Learning Objectives

Learning Objectives • 13-01. Explain what money is. • 13-02. Describe how banks create money. • 13-03. Demonstrate how the money multiplier works.

What Is “Money”? • Money is a tool that greatly simplifies market transactions. • No money? Transactions would be made using a barter system. • Barter: the direct exchange of one good for another, without the use of money. • Money acts as a medium of exchange. Sellers will accept it as payment for goods and services. • Money: anything generally accepted as a medium of exchange.

The Money Supply • Anything that serves all the following purposes can be thought of as money: • Medium of exchange: accepted as payment for goods and services (and debts). • Store of value: can be held for future purchases. • Standard of value: serves as a yardstick for measuring the prices of goods and services.

Modern Concepts • Cash is obviously money because it fills all three purposes. • Checking accounts perform the same market functions as cash. Debit cards act much like a check, so they are money. • Online payment systems and credit cards do not. They can be a medium of exchange but do not fulfill the other purposes. • The essence of money is not its physical form, but its ability to purchase goods and services.

Composition of the Money Supply • Some bank accounts are better substitutes for cash than others. • M1: cash and transactions accounts • Transactions accounts include checking accounts and travelers checks. • Money supply (M1): currency held by the public, plus balances in transactions accounts. • M1 permits direct payment for goods and services.

Composition of the Money Supply • M2: M1 plus savings accounts, etc. • Savings account balances and money market mutual funds are almost as good a substitute for cash as transactions accounts. • Money supply (M2): M1 plus balances in most savings accounts and money market mutual funds. • M2 must be turned into M1 before it can be used to purchase goods and services.

Composition of the Money Supply • Cash is about half of the M1 money supply. Most of the rest are transactions account balances. • M2 is much larger than M1. People hold money in M2 accounts because they can earn some interest on these deposits.

The Economic Importance of Money • How much money is available (the size of the money supply) affects consumers’ ability to purchase goods and services. • This directly affects aggregate demand (AD).

Creation of Money • Cash is either printed or coined. But cash is a very small part of M2. • How is the money in transactions accounts and savings accounts created? • These bank accounts are not physical lumps of cash. They are computer data entries. • A few keystrokes can increase or decrease the money in a bank account.

Creation of Money • Banks create money by making loans. • Grant a loan and increase the borrowers’ checking account with a few keystrokes. • Money is “created.” • The bank’s ability to create money is limited by the Federal Reserve System (the “Fed”). • Thus the Fed controls the basic money supply.

Fractional Reserves • The Fed controls a bank’s ability to create money by making loans. • Each bank is required to maintain a minimum reserve ratio. • Bank reserves: assets held by a bank to fulfill its deposit obligations. • Required reserves: the minimum amount of reserves a bank is required to hold. • Required reserve ratio: the ratio of a bank’s required reserves to its total deposits. Required reserves = Required reserve ratio x Total deposits

Fractional Reserves • Since the bank must set aside some of its deposits to satisfy its required reserves, it can make loans only on the remainder, called excess reserves. • Excess reserves: bank reserves in excess of required reserves. • A minimum reserve requirement directly limits deposit creation (lending) possibilities. Excess reserves = Total reserves – Required reserves

Changes in the Money Supply • When a bank makes a loan, money is created. • The borrower spends the money; the seller deposits it into the firm’s bank account. • That bank now has more excess reserves and can make a loan on it, creating more money. • When the new borrower spends the loan, this cycle continues to repeat itself. • Each time a new loan is made, the money supply increases. • There is a multiplier process going on, just like the income multiplier process in Chapter 10.

The Money Multiplier • Money multiplier: the amount of deposit dollars that the banking system can create from $1 of excess reserves. 1 Money multiplier = Required reserve ratio

The Money Multiplier • The potential of the money multiplier to create loans is summarized in this equation: • If the required reserve ratio is 0.20, the money multiplier is 5. An initial deposit of $100 has $80 of excess reserves and potentially can create $400 of new deposits. Excess reserves x Money multiplier = Potential deposit creation

Excess Reserves as Lending Power • If a bank has no excess reserves, it can make no more loans. • Each bank may lend an amount equal to its excess reserves and no more. • The entire banking system can increase the volume of loans by the amount of excess reserves multiplied by the money multiplier.

Banks and the Circular Flow • Banks perform two essential functions for the macro economy: • 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 required reserves. • Changes in the money supply may in turn alter spending behavior and thereby shift the aggregate demand (AD) curve.

Constraints on Deposit Creation • Deposits. If people prefer to hold onto cash, the deposit creation process will be severely hindered. • Willingness to lend. If banks are reluctant to take risks in lending, they will not fully lend out their excess reserves. • Willingness to borrow. If borrowers are reluctant to take on more debt, fewer loans will be made. • Regulation. The Fed may limit deposit creation by changing reserve requirements.

Learning Objectives