Money is any asset that can be used in making purchases, such as currency and checking account balances. Money has three main functions: It is a medium of exchange, which means that it can be used in transactions. It is a unit of account, in that economic values are typically measured in units of money (e.g., dollars). And it is a store of value, a means by which people can hold wealth. In practice it is difficult to measure the money supply, since many assets have some moneylike features. A relatively narrow measure of money is M1, which includes currency and checking accounts. A broader measure of money, M2, includes all the assets in M1 plus additional assets that are somewhat less convenient to use in transactions than those included in M1.
Because bank deposits are part of the money supply, the behavior of commercial banks and of bank depositors affects the amount of money in the economy. A key factor is the reserve-deposit ratio chosen by banks. Bank reserves are cash or similar assets held by commercial banks, for the purpose of meeting depositor withdrawals and payments. The reserve-deposit ratio is bank reserves divided by deposits in banks. A banking system in which all deposits are held as reserves practices 100 percent reserve banking. Modern banking systems have reserve-deposit ratios less than 100 percent, and are called fractional-reserve banking systems.
Commercial banks create money through multiple rounds of lending and accepting deposits. This process of lending and increasing deposits comes to an end when banks' reserve-deposit ratios equal their desired levels. At that point, bank deposits equal bank reserves divided by the desired reserve-deposit ratio. The money supply equals currency held by the public plus deposits in the banking system.
The central bank of the United States is called the Federal Reserve System, or the Fed for short. The Fed's two main responsibilities are making monetary policy, which means determining how much money will circulate in the economy, and overseeing and regulating financial markets, especially banks. Created in 1914, the Fed is headed by a Board of Governors made up of seven governors appointed by the president. One of these seven governors is appointed chairman. The Federal Open Market Committee, which meets about eight times a year to determine monetary policy, is made up of the seven governors and five of the presidents of the regional Federal Reserve banks.
The Fed can affect the money supply indirectly through its control of the supply of bank reserves. The Fed changes bank reserves through open-market operations, in which the Fed buys or sells government securities in exchange for currency held by banks or the public.
One of the original purposes of the Federal Reserve was to help eliminate or control banking panics. A banking panic is an episode in which depositors, spurred by news or rumors of the imminent bankruptcy of one or more banks, rush to withdraw their deposits from the banking system. Because banks do not keep enough reserves on hand to pay off all depositors, even a financially healthy bank can run out of cash during a panic and be forced to close. The Federal Reserve failed to contain banking panics during the Great Depression, which led to sharp declines in the money supply. The adoption of a system of deposit insurance in the United States eliminated banking panics. A disadvantage of deposit insurance is that if banks or other insured intermediaries make bad loans or financial investments, the taxpayers may be responsible for covering the losses.
In the long run, the rate of growth of the money supply and the rate of inflation are closely linked because a larger amount of money in circulation allows people to bid up the prices of existing goods and services. Velocity measures the speed at which money circulates; equivalently, it is the value of transactions completed in a period of time, divided by the stock of money required to make those transactions. Velocity is defined by the equation V = (P x Y)/M, where V is velocity, P x Y is nominal GDP (a measure of the total value of transactions), and M is the money supply. The definition of velocity can be rewritten as the quantity equation, M x V = P x Y. The quantity equation shows that, if velocity and output are constant, a given percentage increase in the money supply will lead to the same percentage increase in the price level.
