1. ECN 200: Introduction to Economics
Nusrat Jahan
Lecture-8
Money and Inflation

2. The meaning of Money The functions of Money
Money is the set of assets in an economy that people regularly use to buy goods and services from other people.
The functions of Money
Medium of exchange
A medium of exchange is an item that buyers give to sellers when they want to purchase goods and services.
A medium of exchange is anything that is readily acceptable as payment.
Unit of account
A unit of account is the yardstick people use to post prices and record debts.
Store of value
A store of value is an item that people can use to transfer purchasing power from the present to the future.

3. The kinds of Money
Commodity money – Commodity money takes the form of a commodity with intrinsic value.
Examples: Gold, silver, cigarettes.
Fiat Money – Fiat money is used as money because of government money decree. It does not have intrinsic value.
Examples: Coins, currency, check deposits.

4. Real Interest Rate= Nominal Interest Rate- Inflation Rate
The Price of Money: Interest Rate
Interest is the payment made for the use of money.
Interest rate is the amount of interest paid per unit of time expressed as a percentage of the amount borrowed.
Nominal Interest Rate: It measures the yield in taka per year per taka invested i.e. it is the interest rate on money in terms of money.
Real Interest Rate: It measures the quantity of goods we get tomorrow for goods forgone today.
Real Interest Rate= Nominal Interest Rate- Inflation Rate

5. Money Creation Banks and the Money Supply
Banks can influence the quantity of demand deposits in the economy and the money supply.
Reserves are deposits that banks have received but have not loaned out.
In a fractional-reserve banking system, banks hold a fraction of the money deposited as reserves and lend out the rest.
The reserve ratio is the fraction of deposits that banks hold as reserves.

6. Money Creation with Fractional-reserve Banking
When a bank makes a loan from its reserves, the money supply increases
The money supply is affected by the amount deposited in banks and the amount that banks loan.
Deposits into a bank are recorded as both assets and liabilities.
The fraction of total deposits that a bank has to keep as reserves is called the reserve ratio.
Loans become an asset to the bank
Suppose Ms. Borrower deposits deposits $1000 in her checking account at Bank 1.
Assets
Liabilities
Reserves
$1000
Deposits
Total
Table (1): Bank 1’s initial balance sheet

7. This creates more deposits and more reserves to be lent out.
If the banks were to keep 100% of the deposit in reserves no extra money would be created. The $1000 checking deposit would just match the $1000 reserve. Suppose reserve ratio is 10%. Bank 1 must set aside as reserve $100 0f $1000 deposit.
Assets
Liabilities
Reserves
$100
Deposits
$1000
Loans
$900
Total
Table (2): Bank 1’s final balance sheet
When one bank loans money, that money is generally deposited into another bank.
This creates more deposits and more reserves to be lent out.
When a bank makes a loan from its reserves, the money supply increases.
Bank 1 now has $900 more in reserves than it needs to meet the reserve requirement with which it can make loan. At this point in addition to having $1000 of initial deposit Bank 1 now has $900 of demand deposit. The total amount of money becomes $1900.

8. The person who borrows money takes the $900 and deposits it in her account in another bank. If the borrower deposits the money in Bank 2 then Bank 2’s initial balance sheet will have $900 in reserve. It will also have an equal amount of liability in the form of deposit.
Assets
Liabilities
Reserves
$900
Deposits
Total
Table (3): Bank 2’s initial balance sheet
If Bank 2 keeps 10% in reserve and loans out the rest of the money then the final balance sheet of Bank 2 will become-
Assets
Liabilities
Reserves
$90
Deposits
$900
Loans
$810
Total
Table (2): Bank 2’s final balance sheet

9. The money multiplier is the reciprocal of the reserve ratio: M = 1/R
At this point Bank 2 will have an additional demand deposit of $810 and total money will now be $2710.
The Money Multiplier
The money multiplier is the amount of money the banking system generates with each dollar of reserves.
The money multiplier is the reciprocal of the reserve ratio:
M = 1/R
With a reserve requirement, R = 10% or 1/10,
The multiplier is 10.