1. ECONOMICS 5e
Michael Parkin
Money
Chapter 31 in Economics 1

2. Learning Objectives Define money and describe its functions
Explain the economic functions of banks and other financial institutions
Describe the financial innovations 2

3. Learning Objectives (cont.)
Explain how banks create money
Explain why the quantity of money is an important economic magnitude
Explain the quantity theory of money 3

4. Learning Objectives Define money and describe its functions
Explain the economic functions of banks and other financial institutions
Describe the financial innovations of the 1980s and 1990s 4

5. What is Money?
Money is any commodity or token that is generally acceptable as the means of payment.
A means of payment is a method of settling a debt. 5

6. What is Money? Functions of Money 1) Medium of exchange
2) Unit of account
3) Means of payment
4) Store of value
5) World-wide money 6

7. What is Money? Medium of Exchange
A medium of exchange is an object that is generally accepted in exchange for goods and services.
Without money, people would have to exchange goods for goods, or barter. 7

8. What is Money? Unit of Account
A unit of account is an agreed measure for stating the prices of goods and services.
This simplifies value comparisons and purchase decision making if all prices are expressed using a uniform measure. 8

9. The Unit of Account Functions of Money Simplifies Price Comparisons
Price in Price in units
Good money units of another good
Movie $6.00 each 2 six-packs of soda
Soda $3.00 per six-pack 2 ice-cream cones
Ice cream $1.50 per cone 3 packs of jelly beans
Jelly beans $0.50 per pack 2 cups of coffee
Coffee $0.25 per cup 1 local phone call
Instructor Notes:
1) Money as a unit of account: The price of a movie is $6 and the price of a cup of coffee is 25 cents, so the opportunity cost of a movie is 24 cups of coffee ($6.00/25 cents = 24).
2) No unit of account. You go to a movie theater and learn that the price of a movie is 2 six-packs of soda.
3) You go to a candy store and learn that a pack of jelly beans costs 2 cups of coffee.
4) But how many cups of coffee does seeing a movie cost you?
5) To answer that question, you go to the convenience store and find that a six-pack of soda costs 2 ice-cream cones.
6) Now you head for the ice-cream shop, where an ice-cream cone costs 3 packs of jelly beans.
7) Now you get out your pocket calculator: 1 movie costs 2 six-packs of soda, or 4 ice cream cones, or 12 packs of jelly beans, or 24 cups of coffee! 9

10. What is Money? Store of Value
A store of value is any commodity or token that can be held and exchanged later for goods and services. 10

11. What is Money? Means of exchange:
Based on credit relations: buying on credit or selling on credit

12. What is Money? World-wide money
Gold, silver, platinum, USD, Euro, Swiss Frank, British Pound, Swiss Franc and other “hard currencies”

13. What is Money? Money Today consists of: Currency
Deposits at banks and other financial institutions 11

14. What is Money? Money Today (cont.)
Currency is the bills and coins that we use.
Deposits are also money because they can be converted into currency and are used to settle debts. 12

15. What is Money? Official Measures of Money (cont.)
M1 consists of currency and traveler’s checks plus checking deposits.
Includes accounts held by individuals and businesses, but does not include currency held by banks, or currency and checking deposits owned by the U.S. government. 13

16. What is Money? Official Measures of Money (cont.)
M2 consists of M1 plus saving deposits and time deposits. 14

17. What is Money? Official Measures of Money (cont.)
M3 consists of M2 plus large-scale time deposits and term deposits 15

18. What is Money? Are M1 and M2 Really Money? M1 is money
The test of whether an asset is money is whether it serves as a means of payment.
Currency does.
Checking deposits are money because they can be transferred by writing a check.
M1 is money 17

19. What is Money? Are M1 and M2 Really Money? M2 is money
Some savings deposits are readily accessible and can be used as a means of payment.
Other deposits are less liquid.
Liquidity is the property of being instantly convertible into a means of payment with little loss in value.
M2 is money 18

20. What is Money? Other Points Regarding Money
1) Deposits are money but checks are not.
2) Credit cards are not money. 19

21. Learning Objectives Define money and describe its functions
Explain the economic functions of banks and other financial institutions
Describe the financial innovations of the 1980s and 1990s 20

22. Financial Intermediaries
Financial intermediaries are firms that take deposits from households and firms and makes loans to other households and firms. 21

