Functions of Money

Measures of Money

• In the real world, money supply has different definitions: M1 and M2. Money is categorized according to its liquidity. The most liquid items are in M1.
• M1: includes currency (coins minted by the U.S. Treasury and paper currency issued by the Federal Reserve), checkable deposits and traveler’s checks (issued by the commercial banks and thrift institutions).
• Currency and checkable deposits belonging to the federal government, Federal Reserve, or other financial institutions are not included in M1.
• M1 = Currency + Checkable deposits + Traveler’s checks
• M2: includes all of the components of M1 plus near-moneys which includes items like:
• a) Small Time deposits: interest-earning deposits with a value of less than $100,000, and having a specified maturity.
• b) Savings deposits: interest-earning deposits with no specific maturity of maximum value.
• c) Money market accounts: savings that invest in short-term financial instruments, pay higher than savings account interest.
• d) Overnight repurchase agreements: agreements by a financial institutions to sell short –term securities to its customers, accompanied by an agreement to repurchase the securities within 24 hours.
• e) Overnight Eurodollar deposits: 24-hour dollar-denominated deposits held in financial institutions outside the United States.
• M2 = M1 + all near moneys (Such as Small time deposits, Savings deposits, Money market accounts, overnight repurchase agreements, overnight Eurodollar deposits).
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Banks and Money Creation

• History:
• The modern banking system was developed from fractional reserve banking of the early days. Goldsmiths had safes for gold and precious metals, which they often kept for consumers and merchants for a fee. They issued receipts for these deposits. Later on, the receipts came to be used as money in place of gold for their convenience, and goldsmiths became aware that much of the stored gold was never redeemed. Goldsmiths realized they could loan gold by issuing receipts to borrowers, who agreed to pay back gold plus interest. The actual gold in the vaults became only a fraction of the receipts held by borrowers and owners of gold. Fractional reserve banking is significant because banks can create money by lending more than the original reserves on hand.
• Creation of money:
• Individual banks are not allowed to print their own money. But, banks may create money by creating checkable deposits, which are a part of the money supply.
• Suppose the Fed prints $100 and decided to deposit it in Bank X. Bank X sets aside a portion of that $100 that is required reserves (a specific amount that banks must hold as reserves on all deposits), say 10%. The remaining 90%, $90 becomes excess reserves. Bank X can lend that $90 to Customer A, who deposits into his account in Bank Y. At this step, the original $100 remains in the system, and we can now add Customer A’s $90. Bank Y sets aside 10%, and lends out the rest. This process continues until no new excess reserves can be created.
• Federal deposit Insurance Corporation (FDIC)
• Deposits at banks are insured by the FDIC. Such insurance guarantees deposits in amounts of up to $100,000 per depositor before the 2008 recession. Since then, the amount is increased to $250,000. This guarantee gives financial institutions the incentive to make risky loans, and gives depositors confidence for their funds.