Learning Objectives:

• Define money and explain its functions.

• Explain how banks create money.

• Understand the role of the Federal Reserve in managing the money supply.

3.1 The Functions and Properties of Money
Money serves four primary functions: as a medium of exchange (used to buy and sell goods), a unit of account (a standard measure of value), a store of value (a way to hold purchasing power over time), and a standard of deferred payment (used for future payments like loans) .

3.2 Banks and Money Creation
Commercial banks are central to the process of “money creation.” When a bank makes a loan, it does not typically lend out its own cash reserves. Instead, it credits the borrower’s account with a new deposit. This deposit, when spent, becomes a deposit in another bank, which can then lend out a portion of it, effectively multiplying the initial money supply. The bank’s ability to do this is governed by its reserve requirements—the percentage of deposits that the bank is required to hold in reserve .

3.3 The Federal Reserve and Monetary Policy
The Federal Reserve (the “Fed”) is the central bank of the U.S. and manages the country’s money supply and interest rates to promote stable prices and maximum employment . The Fed has three primary tools to implement monetary policy :

1. Reserve Requirements: Changing the amount of reserves banks must hold against deposits, affecting their ability to lend.

2. Discount Operations: The discount rate is the interest rate the Fed charges banks for short-term loans. Changing this rate influences the cost of borrowing for banks.

3. Open Market Operations: The buying and selling of U.S. government securities in the open market. This is the Fed’s most frequently used tool to influence the level of bank reserves and short-term interest rates .