MONEY
12
CHAPTER
Objectives
After studying this chapter, you will able to
 Define money and describe its functions
 Explain the economic functions of banks and other
depository institutions
 Describe some financial innovations that have changed
the way we use money today
 Explain how banks create money
 Explain the effects of the quantity of money on the price
level and real GDP, and explain the quantity theory of
money
Money Makes the World Go Around
Money has taken many forms; what is money now?
What do banks do, and can they create money?
What happens if the amount of money grows rapidly?
What is Money?
Money is any commodity or token that is generally
acceptable as a means of payment.
A means of payment is a method of settling a debt.
Money has three other functions:
 Medium of exchange
 Unit of account
 Store of value
What is Money?
Medium of Exchange
A medium of exchange is an object that is generally
accepted in exchange for goods and services.
In the absence of money, people would need to exchange
goods and services directly, which is called barter.
Barter requires a double coincidence of wants, which is
rare, so barter is costly.
Unit of Account
A unit of account is an agreed measure for stating the
prices of goods and services.
What is Money?
Store of Value
As a store of value, money can be held for a time and later
exchanged for goods and services.
Money in the United States Today
Money in the United States consists of:
 Currency
 Deposits at banks and other depository institutions
Currency is the general term for bills and coins.
What is Money?
The two main official measures of money in the United
States are M1 and M2.
M1 consists of currency outside banks, traveler’s checks,
and checking deposits owned by individuals and
businesses.
M2 consists of M1 plus time deposits, savings deposits,
and money market mutual funds and other deposits.
What is Money?
Figure 12.1 illustrates the
composition of these two
measures in 2001 and
shows the relative
magnitudes of the
components of money.
What is Money?
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 is the property of being instantly convertible into
a means of payment with little loss of value.
Checkable deposits are money, but checks are not–
checks are instructions to banks to transfer money.
Credit cards are not money. Credit cards enable the holder
to obtain a loan quickly, but the loan must be repaid with
money.
Depository Institutions
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:
 Commercial banks
 Thrift institutions
 Money market mutual funds
Depository Institutions
Commercial Banks
A commercial bank is a private firm that is licensed to
receive deposits and make loans.
A commercial bank’s balance sheet summarizes its
business and lists the bank’s assets, liabilities, and net
worth.
The objective of a commercial bank is to maximize the net
worth of its stockholders.
Depository Institutions
To achieve its objective, a bank makes risky loans at an
interest rate higher than that paid on deposits.
But the banks must balance profit and prudence; loans
generate profit, but depositors must be able to obtain their
funds when they want them.
So banks divide their funds into two parts: reserves and
loans.
Reserves are the cash in a bank’s vault and deposits at
Federal Reserve Banks.
Bank lending takes the form of liquid assets, investment
securities, and loans.
Depository Institutions
Thrift Institutions
The thrift institutions are:
 Savings and loan associations
 Savings banks
 Credit unions
Depository Institutions
A savings and loan association (S&L) is a depository
institution that accepts checking and savings deposits and
that makes personal, commercial, and home-purchase
loans.
A savings bank is a depository institution owned by its
depositors that accepts savings deposits and makes
mainly mortgage loans.
A credit union is a depository institution owned by its
depositors that accepts savings deposits and makes
consumer loans.
Depository Institutions
Money Market Mutual Funds
A money market fund is a fund operated by a financial
institution that sells shares in the fund and uses the
proceeds to buy liquid assets such as U.S. Treasury bills.
Depository Institutions
The Economic Functions of Depository Institutions
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.
This spread exists because depository institutions
 Create liquidity
 Minimize the cost of obtaining funds
 Minimize the cost of monitoring borrowers
 Pool risk
Financial Regulation, Deregulation, and
Innovation
Financial Regulation
Depository institutions face two types of regulations:
 Deposit insurance
 Balance sheet rules
Financial Regulation, Deregulation, and
Innovation
Deposits at banks, S&Ls, savings banks, and credit unions
are insured by the Federal Deposit Insurance Corporation
(FDIC).
This insurance guarantees deposits in amounts of up to
$100,000 per depositor.
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.
