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money-banking FAQ

Is all money the same?

Not really, Economists generally identify three different types of money: commodity money, representative money, and fiat money.

What is commodity money?

Commodity money has a value or use aside from its use as money. For example, during the late eighteenth century, farmers in the Pennsylvania backcountry used whiskey for money.

What is representative money?

Representative money can be redeemed for something of real value. In the past, most representative money was backed by gold and silver.

What is fiat money?

Fiat money is money because the government says it is. It is not backed by gold or any other substance of real value. It has no real use or value other than its value as a form of currency.

Do these types of money have anything in common?

Yes, economists also say that all money serves the same three functions. It serves as a medium of exchange, a unit of accounting, and a store of value.

In what sense is money a “medium of exchange?”

Money is a medium of exchange in the sense that we all agree to accept it in making transactions. Merchants agree to accept money in exchange for their goods; employees agree to accept money in exchange for their labor.

In what sense is money a “unit of accounting?”

Money is a unit of exchange in that it provides a simple device for identifying and communicating value. How much is that bicycle? It’s $200. Without this convenient, readily understood unit of accounting, setting and communicating value would be difficult.

In what sense is money a “store of value?”

Money serves as a store of value in that it allows us to store the rewards of our labor or business in a convenient tool. In other words, money lets us store the value of a week of work in a convenient stack of cash.

What type of money does the United States have?

Today, American money is fiat money.

Has the United States always had fiat money?

No. For many decades the United States had representative money. In 1879, the United States joined many other nations on the gold standard. But during the Great Depression, Franklin Roosevelt urged Congress to take the United States off of the gold standard. The value of the dollar was still linked to a certain amount of gold, but the government no longer exchanged dollars for gold. And in 1971, President Richard Nixon took America completely off of the gold standard.

Does that mean that all of American money is fiat money?

Not exactly. Actually fiat money (paper currency) only makes up a part of America’s money supply. The rest consists of demand deposits, such as checking accounts, and “near money.”

What is a demand deposit?

This is a type of bank account from which the funds can be removed at any time, usually by writing a check.

What is near money?

Near money includes things like savings accounts, certificates of deposits (CDs), and money market mutual funds. You can’t actually buy something with these; a retailer can’t subtract his charge from your savings account book. But these can be easily converted to cash or transferred to a checking account. In other words, they are not exactly but near money.

What type of money is most prevalent?

Good question. Economists keep careful track off all of these types of money and refer to them collectively as the money supply.

What exactly is the money supply?

Economists actually break the money supply down into two (and often three or four) categories. M1 includes only fiat money (paper currency and coins) and demand deposits like checking accounts. M2 consists of fiat money, demand deposits, and near money. M1 represents the portion of the money supply with the highest liquidity—that is, it is most easily spent. But it represents only about 18% of the larger money supply or M2. Breaking M2 down further: the amount of currency in circulation equaled about $800 billion, checks totaled about $600 billion, savings accounts represented about $3.6 trillion, CDs added another trillion dollars to M2, and money market funds added about $1.7 trillion.

Who keeps track of all this and makes sure that our money supply is stable?

This is the responsibility of the Federal Reserve System.

What exactly is the Federal Reserve System?

It is a network of national banks established by Congress in 1913 to ensure that the public retained confidence in its money and the financial institutions in which it is held. It consists of twelve Federal Reserve Banks located in major cities across the country. The Fed is administered by a Board of Governors. Its seven members are appointed by the president of the United States.

What are the Federal Reserve System’s primary responsibilities?

It primary job is to oversee the nation’s banks and money supply and make sure that the public retains confidence in both. To accomplish this, the Fed pursues several interrelated tasks.

  1.  it serves as a centralized clearing house for checks.
  2. It sets reserve requirements. It determines the percentage of a bank’s deposits that it must keep on hand or place in the District Federal Reserve Bank and, consequently, what percentage the bank is allowed to lend out.
  3. It serves as “the bankers’ bank.” It extends loans to local banks when they do not have enough cash on hand to handle daily transactions or, more commonly, to meet their reserve requirement.

Does the Federal Reserve System have any other responsibilities?

Yes. The governors of the system also set monetary policy.

What is monetary policy?

This refers to the policies implemented by the Federal Reserve Board to maintain a money supply adequate to fund economic growth but limited enough to prevent inflation.

How does it do this? What are its tools?

Discount Rates, Minimum Reserve Requirements, and Open Market Operations are the tools of Monetary Policy.

How specifically does the Fed use these tools during periods of recession?

During periods of recession, the Fed tries to stimulate growth by lowering the discount rate. This in turn, leads banks to lower the interest rates they charge their customers. And since people are more willing to make a major purchase when they can borrow money at 5%, rather than 7%, individuals are encouraged to borrow and spend more, and business are encouraged to invest and expand. The Fed can also put more money into circulation by lowering the reserve requirement. This enables banks to keep less in reserve and lend out more money to consumers and investors. Finally, the Fed can inject money by buying bonds in the bond market—through these “open market operations” the Fed uses Federal Reserve funds to buy up government securities.

How specifically does the Fed use these tools during periods of inflation?

During periods of inflation, the fed raises interest rates to discourage borrowing, increases reserve requirements in order to keep more money tied up in banks, and sells bonds thereby taking money out of circulation.

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