Transcript Money and Banks

Money

In this chapter we examine the role of money in the
economy. Specifically

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”?

Money is a tool that greatly simplifies market transactions.

No money? Transactions would be made using a barter system.

Barter: the direct exchange of one good for another, without the use of money.

Money acts as a medium of exchange. Sellers will accept it as payment for
goods and services.

Money: anything generally accepted as a medium of exchange.
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The Money Supply

Anything that serves all the following purposes can be
thought of as money:

Medium of exchange: accepted as payment for goods and
services (and debts).

Store of value: can be held for future purchases.

Standard of value: serves as a yardstick for measuring the
prices of goods and services.
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Modern Concepts




Cash is obviously money because it fills all three
purposes.
Checking accounts perform the same market
functions as cash. Debit cards act much like a
check, so they are money.
Online payment systems and credit cards do not.
They can be a medium of exchange but do not
fulfill the other purposes.
The essence of money is not its physical form, but
its ability to purchase goods and services.
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Composition of the Money
Supply

Some bank accounts are better substitutes for cash than
others.

M1: cash and transactions accounts

Transactions accounts include checking accounts and
travelers checks.

Money supply (M1): currency held by the public, plus
balances in transactions accounts.

M1 permits direct payment for goods and services.
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Composition of the Money
Supply

M2: M1 plus savings accounts, etc.

Savings account balances and money market mutual funds
are almost as good a substitute for cash as transactions
accounts.

Money supply (M2): M1 plus balances in most savings
accounts and money market mutual funds.

M2 must be turned into M1 before it can be used to
purchase goods and services.
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Composition of the Money Supply

Cash is about half of the
M1 money supply. Most of
the rest are transactions
account balances.

M2 is much larger than
M1. People hold money in
M2 accounts because
they can earn some
interest on these
deposits.
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The Economic Importance
of Money

How much money is available (the size of the money
supply) affects consumers’ ability to purchase goods and
services.

This directly affects aggregate demand (AD).
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Creation of Money

Cash is either printed or coined. But cash is a very small
part of M2.

How is the money in transactions accounts and savings
accounts created?

These bank accounts are not physical lumps of cash. They
are computer data entries.

A few keystrokes can increase or decrease the money in a
bank account.
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Creation of Money


Banks create money by making loans.

Grant a loan and increase the borrowers’ checking account
with a few keystrokes.

Money is “created.”
The bank’s ability to create money is limited by the
Federal Reserve System (the “Fed”).

Thus the Fed controls the basic money supply.
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Fractional Reserves

The Fed controls a bank’s ability to create money
by making loans.

Each bank is required to maintain a minimum reserve
ratio.

Bank reserves: assets held by a bank to fulfill its deposit
obligations.

Required reserves: the minimum amount of reserves a
bank is required to hold.

Required reserve ratio: the ratio of a bank’s required
reserves to its total deposits.
Required reserves = Required reserve ratio x Total deposits
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Fractional Reserves

Since the bank must set aside some of its deposits to satisfy its required
reserves, it can make loans only on the remainder, called excess reserves.
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Excess reserves: bank reserves in excess of required reserves.

A minimum reserve requirement directly limits deposit creation (lending)
possibilities.
Excess reserves = Total reserves – Required reserves
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Changes in the Money Supply
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When a bank makes a loan, money is created.
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The borrower spends the money; the seller deposits it
into the firm’s bank account.
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That bank now has more excess reserves and can make a
loan on it, creating more money.

When the new borrower spends the loan, this cycle
continues to repeat itself.

Each time a new loan is made, the money supply
increases.
There is a multiplier process going on, just like the
income multiplier process in Chapter 10.
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The Money Multiplier

Money multiplier: the
amount of deposit
dollars that the
banking system can
create from $1 of
excess reserves.
Money multiplier =
1
Required
reserve ratio
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The Money Multiplier
 The
potential of the money multiplier to
create loans is summarized in this equation:
Excess reserves x Money multiplier = Potential deposit creation
 If
the required reserve ratio is 0.20, the
money multiplier is 5. An initial deposit of
$100 has $80 of excess reserves and
potentially can create $400 of new deposits.
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Excess Reserves as Lending
Power

If a bank has no excess reserves, it can make no more
loans.

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
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
Banks perform two essential functions for the macro economy:

Banks transfer money from savers to spenders by lending funds held on
deposit.
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The banking system creates additional money by making loans in excess of
required reserves.
Changes in the money supply may in turn alter spending behavior and
thereby shift the aggregate demand (AD) curve.
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Constraints on Deposit
Creation
Deposits. If people prefer to hold onto cash, the
deposit creation process will be severely
hindered.
 Willingness to lend. If banks are reluctant to take
risks in lending, they will not fully lend out their
excess reserves.
 Willingness to borrow. If borrowers are reluctant
to take on more debt, fewer loans will be made.
 Regulation. The Fed may limit deposit creation
by changing reserve requirements.

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The Economy Tomorrow
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Bank bailouts.
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In 2008 a major banking crisis occurred, originating in
the overheated housing industry.
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Banks financed an upsurge in house prices in 2002-2006.
But prices began to fall in 2007.
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Home values fell below the amount left on their
mortgages, and many home owners ceased paying on their
mortgages.
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Bank assets (mortgages) declined, and many banks
teetered on the brink of failing.

Large numbers of bank failures could lead the economy
into a real depression.
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The Economy Tomorrow


The federal government stepped in to “bail out” these
banks.

Hundreds of billions of government dollars were pumped
into the banking system to prop up the banks.

The purpose was to ensure that credit would continue to
flow in the economy tomorrow.
When the economy recovered, the banks repaid the
bailout money with interest.
13-20