13-2 Learning Objectives Explain what money is Describe how banks create money Demonstrate how the money multiplier works.
13-3 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.
13-4 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.
13-5 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.
13-6 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.
13-7 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.
13-8 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.
13-9 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).
13-10 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.
13-11 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 banks ability to create money is limited by the Federal Reserve System (the Fed). – Thus the Fed controls the basic money supply.
13-12 Fractional Reserves The Fed controls a banks 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 banks required reserves to its total deposits. Required reserves = Required reserve ratio x Total deposits
13-13 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. – 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
13-14 Changes in the Money Supply When a bank makes a loan, money is created. – The borrower spends the money; the seller deposits it into the firms bank account. – 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.
13-15 The Money Multiplier Money multiplier: the amount of deposit dollars that the banking system can create from $1 of excess reserves. 1 Money multiplier = Required reserve ratio
13-16 The Money Multiplier The potential of the money multiplier to create loans is summarized in this equation: 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. Excess reserves x Money multiplier = Potential deposit creation
13-17 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.
13-18 Banks and the Circular Flow Banks perform two essential functions for the macro economy: – Banks transfer money from savers to spenders by lending funds held on deposit. – 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.
13-19 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.