed’s Tools of Monetary Control

1. Definition of Open Market Operations: the purchase and sale of U.S. government bonds by the Fed.

a. If the Fed wants to increase the supply of money, it creates dollars and uses them to purchase government bonds from the public.

b. If the Fed wants to lower the supply of money, it sells government bonds from its portfolio to the public. Money is then taken out of the hands of the public and the supply of money falls.

c. If the sale or purchase of government bonds affects the amount of deposits in the banking system, the effect will be made larger by the money multiplier.

d. Open market operations are easy for the Fed to conduct and are therefore the tool that the Fed uses most often.

2. Definition of Reserve Requirements: regulations on the minimum amount of reserves that banks must hold against deposits.

a. This can affect the size of the money supply through changes in the money multiplier.

b. The Fed rarely uses this tool because of the disruptions in the banking industry that would be caused by frequent alterations of reserve requirements.

3. Definition of Discount Rate: the interest rate on the loans that the Fed makes to banks.

a. When a bank cannot meet its reserve requirements, it may borrow reserves from the Fed.

b. A higher discount rate discourages banks from borrowing at the Fed and likely encourages banks to hold onto larger amounts of their reserves. This in turn lowers the money supply.

c. A lower discount rate encourages banks to lend their reserves (and borrow from the Fed). This will increase the money supply.

d. The Fed also uses discount lending to help financial institutions that are having difficulties.

 

I. Productivity: Its Role and Determinants

A. Why Productivity Is So Important

1. Example: Robinson Crusoe

a. Because he is stranded alone, he must catch his own fish, grow his own vegetables, and make his own clothes.

b. His standard of living depends on his ability to produce goods and services.

2. Definition of Productivity: the amount of goods and services produced for each hour of a worker’s time.

Economic Growth and Public Policy

A. The Importance of Saving and Investment

1. Because capital is a produced factor of production, a country can change the amount of capital that it has.

2. However, there is an opportunity cost of doing so; if resources are used to produced capital goods, fewer goods and services are produced for current consumption.

3. Look at the Production Possibilities Curve.

a. Countries that devote a large share of GDP to investment tend to have high growth rates.

C. Investment from Abroad

1. Saving by domestic residents is not the only way for a country to invest in new capital.

2. Investment in the country by foreigners can also occur.

D. Education

1. Investment in human capital also has an opportunity cost.

a. When students are in class, they cannot be producing goods and services for consumption.

b. In less developed countries, this opportunity cost is considered to be high; as a result, children often drop out of school at a young age.

E. Property Rights and Political Stability

1. Protection of property rights and promotion of political stability are two other important ways that policymakers can improve economic growth.

2. There is little incentive to produce products if there is no guarantee that they cannot be taken. Contracts must also be enforced.

3. Countries with questionable enforcement of property rights or an unstable political climate will also have difficulty in attracting foreign (or even domestic) investment.

F. Free Trade

1. Some countries have tried to achieve faster economic growth by avoiding transacting with the rest of the world.

2. However, we know that trade allows a country to specialize in what it does best and thus consume beyond its production possibilities.

3. When a country trades wheat for steel, it is as well off as it would be if it had developed a new technology for turning wheat into steel.

4. The amount a nation trades is determined not only by government policy but also by geography.

G. The Control of Population Growth

1. High population growth reduces GDP per person.

2. Rapid growth in the number of workers forces other inputs to be spread more thinly between the workers (especially capital).

3. Countries with high population growth rates also have a large number of school-age children, putting strains on the educational system.

4. Some countries have already instituted measures to reduce population growth rates.

5. Policies that foster equal treatment for women should raise economic opportunities for women leading to lower rates of population.

H. Research and Development

1. The primary reason why living standards have improved over time has been due to large increases in technological knowledge.

2. The U.S. government promotes the creation of new technological information by providing research grants and providing tax incentives for firms engaged in research.

3. The patent system also encourages research by granting an inventor the exclusive right to produce the product for a specified number of years.