Money

Money and
and Banks
Banks

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The Uses of Money

Imagine that there was no money.

Barter is the direct exchange of one good
for another, without the use of money.

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The Uses of Money

Anything that serves all of the following

purposes can be thought of as money:
Medium of exchange
Store of value
Standard of value

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The Uses of Money

Medium of exchange accepted as

payment for goods and services (and
debts).

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The Uses of Money

Store of value can be held for future

purchases.
Standard of value measures price of
goods and services

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The Uses of Money

Money facilitates market exchanges

and specialization in production.

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Many Types of Money

In history of the U.S. many things have

been used as money.
There were no U.S. dollars in the early
days of Colonial America.

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Many Types of Money

Greenbacks were issued in 1861 by the

U.S. Federal government.
Confederate states also issued paper
money to finance their side of the U.S.
Civil War.

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Cash vs. Money

The concept of money includes more

than dollar bills and coins.
Checking accounts can and do perform
the same market function as cash.

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Cash vs. Money

Money is anything generally accepted

as a medium of exchange.

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Transactions Accounts

A bank account that permits direct

payments to a third party (e.g., with a
check).

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Transactions Accounts

The balance in your transactions

account substitutes for cash, and is,
therefore, a form of money.

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Basic Money Supply

The basic money supply is referred to

by the abbreviation M1.
M1 is currency held by the public, plus
balances in transactions accounts.

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Basic Money Supply

Cash is a small part of the money

supply.
Currency and coins account for less
than a third of the basic money supply.

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Basic Money Supply

Most money consists of balances in

transactions accounts.

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Composition of the Basic Money
Supply
Total money supply ($1,090 billion)

$537 Currency in circulation

BILLIONS OF DOLLARS

$545 Transactions-account balances

$8 Travelers checks

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Composition of M1

Transaction-account balances
Travelers checks
Currency in circulation
Credit cards are NOT money

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Near Money

Savings accounts
Certificates of deposit
Money market mutual fund

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Aggregate Demand

How much money people have may be

one of the determinants of aggregate
demand.
Aggregate demand is the total quantity of
output demanded at alternative price levels
in a given time period, ceteris paribus.

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Creation of Money

The Bureau of Printing and Engraving

and the U.S. Mint play only a minor role
in creating money.
Most of what we call money is not cash
but bank balances.

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Deposit Creation

A bank effectively creates money when

it makes a loan.
Transactions-account balances are
counted as part of the money supply.

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Deposit Creation

Transactions-account balances are the

largest part of the money supply.

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Deposit Creation

Banks create transactions-account

balances by making loans.

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Deposit Creation

Deposit creation creation of

transaction deposits by bank lending.

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A Monopoly Bank

To keep things simple, assume one

bank in a town, and nobody regulates
bank behavior.

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A Monopoly Bank

You deposit $100 from your piggy bank

into the monopoly bank and receive a
new checking account.

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A Monopoly Bank

When cash or coins are deposited in a

bank, the composition of the money
supply changes, not its size.

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An Initial Loan

The monopoly bank loans $100 to

Campus Radio.
It deposits $100 into Campus Radios
checking account.

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An Initial Loan

The loan is accomplished by a simple

bookkeeping entry.
Money has been created because the
checking account is considered to be
money.

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An Initial Loan

Total bank reserves have remained

unchanged.
Bank reserves are assets held by a bank to
fulfill its deposit obligations.

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Using the Loan

The money supply does not contract

when Campus Radio spends the $100.
The ownership of the deposit changes.

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Fractional Reserves

Bank reserves are only a fraction of

total transactions deposits.

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Fractional Reserves

The reserve ratio is the ratio of a banks

reserves to its total deposits.

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Fractional Reserves

Ability of a monopoly bank to hold

fractional reserves is based on two
facts:
People use checks for most transactions.
There are no other banks.

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Reserve Requirements

If a bank could create money at will, it

would have a lot of control over
aggregate demand.
In reality, no private bank has that much
power.

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Reserve Requirements

The power to create money resides in

the banking system, not in any single
bank.

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Reserve Requirements

The Federal Reserve System requires

banks to maintain some minimum
reserve ratio.

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Required Reserves

Required reserves are the minimum

amount of reserves a bank is required
to hold by government regulation

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Required Reserves

Required reserves are equal to the

required reserve ratio times
transactions deposits.