23. Financial Intermediaries
Four Types of Financial Intermediaries
1) Commercial banks
2) Savings and loan associations
3) Savings banks and credit unions
4) Money market mutual funds 22

24. Financial Intermediaries
Commercial Banks
A commercial bank is a firm, licensed by the Comptroller of the Currency or by a state agency to receive deposits and make loans. 23

25. Financial Intermediaries
Commercial Banks
Their balance sheet lists their assets, liabilities, and net worth.
The assets are what the bank owns.
The liabilities are what the bank owes
These include deposits.
Net worth is the difference between assets and liabilities. 24

26. Financial Intermediaries
Commercial Banks
Their balance sheet is described by the following formula:
Liabilities + Net Worth = Assets 25

27. Financial Intermediaries
Profit and Prudence: A Balancing Act
Banks attempt to maximize the net worth of their stockholders:
They earn profit by lending at a higher interest rate than they borrow.
Lending is risky.
Banks must be prudent in how they use their
deposits. 26

28. Financial Intermediaries
Reserves and Loans
Banks divide their funds into two parts:
Reserves are cash in a bank’s vault plus its deposits at Federal Reserve banks
Loans 27

29. Financial Intermediaries
Three Types of Assets Held by Banks
1) Liquid assets are government Treasury bills and commercial bills.
2) Investment securities are longer-term government bonds and other bonds.
3) Loans are commitments of fixed amounts of money for agreed- upon periods of time. 28

30. Financial Intermediaries
Savings and Loan Associations
A savings and loan association is a financial intermediary that receives checking deposits and savings deposits and that makes personal, commercial, and home-purchase loans. 29

31. Financial Intermediaries
Savings Banks and Credit Unions
A savings bank (mutual savings bank) is a financial intermediary owned by its depositors that accepts deposits and makes mostly home-purchase loans. 30

32. Financial Intermediaries
Savings Banks and Credit Unions
A credit union is a financial intermediary owned by its depositors that accepts savings deposits and makes mostly consumer loans.
The key difference between savings banks and credit unions is that credit unions are owned by a social or economic group such as a firm’s employees. 31

33. Financial Intermediaries
Money Market Mutual Funds
A money market mutual fund is a financial institution that obtains funds by selling shares and uses these funds to buy highly liquid assets such as Treasury bills 32

34. Financial Intermediaries
The Economic Functions of Financial Intermediaries
1) Creating Liquidity
2) Minimizing the cost of borrowing 33

35. Financial Intermediaries
The Economic Functions of Financial Intermediaries
3) Minimizing the cost of monitoring borrowers
4) Pooling Risk 34

36. Financial Regulation, Deregulation, and Innovation
Two types of regulation faced by financial intermediaries:
Deposit insurance
Balance sheet rules 35

37. Financial Regulation, Deregulation, and Innovation
Deposit Insurance
The deposits of most financial intermediaries are insured by the Federal Deposit Insurance Corporation.
Receives its income from compulsory premiums paid by financial intermediaries
Protects depositors 36

38. Financial Regulation, Deregulation, and Innovation
The balance sheet regulations faced by financial intermediaries include:
1) Capital requirements
The minimum amount of an owner’s own financial resources that must be put into an intermediary. 37

39. Financial Regulation, Deregulation, and Innovation
The balance sheet regulations faced by financial intermediaries include:
2) Reserve requirements
Rules setting out the minimum percentages of deposits that must be held in currency or other safe, liquid assets. 38

40. Financial Regulation, Deregulation, and Innovation
The balance sheet regulations faced by financial intermediaries include:
3) Deposit rules
Restrictions on the different types of deposits that an intermediary can accept. 39

41. Financial Regulation, Deregulation, and Innovation
The balance sheet regulations faced by financial intermediaries include:
4) Lending rules
Restrictions on the proportions of different types of loans that an intermediary may make. 40

42. Financial Regulation, Deregulation, and Innovation
Deregulation in the 1980s (USA, UK)
The Depository Institutions’ Deregulation and Monetary Control Act (DIDMCA), passed in 1980, removed many of the distinctions between commercial banks and other financial intermediaries. 41

43. Learning Objectives Define money and describe its functions
Explain the economic functions of banks and other financial institutions
Describe the financial innovations 43

44. Financial Regulation, Deregulation, and Innovation
Financial Innovation
Financial innovation is the development of new ways of borrowing and lending.
Primary aim is to increase the profit from financial intermediation. 44

