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C h a p t e r
12
MONEY
O u t l i n e
Money makes the World Go Around
A. Money has taken many forms; what is money now?
B. What do banks do, and can they create money?
C. What happens if the amount of money grows rapidly?
I.
What is Money?
A. Money is anything that is generally acceptable as a means
of payment.
1. A means of payment is a method of settling a debt.
2. Money has three other functions:
a) Medium of exchange
b) Unit of account
c) Store of value
B. Medium of Exchange
1. A medium of exchange is an object that is generally
accepted in exchange for goods and services.
2. In the absence of money, people would need to exchange
goods and services directly, which is called barter.
3. Barter requires a double coincidence of wants, whereby
each transactor has what the other transactor wants.
This situation is rare, so barter is costly.
C. Unit of Account
1. A unit of account is an agreed measure for stating the
prices of goods and services.
2. Table 27.1 (p. 630/284) illustrates how a unit of
account simplifies price comparisons.
D. Store of Value
As a store of value, money can be held for a time and
later exchanged for goods and services.
E. Money in the United States Today
1. Money in the United States consists of bills and
coins—called currency—and deposits at banks and other
depository institutions.
2. The two main official measures of money in the United
States are M1 and M2.
3. M1 consists of currency outside banks, traveler’s
checks, and checking deposits owned by individuals and
businesses.
4. M2 consists of M1 plus time deposits, savings
deposits, and money market mutual funds and other
deposits.
5. Figure 27.1 (p. 631/285) graphically illustrates the
composition of these two measures in 2001 and shows
the relative magnitudes of the components of money.
6. The items in M1 clearly meet the definition of money;
the items in M2 do not do so quite so clearly but
still are quite liquid. Liquidity measures the ease with
which an asset may be converted into money at a known
price.
7. Checkable deposits are money, but checks are not;
checks merely are the means by which the money is
transferred among people.
8. Credit cards are not money. Credit cards enable the
holder to obtain a loan quickly, but ultimately the
loan must be repaid with money.
II. Depository Institutions
A. A depository institution is a firm that accepts deposits from
households and firms and uses the deposits to make loans
to other households and firms. The deposits of three
types of depository institution make up the nation’s
money:
1. Commercial banks
2. Thrift institutions
3. Money market mutual funds
B. Commercial Banks
1. A commercial bank is a private firm that is licensed to
receive deposits and make loans.
2. A commercial bank’s balance sheet summarizes its
business and lists the bank’s assets, liabilities, and
net worth.
3. The objective of a commercial bank is to maximize the
net worth of its stockholders.
4. To achieve this objective, banks make risky loans at a
higher interest rate than the interest rate they pay
on deposits.
5. But the banks must balance profit and prudence; loans
generate profit, but depositors must be able to obtain
their funds when they want them.
6. So banks divide their funds into two parts: reserves
and loans.
7. Reserves are the cash in a bank’s vault and deposits at
Federal Reserve Banks.
8. Bank lending takes the form of liquid assets,
investment securities, and loans.
C. Thrift Institutions
1. The thrift institutions are savings and loan associations,
savings banks, and credit unions.
2. A savings and loan association (S&L) is a depository
institution that accepts checking and savings deposits
and that make personal, commercial, and home-purchase
loans.
3. A savings bank is a depository institution owned by its
depositors that accepts savings deposits and makes
mainly mortgage loans.
4. A credit union is a depository institution owned by its
depositors that accepts savings deposits and makes
consumer loans.
D. Money Market Mutual Funds
A money market fund is a
institution that sells
proceeds to buy liquid
bills.
E. The Economic Functions
fund operated by a financial
shares in the fund and uses the
assets such as U.S. Treasury
of Depository Institutions
1. Depository institutions make a profit from the spread
between the interest rate they pay on their deposits
and the interest rate they charge on their loans.
2. This spread exists because depository institutions:
a) Create liquidity by accepting deposits that can be
withdrawn instantly and using these deposits to
make long-term loans.
b) Minimize the cost of obtaining funds by pooling
many people’s relatively small deposits into large
sums that can be loaned to many borrowers.
c) Minimize the cost of monitoring borrowers by
specializing in this activity.
d) Pool risk by lending to many different borrowers so
that if one borrower is unable to pay back the loan
the lender loses only a small fraction of total
deposits.
III. Financial Regulation, Deregulation, and Innovation
A. Financial Regulation
1. Depository institutions face two types of regulations:
deposit insurance and balance sheet rules.
2. Deposits at banks, S&Ls, savings banks, and credit
unions are insured by the Federal Deposit Insurance
Corporation (FDIC).
a) This insurance guarantees deposits in amounts of up
to $100,000 per depositor.
b) This guarantee gives depository institutions the
incentive to make risky loans because the
depositors believe their funds to be perfectly
safe; because of this incentive balance sheet
regulations have been established.
3. There are four main balance sheet rules:
a) Capital requirements — regulations setting the
minimum amount of the owners’ financial wealth that
must be at stake in the depository institution.
b) Reserve requirements — rules listing the minimum
percentages of deposits that must be held as
currency or as other safe assets.
c) Deposit rules — restrictions on the type of
deposits that an intermediary may accept.
d) Lending rules — restrictions on the type and size
of loans that can be made by a depository
institution.
B. Deregulation in the 1980s
The 1980s were marked by considerable financial
deregulation, when federal legislation and rule changes
lifted many of the restrictions on depository
institutions, removing many of the distinctions between
banks and others, and strengthening the control of the
Federal Reserve over the system.
