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2. The Functions of Money
The three functions of money are:
 Medium of exchange
 Used to buy goods and services
 Accepted in payments
 Barter system
 Convenient way of exchange: specialization
 Unit of account
 Monetary units (KD) to measure the relative worth
of goods and services
 The price of each good and services is stated in
monetary terms
 Enable buyers to compare between a verity of
goods and services
 Debt, GDP, taxes
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3.  Store of value
 Transfer purchasing power from the present
to the future
 Savings
 Best store of value in short terms
 Efficient liquid asset
 Liquidity: transformation of an asset into goods
and services
 Inflation
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4. The Components
of the Money Supply
 Two definitions of the U.S. money supply are M1 and
M2.
 M1 is the narrowest definition of the money supply,
whereas M2 is a more broadly defined money supply.
Currency includes coins and paper money.
 All coins in circulation are token money.
 Paper money, issued by the Federal Reserve Banks,
are known as Federal Reserve Notes.
Money Definition: M1
M1 money = currency + checkable deposits
The U.S. money supply is guaranteed by government’s
ability to keep the value of money relatively stable.
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5. Value of Money
Money has value because of its acceptability, legal
tender designation, and relative scarcity.
 Government has decreed currency as legal tender;
paper money is a valid and legal means of payment of
debt.
1. Acceptability
2. Legal Tender
3. Relative scarcity
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6. Money and Prices
 The purchasing power of money is the amount of
goods and services a unit of money will buy.
 The purchasing power of the dollar varies inversely
with the price level.
 If the price level rises, the purchasing power of the
dollar falls, and vice versa.
 Inflation may also affect the purchasing power of
money and its acceptability.
 When the government prints too much money, the
purchasing power of money declines.
 Also, runaway inflation may significantly reduce the
purchasing power of the dollar and may cause it to
cease being used as a medium of exchange.
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7. The Federal Reserve System
and The Banking System
 A key element of the U.S. banking system is the
Federal Reserve System (the “Fed”).
 The Fed consists of the Board of Governors of the
Federal Reserve and 12 regional Federal Reserve
Banks.
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8. Board of Governors
 The seven-member group that supervises and
controls the money and banking system of the U.S..
The 12 Federal Reserve Banks
 The 12 banks chartered by the U.S. government to
control the money supply and perform other
functions.
 They collectively serve as the nation’s “central bank”
and also serve as bankers’ bank.
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9. Federal Open Market Committee (FOMC)
 The FOMC is the 12 member Federal Reserve group
determines the purchase and sale policies of the
Federal Reserve Banks in the market for U.S.
securities.
 The Federal Reserve Bank in New York City conducts
most of the Fed’s open market operations.
Commercial Banks and Thrifts
 Of the approximately 7600 commercial banks, three-
fourths are state banks, while the remaining one-fourth
are national banks, chartered by the Federal
government to operate nationally.
 The 11,400 thrift institutions are regulated by agencies
separate and apart from the Board of Governors and
the Federal Reserve Banks.
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10. Fed Functions and
Responsibilities
 The Fed performs the following functions.
 Issues currency
 Sets reserve requirements and holds reserves
 Lends money to banks and thrifts
 Provides the banking system with a means for
collecting checks
 Acts as a fiscal agent for the Federal government
 Supervises the operation of banks
 Controls the money supply
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11. Fed Reserve Independence
 The Federal Reserve is an independent agency of the
government.
 This protects the Fed from political pressure so that
it could effectively control the money supply and
interest rates to foster price-level stability.
Depositing Reserves in
a Federal Reserve Bank
 All commercial banks and thrifts that provide
checkable deposits must by law keep required
reserves.
 Required reserves are an amount of funds equal to
a specified percentage of the bank’s own deposit
liabilities.
 Required reserves must be kept on deposit with the Federal
Reserve Bank or held as cash in the bank’s vault.
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12. Depositing Reserves in
a Federal Reserve Bank
 The “specified percentage” of checkable deposit
liabilities that a commercial bank must be keep as
reserves is known as the reserve ratio.
Reserve Bank’s required reserves
ratio Bank’s checkable-deposit liabilities
=
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13. The End
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