The document summarizes key concepts about money, the money supply, and monetary policy in the United States. It explains that the US dollar is issued by the Federal Reserve and backed by the US government. It describes how the Federal Reserve, made up of the Board of Governors and regional banks, implements monetary policy to control interest rates through managing the money supply. It also outlines how money serves important functions as a medium of exchange, unit of account, and store of value in the US economy.

1. CHAPTER 34
Money, Federal Reserve, and Interest Rates

2. The Functions of Money
The Components of the Money Supply
What “Backs” the Money Supply?
The Federal Reserve and the Banking System
Fed Functions, Responsibilities, and Independence
Money Market and Interest Rate
Chapter Contents

3. Money
• Money: Anything that is generally accepted in payment for
goods or services or in the repayment of debt
• Important!! Term “money” defined in Economics is different
from commonly used word “money” in everyday conversation!

4. Example of Money
So, what can you use for payment at Wal-Mart, McDonald’s, and gas station?
• Currency (cash) including coins and bills
• Cash is an asset. If you have $20 bill, you can spend up to $20 worth of goods and
services (e.g., gasoline).
• Check & debit card (electronic version of check)
• A check is a means of payment, but it is worthless piece of paper unless you write a
payment and sign it.
• Can you write $23,770 check at Toyota dealer to purchase Prius? Yes, only if you
have that amount at your bank.
• You can write a check up to an amount in your checking account without bouncing
your check.
• Your checking account balance is money, not check itself.
• Credit card? Not really. Money must be an asset, not liability for holder.

5. U.S. Dollar Bills
• In modern U.S. economy we use dollar bills and coins as medium of
exchange.
• Dollar bills are called “Federal Reserve Note” because they are IOU
(note payable) issued by the Federal Reserve Banks. They are
assets for holders (households, firms, governments, and foreigners)
of IOUs, but liabilities for issuers (the Federal Reserves) of IOUs.

6. Money and Generally Accepted
• Money must be generally accepted by definition.
• In modern U.S. economy we use worthless paper money rather
than valuable commodity.
• We accept worthless paper money because we expect they are
accepted by others.
• If no one accepts money, money will seize its primary function in an
economy.
• The government guarantees its general acceptance by making it
“legal tender”.

7. Functions of Money
Money has three primary functions in any economy.
• Medium of Exchange
• Anything used to pay for goods and services
• Unit of Account
• Anything used to measure value in economy
• Store of Value
• A repository of purchasing power over time

8. Money as Medium of Exchange
• Monetary exchange: Exchange of goods through money
Ex. You have fish and want a loaf of bread.
(You) Fish  Money (???)  Bread (???)
• Since money comes between two goods in exchange, it is a
medium of exchange.
• Money increases efficiency in economy: Even though this
involves two exchanges, actually it will take less time for
exchanges. So, people can spend more time for production of
goods and services rather than exchange.
• Although we use paper and coins as money, any commodity can
serve as money in society. Example: Yap stone money, American
Indian Wampum.

9. Money as Unit of Account
• In the U.S. a value (price) of every good and service is
quoted in dollars and cents.
• By using “dollar and cent” as a standard unit of value, we can
easily compare value of one good with others.
• Ex. How much is a Big Mac? Around $2.19. How much is a
cheeseburger? About 99¢. So, you know which is more
valuable.

10. Money As Store of Value
• Money can keep its purchasing power over time.
• When you receive your paycheck, you do not need to spend
every dollar right at that moment. You can keep it in bank
account or cash on hand, and spend it later.
• Money is not unique in this function. There are many assets
which can serve as store of value.
• Example: stocks, bonds, bank accounts, Baseball cards
• Liquidity: the ease with which an asset can be converted
into medium of exchange (money)
• Money is the most liquid store of value.

11. Measuring Money Supply
• Money supply (Money aggregate): Amount of money in economy
• M1 includes items used for medium of exchange:
• Currency (bills and coins)
• Checkable deposits (at commercial banks)
• Other liquid deposits (Saving deposits, Money market deposits, Checkable
deposits at thrift institutions)
• Financial institutions offering checkable deposits
• Commercial banks
• Savings and loan associations
• Mutual savings banks
• Credit unions
Thrift Institutions

12. Money Definition M2
• M2 include items which can be converted to medium
of exchange very quickly (high liquidity)
• M1 plus near-monies.
• Small-denominated time deposits (CDs).
• Money market mutual funds (MMMF).