C. Deregulation in the 1990s
In 1994 the Riegle-Neal Interstate Banking and Branching
Efficiency Act was passed, which permits U.S. banks to
establish branches in any state. It led to a wave of
mergers.
D. Financial Innovation
1. The 1980s and 1990s have been marked by financial
innovation—the development of new financial products
aimed at lowering the cost of making loans or at
raising the return on lending.
2. Financial innovation occurred for three reasons:
a) The economic environment, especially of the 1980s,
featured high inflation and high interest rates,
which created risk for intermediaries. Some
innovations, such as variable rate mortgages, were
aimed at lowering this risk.
b) Massive technological change, especially reductions
in the cost of computing and long-distance
communication, brought other innovations.
c) Much innovation was directed at avoiding
regulation.
E. Deregulation, Innovation, and Money
The combination of deregulation and innovation has
produced large changes in the composition of money, both
M1 and M2.
IV. How Banks Create Money
A. Reserves: Actual and Required
1. The fraction of a bank’s total deposits held as
reserves is the reserve ratio.
2. The required reserve ratio is the fraction that banks are
required, by regulation, to keep as reserves. Required
reserves are the total amount of reserves that banks
are required to keep.
3. Excess reserves equal actual reserves minus required
reserves.
B. Creating Deposits by Making Loans in a One-Bank Economy
1. When a bank receives a deposit of currency, its
reserves increase by the amount deposited, but its
required reserves increase by only a fraction
(determined by the required reserve ratio) of the
amount deposited.
2. The bank has excess reserves, which it loans. These
loans can only end up as deposits in our one and only
bank, where they boost deposits without changing total
reserves, which creates money.
3. Figure 27.2 (page 292) illustrates.
C. The Deposit Multiplier
The deposit multiplier is the amount by which an increase in
bank reserves is multiplied to calculate the increase in
bank deposits.
The deposit multiplier = 1/Required reserve ratio.
D. Creating Deposits by Making Loans with Many Banks
1. With many banks, one bank lending out its excess
reserves cannot expect its deposits to increase by the
full amount loaned; some of the loaned reserves end up
in other banks. But then the other banks have excess
reserves, which they loan.
2. Ultimately, the effect in the banking system is the
same as if there was only one bank, so long as all
loans are deposited in banks. Figure 27.3 (page
640/294) illustrates.
V. Money, Real GDP, and the Price Level
A. The Short-Run Effects of a Change in the Quantity of
Money
1. An increase in the quantity of money increases
aggregate demand.
2. The AD curve shifts rightward. Real GDP increases and
the price level rises. Figure 27.4 (page 641/295)
illustrates.
B. The Long-Run Effects of a Change in the Quantity of Money
1. In the long run, real GDP equals potential GDP.
2. An increase in the quantity of money at full
employment increases real GDP and raises the price
level.
3. The money wage rate rises, which decreases short-run
aggregate supply and decreases real GDP but raises the
price level.
4. In the long run, an increase in the quantity of money
leaves real GDP unchanged but raises the price level.
C. The Quantity Theory of Money
1. The quantity theory of money is the proposition that, in
the long run, an increase in the quantity of money
brings an equal percentage increase in the price
level.
2. The quantity theory of money is based on the velocity
of circulation and the equation of exchange.
a) The velocity of circulation is the average number of
times in a year a dollar is used to purchase goods
and services in GDP. Calling the velocity of
circulation V, V = PY/M. Figure 27.6 (page 643/297)
graphs the velocity of circulation for M1 and M2
for 1961–2001.
b) The equation of exchange states that the quantity of
money, M, multiplied by the velocity of
circulation, V, equals the price level, P,
multiplied by real GDP, Y. That is:
MV = PY.
3. The quantity theory assumes that velocity and
potential GDP are not affected by the quantity of
money. Hence
P = (V/Y)M.
4. Because (V/Y) does not change when M changes, a change
in M brings a proportionate change in P. That is, the
change in P, P, is related to the change in M, M, by
the equation:
P = (V/Y)M.
Divide this last equation by the previous one and the
term (V/Y) cancels to give:
P/P = M/M.

P/P is the inflation rate and = M/M is the growth
rate of the quantity of money.
C. The Quantity Theory and the AS-AD Model
1. The quantity theory of money can be interpreted in
terms of the AS-AD model. In the long run, real GDP
equals potential GDP and according to the AS-AD model,
an increase in the quantity of money brings an equal
percentage increase in the price level.
2. The AS-AD model also makes clear why the quantity
theory is a long-run theory. In the short run, an
increase in the quantity of money brings an increase
in real GDP and a smaller than proportionate increase
in the price level.
D. Historical Evidence on the Quantity Theory of Money
1. Historical evidence shows that U.S. money growth and
inflation are correlated, more so in the long run than
the short run, which is broadly consistent with the
quantity theory.
2. Figure 27.7 (page 646/300) graphs money growth and
inflation in the United States from 1931 to 2001.
E. International Evidence on the Quantity Theory of Money
1. International evidence shows a marked tendency for
high money growth rates to be associated with high
inflation rates.
2. Figure 27.8 (page 647/301) shows scatter diagrams of
money growth and inflation for various countries and
regions during the 1980s and 1990s.
F. Correlation, Causation, and Other Influences
1. Correlation is not causation; money growth and
inflation could be correlated because money growth
causes inflation, or because inflation causes money
growth, or because a third factor caused both. But the
combination of historical, international, and other
independent evidence gives us confidence that in the
long run, money growth causes inflation.
2. In the short run, the quantity theory is not correct;
we need the AS-AD model.