What is Money? (Money and Banking)

I. Introduction

Circular Flow Model of Capitalism

Which of the arrows in the figure below represent money flow? Flow (1) is costs and income money flows and flow (4) represents consumer expenditures and business receipts money flows.


Why Monetary Side is Important

Without money there would be barter. Barter is the direct exchange of goods and services for other goods and services. We discussed the problem with barter in the lesson on trade.


a. Definition: the exchange of one good or service for another good or service

b. Problems with barter:

  • coincidence of wants:
    • a situation in which the good or services that one trader desires to obtain is the same as that which another desires to give up and an item that the second trader wishes to acquire is the same as that which the first trader desires to surrender
    • you have to find somebody who wants to trade the item that you want to get AND who also wants the item that you have that you want to trade


    • With barter there will be less specialization because of the difficulty of overcoming the coincidence of wants.
      • If you can't find someone to trade with, you will have to produce it yourself
      • Less specialization means less output and MORE SCARCITY

Without money there would be less trade and therefore less specialization and productive inefficiency. Therefore, from the same quantity of resources, LESS would be produced . Money avoids the double coincidence of wants and allows for more specialization and productive efficiency. Therefore money allows us to use our limited resources wisely and produce MORE with the same amount of resources. this helps to reduce scarcity.

Money facilitates trade and promotes specialization


This is why money is important.

II. What Is Money?

A. Examples of Money
People have used cattle, cigarettes, shells, stones, gold, and even beer as money

So what is Money?

Money is anything that does what money does:

B. Functions of Money
optional: http://www.nd.edu/~cwilber/econ504/504book/outln13d.html

1. Medium of exchange
a. Money can be used for buying and selling goods and services

b. without money we have the problems of barter and the coincidence of wants

c. money allows for greater specialization and trade and productive efficiency

2. Unit of account: Prices are quoted in dollars and cents.

3. Store of value:

  • money allows us to transfer purchasing power from present to future.
  • it is the most liquid (spendable) of all assets,
  • a convenient way to store wealth.


  • What problems does barter entail?
  • Indicate the economic significance of money as a medium of exchange.
  • What is meant by the statement: "We want money only to part with it"?

Barter requires the "double coincidence of wants." If someone wants something, he or she will have to find someone who wishes to part with that good and at the same time wishes to exchange the good for something that the first party wishes to part with.

With money as a medium of exchange, one knows the purchase price of the item to be purchased and its price relative to other items. Money is a very convenient common denominator, a common measure of value that is also used as a medium of exchange. Money also encourages specialization. Without money, workers and other resources could not be paid except in the output produced. All those who participated in the production of the good would have to collectively exchange it for all the goods and service desired by the resource owners.

Money itself has value only in relation to the resources, goods, and services that can be obtained with it. When people say that they want money, they really mean that they want the things that money can buy. In this sense, money imparts value only when someone parts with it.

III. Money Supply (MS)

A. REVIEW - If: MS Interest Rates I AD

B. Money Definitions:

1. M1
a. the most liquid definition of the money supply: they are directly and immediately usable as a medium of exchange

b. M1 includes:

  • currency (coins and paper money)
  • checkable deposit

c. Review: If I take $10 from my wallet and put it into my checking account, what happens to M1?




If I take $10 from my wallet and put it into my checking account, what happens to M1?


M1 does not change

d. The following are NOT part of M1:

  • currency in banks
  • currency and checkable deposits owned by the government
  • currency and checkable deposits owned by the Federal Reserve Banks

2. Money Definition: M2

a. M2 is a little less liquid than M1

b. M2 includes:

  • M1
  • Savings deposits and money market deposit accounts.
  • Certificates of deposit (time accounts) less than $100,000.
  • Money market mutual fund balances, which can be redeemed by phone calls, checks, or through the Internet.


  • Review: If I take $10 out of my wallet and put it into my savings account
    • what happens to M1?
    • what happens to M2?





    If I take $10 out of my wallet and put it into my savings account

    • what happens to M1?
      • It decreases by $10
    • what happens to M2?
      • It does not change, Remember, M2 includes M1

3. Money Definition: M3 includes

a. M2, and

b. large certificates of deposit (time accounts) of $100,000 or more


C. Graph

D. When we say:

MS Interest Rates I AD

Which measure of the MS should we use?


1. we will use M1 just to keep it simple

2. economists generally use M2

3. M2 and M3 are important because they can easily be changed into M1 types of money and influence people's spending of income.

