The Monetary
System:
Fundamentals
Copyright © 2004 South-Western
Mods
23 &
25
Before We Had Money. . .
. . .Bartering was the system for trade!
But, Bartering had built-in problems:
• Requires a double coincidence of wants
• Inconvenient
• Awkward to transport items to trade with/for
• Inefficient
• Takes time to find right person for trade
• Discourages trade, which results in . . .
• more self-sufficiency, which results in . . .
• Lowered standard of living!!
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We Value Money Because of its Functions
• Money has THREE functions in the economy:
Remember it with “M & M’S”
• MEDIUM OF EXCHANGE
• MEASURE OF VALUE
• STORE OF VALUE
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The Functions of Money
1. Medium of Exchange
•
•
A medium of exchange is an item that buyers give
to sellers when they want to purchase goods and
services.
A medium of exchange is anything that is readily
acceptable as payment for buying or selling goods
and services.
•
•
•
Should be uniform—”FUNGIBLE”—”a quarter is a
quarter”
Should be portable—can carry it around
Should be divisible—for large or small transactions
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The Functions of Money
2. Measure of Value
•
A measure of value is the yardstick people use to
post prices and record debts.
•
•
•
Must be familiar
Must be divisible
Must be accepted
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The Functions of Money
3. Store of Value
•
A store of value means that people can use money
to transfer purchasing power from the present to
the future.
•
•
Must be durable
Must have stable value
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So…Money ADDS UP
•
•
•
•
A=acceptable
D=divisible
D=durable
S=stable
• U=uniform
• P=portable
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Difference between Money, Income
and Wealth
“She has a lot of money.”
What exactly does that mean??
The possibilities:
She has piles of currency in her basement
She earns a large salary
She owns a large amount of wealth
Idea of stock and flow variables
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Liquidity
• The ease with which an asset can be converted
into the economy’s medium of exchange, i.e.
money.
• Money is most liquid asset
• Stocks, bonds, real estate are other types of assets—
they are less liquid
• You need to decide which is most important to you
when holding wealth: liquidity or store of value
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The Kinds of Money
• Commodity money takes the form of a
commodity with intrinsic value.
• Examples: Gold, silver, cigarettes in prison.
• Fiat money is used as money because of
government decree.
• It does not have intrinsic value.
• Examples: Coins, currency, check deposits.
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Examining Currency
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The Money Supply in the U.S.
Economy
• Money is the set of assets in an economy that
people regularly use to buy goods and services
from other people.
• That set of assets includes several types of
“money”
• M1 Money Supply
• M2 Money Supply
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Money in the U.S. Economy—March 2013
Billions
of Dollars
M2
$10412
• Savings deposits
• Small time deposits
• Money market
mutual funds
• A few minor categories
($7994.7 billion)
M1
$2417.3
0
• Demand deposits
• Traveler’s checks
• Other checkable deposits
($1,315 billion)
• Currency
($1,102.3 billion)
• Everything in M1
($2,417.3 billion)
Copyright©2003 Southwestern/Thomson Learning
Banking’s role with Money
• The Goldsmiths and the Knights of Old
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Financial Intermediaries: Banks
Banks
• take deposits from people who want to save and use
the deposits to make loans to people who want to
borrow.
• pay depositors interest on their deposits and charge
borrowers slightly higher interest on their loans.
• help create a medium of exchange by allowing
people to write checks against their deposits.
• A medium of exchange is an item that people can
easily use to engage in transactions.
• This facilitates the purchases of goods and services
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How Fractional-Reserve Banking
Works
• Deposits are the money “stored” in bank
accounts
• Reserves are deposits that banks have received
but have not loaned out.
• In a fractional-reserve banking system, banks
hold a fraction of the money deposited as
reserves and lend out the rest.
• Reserve Ratio
• The reserve ratio is the fraction of deposits that
banks hold as reserves.
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Banking Accounting
• Deposits into a bank are recorded as
both assets and liabilities.
• The fraction of total deposits that a bank
has to keep as reserves is called the
reserve ratio.
• Loans become an asset to the bank.
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Banking Accounting
• This T-Account shows a bank that…
First National Bank
• accepts deposits,
• keeps a portion
as reserves,
• and lends out
the rest.
• It assumes a
reserve ratio
of 10%.
Assets
Reserves
$10.00
Liabilities
Deposits
$100.00
Loans
$90.00
Total Assets
$100.00
Total Liabilities
$100.00
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BANKS AND THE MONEY
SUPPLY
• When one bank loans money, that money is
generally deposited into another bank.
• This creates more deposits and more reserves to
be lent out.
When a bank makes a loan from
its reserves, the money supply
increases.
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Money Creation with
Fractional-Reserve Banking
First National Bank
Assets
Liabilities
Reserves
$10.00
Deposits
$100.00
Loans
Second National Bank
Assets
Reserves
$9.00
Liabilities
Deposits
$90.00
Loans
$90.00
Total Assets
Total Liabilities
$100.00
$100.00
$81.00
Total Assets
$90.00
Total Liabilities
$90.00
Money Supply = $190.00!
Copyright © 2004 South-Western
How much money is eventually
created in this economy?
The money multiplier helps you calculate the
amount of money the banking system generates
with each dollar of reserves.
• The money multiplier is the reciprocal of the
reserve ratio:
M = 1/R
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Money Multiplier Example
1. Money Multiplier formula:
M = 1/R
• With a reserve requirement of 20% or 1/5,
you solve for M by figuring 1/.2
1/.2 = 5 So…M = 5
•
The money multiplier is 5—the money supply from
that deposit will expand by 5
•
So, a $1000 deposit will create $5000 worth
of money
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Increasing the Money Supply
• Penny demonstration
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