Macroeconomics ECON202
Guided notes
Chapter 17 Money and the Federal Reserve
Big Questions to study
A. What is money?
• Money is primarily the medium of exchange in an economy; it’s what people trade for goods and
services. Money also functions as a unit of account and a store of value.
• Money includes more than just physical currency; it also includes bank deposits, because people often
make purchases with checks or cards that withdraw from their bank accounts. M1 and M2 are two
measures of the money supply. M2 is the more commonly used measure today.
B. How do banks create money?
• Banks create money whenever they extend a loan. A new loan represents new purchasing power, while
the deposit that backs the loan is also considered money.
C. How does the Federal Reserve control the money supply?
• The primary tool of monetary policy is open market operations, which the Fed conducts through the
buying and selling of bonds. Quantitative easing is a special form of open market operations
introduced in 2008. To increase the money supply, the Fed buys bonds. To decrease the money supply,
the Fed sells bonds.
• The Fed has several other tools to control the money supply, including reserve requirements and the
discount rate, but these tools have not been used in quite a while.
Flow of Chapter 17
A. What is money?
- Three kinds of money
1
, - Three uses of money.
B. How do banks create money?
- Banks create money by lending out money
C. The roles of Federal Reserve
A. What is money?
Money includes paper bills and coins, which are currency.
Three different kinds of money:
1. commodity money, e.g., gold, silver
2. commodity backed money: the money can be exchanged for a commodity.
e.g., silver certificate in U.S. before 1971 and gold standard in the U.S. before 1933
3. Fiat money: no value at all, just paper. Value comes from the promise by the government.
Why using fiat money?
1. If tying the currency to a commodity, when the market value of the commodity fluctuates, the value
of the currency fluctuates.
2. The government can better control the money supply.
• Currency: is the paper bills and coins used to buy goods and services
• People make many purchases without currency
• Money: is any generally accepted means of payment
A1. Three functions of money
1. a medium of exchange
2. a unit of account
3. a store of value
2
,1. A medium of exchange: money is how we pay for goods and services.
2. A unit of account: The measure in which prices are quoted.
3. Store of value: a means of holding wealth.
A1a. A Medium of Exchange
• If you want to buy groceries —> you offer money in exchange for them
• If you work —> you accept money as payment for your labor
• A Medium Of Exchange: is what people trade for goods and services
• Money is a common medium of exchange
• Modern economies generally have a government-provided medium of exchange.
• In the U.S. —> the government provides our dollar currency
• Even in economies without government provision —> a preferred medium of exchange usually
emerges
• Ex: In colonial Virginia —> before there was any government mandate regarding money,
tobacco became the accepted medium of exchange
• Some medium of exchange evolves in any economy —> the primary reason is the inefficiency of
barter (which is money’s alternative)
• Barter: involves the trade of a goods or service in the absence of a commonly accepted medium
of exchange
• If you want food in a barter economy —> you must find a grocer who also happens to
want whatever you want to trade
• Maybe you can offer only your labor services —> but the grocer wants a new cash
register
3
, • In that case —> you have to try to find someone who has a cash register and
also wants to trade it for your labor
• Barter requires a Double Coincidence of Wants: occurs when each party in an
exchange transaction happens to have what the other party desires
• Very unusual —> which is why a medium of exchange naturally
evolves in any exchange environment
• Historically —> the first medium of exchange in an economy has been a commodity that is actually
traded for goods and services
• Commodity Money: involves the use of an actual good for money
• In this situation —> the good itself has value apart from its function as money
• Ex: gold, silver, and the tobacco of colonial Virginia
• Commodities are often difficult to carry around
• Due to transportation costs —> money evolved into certificates that represented a
fixed quantity of the commodity
• These certificates became the medium of exchange but were still tied to the
commodity because they could be traded for the actual commodity if the
holder demanded it
• Commodity-Backed Money: is money you can exchange for a commodity at
a fixed rate
• Ex: until 1971 —> U.S. dollars were fixed invalid to specific quantities
of silver and gold
• Until 1964 —> we also had commodity coins in the U.S.
