1. The Money Supply
Chapter 22

2. AN OVERVIEW OF MONEY WHAT IS MONEY?
Money is anything that is generally accepted as a medium of exchange
A Means of Payment, or Medium of Exchange
A Store of Value
A Unit of Account

3. AN OVERVIEW OF MONEY A Means of Payment, or Medium of Exchange
barter The direct exchange of goods and services for other goods and services
A barter system requires a double coincidence of wants for trade to take place
medium of exchange, or means of payment What sellers generally accept and buyers generally use to pay for goods and services

4. AN OVERVIEW OF MONEY A Store of Value
store of value An asset that can be used to transport purchasing power from one time period to another
liquidity property of money The property of money that makes it a good medium of exchange as well as a store of value: It is portable and readily accepted and thus easily exchanged for goods
The main disadvantage of money as a store value is that the value of money falls when the prices of goods and services rise

5. AN OVERVIEW OF MONEY A Unit of Account
unit of account A standard unit that provides a consistent way of quoting prices

6. COMMODITY AND FIAT MONIES
AN OVERVIEW OF MONEY
COMMODITY AND FIAT MONIES
commodity monies Items used as money that also have intrinsic value in some other use
Example: gold
fiat, or token, money Items designated as money that are intrinsically worthless

7. AN OVERVIEW OF MONEY
Why would anyone accept worthless scraps of paper as money instead of something that has some values, such as gold?
If your answer is “because the paper money is backed by gold or silver”, you are wrong
There was a time when paper money in circulation were convertible directly into gold
However, paper money is no longer backed by any commodity
The public accepts paper money as a means of payment and a store of value because the government has taken steps to ensure that its money is accepted

8. AN OVERVIEW OF MONEY
legal tender Money that a government has required to be accepted in settlement of debts
Aside from declaring its currency legal tender, the government usually does one another thing to ensure that paper money will be accepted:
It promises the public that it will not print paper money so fast that it loses its value
currency debasement The decrease in the value of money that occurs when its supply is increased rapidly

9. MEASURING THE SUPPLY OF MONEY
AN OVERVIEW OF MONEY
MEASURING THE SUPPLY OF MONEY
Recall that money is used to buy things (a means of payment); to hold wealth (a store value); and to quote prices (a unit of account)
M1: Transactions Money
M1, or transactions money Money that can be directly used for transactions
M1 ≡ currency held outside banks + demand deposits + traveler’s checks + other checkable deposits

10. AN OVERVIEW OF MONEY Demand deposits or checking accounts
Depositors have the right to go to the bank and cash in (demand) their entire checking account balances at any time
This is why checking accounts are included as part of the amount of money you hold
Checkable deposits is any deposit account with a bank on which a check can be written

11. AN OVERVIEW OF MONEY M2: Broad Money
near monies Close substitutes for transactions money, such as savings accounts and money market accounts
M2, or broad money M1 plus savings accounts, money market accounts, and other near monies
M2 ≡ M1 + savings accounts + money market accounts + other near monies

12. AN OVERVIEW OF MONEY Beyond M2
There are no rules for deciding what is money and what is not
Example: credit cards
This poses problems for economists and those in charge of economic policy

13. AN OVERVIEW OF MONEY
For our purposes, “money” will always refer to transactions money, M1
M1 is the sum of two general categories:
Currency in circulation
Deposits

14. AN OVERVIEW OF MONEY THE PRIVATE BANKING SYSTEM
financial intermediaries Banks and other institutions that act as a link between those who have money to lend and those who want to borrow money

15. A HISTORICAL PERSPECTIVE: GOLDSMITHS
HOW BANKS CREATE MONEY
A HISTORICAL PERSPECTIVE: GOLDSMITHS
Suppose you go to a goldsmith who is functioning only as a depositor and ask for a loan of 20 ounces of gold
Suppose that the goldsmith has 100 ounces of gold on deposit in his safe and receipts for exactly 100 ounces of gold out to various people who deposited the gold
If goldsmith decides he is tired of being a mere goldsmith and wants to become a real bank, he will loan some gold
You actually want a slip of paper that represents 20 ounces of gold
The goldsmith in essence “creates” money for you by giving you a receipt for 20 ounces of gold