13. Components of Money Supplies M1 and M2
• For M1, majority is other
liquid deposits.
• For M2, majority
is M1.

14. Money and Prices
• Prices affect purchasing power of money.
• Purchasing Power: Amount of goods and services
money can purchase.
• Hyperinflation renders money unacceptable.
• When there are too many money in public, prices of goods
increase and a purchasing power of money falls.
• Stabilizing money’s purchasing power:
• Intelligent management of the money supply—
monetary policy

15. Functions of Central Bank
• Each country has one central bank which is responsible for
• Conducting monetary policy.
• Regulating an amount of money supply in economy.
• Supervising banks.
• In the United States, the federal reserve system (the Fed) acts as
the central bank.
• The federal government have attempted to establish a single central
bank twice, but due to fear of concentration of economic and monetary
power, the Congress abolished such institutions.
• In 1931 the Congress established the twelve regional Federal Reserve
banks.

16. Organizational Structure of the Federal
Reserve System
Three main organizational components of the Federal Reserve
System:
• Regional Federal Reserve banks
• Board of Governors
• Federal Open Market Committee

17. Federal Reserve and Its Relationship to the Public

18. Regional Federal Reserve Banks
• The U.S. is divided into twelve Federal Reserve districts.
• Each district has one Federal Reserve bank.
• Ex. Federal Reserve Bank of Richmond covers states of Maryland,
Virginia, North Carolina, and South Carolina.
• By dividing into twelve districts, no one Federal Reserve bank can
dominate in the U.S. economy.
• Regional Federal Reserve banks act like “bankers’ bank”
• Clearing checks
• Hold deposits of banks as reserves
• Setting a discount rate and making discount loans to banks in their districts
• Issuing new currency and withdrawing damaged currency

19. The 12 Federal Reserve Districts

20. U.S. Dollar Bills
• U.S. dollar bills are issued by the Federal Reserve banks.
13-20
Emblem of the Federal
Reserve System
“Federal Reserve Note” means
IOU (note payable) issued by
the Federal Reserve System.
Federal Reserve Bank of
San Francisco issued
this note.

21. Member Banks and Other Depository Institutions
• All national banks are required to be members of the Federal
Reserve System.
• Currently, about 38% of the commercial banks are members of
the Federal Reserve System.
• Member banks are stockholders of the regional Federal reserve
bank.
• Depository Institutions Deregulation and Monetary Control Act of
1980 requires all depository institutions (member and
nonmember banks) to hold required reserves.
• 4,600 commercial banks + 7,000 thrift institutions

22. Global Perspective 34.1
THE WORLD’S 12 LARGEST COMMERCIAL BANKS, 2021

23. Board of Governors
• The Board of Governors acts like the headquarter of the Federal
Reserve System.
• Located in Washington, D.C.
• Seven members of the Board of Governors are appointed by the president of
the United States and confirmed by the Senate.
• Each member serves for nonrenewable 14-year term and comes from
different districts.
• The chairman of the Board of Governors is chosen from the seven governors.
• Serves for renewable four-year term.
• Acts like the CEO of the Federal Reserve System.
• Jerome Powell is the current chairman.
13-23

24. Federal Open Market Committee
• The Federal Open Market Committee (FOMC)
• Makes decisions on monetary policy.
• the conduct of open market operations
• setting a target rate on federal funds
• Meets eight times a year
• Consists of twelve members: the seven members of the Board of
Governors, the president of the Federal Reserve Bank of New
York, and the presidents of four other Federal Reserve banks.
• Directed by the chairman of the Board of Governors

25. Functions of Federal Reserve
• Issue currency (Regional Federal Reserve banks)
• Hold reserves and set reserve requirements (the Fed ended
reserve requirements 2020, however)
• Lend money to banks (Regional Federal Reserve banks)
• Collect checks (Regional Federal Reserve banks)
• Act as a fiscal agent for U.S. government (Board of Governors)
• Supervise banks (Regional Federal Reserve banks & Board of
Governors)
• Control the money supply (FOMC)

26. Federal Reserve Independence
• Established by Congress as an independent agency
• Protects the Fed from political pressures
• Enables the Fed to take actions to increase interest rates in
order to stem inflation as needed
LO34.5
13-26

