Chapter 13:Chapter 13:Money and BanksMoney and Banks

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

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The Uses of MoneyThe Uses of Money

oIf there were no money, we’d have to rely on barter:oBarter is the direct exchange of one good for

another, without the use of money.

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The Uses of MoneyThe Uses of Money

oAnything 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 MoneyThe Uses of Money

oThe three functions of money:oMedium of exchange–is accepted as

payment for goods and services (and debts).

oStore of value–can be held for future purchases.

oStandard of value–serves as a yardstick for measuring the prices of goods and services.

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The Many Uses and Types of MoneyThe Many Uses and Types of Money

oMoney facilitates the market exchanges that permit specialization in production.

oIn the history of the U.S. many things have been used as money.

oThere were no U.S. dollars in the early days of Colonial America.

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Many Types of MoneyMany Types of Money

o“Greenbacks” were issued in 1861 by the U.S. federal government.

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

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Cash versus MoneyCash versus Money

oThe concept of money includes more than dollar bills and coins.

oChecking accounts can and do perform the same market function as cash.

oMoney is anything generally accepted as a medium of exchange.

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Transactions AccountsTransactions Accounts

oA transactions account is a bank account that permits direct payments to a third party (e.g., with a check).

oThe balance in your transactions account substitutes for cash and, therefore, is a form of money.

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Basic Money SupplyBasic Money Supply

oThe basic money supply is typically referred to by the abbreviation M1.

oM1 is currency held by the public, plus balances in transactions accounts.

oCash is only part of the money supply; most money consists of balances in transactions accounts.

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Basic Money SupplyBasic Money Supply

oCredit cards are another popular medium of exchange.

oCredit cards are not a form of money.

oThey are simply a payment service, not a store of value.

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Composition of the Basic Money Supply (M1)Composition of the Basic Money Supply (M1)

oThe money supply (M1) includes:oCurrency in circulation

oTransaction-account balances

oTraveler’s checks

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Near MoneyNear Money

oSavings accounts

oCertificates of deposit (CDs)

oMoney-market mutual funds

oThese represent additional measures of the money supply (M2, M3, etc.).

oWe will limit our discussion to M1, the basic money supply.

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Aggregate DemandAggregate Demand

oHow much money people have may be one of the determinants of aggregate demand:oAggregate 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 MoneyCreation of Money

oThe Bureau of Engraving and Printing and the U.S. Mint play only a minor role in creating money.

oMost of what we call money is not cash but bank balances.

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Deposit CreationDeposit Creation

oIn making a loan, a bank effectively creates money, because transactions-account balances are counted as part of the money supply.

oBanks create transactions-account balances by making loans.

oDeposit creation–the creation of transactions deposits by bank lending.

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A Monopoly BankA Monopoly Bank

oTo keep things simple, assume one bank in a town, and no one regulates bank behavior.

oYou deposit $100 from your piggy bank into the monopoly bank and receive a new checking account.

oWhen you deposit cash or coins in a bank, you are changing the composition of the money supply, not its size.

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An Initial LoanAn Initial Loan

oThe monopoly bank loans $100 to Campus Radio.

oIt deposits $100 into Campus Radio’s checking account.

oThe loan is accomplished by a simple bookkeeping entry.

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An Initial LoanAn Initial Loan

oMoney has been created because the checking account is considered to be money.

oTotal bank reserves have remained unchanged:oBank reserves are assets held by a bank to

fulfill its deposit obligations.

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Using the LoanUsing the Loan

oThe money supply does not contract when Campus Radio spends the $100.

oThe ownership of the deposit changes.

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Fractional ReservesFractional Reserves

oBank reserves are only a fraction of total transactions deposits.

oThe reserve ratio is the ratio of a bank’s reserves to its total transactions deposits:

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Fractional ReservesFractional Reserves

oThe ability of a monopoly bank to hold fractional reserves results from two facts:

– People use checks for most transactions.– There is no other bank.

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Reserve RequirementsReserve Requirements

oIf a bank could create money at will, it would have a lot of control over aggregate demand.

oIn reality, no private bank has that much power.

oThe power to create money resides in the banking system, not in any single bank.

