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© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Money and Banks Chapter 13.

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Presentation on theme: "© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Money and Banks Chapter 13."— Presentation transcript:

1 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Money and Banks Chapter 13

2 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Introduction n This chapter answers the following questions: l What is money? l How is money created? l What role do banks play in the circular flow of income and spending?

3 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin What Is Money? n Without money, you would have to use barter to get items you want. n Barter is the direct exchange of one good for another, without the use of money.

4 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Money Supply n Anything that serves all of the following purposes can be thought of as money: l Medium of exchange l Store of value l Standard of value

5 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Purposes of Money n Medium of exchange – Is accepted as payment for goods and services (and debts). n Store of value – Can be held for future purchases. Standard of value n Standard of value – Serves as a measurement for the prices of goods and services.

6 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Modern Concepts n Money is anything generally accepted as a medium of exchange. n The “greenbacks” we carry around today are not the only form of “money” we use.

7 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Checking Accounts n Checking accounts can and do perform the same market functions as cash. n They must be included into our concept of money.

8 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Credit Cards n Credit cards are another popular medium of exchange but are not money. n They are only a payment service with no store of value in and of themselves.

9 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin M1: Cash and Transactions Accounts n Money supply (M1): - Currency held by the public, plus balances in transactions accounts. n M1 includes currency in circulation, transaction-account balances, and traveler’s checks.

10 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin M1: Cash and Transactions Accounts n A transactions account is a bank account that permits direct payment to a third party, for example, with a check. n Transaction-account balances are the largest component of the money supply.

11 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin M2: M1 + Savings Accounts, etc. n M2 money supply – M1 plus balances in most savings accounts and money market mutual funds. n Savings-account balances are almost as good a substitute for cash as transaction- account balances.

12 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin M2: M1 + Savings Accounts, etc. n How much money is available affects consumers’ ability to purchase goods and, services – aggregate demand. l Aggregate demand is the total quantity of output demanded at alternative price levels in a given time period, ceteris paribus.

13 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin M2: M1 + Savings Accounts, etc. n The official measures of the money supply (particularly M1 and M2) are fairly reliable benchmarks for gauging how much purchasing power market participants have.

14 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Composition of the Money Supply Currency in circulation ($569 billion) Transactions-account balances ($612 billion) Savings account balances ($3167 billion) Money market mutual funds and deposits ( $1027 billion) Traveler’s checks ($8 billion) M2 ($5383 billion) M1 ($1189 billion)

15 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Creation of Money n The deposit of funds into a bank does not change the size of the money supply. n It changes the composition of the money supply (transfers from cash to transaction deposits).

16 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Deposit Creation n Deposit creation is the creation of transactions deposits by bank lending. n When a bank makes a loan, it effectively creates money because transactions- account balances are counted as part of the money supply.

17 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Deposit Creation n There are two basic principles of the money supply: l Transactions-account balances are a large portion of our money supply. l Banks can create transactions-account balances by making loans.

18 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Bank Regulation n The deposit-creation activities of banks are regulated by the government. n The Federal Reserve System limits the amount of bank lending, thereby controlling the basic money supply.

19 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin A Monopoly Bank n When someone deposits cash or coins in a bank, they are changing the composition of the money supply, not its size.

20 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Initial Loan n The monopoly bank loans $100 to the a client and issues a checking account. n This loan is accomplished by a simple bookkeeping entry.

21 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Initial Loan n Total bank reserves have remained unchanged. n Bank reserves are assets held by a bank to fulfill its deposit obligations. n Money has been created because the checking account is considered to be money.

22 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Secondary Deposits n In a one bank system, when the client uses the loan, the money supply does not contract, rather ownership of deposits change.

23 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Fractional Reserves n Bank reserves are only a fraction of total transaction deposits. n The reserve ratio is the ratio of a bank's reserves to its total deposits.

24 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Fractional Reserves n The Federal Reserve System requires banks to maintain some minimum reserve ratio.

25 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The T-account of the Bank n 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).

26 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Money Creation AssetsLiabilities University Bank +$ in coins +$ in deposits Money Supply Cash held by the public–$100 Transactions deposits at bank+$100 Change in M0

27 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Money Creation AssetsLiabilities University Bank +$ in coins +$100 in loans +$ in your account +$ in borrower’s account Cash held by the public no change Transactions deposits at bank+$100 Change in M+$100 Money Supply

28 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Required Reserves n 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

29 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin A Multibank World n In reality, there is more than one bank. n The ability of banks to make loans depends on access to excess reserves. n Example: If a bank is required to hold $20 in reserves but has $100 currently, it can lend out the $80 excess.

