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Learning Objectives Explain what money is.

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Presentation on theme: "Learning Objectives Explain what money is."— Presentation transcript:


2 Learning Objectives 13-01. Explain what money is.
Describe how banks create money. Demonstrate how the money multiplier works. We will review the chapter based on these objectives.

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. It might be useful to do a mind game: Have your students create a scene at a fast-food restaurant where only barter is allowed. Summarize by showing how much slower transactions would be … and how some transactions will not occur at all.

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. Money needs to serve all three purposes. This eliminates credit cards as money, for example. See the next slide.

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. It might be time to explode a myth. Actual cash available is not sufficient to conduct all transactions. Most money is in the form of electronic data.

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. M1–most liquid form of money; most easily spendable. You might characterize asset liquidity as how easy is it to “flow through your fingers.” Water will easily–the most liquid form of H2O. Ice is a less liquid form of H2O; it has to be converted into water before it can flow through your fingers.

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. M2 is less liquid than M1; it has to be converted into M1 before it can be spent.

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. The sizes of these figures are sometimes a surprise to the students. It might be worthwhile to reassert the difference in size between cash and other money measures.

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). Here begins the connection between money available to spend and spending.

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. Again, you might need to destroy another myth. The money you put in the bank is not just sitting there as a lump of cash waiting for you to come back and get it.

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 bank’s ability to create money is limited by the Federal Reserve System (the “Fed”). Thus the Fed controls the basic money supply. This leads into the concept of fractional reserve banking as a control on the creation of money by banks when they make loans.

12 Required reserves = Required reserve ratio x Total deposits
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. Each bank is limited in loan making to a fraction of its deposits. Required reserves = Required reserve ratio x Total deposits

13 Excess reserves = Total reserves – Required reserves
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 Excess reserves are the maximum amount that any bank can lend.

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 firm’s 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. This can be made into a participation game in class: Have one student get a loan of, say, $1,000, and have her spend it at another student’s “store.” This vendor deposits the $1,000 in her bank, which sets aside $200 as required reserves and lends the rest to another student. Continue the cycle. Have a student at the board keeping track of how the money supply is increasing.

15 The Money Multiplier Money multiplier: the amount of deposit dollars that the banking system can create from $1 of excess reserves. You might stress the analogy to the government spending multiplier. 1 Money multiplier = Required reserve ratio

16 Excess reserves x Money multiplier = Potential deposit creation
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 Here we distill money creation into one equation.

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. In ordinary times, it might have been useful to stop here and stress that a bank earns interest on loans made, so it desires to lend out all excess reserves. But 2011 – 2012 were not ordinary times. Banks were concerned about the risk of nonpayment of loans, and placed excess reserves into other, nonloan assets. If excess reserves are not lent out, the money multiplier is ineffective.

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. If the banks do not lend out excess reserves, they do not fulfill the function outlined in the first bullet.

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. Prior to the meltdown of , these constraints were mainly theoretical. Not so now.

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