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Required Reserves

The minimum reserve requirement

directly limits deposit-creation
possibilities.

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Excess Reserves

Excess reserves are bank reserves in

excess of required reserves.

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Excess Reserves

The ability of banks to make loans

depends on access to excess reserves.

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Excess Reserves

If a bank currently has $100 in reserves

and is required to hold $75, it can lend
out the $25 excess.

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Excess Reserves

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Excess Reserves

So long as a bank has excess reserves

it can make loans.

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A Multi-Bank World

In reality there is more than one bank in

town.
The key issue is not how much excess
reserves any specific bank holds.
It is how much excess reserves exist in
the entire banking system.

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The Money Multiplier

Excess reserves are the source of bank

lending authority.
The cumulative amount of new loans is
determined by the money multiplier.

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The Money Multiplier

The money multiplier is the number of

deposit (loan) dollars that the banking
system can create from $1 of excess
reserves.

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The Money Multiplier Process

Initial deposit of $100 made at

University Bank.

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The Money Multiplier Process

University Bank keeps $75 (75% of the

$100 new deposit) on reserve and
loans out $25 which is deposited in
Bank Two.

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The Money Multiplier Process

Bank Two keeps 75% of the new

deposit on reserve ($18.75) and loans
out $6.25.

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The Money Multiplier Process

Bank three keeps 75% of the new

deposit on reserve ($4.69) and loans
out $1.56.
Etc., etc., etc.

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The Money Multiplier Process

Loan $25 Loan $6.25 Loan $1.56

Initial
deposit University Bank Bank Bank etc.
($100) Bank #2 #3 #4

Deposit Deposit Deposit

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Limits of Deposit Creation

The potential of the money multiplier to

create loans is summarized by the
equation:

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Limits of Deposit Creation

If the required reserve ratio = .75:

The multiplier = 1.33
If the banking system has $25 in excess
reserves:
Potential deposit creation is $25 x 1.33 =
$33.25

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Excess Reserves as Lending
Power
Each bank may lend an amount equal
to excess reserves and no more.

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Excess Reserves as Lending
Power
The entire banking system can increase
the volume of loans by the amount of
the systems excess reserves multiplied
by the money multiplier.

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The Macro Role of Banks

Since virtually all market transactions

involve the use of money, banks must
have some influence on macro
outcomes.

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Financing Aggregate Demand

Banks perform two functions:

Banks transfer money from savers to
spenders by lending funds held on deposit.
The banking system creates additional
money by making loans in excess of total
reserves.

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Financing Aggregate Demand

Increases in money supply tend to

increase aggregate demand.
Aggregate demand declines when the
money supply shrinks.

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Financing Aggregate Demand

The banking system can create any

desired level of money supply if allowed
to expand or reduce loan activity at will.

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Banks in the Circular Flow
Income Domestic
Consumers consumption

Saving
Factor Loans Product
markets BANKS markets
Loans

Sales
receipts
Wages,
Business
dividends, etc. Investment
firms expenditures

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Constraints on Lending Activity

There are four major constraints on the

ability of banks to make loans.

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Bank Deposits

Willingness of consumers and

businesses to continue using and
accepting checks rather than cash.

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Willing Borrowers

Willingness of consumers and

businesses and governments to borrow
money from banks.

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Willing Lenders

Banks may not be willing to satisfy

credit demands choosing instead to
hold excess reserves.

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Government Regulation

The Federal Reserve regulates bank

lending practices.

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Digital Money

The most common forms of money

cannot be used as a medium of
exchange in electronic malls.

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Credit Cards

Almost all Internet purchases are

completed with a credit card.

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Credit Cards

Dependence on credit cards limits the

potential of e-commerce because of:
Security issues such as credit card number
theft.
Use and sale of credit card databases by
e-retailers for undisclosed purposes.

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E-Payments

Some companies offer a quasi-banking

service by storing purchasing power
that consumers and e-retailers can
access.

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E-Payments

Consumers must "deposit" e-cash with

credit card advances.

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Speed of Spending

Consumers still need cash and

checking-account balances to pay for
their e-purchases.

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Speed of Spending

Virtual malls allow consumers to spend

money balances faster, thereby
boosting aggregate demand.

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 Money
Money and
and Banks
Banks
End of Chapter 13

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