30 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Excess Reserves n Excess reserves are bank reserves in excess of required reserves. Excess reserves = Total reserves – Required reserves

31 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Excess Reserves n So long as a bank has excess reserves, it can make loans. n Excess reserves are reserves a bank is not required to hold.

32 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Changes in the Money Supply n The creation of transaction deposits via new loans is the same thing as creating money. n As the excess reserves are loaned out again, more deposits are created and thus more money is created.

33 Deposit Creation AssetsLiabilities University Bank Required Reserves$20 Excess Reserves$80 Your account $100 Total Assets $100 Total Liabilities $100 AssetsLiabilities Eternal Savings Total AssetsTotal Liabilities © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

34 Deposit Creation AssetsLiabilities University Bank Required Reserves$36 Excess Reserves$64 Loans$80 Your account $100 Campus Radio account$ 80 Total Assets $180 Total Liabilities $180 AssetsLiabilities Eternal Savings Total AssetsTotal Liabilities © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

35 Deposit Creation AssetsLiabilities University Bank Required Reserves$20 Excess Reserves$ 0 Loans$80 Your account $100 Campus Radio account$ 0 Total Assets $100 Total Liabilities $100 AssetsLiabilities Eternal Savings Required Reserves$16 Required Reserves$64 Atlas Antenna account $80 Total Assets $80 Total Liabilities $90 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

36 Deposit Creation AssetsLiabilities University Bank Required Reserves$20 Excess Reserves$ 0 Loans$80 Your account $100 Campus Radio account$ 0 Total Assets $100 Total Liabilities $100 AssetsLiabilities Eternal Savings Required Reserves$29 Required Reserves$51 Loans$64 Atlas Antenna account$80 Herman’s Hardware account$64 Total Assets $144 Total Liabilities $144 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

37 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Money Multiplier n In a multi-bank system, deposits created by one bank invariably end up as reserves in another bank. n This process can theoretically continue until all banks have zero excess reserves (no more loans can be made).

38 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Money Multiplier n The money multiplier is the number of deposit (loan) dollars that the banking system can create from $1 of excess reserves.

39 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Money Multiplier n When a new deposit enters the banking system, it creates both excess and required reserves. n The required reserves represent leakage from the flow of money, since they cannot be used to create new loans.

40 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Money Multiplier n Excess reserve can be used for new loans. n Once those loans are made, they typically become transactions deposits elsewhere in the banking system.

41 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Money Multiplier n Some additional leakage into required reserves occurs, and further loans are made. n The entire banking system can increase the volume of loans by the amount of excess reserves multiplied by the money multiplier.

42 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Money Multiplier n 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

43 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Money Multiplier Process Required reserves Excess reserves Leakage into The public

44 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Excess Reserves as Lending Power n Each bank may lend an amount equal to its excess reserves and no more. n The entire banking system can increase the volume of loans by the amount of excess reserves multiplied by the money multiplier.

45 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Banks and the Circular Flow n Banks perform two essential functions for the macro economy: l Banks transfer money from savers to spenders by lending funds (reserves) held on deposit. l The banking system creates additional money by making loans in excess of total reserves.

46 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Banks and the Circular Flow n Market participants respond to changes in the money supply by altering their spending behavior (shifting the aggregate demand curve).

47 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Banks in the Circular Flow Loans Factor markets Product markets Business firms Consumers BANKS Saving Investment expenditures Sales receipts Wages, dividends, etc. Income Domestic consumption

48 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Financing Injections n The consumer saving is a leakage. n 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.

49 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Financing Injections n A substantial portion of consumer saving is deposited in banks. n These and other bank deposits can be used to make loans, thereby returning purchasing power to the circular flow.

50 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Financing Injections n The banking system can create any desired level of money supply if allowed to expand or reduce loan activity at will.

51 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Constraints on Deposit Creation n There are three major constraints on deposit creation: l Deposits – Consumers must be willing to use and accept checks rather than cash. l Borrowers – Consumers must be willing to borrow the money that banks provide. l Regulation – The Federal Reserve sets the ceiling on deposit creation.


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