16. HOW BANKS CREATE MONEY
There will be receipts for 120 ounces of gold in circulation instead of the 100 ounces worth of receipts before your loan and the supply of money will have increased
Goldsmiths-turned-bankers did face certain problems
Once they started to make loans, their receipts outstanding (claims on gold) were greater than the amount of gold they have had in their vaults
If the owners of the 120 ounces worth of gold receipts all presented their receipts and demanded their gold at the same time, the goldsmith would be in trouble
run on a bank Occurs when many of those who have claims on a bank (deposits) present them at the same time

17. THE MODERN BANKING SYSTEM
HOW BANKS CREATE MONEY
THE MODERN BANKING SYSTEM
A Brief Review of Accounting
“The books always balance”
Assets are things a firm owns that are worth something
For a bank, these assets include the bank building, cash in its vaults, bonds, stocks, loans, cash on hand and deposits with Central Bank (as banks keep a certain portion of their deposits on hand as vault cash or on deposit with Central Bank)

18. HOW BANKS CREATE MONEY Liabilities are the firm’s debts-what it owes
A bank’s liabilities are the promises to pay and its deposits
Deposits are debts owned to the depositors, because when you deposit money in your account, you are in essence making a loan to the bank

19. HOW BANKS CREATE MONEY
If we add up a firm’s assets and then subtract the total amount it owes to all those who have lent it funds, the difference is the firm’s net worth
Assets − Liabilities ≡ Net Worth or
Assets ≡ Liabilities + Net Worth

20. HOW BANKS CREATE MONEY
To keep track of a bank’s financial position using a simplified balance sheet called a T-account
The bank’s assets are listed on the left side and its liabilities and net worth are on the right side
By definition, the balance sheet always balances, so that the sum of the items on the left side of T-account is exactly equal to the sum of the items on the right side

21. HOW BANKS CREATE MONEY
T-Account for a Typical Bank (millions of dollars)

22. HOW BANKS CREATE MONEY A bank having $110 million in assets of which:
$20 million are reserves (the deposits that the bank has made at Central Bank and its cash on hand)
$90 million are loans
reserves The deposits that a bank has at the Central Bank plus its cash on hand

23. HOW BANKS CREATE MONEY
Why do banks hold reserves/deposits at Central Bank?
The most important reason is the legal requirement that they hold a certain percentage of their deposit liabilities as reserves
required reserve ratio The percentage of its total deposits that a bank must keep as reserves at the Central Bank
If the reserve ratio is 20 percent, then a bank with deposits of $100 million must hold $20 million as reserves, either as cash or as deposits at Central Bank
We assume that banks hold all of their reserves in the form of deposits at the Central Bank

24. HOW BANKS CREATE MONEY On the liabilities side:
The bank has taken deposits of $100 million, so it owes this amount to its depositors
The bank has a net worth of $10 million to its owners
$110 million in assets - $100 million in liabilities = $10 million net worth

25. HOW BANKS CREATE MONEY
When some item on a bank’s balance sheet changes, there must be at least one other change somewhere else to maintain balance
If bank’s reserves increase by $1, then one of the following must also be true:
Its other assets (loans) decrease by $1
Its liabilities (deposits) increase by $1
Its net worth increases by $1

26. excess reserves ≡ actual reserves − required reserves
HOW BANKS CREATE MONEY
THE CREATION OF MONEY
Banks usually make loans up to the point where they can no longer do so because of the reserve requirement restriction
A bank’s required amount of reserves is equal to the required reserve ratio times the total deposits in the bank
excess reserves The difference between a bank’s actual reserves and its required reserves
excess reserves ≡ actual reserves − required reserves
Banks make loans up to the point where their excess reserves are zero

27. HOW BANKS CREATE MONEY
If a bank has excess reserves, it has credit available and it can make loans
A bank can make loans only if it has excess reserves
When a bank makes a loan, it creates a demand deposit for the borrower
This creation of a demand deposit causes the bank’s excess reserves to fall because the extra deposits created by the loan use up some the excess reserves the bank has on hand

