Macroeconomics
Unit 13
Money and Financial Institutions
Top 5 Concepts
Introduction
In this unit we learn about our financial system and its
importance to our economy.
The money supply is classified by its accessibility. The cash in
our wallet or purse being the most accessible form of money.
We will also learn about how banks create money. Yes, banks
actually create new money from deposits they receive!
Concept 1: Money
Before we had money, people engaged in
barter. Barter is the direct exchange of one
good for another, without the use of money.
Barter continues to exist today, especially
within countries with unstable currency.
Have you ever bartered? For example, if a
friend helps you repair your car and in
return you help him paint his house you are
engaging in barter.
Concept 2: Money Supply
Money is considered anything generally
accepted as a medium of exchange. Money
has a value which can be used to measure the
prices of goods and services.
In today’s society the concept of money can be
applied to not only the currency and coins you
have, but checks, ATM cards, credit cards, etc.
Checks continue to be the most common form
of payment in the U.S. In Japan and Europe,
most transactions are handled by cash and
credit.
Concept 2: Money Supply
The supply of money is measured and placed into categories
based upon its accessibility. Accessibility refers to how easily
you can access and use the money.
The first category is called M1. M1 contains the total dollar
amount of currency and coins in circulation. M1 also includes
transaction (checking) account balances.
M1 also contains traveler’s checks that are not issued by
banks. For example, American Express Travelers Checks.
Almost $1.3 trillion is found within this first category.
Concept 2: Money Supply
The next category of money is called M2. M2 contains all
balances under M1, plus:
M2 also contains savings accounts and time deposits
(certificates of deposit) of less than $100,000. M2 also includes
money market mutual funds. M2 does NOT contain stock or
bond market mutual funds!
The new categories under M2 adds an additional $4.9 trillion to
the money supply! Remember that M2 also includes the
categories under M1, so the total money supply for both
categories is around $6.2 trillion.
Concept 2: Money Supply
The next category is called M3. M3 contains everything under
M2 and M1. M3 also contains time deposits over $100,000.
M3 includes bank repurchase agreements. Bank repurchase
agreements are short-term loans to banks.
M3 also includes overnight Eurodollars. Overnight Eurodollars
are deposits of U.S. currency held at foreign banks, or U.S.
currency deposits held by U.S. banks overseas. Overnight
refers to the short time period the funds are held on deposit.
Concept 2: Money Supply
The highest and least accessible category of the money supply
is called L (sorry – it’s NOT M4). L includes all categories of
money under M3, M2, and M1, plus:
L also contains U.S. Treasury Bills, Treasury Bonds and U.S.
Savings Bonds.
L also includes bankers’ acceptances, term Eurodollars, and
commercial paper issued by corporations. What are these
items? Let’s find out!
Concept 2: Money Supply
Bankers’ Acceptances are guarantees of payment issued to
corporations buying products from overseas entities.
Term Eurodollars are time deposits held in U.S. currency by
foreign banks or U.S. banks located overseas.
Commercial paper is a debt or loan issued by a private
corporation not backed by any collateral or assets.
Note: The Eurodollars we are referring to here is not the new
currency of Europe called the Euro.
Concept 3: Types of Banks
Commercial banks are financial institutions that offer a full
range of consumer and business services including savings
and checking accounts and loans.
Most of the demand deposits (checking accounts) and almost
half of the total savings deposits are held by commercial banks.
Savings and loan associations are financial institutions that
offer limited consumer services; usually savings accounts and
home mortgages.
Concept 3: Types of Banks
Mutual Savings Banks are financial institutions that offer
consumer orientated services including checking and savings
accounts, loans, and mortgages.
Credit Unions are a unique type of financial institution. They
are an association formed by a group to offer its members
checking and savings services, loans and mortgages. Credit
unions require membership in a group and concentrate their
services on consumers. Credit unions are non-profit and tax
exempt.
Concept 4: Money Creation
Banks can create money and
increase the supply of money by
making loans. Banks can loan a
certain percentage of their deposits –
checking, savings, and certificates of
deposit.
A bank must keep a certain portion of
its deposits in reserve. Bank
reserves are assets held by a bank
to fulfill its deposit obligations. The
percentage of reserves is controlled
by the Federal Reserve.
Concept 4: Money Creation
Banks are required by the Federal Reserve to keep a
percentage of their deposits in reserve. The percentage a bank
is required to keep in reserve is called the reserve ratio.