4. The ease of shifting between M1, M2, and M3 complicates the task of controlling the spendable money supply.

E. What is not money?

1. currency and checkable deposits of the government, Federal Reserve, and banks
2. income is not money
  • income is a FLOW concept: you earn income over time (e.g.. $500 a week)
  • money is a STOCK concept: you have a given amount at a point in time ( e.g. $500 in your wallet and checking account right now)
  • when we talk about "money demand" we will mean a demand for more liquidity (more in my wallet) NOT an increase in my income
  • Can you get an increase in your income and have less money?
    • YES, if you put more of your income in the stock market and less in your checking account

3. credit cards

  • Credit cards are not money, but their use involves short-term loans; their convenience allows you to keep M1 balances low because you need less for daily purchases.

F. Why is money "money"? -- What "backs" the money supply?)

1. money as debt
a. The government's ability to keep its value stable provides the backing.

b. People cannot convert paper money into a fixed amount of gold or any other precious commodity

2. value of money: why is money, money?

a. acceptability, because we accept it as money.
  • sometimes checks are not accepted, then they are not money
  • sometimes you cannot pay in cash, then cash is not money

b. " legal tender " is fiat money - it is money just because the government says so

c. relative scarcity -

  • The relative scarcity of money compared to goods and services will allow money to retain its purchasing power.
  • The government tries to keep supply stable with appropriate fiscal policy.
  • Monetary policy tries to keep money relatively scarce to maintain its purchasing power, while expanding enough to allow the economy to grow.
  • If the money supply expand too quickly (is relatively less scarce) it will lose some purchasing power
  • An extreme example of this was German hyperinflation. After World War I the German government issued so much paper money that the German mark became nearly worthless.

IV. Money Demand

1. What is it?
  • MD is our demand for liquidity
  • it is our demand to keep some of our wealth in our wallets, purses, and checking accounts
  • it is NOT a request for higher wages at work

2. Sources of money demand: why do we want to hold M1 money?

a. transactions demand for money
1) definition:
  • we keep M1 money in order to buy things
  • the demand for money as a medium of exchange

2) transactions demand and nominal GDP

  • directly related: when GDP increases the transactions demand for money also increases (shifts to the right).
  • the main determinant of transactions demand is nominal GDP

3) transactions demand and interest rates

  • we'll assume that they are unrelated

4) graphically

b. asset demand

1) definition:
  • we keep some money so that we can spend it later
  • the demand for money as a store of value

2) What determines how much money (M1) we keep in our wallets, purses, and checking accounts?

  • problem with holding money: you are not earning interest on it
  • asset demand and interest rates are inversely related
    • if interest rates are high, people will keep less in their pockets and more in their savings accounts (and as other interest earning assets)
    • if interest rates are low, people will keep more money in their pockets, because they are not losing much and it is more convenient

3) graphically

c. total money demand

  • MD = transactions demand + asset demand
  • Graph

Graph from the textbook:


V. The Money Market


A. If MS decreases:
  • interest rates will rise

B. If MS increases:

  • interest rates will fall

C. Graph

D. Quick Review Quiz

VI. The Federal Reserve and the Banking System

A. Structure of the Federal Reserve System
1. Board of Governors
  • seven members
  • appointed by the US president and confirmed by the senate
  • 14 year terms
  • the US president selects the chairperson (currently Alan Greenspan)

2. Federal Open Market Committee (FOMC)

  • 12 members:
    • the 7 members of the BOG
    • the president of the New York Federal Reserve Bank
    • 4 of the other 12 Fed bank presidents on a rotating basis
  • conduct open market operations (OMO - see chapter 15)

3. The 12 Federal Reserve Banks

a. they act like a central bank coordinated by the Fed BOG

b. quasi-public banks

  • each Federal Reserve Bank is owned by the private commercial banks in its district
  • but the BOG, a government body, sets the basic policies
  • making a profit is not their goal
  • goal is to help the economy

c. a bank for banks

  • banks keep deposits at the Fed
  • banks take out loans from the Fed (DR see chapter 15)

4. Commercial Banks and Thrift Institutions


B. Functions of The Federal Reserve System (Fed)

1. issue currency = Federal Reserve Notes

2. setting reserve requirements (RR see chapter 15)

3. lending money to banks and thrifts (the discount rate -DR- is the interest rate banks are charged for borrowing from the Fed)

4. providing for check collection

3. acting as fiscal agent for the US government

4. supervising banks

5. controlling the money supply

C. Federal Reserve Independence

1. The Federal reserve is quite independent of political control
  • The BOG is appointed by the president, BUT
  • for 14 year terms

2. controversy

  • Advocates of independence fear that more political ties would cause the Fed to follow expansionary policies and create too much inflation, leading to an unstable currency such as exists in some other countries


  • Most countries maintain political control over their central banks


  • The 12 members of the FOMC can decide to decrease the MS (to fight inflation) and put millions of people out of work and there is little recourse. Politicians may complain but they can do little.