45. Financial Regulation, Deregulation, and Innovation
The three main influences on financial innovation are:
1) Economic environment
2) Technology
3) Regulation 45

46. Financial Regulation, Deregulation, and Innovation
Financial Innovations
Variable interest rate mortgages
Widespread credit card usage
Rise in the importance of the Eurodollar
Paying interest on checkable deposits 46

47. Learning Objectives Explain how banks create money
Explain why the quantity of money is an important economic magnitude
Explain the quantity theory of money 47

48. How Banks Create Money Reserves: Actual and Required
The reserve ratio is the fraction of a bank’s total deposits that are held in reserves.
The required reserve ratio is the ratio of reserves to deposits that banks are required, by regulation, to hold.
Excess reserves are actual reserves minus required reserves. 48

49. Let’s see an example of how
How Banks Create Money
Creating Deposits by Making loans in a One-Bank Economy
Let’s see an example of how
banks create money. 49

50. Creating Money at the One-and-Only Bank
Balance sheet on January 1
Assets
(millions of dollars)
Liabilities
(millions of dollars)
Reserves $100 Deposits $400
Loans $300
Total $400 Total $400
Instructor Notes:
1) In the table, the One-and-Only Bank has deposits of $400 million, loans of $300 million, and reserves of $100 million.
2) The bank’s required reserve ratio is 25percent.
3) When the banks receives a deposit of $1 million 50

51. Creating Money at the One-and-Only Bank
Balance sheet on January 2
Assets
(millions of dollars)
Liabilities
(millions of dollars)
Reserves $101 Deposits $401
Loans $300
Total $401 Total $401
Instructor Notes:
1) When the banks receives a deposit of $1 million, as shown, it has excess reserves.
2) It lends $3 million and creates a further $3 million of deposits. 51

52. Creating Money at the One-and-Only Bank
Balance sheet on January 3
Assets
(millions of dollars)
Liabilities
(millions of dollars)
Reserves $101 Deposits $404
Loans $303
Total $404 Total $404
Instructor Notes:
Deposits increase by $3 million, and loans increase by $3 million. 52

53. How Banks Create Money
The Deposit Multiplier 53

54. banking system creates money.
How Banks Create Money
Creating Deposits by Making Loans with Many Banks
Let’s see how the
banking system creates money. 54

55. The Multiple Creation of Bank Deposits
The sequence
The running tally
Reserves
Loans
Deposits
Deposit
$100,000
Reserve
$25,000
Loan
$75,000
$25,000
$75,000
$100,000
Instructor Notes:
1) When a bank receives deposits, it keeps 25 percent in reserves and lends 75 percent.
2) The amount lent becomes a new deposit at another bank.
3) The next bank in the sequence keeps 25 percent and lends 75 percent, and the process continues until the banking system has created enough deposits to eliminate its excess reserves.
4) The running tally tells us the amounts of deposits and loans created at each stage.
5) At the end of the process, an additional $100,000 of reserves creates an additional $400,000 of deposits.
Deposit
$75,000
Reserve
$18,750
Loan
$56,250
$43,750
$131,250
$175,000 59

56. The Multiple Creation of Bank Deposits
The sequence
The running tally
Reserves
Loans
Deposits
Deposit
$56,250
$43,750
$131,250
$175,000
$57,813
$173,437
$231,250
Reserve
$14,063
Loan
$42,187
$68,360
$205,077
$273,437
Instructor Notes:
1) When a bank receives deposits, it keeps 25 percent in reserves and lends 75 percent.
2) The amount lent becomes a new deposit at another bank.
3) The next bank in the sequence keeps 25 percent and lends 75 percent, and the process continues until the banking system has created enough deposits to eliminate its excess reserves.
4) The running tally tells us the amounts of deposits and loans created at each stage.
5) At the end of the process, an additional $100,000 of reserves creates an additional $400,000 of deposits.
Deposit
$42,187
Reserve
$10,547
Loan
$31,640 62

57. The Multiple Creation of Bank Deposits
The sequence
The running tally
Reserves
Loans
Deposits
$68,360
$205,077
$273,437
Loan
$31,640
Reserve
$10,547
and
so on...
$100,000
$300,000
$400,000
Instructor Notes:
1) When a bank receives deposits, it keeps 25 percent in reserves and lends 75 percent.
2) The amount lent becomes a new deposit at another bank.
3) The next bank in the sequence keeps 25 percent and lends 75 percent, and the process continues until the banking system has created enough deposits to eliminate its excess reserves.
4) The running tally tells us the amounts of deposits and loans created at each stage.
5) At the end of the process, an additional $100,000 of reserves creates an additional $400,000 of deposits. 64