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Reserve RequirementsReserve Requirements

oThe Federal Reserve System requires banks to maintain some minimum reserve ratio.

oRequired reserves are the minimum amount of reserves a bank is required to hold by government regulation.

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Reserve RequirementsReserve Requirements

oRequired reserves are equal to the required reserve ratio times transactions deposits:

oThe minimum reserve requirement directly limits deposit-creation possibilities.

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Excess ReservesExcess Reserves

oExcess reserves are bank reserves in excess of required reserves:

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Excess ReservesExcess Reserves

oThe ability of banks to make loans depends on access to excess reserves.

oSo long as a bank has excess reserves, it can make additional loans.

oIf 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 ReservesExcess Reserves

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A Multibank WorldA Multibank World

oIn reality there is more than one bank in town.

oThe key issue is not how much excess reserves any specific bank holds but how much excess reserves exist in the entire banking system.

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The Money MultiplierThe Money Multiplier

oExcess reserves are the source of bank lending authority.

oThe cumulative amount of new loans is determined by the money multiplier.

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The Money MultiplierThe Money Multiplier

oThe 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 ProcessThe Money Multiplier Process

oAn initial deposit of $100 made at University Bank.

oUniversity Bank keeps $75 (75% of the $100 new deposit) on reserve and loans out $25 which is deposited in Bank Two.

oBank Two keeps 75% of the new deposit on reserve ($18.75) and loans out $6.25

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The Money Multiplier ProcessThe Money Multiplier Process

oBank Three keeps 75% of the new deposit on reserve ($4.69) and loans out $1.56.

oThis process continues until all excess reserves have disappeared.

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Limits to Deposit CreationLimits to Deposit Creation

oThe potential of the money multiplier to create loans is summarized by the equation:

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Limits to Deposit CreationLimits to Deposit Creation

oIf the required reserve ratio = .75:

– The multiplier = 1.33

o 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 PowerExcess Reserves as Lending Power

oEach bank may lend an amount equal to its excess reserves and no more.

oThe entire banking system can increase the volume of loans by the amount of excess reserves multiplied by the money multiplier.

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The Macro Role of BanksThe Macro Role of Banks

oBanks can create money.

oSince virtually all market transactions involve the use of money, banks must have some influence on macro outcomes.

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Financing Aggregate DemandFinancing Aggregate Demand

oBanks perform two essential functions:oBanks transfer money from savers to

spenders by lending funds (reserves) held on deposit.

oThe banking system creates additional money by making loans in excess of total reserves.

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Financing Aggregate DemandFinancing Aggregate Demand

oIncreases in the money supply tend to increase aggregate demand.

oAggregate demand declines when the money supply shrinks.

oThe banking system can create any desired level of money supply if allowed to expand or reduce loan activity at will.

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Constraints on Money CreationConstraints on Money Creation

oThere are four major constraints on banks’ lending ability:oBank Deposits

oWilling Borrowers

oWilling Lenders

oGovernment Regulation

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Bank DepositsBank Deposits

oBank reserves will be lower if people prefer to hold cash rather than make deposits in their transactions accounts.

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Willing Borrowers and LendersWilling Borrowers and Lenders

oIf consumers, businesses, and governments don’t want to borrow, less deposits will be created.

oBanks may not be willing to satisfy credit demands, choosing instead to hold excess reserves.

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Government RegulationGovernment Regulation

oThe Federal Reserve regulates bank lending practices.

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Digital MoneyDigital Money

oThe most common forms of money cannot be used as a medium of exchange in electronic malls.

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Credit CardsCredit Cards

oAlmost all Internet purchases are completed with a credit card.

oDependence on credit cards limits the potential of e-commerce because:oSecurity issues such as credit card number

theft.

oUse and sale of credit card databases by e-retailers for undisclosed purposes.

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E-PaymentsE-Payments

oSome companies offer a quasi-banking service by storing purchasing power that consumers and e-retailers can access.

oConsumers must “deposit” e-cash with credit card advances.

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Speed of SpendingSpeed of Spending

oConsumers still need cash and checking-account balances to pay for their e-purchases.

oVirtual malls allow consumers to spend money balances faster, thereby boosting aggregate demand.

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Money and Money and BanksBanks

End of Chapter 13End of Chapter 13

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