28. HOW BANKS CREATE MONEY
Balance Sheets of a Bank in a Single-Bank Economy

29. HOW BANKS CREATE MONEY
Assume there is only one private bank in the country
The required reserve ratio is 20 percent
The bank starts off with nothing: Panel 1
Someone deposits $100 in the bank
The bank deposits the $100 with the central bank and it now has $100 in reserves: Panel 2
The bank now has assets (reserves) of $100 and liabilities (deposits) of $100

30. HOW BANKS CREATE MONEY
If the required reserve ratio is 20 percent, the bank has excess reserves of $80
How much can the bank lend and still meet the reserve requirement? (Suppose no cash withdrawal)
With $80 of excess reserves, the bank can have up to $400 of additional deposits
The $100 in reserves plus $400 in loans (as deposits) equal $500 in deposits
With $500 in deposits and a required reserve ratio of 20 percent, the bank must have reserves of $100 (that is 20 percent of $500): Panel 3
The bank can lend no more than $400 because it reserve requirement must not exceed $100

31. HOW BANKS CREATE MONEY
The money supply (M1) equals cash in circulation plus deposits
Before the initial deposit, the money supply was $100 ($100 cash and no deposits)
After the deposit and the loans, the money supply is $500 (no cash and $500 in deposits)
When loans are converted into deposits, the supply of money can change

32. HOW BANKS CREATE MONEY What happens when there are many banks?
Assume that I make an initial deposit of $100 in bank 1 and the bank deposits the entire $100 with the Central Bank: Panel 1
All loans that a bank makes are withdrawn from the bank as the individual borrowers write checks to pay for merchandise
After my deposit, bank 1 can make a loan up to $80 to Person X, because given 20 percent required reserve ratio, it needs to keep only $20 of its $100 deposit as reserves

33. HOW BANKS CREATE MONEY
The Creation of Money When There Are Many Banks

34. HOW BANKS CREATE MONEY
Bank 1’s balance sheet at the moment of the loan to Person X appears in Panel 2
Bank 1 now has loans of $80
It has credited Person X’s account with the $80, so its total deposits are $180 ($80 in loans plus $100 in reserves)
Person X then writes a check for $80 for another good to sold by Person Y
Person Y deposits Person X’s check in bank 2

35. HOW BANKS CREATE MONEY
When the check clears, bank 1 transfers $80 in reserves to bank 2
Bank 1’s balance sheet: Panel 3
Bank 1’s assets include reserves of $20 and loans of $80; its liabilities are $100 in deposits
Both sides balance: The bank’s reserves are 20 percent of its deposits and is fully loaned up

36. HOW BANKS CREATE MONEY Look at bank 2
Because bank 1 has transferred $80 in reserves to bank 2, now it has $80 in deposits and $80 in reserves: Panel 1, bank 2
Its reserve requirement ratio is also 20 percent, so it has excess reserves of $64 on which it can make loans
Assume bank 2 loans the $64 to Person Z to pay for a good sold by Person T and Person Z writes a check for $64 payable to Person T
The final position of bank 2 (transfer of $64 in reserves to bank 3) is reserves of $16, loans of $64 and deposits of $80: Panel 3, bank 2

37. HOW BANKS CREATE MONEY
Person T deposits Person Z’s check in its account with bank 3
Bank 3 has excess reserves, because it has added $64 to its reserves
With a reserve requirement ratio of 20 percent, bank 3 loan out $51.20 (80 percent of $64, leaving 20 percent in required reserves to back the $64 deposit): Panel 3, bank 3
As the process is repeated over, the total amount of deposits created is $500, the sum of the deposits in each of the banks

38. HOW BANKS CREATE MONEY THE MONEY MULTIPLIER
An increase in bank reserves leads to a greater than one-for-one increase in the money supply
Economists call the relationship between the final change in deposits and the change in reserves that caused this change the money multiplier
Stated somewhat differently, the money multiplier is the multiple by which deposits can increase for every dollar increase in reserves

39. HOW BANKS CREATE MONEY
Reserves increased by $100 when the $100 in cash was deposited in a bank
The amount of deposits increased by $500 ($100 from the initial deposits, $400 from the loans made by banks from their excess reserves)
The money multiplier is $500/$100=5

