Money and Banks
Chapter 13
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Introduction

This chapter answers the following
questions:
 What
is money?
 How is money created?
 What role do banks play in the circular flow of
income and spending?
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What Is Money?
Without money, you would have to use
barter to get items you want.
 Barter is the direct exchange of one good
for another, without the use of money.

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The Money Supply

Anything that serves all of the following
purposes can be thought of as money:
 Medium
of exchange
 Store of value
 Standard of value
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Purposes of Money
Medium of exchange – Is accepted as
payment for goods and services (and
debts).
 Store of value – Can be held for future
purchases. Standard of value
 Standard of value – Serves as a
measurement for the prices of goods and
services.

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Modern Concepts
Money is anything generally accepted as a
medium of exchange.
 The “greenbacks” we carry around today
are not the only form of “money” we use.

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Checking Accounts
Checking accounts can and do perform the
same market functions as cash.
 They must be included into our concept of
money.

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Credit Cards
Credit cards are another popular medium
of exchange but are not money.
 They are only a payment service with no
store of value in and of themselves.

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M1: Cash and Transactions
Accounts
Money supply (M1): - Currency held by
the public, plus balances in transactions
accounts.
 M1 includes currency in circulation,
transaction-account balances, and
traveler’s checks.

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M1: Cash and Transactions
Accounts
A transactions account is a bank account
that permits direct payment to a third party,
for example, with a check.
 Transaction-account balances are the
largest component of the money supply.

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M2: M1 + Savings Accounts,
etc.
M2 money supply – M1 plus balances in
most savings accounts and money market
mutual funds.
 Savings-account balances are almost as
good a substitute for cash as transactionaccount balances.

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M2: M1 + Savings Accounts,
etc.

How much money is available affects
consumers’ ability to purchase goods and,
services – aggregate demand.
 Aggregate
demand is the total quantity of
output demanded at alternative price levels in
a given time period, ceteris paribus.
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M2: M1 + Savings Accounts,
etc.

The official measures of the money supply
(particularly M1 and M2) are fairly reliable
benchmarks for gauging how much
purchasing power market participants
have.
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Composition of the Money
Supply
M2
($5383 billion)
Money market mutual funds and deposits ($1027 billion)
Savings account balances ($3167 billion)
M1
($1189 billion)
Traveler’s checks ($8 billion)
Transactions-account balances ($612 billion)
Currency in circulation ($569 billion)
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Creation of Money
The deposit of funds into a bank does not
change the size of the money supply.
 It changes the composition of the money
supply (transfers from cash to transaction
deposits).

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Deposit Creation
Deposit creation is the creation of
transactions deposits by bank lending.
 When a bank makes a loan, it effectively
creates money because transactionsaccount balances are counted as part of
the money supply.

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Deposit Creation

There are two basic principles of the
money supply:
 Transactions-account
balances are a large
portion of our money supply.
 Banks can create transactions-account balances
by making loans.
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Bank Regulation
The deposit-creation activities of banks are
regulated by the government.
 The Federal Reserve System limits the
amount of bank lending, thereby controlling
the basic money supply.

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A Monopoly Bank

When someone deposits cash or coins in a
bank, they are changing the composition of
the money supply, not its size.
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The Initial Loan
The monopoly bank loans $100 to the a
client and issues a checking account.
 This loan is accomplished by a simple
bookkeeping entry.

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The Initial Loan
Total bank reserves have remained
unchanged.
 Bank reserves are assets held by a bank
to fulfill its deposit obligations.
 Money has been created because the
checking account is considered to be
money.

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Secondary Deposits

In a one bank system, when the client uses
the loan, the money supply does not
contract, rather ownership of deposits
change.
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Fractional Reserves
Bank reserves are only a fraction of total
transaction deposits.
 The reserve ratio is the ratio of a bank's
reserves to its total deposits.

Bank reserves
Reserve ratio =
Total deposits
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Fractional Reserves

The Federal Reserve System requires
banks to maintain some minimum reserve
ratio.
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The T-account of the Bank

The books of a bank must always balance,
because all of the assets of the bank must
belong to someone (its depositors or its
owners).
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Money Creation
University Bank
Assets
+$100.00 in
coins
Money Supply
Liabilities
+$100.00 in
deposits
Cash held by the public
Transactions deposits
at bank
Change in M
McGraw-Hill/Irwin
–$100
+$100
0
© The McGraw-Hill Companies, Inc., 2003
Money Creation
University Bank
Assets
Liabilities
+$100.00 in
coins
+$100 in
loans
+$100.00 in
your account
+$100.00 in
borrower’s
account
McGraw-Hill/Irwin
Money Supply
Cash held by the public
Transactions deposits
at bank
Change in M
no change
+$100
+$100
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Required Reserves

Required reserves are the minimum
amount of reserves a bank is required to
hold by government regulation; Equal to
required reserve ratio times transactions
deposits.
Required reserves = minimum reserve ratio
X total deposits
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A Multibank World
In reality, there is more than one bank.
 The ability of banks to make loans
depends on access to excess reserves.
 Example: If a bank is required to hold $20
in reserves but has $100 currently, it can
lend out the $80 excess.

