Money and
the Banking System
Ch 13: Pg 244-254
Ch 14: All
Chap 13,14 Vocabulary

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Medium of
exchange
Unit of account
Store of value
Transactions
demand
Asset demand
Total demand for
money

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Fractional Reserve
Banking System
Liquidity
Stocks
Bonds
Fiat money
2
What is Money

Money works best when it meets these criteria:
•
•
•
•
•
Portable
Durable
Divisible
Acceptable
Stable
3
Functions of Money
1.
Money serves as a medium of
exchange:
•
2.
Money Serves as a unit of account:
•
3.
A medium of exchange is the property
of money that exchange is made
through the use of money.
Unit of account is the property of
money that prices are quoted in terms of
money.
Money serves as a store of value:
•
Store of value is the property of money
that it preserves value until it is used in
an exchange.
4
What Gives Money its Value?

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Our money has value because the
government “says” it has value.
We accept paper dollars because we
know that other people will accept dollars
later when we try to spend them.
The dollar is NOT backed by gold or
silver. Our currency is “fiat” money; or
money by decree.
Fiscal and Monetary Policies control the
value of the dollar by controlling the
supply.
5
Measuring Money in the U.S.
Economy: M1 Money Supply
Components of M1,
January 2004
Currency
held outside
banks
$ 665
billion
Demand
(checking)
deposits
301
billion
Other
checkable
deposits
313
billion
Travelers’
checks
8
billion
Total of M1
$1,287
billion
Other
checkable
deposits
24%
Travelers'
checks
1%
Currency
52%
Demand
deposits
23%
M1 is very liquid (spendable).
Other measures of the money
supply are not as liquid. When
we speak of money in
economics, we are referring
6
to M1
Measuring Money in the U.S.
Economy: M2/M3 Money Supply

A broader definition of money, known as M2,
includes assets that can be easily turned into
M1. M2 includes:
• M1 + savings accounts + money market accounts +
certificates of deposit (CDs) valued at less than
$100,000 + money market mutual fund accounts

M3 is an additional measure which is
composed of M2 + CD’s over $100,000
• Not as liquid as M1 or M2


There are several other money measures
used by the Fed, but we will not cover them.
Credit cards are loans and are NOT part of
the money supply.
7
M1 and M2, August 2008
Current M1, M2

http://www.federalreserve.gov/relea
ses/h6/current/
9
What’s with All the Currency?
$775.4 billion of currency in circulation. That’s $2,570 in cash
for every man, woman, and child in the United States. How many
people do you know who carry $2,570 in their wallets? Not many.
So where is all that cash? Part of the answer is that it isn’t in
individuals’ wallets: it’s in cash registers.
Economists also believe that cash plays an important role in
transactions that people want to keep hidden. Small businesses
and the self-employed sometimes prefer to be paid in cash so
they can avoid paying taxes by hiding income from the Internal
Revenue Service.
The most important reason for those huge currency holdings,
however, is foreign use of dollars. The Federal Reserve estimates
that 60% of U.S. currency is actually held outside the United
States.
The Banking System
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There was a wave of bank runs in the early 1930s. To
bring the panic to an end Franklin Delano Roosevelt
declared a national “bank holiday,” closing all banks
for a week to give bank regulators time to close
unhealthy banks and certify healthy ones.
Since then, regulation has protected the United States
and other wealthy countries against most bank runs.
There are some limits on deposit insurance; in
particular, currently only the first $250,000 of any
bank account is insured. As a result, there can still be
a rush out of a bank perceived as troubled.
Bank Failures
A Bank’s Balance Sheet (T-Chart)

The balance sheet of a commercial bank
shows how a bank raises and uses money:
• Liabilities are the sources of funds for
the bank. The bank is “liable” for
returning funds to depositors.
• Assets generate income for the bank.
Loans are assets for the bank because a
borrower must pay interest to the bank.
• Owners’ equity refers to the funds that
owners must place into the bank so it
has some startup funds.
12
Balance Sheet for a Commercial Bank
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Reserves are assets that are not lent out.
Required reserves are the fraction of
banks’ deposits they are legally required to
hold in their vaults or as deposits at the Fed.
Excess reserves are any additional reserves
that a bank chooses to hold beyond what is
required.
Excess + Required Reserves = Total Reserves
When a customer makes a cash deposit, the
bank’s reserves increase. Since the currency
held by the public decreases but checking
deposits increase, the money supply remains
unchanged.
13
How Banks Create Money ?

