What Is Money and Why Do We Need It?
Money Assets that people are generally willing to accept in
exchange for goods and services or for payment of debts.
Asset Anything of value owned by a person or a firm.
The Functions of Money
• Medium of exchange: buy stuff with money
No need to barter
• Unit of account: post prices/keep books in money terms
• Standard of deferred payment: need money to pay debts
• Store of value
Hold money on chance prices of other assets fall
What Can Serve as Money?
Criteria for an asset to be a medium of exchange:
1 It must be acceptable to most people.
2 It should be of standardized quality.
3 It should be durable.
4 It should be valuable relative to its weight.
5 It should be divisible.
Currency is fine… “fiat money”
Checking account balances are just as good.
Electronic “money” is even better.
Precious metals serve when confidence falters.
Commodity money.
How Is Money Measured in the United States Today?
M1: The Narrowest Definition of the Money Supply
M1 includes means of payment:
1 Currency: paper money and coins in circulation.
•
“in circulation” means not held by banks or the
government
2 The value of all checking account deposits at banks
3 The value of traveler’s checks
1 Because balances in checking accounts are in the money supply, banks play
an important role in the way money supply increases and decreases.
What about Credit Cards and Debit Cards?
You haven’t paid until you write a check to your bank.
How Is Money Measured
in the United States Today?
M1: The Narrowest Definition of the Money Supply
Figure 25-1
Measuring the Money Supply, July 2009
The Federal Reserve uses two different measures of the money supply: M1 and M2.M2 includes all the assets in
M1, as well as the additional assets shown in panel (b).
How Do Banks Create Money in a Fractional
Reserve Banking System?
Reserves Deposits that a bank keeps as cash in its vault or
on deposit with the Federal Reserve.
Required reserves Reserves that a bank is legally required
to hold, based on its checking account deposits.
Required reserve ratio The minimum fraction of deposits
banks are required by law to keep as reserves.
Excess reserves Reserves that banks hold over and above
the legal requirement.
Banks buy interest yielding assets with deposits they
don’t keep in reserves:
•Gov’t securities, loans to households and firms
How Do Banks Create Money?
A Bank’s Balance Sheet
How Do Banks Create Money?
How Do Banks Create Money?
How Do Banks Create Money?
Bank Balance Sheets
Balance Sheet for Bank of
America, December 31,
2008
The items on a bank’s balance
sheet of greatest economic
importance are its reserves,
loans, and deposits.
The difference between the value
of Bank of America’s total assets
and its total liabilities is equal to
its stockholders’ equity.
As a consequence, the left side
of the balance sheet always
equals the right side.
How Do Banks Create Money?
BANK
Wachovia
INCREASE IN
CHECKING
DEPOSITS
$1,000
PNC
+ 900
(= 0.9 x $1,000)
Third Bank
+ 810
(= 0.9 x $900)
Fourth Bank
+ 729
(= 0.9 x $810)
.
+•
.
+•
.
+
Total Change in Checking
Account Deposits
=$10,000
How Do Banks Create Money?
Simple deposit multiplier The ratio
of the amount of deposits created by
banks to the amount of new reserves.
1
Simple deposit multiplier 
RR
Change in checking account deposits  Change in bank reserves x
Change in bank reserves
=
1
RR
RR x Change in deposits
The Simple Deposit Multiplier versus the Real-World Deposit Multiplier:
•Not everything that one bank lends gets deposited in other banks.
– Much leaks out as currency holdings rather than deposits.
•And banks may not lend to full extent the can…they hold excess reserves.
Real world deposit multiplier is less than the simple multiplier.
The Functions of a Modern Central Bank
The Banker’s Bank:
Lender of last resort in crises
• Bank run: When many depositors rush to withdraw money at the
same time...They “run” to get to the cashier.
• Silent run: Major creditors don’t turn over their loans to a bank.
• Bank panic: Many banks experience runs at the same time.
Operates clearing system for interbank
payments.
Oversees financial intermediaries
- ensure their soundness.
- ensure public confidence
The Government's Bank:
– Manages government transactions.
– Controls availability of money and credit.
The Federal Reserve System
The Organization of the Federal Reserve System
Federal Reserve Districts
How the Federal Reserve Manages the Money Supply
Monetary policy The actions the Federal Reserve takes to manage the money
supply and interest rates in pursuit of economic objectives.
To manage the money supply, the Fed uses three monetary policy tools:
1 Open market operations: Fed buys and sells gov’t securities
• Federal Open Market Committee (FOMC) sets target federal funds rate.
• “Federal funds” are reserves that banks borrow and lend to each other.
• Fed buys bonds to increase the supply of reserves and lower the fed funds
rate.
2 Discount policy: Fed lends to banks @ discount rate
 injects reserves into banking system directly
3 Reserve requirements: lowering reserve requirement converts
required reserves to excess reserves that banks can lend
Two other actors—the nonbank public and banks—also influence the money
supply.
Multiple Creation of Money and Credit
The Fed’s Balance Sheet
Owns
Gold, Forex
Owes
.
Federal Reserve Notes
•Currency in Circulation
Vault Cash
Reserves
Bank IOUs
(Discount loans)
Bank Deposits @ Fed
Bank A
Bank B
:
Securities
Gov’t Deposits
Gov’t Bonds
MBSs
Miscellaneous
Monetary Base
High Powered
= MB
Money = H = MB
Note: MB = Currency + Bank Reserves = Cu + R
Ms = Currency + Demand Deposits = Cu + D
Fed buys something … MB up
A bond
A bank IOU
Seller deposits proceed in Bank A
Money supply increases
Bank A’s deposits @ Fed up
Bank A now has more reserves
Bank A holds reserves against its
new deposit (required + excess)
Bank A makes loan to customer
Borrower now has more
deposits
Money has just been created
Borrower buys something
Seller holds onto currency and
deposits the rest in its Bank B
Bank B’s deposits @ Fed up
:
The Quantity Theory of Money
Connecting Money and Prices: The Quantity Equation
M×V=P×Y
Velocity of money The average number of times each
dollar in the money supply is used to purchase goods and
services included in GDP.
P xY
V
M
The Quantity Theory Explanation of Inflation
We can transform the quantity equation from:
to:
M xV  P x Y
Growth rate of the money supply + Growth rate
of velocity = Growth rate of the price level (or
inflation rate) + Growth rate of real output
or
Inflation rate = Growth rate of the money supply +
Growth rate of velocity − Growth rate of real output
If velocity is constant, then the growth rate of velocity is zero.
This allows us to rewrite the equation one last time:
Inflation rate = Growth rate of the money
supply − Growth rate of real output
High Rates of Inflation
Very high rates of inflation—in excess of hundreds or
thousands of percentage points per year—are known as
hyperinflation.
Economies suffering from high inflation usually also suffer
from very slow growth, if not severe recession.
The Quantity Theory of Money
High Inflation in Argentina
Money Growth and Inflation in Argentina
Making
the
Connection
The German Hyperinflation
of the Early 1920s
During the hyperinflation of the
1920s, people in Germany used
paper currency to light their stoves.
Key Terms
Asset
Bank panic
Bank run
Commodity money
Discount loans
Discount rate
Excess reserves
Federal Open Market
Committee (FOMC)
Federal Reserve System
Fiat money
Fractional reserve banking
system
M1
M2
Monetary policy
Money
Open market operations
Quantity theory of money
Required reserve ratio
Required reserves
Reserves
Simple deposit multiplier
Velocity of money