© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 15: Money, Banks, and the Federal Reserve System 1 of 37 Money & Assets Money: Assets that people are generally willing to accept in exchange for goods and services or for payment of debts. Asset: Anything of value owned by a person or a firm.

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 15: Money, Banks, and the Federal Reserve System 2 of 37 Barter and the Invention of Money? Barter Economies: economies where goods & services are traded directly for other goods & services. Commodity money: A good used as money that also has value independent of its use as money.

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 15: Money, Banks, and the Federal Reserve System 3 of 37 Why Do We Need Money? ……….because by making exchange easier, money allows for specialization and higher productivity.

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 15: Money, Banks, and the Federal Reserve System 4 of 37 The Functions of Money? Anything used as money – whether a deerskin, a barrel of oil, or a dollar bill – should fulfill the following four functions:  MEDIUM OF EXCHANGE  UNIT OF ACCOUNT  STORE OF VALUE  STANDARD OF DEFERRED PAYMENT

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 15: Money, Banks, and the Federal Reserve System 5 of 37 What Can Serve As Money? The five criteria of a suitable good as a medium of exchange.  The good must be acceptable to (that is, usable by) most traders.  It should be of standardized quality, so that any two units are identical.  It should be durable, so that value is not lost by spoilage.  It should be valuable relative to its weight so that amounts large enough to be useful in trade can be easily transported.  The medium of exchange should be divisible because different goods are valued differently. Fiat money: Money, such as paper currency, that is authorized by a central bank or governmental body and that does not have to be exchanged by the central bank for gold or some other commodity money.

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 15: Money, Banks, and the Federal Reserve System 6 of 37 How Do We Measure Money Today? M1: The Narrowest Definition of the Money Supply M1: The narrowest definition of the money supply: the sum of currency in circulation, checking account balances in banks, and holdings of traveler’s checks. It includes: 1.All the paper money and coins that are in circulation – meaning what is not held by banks or the government. 2.The value of all checking account balances at banks. 3.The value of traveler’s checks.

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 15: Money, Banks, and the Federal Reserve System 7 of 37 How Do We Measure Money Today? M2: A Broader Definition of Money M2: A broader definition of the money supply: M1 plus savings account balances, small-denomination time deposits, balances in money market deposit accounts in banks, and non-institutional money market fund shares. Two key points about the money supply to keep in mind are: 1.The money supply consists of both currency and balances in checking accounts and traveler’s checks. 2.Because balances in checking accounts are included in the money supply, banks play an important role in the process by which the money supply increases and decreases.

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 15: Money, Banks, and the Federal Reserve System 8 of 37 How Do We Measure Money Today?

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 15: Money, Banks, and the Federal Reserve System 9 of 37 How Do Banks Create Money? Reserves: Deposits that a bank keeps as cash in its vault or on deposit with the Federal Reserve. Required reserves: Reserves that a bank is legally required to hold, based on its checking account deposits. Excess reserves: Reserves that banks hold over and above the legal requirement.

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 15: Money, Banks, and the Federal Reserve System 10 of 37 How Do Banks Create Money? Using T-Accounts to Show How a Bank Can Create Money

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 15: Money, Banks, and the Federal Reserve System 11 of 37 How Do Banks Create Money? Using T-Accounts to Show How a Bank Can Create Money

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 15: Money, Banks, and the Federal Reserve System 12 of 37 How Do Banks Create Money? Using T-Accounts to Show How a Bank Can Create Money

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 15: Money, Banks, and the Federal Reserve System 13 of 37 How Do Banks Create Money? Using T-Accounts to Show How a Bank Can Create Money

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 15: Money, Banks, and the Federal Reserve System 14 of 37 How Do Banks Create Money? Using T-Accounts to Show How a Bank Can Create Money BANKINCREASE IN CHECKING ACCOUNT DEPOSITS Wachovia$1,000 PNC$900(= 0.9 x $1,000) Third Bank$810(= 0.9 x $900) Fourth Bank$729(= 0.9 x $810) Total Change in Checking Account Deposits$10,000 Simple Deposit Multiplier: the ratio of the amount of deposits created by banks to the amount of new reserves. Change in checking account deposits = Change in bank reserves x (1/RR)

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 15: Money, Banks, and the Federal Reserve System 15 of 37 How Do Banks Create Money? Suppose you find $5,000 cash and deposit it into your checking account at WAMU. At the time of your deposit, your bank has no excess reserves. Also, WAMU’s required reserve ratio is.10. a. Use a T-account to show the initial effect of this transaction on your bank’s balance sheet. b. Suppose that WAMU makes the maximum loan they can from the money you deposited. Use a T-account to show the initial effect on WAMU’s balance sheet from granting the loan. Also, don’t forget to include the transaction from question (a). c. Now suppose that whoever took out the loan in question (b) writes a check for this amount and that the person receiving the check deposits it in Wells Fargo. Show the effect of these transactions on the balance sheets of WAMU and Wells Fargo, after the check has cleared. On the T-account for WAMU, include the transactions from questions (a) and (b). d. What is the maximum increase in checking account deposits that can result from your $5,000 deposit? What is the maximum increase in the money supply? Explain.

© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 15: Money, Banks, and the Federal Reserve System 16 of 37 Showing How Banks Create Money Bank of America AssetsLiabilities Reserves+$5,000Deposits+$5,000 WAMU AssetsLiabilities Reserves+$5,000Deposits+$5,000 Loans+$4,500Deposits+$4,500 WAMU AssetsLiabilities Reserves +$500Deposits +$5,000 Loans +$4,500 Wachovia Bank AssetsLiabilities Reserves +$4,500Deposits +$4,500