Ch. 11: Money and
Banking
James R. Russell, Ph.D., Professor of Economics & Management, Oral Roberts University
©2005 Thomson Business & Professional Publishing, A Division of Thomson Learning
1
Money


Money: any good that is widely
accepted for purposes of exchange
and in the repayment of debts.
Barter: exchanging goods and
services for other goods and services
without the use of money.
2
Functions of Money



Medium of Exchange: anything
that is generally acceptable in
exchange for goods and services.
Unit of Account: a common
measure in which relative values are
expressed.
Store of Value: the ability of an
item to hold value over time.
3
Money Versus Barter

Making exchanges takes longer in a barter
system
– Finding what you want
– Finding a double coincidence of wants


Some goods are more readily accepted than
other goods.
Historically, goods that have evolved into
money are: gold, silver, copper, cattle, rocks,
and shells.
4
Money in a Prisoner Of
War Camp




R.A Radford, WWII
POW
Red Cross Packages
cigarettes, toiletries,
chocolate,cheese,
canned meats, etc.
Barter System
Developed
Cigarettes Evolved Into
the Currency of Choice
5
Money, Leisure, and
Output


A money based economy frees
up time spent looking for
someone interested in your
goods, who has something
you want.
A person’s standard of living
is, to a degree, is dependent
on the number and quality of
goods he consumes and the
amount of leisure he
consumes.
6
What Gives Money its
Value?



Our money has value because of its
general acceptability.
We accept paper dollars because we
know that other people will accept
dollars later when we try to spend
them.
Money has value to people because it
is widely accepted in exchange for
other goods that are valuable.
7
M1 Money Supply

M1: the narrow
definition of the
money supply or
transactions money.

M1 consists of:
– currency held
outside banks
– checkable
deposits
– traveler’s checks
Year
M1 Money
Supply
(billions of
dollars)
2000
$1,103
2001
$1,136
2002
$1,192
2003
$1,263
2004
$1,330
8
M2 Money Supply




M1
Savings deposits
(including money
market deposit
accounts)
Small denomination
time deposits
Money market
mutual funds
(noninstitutional)
Year
M2 Money
Supply
(billions of
dollars)
2000
$4,802
2001
$5,220
2002
$5,615
2003
$5,999
2004
$6,282
9
Where Do Credit Cards Fit
In?


A credit card is an instrument or
document that makes it easier for the
holder to obtain a loan.
Credit card transactions shift around
the existing quantity of money
between various individuals and firms,
but do not change the total money
available.
10
Self-Test



Why (not how) did money evolve out
of a barter economy?
If individuals remove funds from their
checkable deposits and transfer them
to their money market accounts, will
M1 fall and M2 rise? Explain.
How does money reduce the
transaction costs of making
exchanges?
11
How Banking Developed




Early bankers used goldsmith’s
warehouse receipts.
Early bankers began to issue receipts for
more gold than they had on hand.
This was the beginning of fractional
reserve banking.
Fractional Reserve Banking: arrangement
that allows banks to hold reserves equal
to only a fraction of their deposit
liabilities.
12
The Federal Reserve
System



The Federal Reserve System (the
Fed): the central bank of the United
States.
The Fed is essentially a bank’s bank.
The Fed’s chief function is to control
the nation’s money supply.
13
The Money Creation
Process: Definitions




Bank Reserves: the sum of bank deposits
at the Fed and vault cash.
Required Reserve Ratio: a percentage of
each dollar deposited that must be held on
reserve.
Required Reserves: the minimum
amount of reserves a bank must hold
against its checkable deposits.
Excess Reserves: any reserves held
beyond the required amount.
14
The Banking System and The
Money Creation Process




The Fed prints funds, and Bill deposits the
funds in his bank.
The Reserves of the bank increases, while
the reserves of no other bank decreased.
The banking system makes loans and in
the process creates checkable deposits.
By extending loans and creating checkable
deposits, the banking industry has
increased the money supply.
15
The Banking System and
The Money Creation Process
Bank A
Assets
Liabilities
Reserves $1,000 Checkable deposits (Bill) $1,000
16
The Banking System and
The Money Creation Process
Bank A
Assets
Required
Reserves
Liabilities
Checkable
$100 deposits (Bill)
Excess
Reserves
$900
$1,000
17
The Banking System and
The Money Creation Process
Bank A
Assets
Liabilities
Required Reserves
$100
Excess Reserves
$900
Loans
$900
See the next T-account
18
The Banking System and
The Money Creation Process
Bank A
Assets
See the previous Taccount
Liabilities
Checkable deposits (Bill)
Checkable deposits
(Jenny)
$1,000
$900
19
The Banking System and
The Money Creation Process
Bank A
Assets
Required
reserves
Excess reserves
Loans
Liabilities
$100 Checkable deposits (Bill)
$1,000
$0
Checkable deposits
$900
(Jenny)
$0
20
The Banking System and
The Money Creation Process
Bank B
Assets
Liabilities
Checkable deposits
Reserves $900 (CD Retailer)
$900
21
Exhibit 1: The Banking System
Creates Checkable Deposits (Money)
22
The Banking System And The
Money Expansion Process

When the $9000 that bankers created in
new checkable accounts is added to the
$1000 the Fed initially printed, we see that
$10,000 has been added to the money
supply.
Maximum change in checkable deposits = (1/r) x R


where r = the required reserve ratio and R
is the change in reserves resulting from the
original injection of funds.
Simple Deposit Multiplier: (1/r)
23
Why Maximum? No Cash
Leakages And Zero Excess
Reserves
Assumptions:
 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 is the maximum
possible change.
24
Who Created What?


The money
expansion process
has two major
players: the Fed, and
the Banking System.
The maximum
change in bankable
deposits is equal to:
(1/r) x ER, where
ER is the excess
reserves.
25
The Banking System and
The Money Destruction
Process
Bank A
Assets
Liabilities
- Checkable
Reserves $1,000 deposits (Bill)
-$1,000
26
The Banking System and
The Money Destruction
Process
Bank B
Assets
Liabilities
Checkable
Reserves -$900 deposits
-$900
27
Exhibit 2: The Money
Expansion and Contraction
Processes
28
Self-Test



If a bank’s deposits equal $579 million and the
required-reserve ratio is 9.5%, what dollar
amount must the bank hold in reserve form?
If the Fed creates $600 million in new reserves,
what is the maximum change in checkable
deposits that can occur if the required-reserve
ratio is 10%?
Bank A has $1.2 million in reserves and $10
million in deposits. The required-reserve ratio
is 10%. If Bank A loses $200,000 in reserves,
by what dollar amount is it reserve deficient?
29
Coming Up (Ch. 12): The Federal
Reserve System
30