Summary

1. Money is the stock of assets used for transactions. It serves as a store of value, a unit of account, and a medium of exchange. Different sorts of assets are used as money: commodity money systems use an asset with intrinsic value, whereas fiat money systems use an asset whose sole function is to serve as money. In modern economies, a central bank such as the Federal Reserve is responsible for controlling the supply of money.

2. The system of fractional–reserve banking creates money because each dollar of reserves generates many dollars of demand deposits.

3. To start a bank, the owners must contribute some of their own financial resources, which become the bank’s capital. Because banks are highly leveraged, however, a small decline in the value of their assets can potentially have a major impact on the value of bank capital. Bank regulators require that banks hold sufficient capital to ensure that depositors can be repaid.

4. The supply of money depends on the monetary base, the reserve–deposit ratio, and the currency–deposit ratio. An increase in the monetary base leads to a proportionate increase in the money supply. A decrease in the reserve–deposit ratio or in the currency–deposit ratio increases the money multiplier and thus the money supply.

5. The Federal Reserve influences the money supply either by changing the monetary base or by changing the reserve ratio and thereby the money multiplier. It can change the monetary base through open-market operations or by making loans to banks. It can influence the reserve ratio by altering reserve requirements or by changing the interest rate it pays banks for reserves they hold.