27. Fractional Reserve Banking
• Banks make profits by charging high interest rates on loans and
giving low interest rates on checkable deposits.
• To make more profits, banks should loan out as much as
possible.
• Banks must maintain cash and liquid assets to meet demand
by depositors for withdrawals and spendings of deposits.
• Fractional reserve banking: a system under which banks keep as
reserves only a fraction of the funds they hold on deposit.
• Reserves: Sum of Vault cash and deposits at the Fed
Reserves = Vault cash + Deposits at the Fed

28. Interest Rates
• Interest rate is an opportunity cost of holding money -
the price paid for the use of money
• There are many different interest rates in economy
• Short-term interest rate is determined in money market.
• Other interest rates follow the short-term interest rate
changes.

29. Money Market
• Market interest rate is determined through interaction
of demand for money and supply of money in money
market.
• Demand for money comes from households and firms.
• Supply of money comes from the Federal Reserve
through the banking system.

30. Demand for Money
• Two reasons for holding money
• Transactions demand
• Money as medium of exchange
• Households and firms need money for making payments – they
need to carry cash or keep funds in checking accounts.
• Asset demand
• Money as store of value
• Households and firms keep money for later spending purpose
• Total money demand, Dm

31. Transaction Demand for Money
• Transactions demand, Dt
• When households and firms want to spend more, then
must hold more money.
• Households’ income (real GDP) spending money
demand
• Independent of the interest rate

32. Asset Demand for Money
• Asset demand, Da
• Money is one of many alternatives of store of value
• Other store of value (e.g., bonds) pays interest. Interest rate
is an opportunity cost of holding money rather than bonds.
• Interest rate demand for bonds  demand for money
• Varies inversely with the interest rate

33. Demand for Money
Rate
of
interest,
i
(percent)
10
7.5
5
2.5
0 50 100 150 200
Amount of money
demanded
(billions of dollars)
Amount of money
demanded
(billions of dollars)
Amount of money
demanded
(billions of dollars)
=
+
(a)
Transactions
demand for
money, Dt
(b)
Asset
demand for
money, Da
(c)
Total demand for money,
Dm = Dt +Da,
Dt Da Dm
50 100 150 200
10
7.5
5
2.5
0 50 100 150 200 250 300
10
7.5
ie
2.5
0
Rate
of
interest,
i
(percent)
Rate
of
interest,
i
(percent)

34. Supply of Money
• Money supply is the total quantity of money in
economy
• M1 includes currencies and checkable deposits
• Money supply is determined by
• the reserves held by banks as a source of loans
• Money supply curve is vertical at the actual quantity of
money in economy.

35. Money Market Equilibrium
Amount of money
demanded and supplied
(billions of dollars)
(c)
Total demand for
money, Dm = Dt +Da, and
supply of money, Sm
Dm
Sm
50 100 150 200 250 300
10
7.5
ie
2.5
0
Rate
of
interest,
i
(percent)
• The demand for money
and supply of money
determine the equilibrium
in money market and the
equilibrium interest rate.

36. Interest Rates
• Changes in money demand or money supply affect the
equilibrium interest rate.
• The Federal Reserve controls the money supply (sum of
currencies and checkable deposits), by
• Issuing new currencies or withdrawing old currencies from circulation.
• Changing the quantity of reserves in banking system, which affects
the ability of banks to make loans, then quantity of checkable
deposits.
• By changing money supply the Federal Reserve can control the
equilibrium interest rate in money market.

37. Money Supply and Interest Rate
• A decreases in money supply
(from Sm1 to Sm2) increases the
equilibrium interest rate (from
8% to 10%).
• An increases in money supply
(from Sm1 to Sm3) decreases
the equilibrium interest rate
(from 8% to 6%).
Rate
of
interest,
i
(percent)
Amount of money
demanded and supplied
(billions of dollars)
Sm2 Sm1 Sm3
Dm
The market for money
0 $125 $150 $175
10
8
6

38. Disclaimer
• Please do not copy, modify, or distribute this presentation
• without author’s consent.
• This presentation was created and owned by
• Dr. Ryoichi Sakano
• North Carolina A&T State University
• It includes copy-righted materials from
©2021 McGraw Hill Education. All rights reserved. No reproduction or further distribution without the prior written consent of McGraw Hill Education.