40. Money multiplier ≡ 1/required reserve ratio
HOW BANKS CREATE MONEY
money multiplier The multiple by which deposits can increase for every dollar increase in reserves; equal to 1 divided by the required reserve ratio
Money multiplier ≡ 1/required reserve ratio

41. FUNCTIONS OF THE CENTRAL BANK
The crucial role is to control the money supply
The Central Bank also performs several important functions for banks
Clearing interbank payments
Regulating the banking system
Assisting banks in a difficult financial position
Managing exchange rates and the nation’s foreign exchange reserves

42. HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY
WHAT IS THE ROLE OF RESERVES?
The required reserve ratio establishes a link between the reserves of the commercial banks and the deposits (money) that commercial banks are allowed to create
The reserve requirement determines how much a bank has available to lend
If the required reserve ratio is 20 percent, each of 1 TL of reserves can support 5 TL in deposits
As the money supply is equal to the sum of deposits inside banks and the currency in circulation outside of banks, reserves provide the power the Central Bank needs to control the money supply

43. HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY
If the Central Bank wants to increase the supply of money, it creates more reserves, thereby freeing banks to create additional deposits by making more loans
If it wants to decrease the money supply, it reduces reserves
Three tools are available to the Central Bank for changing the money supply:
(1) changing the required reserve ratio
(2) changing the discount rate
(3) engaging in open market operations

44. HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: THE REQUIRED RESERVE RATIO
Assume the initial required reserve ratio is 20 percent
Panel 1: Central Bank’s balance sheet
Reserves are $100 billion
Currency outstanding is $100 billion
The total value of Central Bank’s assets is $200 billion that is assumed to be all in government securities
Assume no excess reserves
The $100 billion in reserves supports $500 billion in deposits at the commercial banks
The money multiplier equals 1/required reserve ratio=1/0.2=5
Thus $100 billion in reserves can support $500 billion in deposits
The supply of money is $600 billion: $100 billion in currency and $500 billion in deposits at the commercial banks

45. HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: THE REQUIRED RESERVE RATIO

46. The money multiplier is 1/0.125=8
HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: THE REQUIRED RESERVE RATIO
Suppose the Central Bank wants to increase the supply of money to $900 billion
If it lowers the required reserve ratio from 20 percent to 12.5 percent (Panel 2), then the same $100 billion of reserves could support $800 billion in deposits
The money multiplier is 1/0.125=8
The total money supply would be $800 billion in deposits plus the $100 billion in currency, a total of $900 billion

47. The result is a decrease in the money supply
HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: THE REQUIRED RESERVE RATIO
Decreases in the required reserve ratio allow banks to have more deposits with the existing volume of reserves
As banks create more deposits by making loans, the supply of money (currency plus deposits) increases
If the Central Bank wants to restrict the supply of money, it can raise the required reserve ratio, in which case banks will find that they have insufficient reserves and must therefore reduce their deposits by “calling in” some of their loans
The result is a decrease in the money supply

48. HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY
THE DISCOUNT RATE
discount rate Interest rate that banks pay to the Central Bank to borrow from it

49. HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: THE DISCOUNT RATE
Assume there is only one bank in the country and the required reserve ratio is 20 percent
The initial position of Central Bank: Panel 1
Assets: $160 securities
Liabilities: $80 reserves and $80 currency
The initial position of bank: Panel 1
Assets: $80 reserves and $320 loans
Liabilities: $400 deposits
The money supply (currency plus deposits) is $480

50. HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: THE DISCOUNT RATE

51. HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: THE DISCOUNT RATE
In Panel 2, the bank has borrowed $20 from the Central Bank
By using this $20 as a reserve, the bank can increase its loans by $100, from $320 to $420
As required reserve ratio of 20 percent gives a money multiplier of 5; having excess reserves of $20 allows the bank to create an additional $100 in deposits
The money supply thus increased from $480 to $580

52. HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: THE DISCOUNT RATE
Bank borrowing from the Central Bank leads to an increase in the money supply
The Central Bank can influence bank borrowing, and thus the money supply, through the discount rate:
The higher the discount rate, the higher the cost of borrowing, and the less borrowing banks will want to do

53. HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: OPEN MARKET OPERATIONS
open market operations The purchase and sale by the Central Bank of government securities in the open market; a tool used to expand or contract the amount of reserves in the system and thus the money supply
The most significant tool

54. HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: OPEN MARKET OPERATIONS
When the Central Bank purchases a security, the quantity of reserves expands, increasing the money supply
When the Central Bank sells a security (or bond), the quantity of reserves reduces, decreasing the money supply

55. HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: OPEN MARKET OPERATIONS
Suppose that the Central Bank wants to decrease the supply of money
If it can reduce the volume of bank reserves on the liabilities side of its balance sheet, it will force banks in turn to reduce their own deposits (to meet the required reserve ratio)
Since these deposits are part of the supply of money, the supply of money will contract

56. HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: OPEN MARKET OPERATIONS
What happens if the Central Bank sells some of its holdings of government securities to the public?
The Central Bank’s holdings of government securities must decrease
How do in return the purchasers of securities pay for what they have bought?
By writing checks drawn on their banks and payable to the Central Bank

57. HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: OPEN MARKET OPERATIONS
In Panel 1, the Central Bank has $100 billion of government securities
Its liabilities consist of $20 billion of deposits (that are the reserves of commercial banks) and $80 billion of currency
With the required reserve ratio at 20%, the $20 billion of reserves can support $100 billion of deposits in the commercial banks
The commercial banking system is fully loaned up
Zeynep has assets of $5 billion and no debts, so her net worth is $5 billion (look at Panel 1)

58. HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: OPEN MARKET OPERATIONS
The Central Bank sells $5 billion in government securities to Zeynep
Zeynep pays for the securities by writing a check to the Central Bank, drawn on her bank
The Central Bank then reduces the reserve account of her bank by $5 billion
Look at Panel 2
The supply of money (currency plus deposits) has fallen from $180 billion to $175 billion

59. HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: OPEN MARKET OPERATIONS

60. HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: OPEN MARKET OPERATIONS
As a result of the Central Bank’s sale of securities, the amount of reserves has fallen from $20 billion to $15 billion, while deposits have fallen from $100 billion to $95 billion
With a required reserve ratio of 20 percent, banks must have 0.2X$95=$19 billion in reserves
Banks are under their required reserve ratio by $4 billion
So, banks must decrease their loans and their deposits

61. HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: OPEN MARKET OPERATIONS
The final equilibrium position is Panel 3
Commercial banks have reduced their loans by $20 billion
The change in deposits from Panel 1 to Panel 3 is $25 billion that is 5 times the size of the change in reserves that the Central Bank brought through its $5 billion open market sale of securities
That is our money multiplier
The change in money (-$25 billion) is equal to the money multiplier (5) times the change in reserves (-$5 billion)

62. HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: OPEN MARKET OPERATIONS
What happens when the Central Bank purchases a government security?
Suppose Ali holds $100 in Treasury bill, which the Central Bank buys from him
The Central Bank writes him a check for $100 and Ali then take the $100 check and deposit it in his bank
This increases the reserves of his bank by $100 and begins a new episode in the money expansion story

63. HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: OPEN MARKET OPERATIONS
With a reserve requirement ratio of 20%, his bank can now lend out $80
If that $80 is spent and ends up back in a bank, that bank can lend $64 and so forth
The Central Bank can expand the money supply by buying government securities from people who own them

64. HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: OPEN MARKET OPERATIONS
We can sum up the effect of these open market operations this way:
An open market purchase of securities by the Central Bank results in an increase in reserves and an increase in the supply of money by an amount equal to the money multiplier times the change in reserves
An open market sale of securities by the Central Bank results in a decrease in reserves and a decrease in the supply of money by an amount equal to the money multiplier times the change in reserves

65. THE SUPPLY CURVE FOR MONEY
To begin with, the Central Bank’s choice of the value for the money supply does not depend on the interest rate
We can draw the money supply curve as a vertical line
Assume that the money supply curve is vertical

66. THE SUPPLY CURVE FOR MONEY
Interest rate
Money supply
Money supply