Financial Regulation, Deregulation, and
Innovation
There are four main balance sheet rules:
 Capital requirements
 Reserve requirements
 Deposit rules
 Lending rules
Financial Regulation, Deregulation, and
Innovation
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.
Financial Regulation, Deregulation, and
Innovation
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.
Financial Regulation, Deregulation, and
Innovation
Financial Innovation
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.
Financial innovation occurred for three reasons:
 The economic environment--high inflation
 Massive technological change
 Avoidance of regulation
Financial Regulation, Deregulation, and
Innovation
Deregulation, Innovation, and Money
The combination of deregulation and innovation has
produced large changes in the composition of money, both
M1 and M2.
How Banks Create Money
Reserves: Actual and Required
The fraction of a bank’s total deposits held as reserves is
the reserve ratio.
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.
Excess reserves equal actual reserves minus required
reserves.
How Banks Create Money
Creating Deposits by Making Loans in a One-Bank
Economy
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.
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.
How Banks Create Money
Figure 12.2 illustrates how
one bank create money by
making loans.
How Banks Create Money
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.
How Banks Create Money
Creating Deposits by Making Loans with Many Banks
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.
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.
How Banks Create Money
Figure 12.3
illustrates money
creation with many
banks.
Money, Real GDP, and the Price Level
The Short-Run Effects of a Change in the Quantity of
Money
An increase in the quantity of money increases aggregate
demand.
The AD curve shifts rightward. Real GDP increases and
the price level rises.
Money, Real GDP, and the Price Level
Figure 12.4 illustrates the
effects of an increase in
the quantity of money
starting from below
potential GDP.
Money, Real GDP, and the Price Level
The Long-Run Effects of a Change in the Quantity of
Money
In the long run, real GDP equals potential GDP.
An increase in the quantity of money at full employment
increases real GDP and raises the price level.
The money wage rate rises, which decreases short-run
aggregate supply and decreases real GDP but raises the
price level.
In the long run, an increase in the quantity of money
leaves real GDP unchanged but raises the price level.
Money, Real GDP, and the Price Level
Figure 12.5 illustrates the
effects of an increase in
the quantity of money
starting from potential
GDP.
Money, Real GDP, and the Price Level
The Quantity Theory of Money
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.
The quantity theory of money is based on the velocity of
circulation and the equation of exchange.
The velocity of circulation is the average number of
times in a year a dollar is used to purchase goods and
services in GDP.
Money, Real GDP, and the Price Level
Calling the velocity of circulation V, the price level P, real
GDP Y, and the quantity of money M
V = PY/M.
Figure 12.6 on the next slide graphs the velocity of
circulation for M1 and M2 for 1961–2001.
Money, Real GDP, and the Price Level
Money, Real GDP, and the Price Level
The equation of exchange states that
MV = PY
The quantity theory assumes that velocity and potential
GDP are not affected by the quantity of money.
So
P = (V/Y)M
Because (V/Y) does not change when M changes, a
change in M brings a proportionate change in P.
Money, Real GDP, and the Price Level
That is, the change in P, P, is related to the change in M,
M, by the equation:
P = (V/Y)M
Divide this equation by
P = (V/Y)M
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.
Money, Real GDP, and the Price Level
The Quantity Theory and the AS-AD Model
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 rise in the price level.
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.
Money, Real GDP, and the Price Level
Historical Evidence on the Quantity Theory of Money
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.
Money, Real GDP, and the Price Level
Figure 12.7
graphs money
growth and
inflation in the
United States
from 1931 to
2001.
Part (a) shows
year-to-year
changes.
Money, Real GDP, and the Price Level
Part (b) shows
decade
average
changes.
Money, Real GDP, and the Price Level
International Evidence on
the Quantity Theory of
Money
International evidence
shows a marked tendency
for high money growth rates
to be associated with high
inflation rates.
Figure 12.8 shows the
evidence.
Money, Real GDP, and the Price Level
Correlation, Causation, and Other Influences
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 causes both.
But the combination of historical, international, and other
independent evidence gives us confidence that in the long
run, money growth causes inflation.
In the short run, the quantity theory is not correct; we need
the AS-AD model.
MONEY
THE END
12
CHAPTER