1 The Meaning of Money
Money is the set of assets in an economy that people regularly
use to buy goods and services from other people.
Money serves three functions in economy:
1. Medium of Exchange: an item that buyers give to sellers
when they want to purchase goods and services.
2. Unit of Account: the yardstick people use to post prices
and record debts. One doesn't have to keep track of possible
relative prices. If the are N dierent commodities, then there
are N (N ; 1)=2 dierent relative prices.
3. Store of Value: an item that people can use to transfer
purchasing power from the present to the future. Notice
that the higher the ination rate the less role money has as
a store of value.
Liquidity is the ease with which an asset can be converted into
the economy's medium of exchange.
1. Money is the most liquid asset available.
2. Other assets (such as stocks, bonds, and real estate) vary in
their liquidity.
3. Trade-O: People have to balance the liquidity of each possible asset against the asset's usefulness as a store of value.
The Kinds of Money:
1. Commodity Money is money that takes the form of a commodity with intrinsic value.
2. Fiat Money is money without intrinsic value that is used as
money because of government decree.
2 Money in the U.S. Economy
The quantity of money circulating in the United States is some-
times called the money stock (M1).
Included in the measure of the money stock are currency, demand
deposits and other monetary assets.
1. Currency: the paper bills and coins in the hands of the
public.
2. Demand Deposits are balances in bank accounts that depositors can access on demand by writing a check.
3. Other Checkable Deposits are made up of NOW (Negotiable Order of Withdrawal") and ATS (\Automatic Transfer Service") accounts. These are checking accounts that
earn interest which is legally forbidden for ordinary demand
deposits.
Notice that credit-card balances are not included in the money
stock. Credit card purchases are simply promises to pay the good
or service later. Hence, credit-card accounts reduce the need for
the quantity of the medium of exchange.
The other two denitions of money are.
1. M2 includes (in addition to M1) savings deposits, small time
deposits, money market mutual funds, overnight repurchase
agreements and eurodollars. M2 is mostly held by individuals
2. M3 includes (in addition to M2) certain accounts such as
large time deposits, wholesale-type money market mutual
funds, and term repurchase agreements and eurodollars that
are held entities other than individuals.
Table 1: Five measures of the money stock for the U.S. economy. Note: M0 is also called
monetary base or \inside money" or \high-powered money." Note: M1 = M0 + deposits ;
reserves. Source: http://www.federalreserve.gov/releases/.
Measure Amount in Dec 2000 What's Included
Reserves $38 billion
Vault cash and bank deposits at Fed
M0
$582 billion
Currency held by public
Reserves
M1
$1,089 billion
Currency held by public
Traveler's checks
Demand deposits
Other checkable deposits
M2
$4,933 billion
Everything in M1
Savings deposits
Small time deposits (less than $100,000)
Retail-type money market mutual funds
Overnight repurchase agreements
Overnight Eurodollars
M3
$7,044 billion
Everything in M2
Large time deposits (more than $100,000)
Wholesale-type money market mutual funds
Term repurchase agreements
Term Eurodollars
3 Financial Institutions in the U.S. Economy
Financial Markets are the nancial institutions through which
savers can directly provide funds to borrowers. Important examples are:
1. The Bond Market. [More about bonds in a few weeks.]
2. The Stock Market.
(a) Stock is a claim to partial ownership in a rm.
(b) The sale of stock to raise money is called equity nance;
the sale of bonds to raise money is called debt nance.
Financial Intermediaries are nancial institutions through which
savers can indirectly provide funds to borrowers. Important examples are:
1. Banks.
(a) Banks take in deposits from people who want to save and
then lend them out to others who want to borrow.
(b) Banks pay savers interest on their deposits and charge
borrowers a higher rate of interest to cover the costs of
running the bank and provide the bank owners with some
amount of prot.
(c) Banks also play another important role in the economy by
allowing individuals to use checking deposits as a medium
of exchange.
2. Mutual Funds are institutions that sell shares to the public
and use the proceeds to buy a portfolio of stocks and bonds.
4 Banks and the Money Supply
4.1 The Simple Case of 100-Percent-Reserve Banking
Example: Suppose that currency is the only form of money and
the total amount of currency is $100.
A bank is created as a safe place to store currency; all deposits
are kept in the vault until the depositor withdraws them.
{ Reserves are deposits that banks have received but have not
loaned out.
{ Under the example described above, we have 100-percentreserve banking.
Table 2: The nancial position of the bank can be described with a T-account:
Assets
Liabilities
Reserves: $100.00 Deposits: $100.00
Note that the money supply in this economy is unchanged.
If banks hold all deposits in reserve, banks do not inuence the
supply of money.
4.2 Money Creation with Fractional-Reserve Banking
Fractional-Reserve Banking is a banking system in which banks
hold only a fraction of deposits as reserves.
Reserve Ratio is the fraction of deposits that banks hold as
reserves.
Example: Same as above, but the bank decides to set its reserve
ratio equal to 10% and loan out the remainder of the deposits.
Table 3: The nancial position of the bank can be described with a T-account:
Assets
Liabilities
Reserves: $10.00 Deposits: $100.00
Loans: $90.00
When the bank makes these loans, the money supply changes.
1. Before the bank made any loans, the money supply was equal
to the $100 worth of deposits.
2. Now, after the loans, deposits are still equal to $100, but borrowers now also hold $90 worth of currency from the loans.
3. Therefore, when banks hold only a fraction of deposits in
reserve, banks create money.
Note that, while new money has been created, so has debt. There
is no new wealth created by this process.
4.3 The Money Multiplier
The creation of the money does not stop at this point.
Borrowers usually borrow money to purchase something and
then the money likely becomes redeposited elsewhere.
Suppose a person borrowed the $90 to purchase something and
the funds then get redeposited in a second bank.
Table 4: Here is this bank's T-account (assuming that it also sets its reserve ratio to 10%):
Assets
Liabilities
Reserves: $9.00 Deposits: $90.00
Loans: $81.00
If the $81 in loans becomes redeposited in another bank, this
process will go on and on.
Each time the money is deposited and a bank loan is created,
more money is created.
Money Multiplier is the amount of money the banking system
generates with each dollar of reserves.
1
money multiplier =
reserve ratio