Chapter 13: Money, Banks, and the Federal Reserve System
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
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What Can Serve as Money?
Chapter 13: Money, Banks, and the Federal Reserve System
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.
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Chapter 13: Money, Banks, and the Federal Reserve System
Money without a Government? The
Strange Case of the Iraqi Dinar
Many Iraqis continued to use currency with Saddam’s picture
on it, even after he was forced from power.
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Chapter 13: Money, Banks, and the Federal Reserve System
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.
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Chapter 13: Money, Banks, and the Federal Reserve System
How Is Money Measured in the United States Today?
M1: The Narrowest Definition
of the Money Supply
M2: A Broader Definition
of the Money Supply
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Chapter 13: Money, Banks, and the Federal Reserve System
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
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Chapter 13: Money, Banks, and the Federal Reserve System
How Do Banks Create Money?
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Chapter 13: Money, Banks, and the Federal Reserve System
How Do Banks Create Money?
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Chapter 13: Money, Banks, and the Federal Reserve System
How Do Banks Create Money?
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Chapter 13: Money, Banks, and the Federal Reserve System
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
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Chapter 13: Money, Banks, and the Federal Reserve System
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.
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Chapter 13: Money, Banks, and the Federal Reserve System
The Federal Reserve System
The Organization of the Federal Reserve System
Federal Reserve Districts
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Chapter 13: Money, Banks, and the Federal Reserve System
How the Federal Reserve Manages the Money Supply
Monetary policy The actions the Federal Reserve takes to manage the
money supply and interest rates to pursue 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
Two other actors—the nonbank public and banks—
also influence the money supply.
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Chapter 13: Money, Banks, and the Federal Reserve System
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
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The Quantity Theory Explanation of Inflation
Chapter 13: Money, Banks, and the Federal Reserve System
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
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Chapter 13: Money, Banks, and the Federal Reserve System
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.
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The Quantity Theory of Money
Chapter 13: Money, Banks, and the Federal Reserve System
High Inflation in Argentina
Money Growth and Inflation in Argentina
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Making
Chapter 13: Money, Banks, and the Federal Reserve System
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.
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Chapter 13: Money, Banks, and the Federal Reserve System
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
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