SUMMARY

1. Money is any asset that can easily be used to purchase goods and services. Currency in circulation and checkable bank deposits are both considered part of the money supply. Money plays three roles: it is a medium of exchange used for transactions, a store of value that holds purchasing power over time, and a unit of account in which prices are stated.

2. Over time, commodity money, which consists of goods possessing value aside from their role as money, such as gold and silver coins, was replaced by commodity-backed money, such as paper currency backed by gold. Today the dollar is pure fiat money, whose value derives solely from its official role.

3. The Federal Reserve calculates two measures of the money supply. M1 is the narrowest monetary aggregate, containing only currency in circulation, traveler’s checks, and checkable bank deposits. M2 includes a wider range of assets called near-moneys, mainly other forms of bank deposits, that can easily be converted into checkable bank deposits.

4. Banks allow depositors immediate access to their funds, but they also lend out most of the funds deposited in their care. To meet demands for cash, they maintain bank reserves composed of both currency held in vaults and deposits at the Federal Reserve. The reserve ratio is the ratio of bank reserves to bank deposits. A T-account summarizes a bank’s financial position, with loans and reserves counted as assets and deposits counted as liabilities.

5. Banks have sometimes been subject to bank runs, most notably in the early 1930s. To avert this danger, depositors are now protected by deposit insurance, bank owners face capital requirements that reduce the incentive to make overly risky loans with depositors’ funds, and banks must satisfy reserve requirements.

6. When currency is deposited in a bank, it starts a multiplier process in which banks lend out excess reserves, leading to an increase in the money supply—so banks create money. If the entire money supply consisted of checkable bank deposits, the money supply would be equal to the value of reserves divided by the reserve ratio. In reality, much of the monetary base consists of currency in circulation, and the money multiplier is the ratio of the money supply to the monetary base.

7. The monetary base is controlled by the Federal Reserve, the central bank of the United States. The Fed regulates banks and sets reserve requirements. To meet those requirements, banks borrow and lend reserves in the federal funds market at the federal funds rate. Through the discount window facility, banks can borrow from the Fed at the discount rate.

8. Open-market operations by the Fed are the principal tool of monetary policy: the Fed can increase or reduce the monetary base by buying U.S. Treasury bills from banks or selling U.S. Treasury bills to banks.

9. In response to the Panic of 1907, the Fed was created to centralize the holding of reserves, inspect banks’ books, and make the money supply sufficiently responsive to varying economic conditions.

10. The Great Depression sparked widespread bank runs in the early 1930s, which greatly worsened and lengthened it. Federal deposit insurance was created, and the government recapitalized banks by lending to them and by buying shares of banks. By 1933, banks had been separated into two categories: commercial banks (covered by deposit insurance) and investment banks (not covered). Public acceptance of deposit insurance finally stopped the bank runs of the Great Depression.

11. The savings and loan (thrift) crisis of the 1980s arose because insufficiently regulated S&Ls engaged in overly risky speculation and incurred huge losses. Depositors in failed S&Ls were compensated with taxpayer funds because they were covered by deposit insurance. The crisis caused steep losses in the financial and real estate sectors, resulting in a recession in the early 1990s.

12. During the mid-1990s, the hedge fund LTCM used huge amounts of leverage to speculate in global financial markets, incurred massive losses, and collapsed. LTCM was so large that, in selling assets to cover its losses, it caused balance sheet effects for firms around the world, leading to the prospect of a vicious cycle of deleveraging. As a result, credit markets around the world froze. The New York Fed coordinated a private bailout of LTCM and revived world credit markets.

13. Subprime lending during the U.S. housing bubble of the mid-2000s spread through the financial system via securitization. When the bubble burst, massive losses by banks and nonbank financial institutions led to widespread collapse in the financial system. To prevent another Great Depression, the Fed and the U.S. Treasury expanded lending to bank and nonbank institutions, provided capital through the purchase of bank shares, and purchased private debt. Because much of the crisis originated in nontraditional bank institutions, the crisis of 2008 indicated that a wider safety net and broader regulation are needed in the financial sector. The 2010 Dodd-Frank bill, the biggest financial reform since the 1930s, is an attempt to prevent another crisis.