4
Guided notes
Chapter 17 Money and the Federal Reserve
Big Questions to study
A. What is money?
• Money is primarily the medium of exchange in an economy; it’s what people trade for goods and
services. Money also functions as a unit of account and a store of value.
• Money includes more than just physical currency; it also includes bank deposits, because people often
make purchases with checks or cards that withdraw from their bank accounts. M1 and M2 are two
measures of the money supply. M2 is the more commonly used measure today.
B. How do banks create money?
• Banks create money whenever they extend a loan. A new loan represents new purchasing power, while
the deposit that backs the loan is also considered money.
C. How does the Federal Reserve control the money supply?
• The primary tool of monetary policy is open market operations, which the Fed conducts through the
buying and selling of bonds. Quantitative easing is a special form of open market operations
introduced in 2008. To increase the money supply, the Fed buys bonds. To decrease the money supply,
the Fed sells bonds.
• The Fed has several other tools to control the money supply, including reserve requirements and the
discount rate, but these tools have not been used in quite a while.
Flow of Chapter 17
A. What is money?
- Three kinds of money
1
, - Three uses of money.
B. How do banks create money?
- Banks create money by lending out money
C. The roles of Federal Reserve
A. What is money?
Money includes paper bills and coins, which are currency.
Three different kinds of money:
1. commodity money, e.g., gold, silver
2. commodity backed money: the money can be exchanged for a commodity.
e.g., silver certificate in U.S. before 1971 and gold standard in the U.S. before 1933
3. Fiat money: no value at all, just paper. Value comes from the promise by the government.
Why using fiat money?
1. If tying the currency to a commodity, when the market value of the commodity fluctuates, the value
of the currency fluctuates.
2. The government can better control the money supply.
• Currency: is the paper bills and coins used to buy goods and services
• People make many purchases without currency
• Money: is any generally accepted means of payment
A1. Three functions of money
1. a medium of exchange
2. a unit of account
3. a store of value
2
,1. A medium of exchange: money is how we pay for goods and services.
2. A unit of account: The measure in which prices are quoted.
3. Store of value: a means of holding wealth.
A1a. A Medium of Exchange
• If you want to buy groceries —> you offer money in exchange for them
• If you work —> you accept money as payment for your labor
• A Medium Of Exchange: is what people trade for goods and services
• Money is a common medium of exchange
• Modern economies generally have a government-provided medium of exchange.
• In the U.S. —> the government provides our dollar currency
• Even in economies without government provision —> a preferred medium of exchange usually
emerges
• Ex: In colonial Virginia —> before there was any government mandate regarding money,
tobacco became the accepted medium of exchange
• Some medium of exchange evolves in any economy —> the primary reason is the inefficiency of
barter (which is money’s alternative)
• Barter: involves the trade of a goods or service in the absence of a commonly accepted medium
of exchange
• If you want food in a barter economy —> you must find a grocer who also happens to
want whatever you want to trade
• Maybe you can offer only your labor services —> but the grocer wants a new cash
register
3
, • In that case —> you have to try to find someone who has a cash register and
also wants to trade it for your labor
• Barter requires a Double Coincidence of Wants: occurs when each party in an
exchange transaction happens to have what the other party desires
• Very unusual —> which is why a medium of exchange naturally
evolves in any exchange environment
• Historically —> the first medium of exchange in an economy has been a commodity that is actually
traded for goods and services
• Commodity Money: involves the use of an actual good for money
• In this situation —> the good itself has value apart from its function as money
• Ex: gold, silver, and the tobacco of colonial Virginia
• Commodities are often difficult to carry around
• Due to transportation costs —> money evolved into certificates that represented a
fixed quantity of the commodity
• These certificates became the medium of exchange but were still tied to the
commodity because they could be traded for the actual commodity if the
holder demanded it
• Commodity-Backed Money: is money you can exchange for a commodity at
a fixed rate
• Ex: until 1971 —> U.S. dollars were fixed invalid to specific quantities
of silver and gold
• Until 1964 —> we also had commodity coins in the U.S.
4
