understand how a fractional-reserve banking system operates;
know how the government can influence the money supply;
understand the concept of the money multiplier; and
know what a financial intermediary is.
8.1 What Is Money?
Money is defined as anything that is widely accepted in payment for goods and services and to pay off debt. Many things can serve this purpose, as evidenced historically by the use of cigarettes in prisoner-of-war camps and ownership titles to large stone wheels on the South Pacific island of Yap. This definition creates a serious problem in measuring a country's money supply. What should be counted as money? Should we count cigarettes and stone wheels? Different choices of what should be counted as money give rise to different measures of the money supply. These measures are called monetary aggregates.
In our society, dollar bills and coins in the hands of the public should definitely be counted as money because they are almost universally accepted as payment. Although not quite so widely accepted as cash, traveler's checks are sufficiently widely accepted as payment that it is reasonable to include them in our measure of money. Personal checks are also widely accepted as payment, suggesting that balances in checking accounts (often called demand deposits because balances in such accounts can be accessed on demand by writing a check) should be included when measuring money. There is little dispute about whether these three items cash, traveler's checks, and balances in checkable accounts should be included in our economy's measure of money. Adding these together produces the monetary aggregate M1, the narrow definition of money.
Money plays four main roles in our society: as a medium of exchange, as a unit of account, as a store of value, and as a standard of deferred payment. The key feature of money, as far as macroeconomics is concerned, is its use as a medium of exchange because it is through this role that control over the money supply is connected to spending and thus to overall economic activity. To be a good medium of exchange, money must be accepted by people when buying and selling their productive resources or goods and services. It should be portable, and it has to be divisible so that large and small transactions can be made. The aggregate M1 captures this dimension of money because it includes those items most widely used as media of exchange. (About 85% of household purchases are made using M1 bal-