Let’s assume that banks are required to
keep 10% of their deposits as required
reserves. The required reserved ratio is
the ratio of reserves a bank must retain
based upon its deposits. After a customer
makes a $1,000 deposit, the bank’s
balance sheet changes as follows,
assuming they loan out their new excess
reserves.:
14
The Process of Money Creation
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First Bank of Hollywood
makes a $900 loan
which is used to open a
checking account in the
Second Bank of
Burbank, with a
balance of $900.
The Second bank of
Burbank makes loans
in the amount of $810,
which are deposited in
the Third Bank of
Venice, and so on.
15
The Process of Money Creation
The increase in the money supply, M1, resulting from the increase
in the $1,000 deposit equals $10,000 - $1,000 = $9,000.—next slide
16
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How the Money Multiplier Works
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The original $1,000 cash deposit has
created checking account balances equal
to:
$1,000 + $900 + $810 + $729 + $656.10 +.…=
$10,000

The general formula for deposit creation
is:
1
increase in checking account balances 
x initial deposit
reserve ratio
Increase in checking account balances = 1/0.1 x 1000 = 10 x 1000 = $10,000
• The increase in the money supply, M1,
resulting from the increase in the $1,000
deposit equals $10,000 - $1,000 = $9,000.
17
How the Money Multiplier Works

The money multiplier shows the
total increase in checking account
deposits for any initial cash deposit.
The formula for the multiplier is:
1
reserve ratio

The initial cash deposit triggers
additional rounds of deposits and
lending by banks, which leads to a
multiple expansion of deposits.
18
How the Money Multiplier Works
Assumptions:

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All monies were deposited in bank checking
accounts.
Every bank lent all its excess reserves,
leaving every bank with zero excess reserves.
Because we assumed no cash leakages and
zero excess reserves, the change in checkable
deposits (increase in money supply) is the
maximum possible change.
19
How the Money Multiplier Works in
Reverse
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The money multiplier also works in reverse.
Assuming a reserve ratio of 10%, a
withdrawal of $1,000 reduces reserves by
$100, and results in $900 less the bank will
have to lend out.
It is important to note that when one
individual writes a check to another, and the
other deposits the check in the bank, the
money supply will not change. Instead, the
expansion in one bank’s reserves will offset
the contraction in the reserves of the other.
Likewise if cash is deposited into a checking
account, the money supply (M1) will not
change.
20
The Money Expansion and
Contraction Processes
21
Demand for Money (M1)


DO NOT confuse Demand for Money with the
Loanable Funds Market (from Chapter 12)
Transaction Demand
• Money used daily
• Not dependant upon interest

Asset Demand
• Money used to purchase assets (stocks, bonds,
etc)
• Affected by interest rates

Transaction + Asset = Total Demand
22
THE DEMAND FOR MONEY
7.5
5
2.5
Dt
0
50 100 150 200 250 300
Amount of money
demanded (billions
of dollars)
Rate of interest, i (percent)
Rate of interest, i (percent)
10
Asset
Demand, Da
=
Rate of interest, i (percent)
+
Transactions
Demand, Dt
10
7.5
5
2.5
Da
0 50 100 150 200 250 300
Amount of money
demanded (billions
of dollars)
Total demand
for money, Dm
10
7.5
5
2.5
0
Dm
50 100 150 200 250 300
Amount of money
demanded (billions
of dollars)
23
The
interest
rate
referred to
is the
Federal
Funds
rate.
Rate of interest, i (percent)
THE MONEY MARKET
Sm
10
Suppose the money
supply is decreased
from $200 billion, Sm,
$150 billion Sm1.
ie to
See next slide)
7.5
5
Dm
2.5
0
0
50
100
150
200 250 300
Amount of money demanded
(billions of dollars)
24
Rate of interest, i (percent)
THE MONEY MARKET
Sm1
Sm
10
7.5
ie
5
Dm
2.5
0
As the money supply
decreases, the interest
rate increases from 5%
to 7.5%
0
50
100
150
200 250 300
Amount of money demanded
(billions of dollars)
25
Interest Rates and Bond Prices
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Bonds are promises to pay money in the
future. Bonds are loans. The price of a
bond one year from now is the promised
payment divided by 1 plus the interest rate.
For example, a bond that promises to pay
$106 a year, with an interest rate is 6% per
year, would cost today:
$106
price of bond 
1  $100
(1  0.06)
• In other words, if you can invest at 6% per year, you
would be willing to pay $100 today for a promised
payment of $106 next year.
26
Bond prices change in the
opposite direction of interest
rates
Promised
Payment
$106
price of bond 
Int.
Rate
6%
Promised
Payment
Interest
Rate
$106
4%
$106
$106

$100
price
of
bond

1
1  $101.92
(1  0.06)
(1  0.04)
• When the interest rate falls from 6% to 4%, you have
to pay $101.92 today to have $106 next year. And if
the interest rate rose to 8%, for example, you would
pay only $98.15.
27
How Bond Prices Affect Money
Supply

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If money supply decreases; interest rates
increase; people sell bonds to get money;
# of bonds increase; cost of bonds
decrease and the lower cost creates a
higher yield
Banks increase interest rates to compete
with bonds; higher interest rates leads to
higher deposits/savings
This process is reversed if money supply
increases
28
Treasury Rates
10 Year Treasury Rate
29