Reserve ratio – the ratio of a bank’s reserves to its total
transactions deposits. Using the reserve ratio, a bank can
determine the actual dollar amount of reserves it is required to
keep.
Required reserves – the minimum amount of reserves a bank
is required to hold. The amount of required reserves is based
upon the reserve ratio.
Concept 4: Money Creation
Required reserves = reserve ratio X total deposits
For example, if a bank has total deposits of $100,000, and the
reserve ratio is .75, then the required reserves =
.75 X $100,000 = $75,000
The bank would be required to keep $75,000 in reserves and
could loan up to $25,000.
Concept 4: Money Creation
The amount a bank has available for loans and money creation
is called the excess reserves. Excess reserves are bank
reserves in excess of required reserves.
Excess reserves = total reserves – required reserves
Looking at our previous example of a bank with $100,000 in
deposits and required reserves of $75,000:
Excess reserves = $100,000 - $75,000 = $25,000
Concept 4: Money Creation
Another example:
Suppose a bank has total deposits of $500,000, loans in the
amount of $300,000, and a required reserve ratio of .20. What
is the dollar amount of the required reserves?
Required reserves = reserve ratio X total deposits
.20 X $500,000 = $100,000, answer
What is the dollar amount of excess reserves for this bank?
Hmmm…
Concept 4: Money Creation
This bank has deposits of $500,000, loans of $300,000 and
required reserves of $100,000.
$500,000 - $300,000 - $100,000 = $100,000 in Excess
Reserves
Remember to subtract the loan balance from the deposits, and
then subtract the dollar amount required in reserves, to find the
Excess Reserves.
Concept 4: Money Creation
The total amount of excess reserves is available for loans and
money creation. Banks make most of their profits on the
interest they charge on loans to consumers and businesses.
When a bank makes a loan, the loan recipient uses the loan to
purchase something. The loan check is either deposited by the
borrower or by the entity the purchase was made from.
By depositing the check at the same bank or another bank,
bank reserves are increased.
Concept 4: Money Creation
Further bank loans can be made from the deposited loan
check, subject to the reserve requirement.
For example, a bank makes a $1000 loan to a consumer. The
consumer buys a new TV and the electronics store deposits the
check in a bank. The bank can use the additional deposit to
increase the supply of money by more than the original $1000
bank loan. This increase in the supply of money is called the
money multiplier.
The money multiplier is the number of deposit (loan) dollars
that the banking system can create from each $1 of excess
reserves.
Concept 4: Money Creation
Money Multiplier = 1/required reserve ratio
For example, if the required reserve ratio is 20% or .20, then
the money multiplier =
1/.20 = 5
We use the money multiplier to determine what happens to the
money supply if excess reserves are increased or decreased.
For example, if excess reserves are $100 and the money
multiplier is 5, we know that the potential deposit creation (
growth of the money supply) is = $500.
The Money Multiplier at Work
Reserve Ratio: 20%
Multiplier: 5
Original deposit
Bank A loans:
Bank B loans
Bank C loans



Total money supply
=$
=$
=$
=$
100.00
80.00 [=0.8 x $100.00]
64.00 [=0.8 x $80.00]
51.20 [=0.8 x $64.00]



= $ 500.00
Concept 4: Money Creation
Through the money multiplier process, banks
create additional funds that can be borrowed by
individuals and businesses.
Funds are borrowed to purchase many items:
cars, homes, machinery, land, etc.
The borrowing activity stimulates the economy.
Therefore, if more or less economic activity is
desired, banks can play a major role in changing
economic conditions.
Concept 5: Constraints
The banking system faces four constraints as it creates
deposits and money:
• People must continue to use checks and banking accounts.
If cash becomes a preferred method of payment rather than
checks, the money multiplier is affected.
• People and businesses are interested in borrowing money to
purchase goods and services. If consumers or businesses are
reluctant to borrow money because of economic uncertainty,
banks will be unable to use their excess reserves to increase
the supply of money.
Concept 5: Constraints
• The reserve requirement can change which affects the
lending ability of banks. If the Federal Reserve increases the
reserve requirement, banks will have fewer excess reserves. A
decrease in excess reserves reduces the ability of banks to
increase the supply of money (limits deposit creation).
• Banks must be willing to lend money. If there is economic
uncertainty, very low interest rates or problems with increasing
loan defaults, banks may be less willing to lend money.
Summary
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Barter
Definitions, categories of money.
Types of banks.
Money creation.
Reserve ratio, excess reserves, required reserves.
Money multiplier.
Constraints.