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Excess Reserves

Excess reserves are bank reserves in
excess of required reserves.
Excess reserves = Total reserves
– Required reserves
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Excess Reserves
So long as a bank has excess reserves, it
can make loans.
 Excess reserves are reserves a bank is not
required to hold.

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Changes in the Money Supply
The creation of transaction deposits via
new loans is the same thing as creating
money.
 As the excess reserves are loaned out
again, more deposits are created and thus
more money is created.

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Deposit Creation
University Bank
Assets
Liabilities
Required
Reserves $20
Excess
Reserves $80
Your
account
Total Assets
$100
Total Liabilities
$100
McGraw-Hill/Irwin
Eternal Savings
Assets
Liabilities
$100
Total Assets
Total Liabilities
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Deposit Creation
University Bank
Assets
Liabilities
Required
Reserves $36
Excess
Reserves $64
Loans
$80
Your
account $100
Campus
Radio
account $ 80
Total Assets
$180
Total Liabilities
$180
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Eternal Savings
Assets
Total Assets
Liabilities
Total Liabilities
© The McGraw-Hill Companies, Inc., 2003
Deposit Creation
University Bank
Assets
Liabilities
Eternal Savings
Assets
Liabilities
Required
Reserves $20
Excess
Reserves $ 0
Loans
$80
Your
account $100
Campus
Radio
account $ 0
Required
Reserves $16
Required
Reserves $64
Atlas
Antenna
account $80
Total Assets
$100
Total Liabilities
$100
Total Assets
$80
Total Liabilities
$90
McGraw-Hill/Irwin
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Deposit Creation
University Bank
Assets
Liabilities
Eternal Savings
Assets
Liabilities
Required
Reserves $20
Excess
Reserves $ 0
Loans
$80
Your
account $100
Campus
Radio
account $ 0
Required
Reserves $29
Required
Reserves $51
Loans
$64
Atlas
Antenna
account $80
Herman’s
Hardware
account $64
Total Assets
$100
Total Liabilities
$100
Total Assets
$144
Total Liabilities
$144
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The Money Multiplier
In a multi-bank system, deposits created
by one bank invariably end up as reserves
in another bank.
 This process can theoretically continue
until all banks have zero excess reserves
(no more loans can be made).

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The Money Multiplier
The money multiplier is the number of
deposit (loan) dollars that the banking
system can create from $1 of excess
reserves.
1
Money multiplier =
Required reserve requirement

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The Money Multiplier
When a new deposit enters the banking
system, it creates both excess and
required reserves.
 The required reserves represent leakage
from the flow of money, since they cannot
be used to create new loans.

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The Money Multiplier
Excess reserve can be used for new loans.
 Once those loans are made, they typically
become transactions deposits elsewhere in
the banking system.

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The Money Multiplier
Some additional leakage into required
reserves occurs, and further loans are
made.
 The entire banking system can increase
the volume of loans by the amount of
excess reserves multiplied by the money
multiplier.

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The Money Multiplier

The money supply can be increased
through the process of deposit creation to
this limit:
Potential deposit creation =
Excess reserves of banking system
X Money multiplier
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The Money Multiplier Process
The public
Excess reserves
Leakage into
Required
reserves
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Excess Reserves as Lending
Power
Each bank may lend an amount equal to its
excess reserves and no more.
 The entire banking system can increase
the volume of loans by the amount of
excess reserves multiplied by the money
multiplier.

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Banks and the Circular Flow

Banks perform two essential functions for
the macro economy:
 Banks
transfer money from savers to spenders
by lending funds (reserves) held on deposit.
 The banking system creates additional money
by making loans in excess of total reserves.
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Banks and the Circular Flow

Market participants respond to changes in
the money supply by altering their
spending behavior (shifting the aggregate
demand curve).
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Banks in the Circular Flow
Wages,
dividends, etc.
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Product
markets
BANKS
Loans
Factor
markets
Saving
Loans
Income
Domestic
consumption
Consumers
Business
firms
Sales
receipts
Investment
expenditures
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Financing Injections
The consumer saving is a leakage.
 A recessionary gap will emerge, creating
unemployment if additional spending by
business firms, foreigners, or governments
does not compensate for consumer saving
at full employment.

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Financing Injections
A substantial portion of consumer saving is
deposited in banks.
 These and other bank deposits can be
used to make loans, thereby returning
purchasing power to the circular flow.

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Financing Injections

The banking system can create any
desired level of money supply if allowed to
expand or reduce loan activity at will.
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Constraints on Deposit
Creation

There are three major constraints on
deposit creation:
 Deposits
– Consumers must be willing to use
and accept checks rather than cash.
 Borrowers – Consumers must be willing to
borrow the money that banks provide.
 Regulation – The Federal Reserve sets the
ceiling on deposit creation.
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