Chapter 14:  Money, money money.  What is its function in our market economy?  How much money is there?  What are the definitions of money?  What gives our money value?   What are the major characteristics of the U.S. financial system?  What is the Federal Reserve?  What are its functions?  This chapter is loaded with information, so plan to spend some time with it.

The functions of money:  Money serves three important functions in a modern market economy:

1.    Medium of exchange:

2.    Standard of value or unit of account:

3.    Store of value:

*    Liquidity is a characteristic of any asset and refers to the ease with which that asset can be converted into another form, especially money.  By definition, money has perfect liquidity.  Financial assets (bonds and money) generally have greater liquidity than real assets such as personal and real property.

How large is the U.S. money stock? Or, put differently, just exactly how much money is there in our economy?  The answer depends on which definition of money we use.  We will focus on the three most popular definitions of money used by the monetary authorities.

M1  =  Currency in circulation  +  Checkable deposits

    This is the narrowest definition of money, including only those forms of money that have perfect liquidity.  Often referred to as "pure money," M1 includes those forms of money immediately usable as a medium of exchange.

M2  =  M1  +  Savings deposits (including MMDAs)  + Small time deposits (less than $100,000) +   MMMFs held by individuals 

    M2 is often referred to as "near money" because it is composed of highly liquid financial assets that do not function directly as a medium of exchange but can readily converted into currency.

MZM  =  M2  -  Small time deposits  +  MMMFs held by businesses

What gives our money value?  Or, why is a dollar worth a dollar?

First of all, remember that money is debt.  Currency  (Federal Reserve Notes) is the circulating debt of the Federal Reserve Bank that issued the note.  And checkable deposits reflect the debt of commercial banks.  But, we are still left with the question of what gives it value?  The answer has three parts.

Relative scarcity  -  Money derives its value from its scarcity.  As with any commodity the value of money is derived from demand and supply.  With a reasonable constant demand for money, the supply determines the value or purchasing power.

Legal tender - Our money is fiat money.  This means it is money in our society because the government has declared it to be legal tender.  Legal tender simply means that currency must be accepted in payment of a debt or the creditor forfeits his right to sue for nonpayment.

Acceptability - Most importantly, money has value because we are willing to accept it as a medium of exchange.  We are willing to accept it because we have no doubt that it will be accepted from us in payment for goods and services.  This acceptability is founded in the stability of our social, political and economic institutions.

The Federal Reserve and the U.S. Banking System

Unlike many countries, the United States does not have a "national bank," meaning a bank owned and controlled by the national government.  However, like all countries, we do need a "central bank" necessary to serve the fiscal needs of the government and most importantly to carry out monetary policy.  Our central bank is really a central banking system known as the Federal Reserve Banking System.  It is a privately owned banking system, controlled by the Federal Reserve Board, an institution of the federal government.  This central banking system was created by Congress in the Federal Reserve Act of 1913.  The central banking authority rests with the Board of Governors which controls the twelve Federal Reserve District Banks, and through those banks, the banking system. We will be most concerned with the most powerful and important entity assisting the Board of Governors, the Federal Open Market Committee (FOMC). The FOMC is responsible for setting monetary policy.  So, when you see in the news that the Fed is meeting next week, it is referring to the FOMC.

On pages 237 and 238 the author explains the functions of the Fed.  We will talk about many of those, but be clear that the most important of these many functions is responsibility for regulating the supply of money and indirectly influencing interest rates.