58. Learning Objectives Explain how banks create money
Explain why the quantity of money is an important economic magnitude
Explain the quantity theory of money 81

59. Money, Real GDP, and the Price Level
The Quantity Theory of Money
The quantity theory of money is the proposition that in the long run, an increase in the quantity of money brings an equal percentage increase in the price level.
This theory is based upon the velocity of circulation and the equation of exchange. 82

60. Money, Real GDP, and the Price Level
The Quantity Theory of Money
The velocity of circulation is the average number of times a dollar of money is used annually to buy goods and services that make up GDP. 83

61. Money, Real GDP, and the Price Level
GDP equals the price level (P) times real GDP (Y), or:
GDP = PY 84

62. Money, Real GDP, and the Price Level
Make the quantity of money M, and the velocity of circulation V is determined by:
V = PY/M 85

63. The Velocity of Circulation in the United States: 1930–1999
Instructor Notes:
1) The velocity of circulation of M1 has increased over the years because financial innovation has developed M1 substitutes.
2) The velocity of circulation of M2 has been relatively stable because the M1 substitutes that have resulted from financial innovation are new types of deposits that are part of M2. 86

64. Money, Real GDP, and the Price Level
The equation of exchange states that the quantity of money (M) multiplied by the velocity of circulation (V) equals GDP, or
MV=PY 87

65. Money, Real GDP, and the Price Level
We can convert the equation of exchange into the quantity theory of money by making two assumptions:
1) The velocity of circulation is not influenced by the quantity of money.
2) Potential GDP is not influenced by the quantity of money. 88

66. Money, Real GDP, and the Price Level
Assuming this is true, the equation of exchange tells us that a change in the quantity of money causes an equal proportional change in the price level. 89

67. Money, Real GDP, and the Price Level
This can be shown by using the equation of exchange to solve for the price level.
P = (V/Y)M 90

68. Money, Real GDP, and the Price Level
In the long run, real GDP equals potential GDP, so the relationship between the change in the price level and the quantity of money is: 91

69. Money, Real GDP, and the Price Level
Dividing this equation by an earlier one, P = (V/Y)M, gives us 92

70. Money, Real GDP, and the Price Level
This equation shows that the proportionate change in the price level equals the proportionate change in the quantity of money.
This gives us the quantity theory of money:
In the long run, the percentage increase in the price level equals the percentage increase in the quantity of money. 93

71. Money, Real GDP, and the Price Level
The AS-AD model predicts the same outcome as the quantity theory of money.
It also predicts a less precise relationship between the quantity of money and the price level in the short run than in the long run. 94

72. Money, Real GDP, and the Price Level
Historical Evidence on the Quantity Theory of Money
The data are broadly consistent with the quantity theory of money, but the relationship is not precise.
The relationship is stronger in the long run than in the short run. 95

73. Money Growth and Inflation in the United States
Instructor Notes:
1) Year-to-year fluctuations in money growth and inflation are loosely correlated but decade average fluctuations in money growth and inflation are closely correlated.
2) The burst of postwar inflation was caused by rapid money growth during World War II, and the rise in inflation during the 1970s was caused by more rapid money growth during the 1960s. 96

74. Money Growth and Inflation in the United States
Instructor Notes:
1) Year-to-year fluctuations in money growth and inflation are loosely correlated but decade average fluctuations in money growth and inflation are closely correlated.
2) The burst of postwar inflation was caused by rapid money growth during World War II, and the rise in inflation during the 1970s was caused by more rapid money growth during the 1960s. 97

75. Money Growth and Inflation in the World Economy
Instructor Notes:
Inflation and money growth in 60 countries and low-inflation countries show a clear positive relationship between money growth and inflation. 98

76. Money Growth and Inflation in the World Economy99

77. Money, Real GDP, and the Price Level
Correlation, Causation, and Other Influences
The evidence shows that money growth and inflation are correlated.
100

78. Money, Real GDP, and the Price Level
Correlation, Causation, and Other Influences
This does not represent causation.
Does money growth cause inflation, or does inflation cause money growth?
Does some other factor cause inflation (deficit spending)?
101