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Chapter 13:Money and Banks

  Copyright © 2013 by The McGraw-Hill Companies, Inc !ll rights reser"e# McGraw-Hill$Irwin

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Money

• In this chapter we examine the roleof money in the economy. Specically

 – What is money? – How is money created?

 – What role do banks play in the circular

ow of income and spendin?

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!earnin "b#ecti$es

• %&'(%. )xplain what money is.

• %&'(*. +escribe how banks create

money.

• %&'(&. +emonstrate how the moneymultiplier works.

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What Is ,Money-?

• Money is a tool that reatly simpliesmarket transactions. –

o money? /ransactions would be madeusin a barter system.• 0arter1 the direct exchane of one ood for

another2 without the use of money.

 – Money acts as a medium of exchane.

Sellers will accept it as payment for oodsand ser$ices.

 – Money1 anythin enerally accepted as amedium of exchane.

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 /he Money Supply

• 3nythin that ser$es all the followinpurposes can be thouht of as money1

 –

Medium of exchane1 accepted as paymentfor oods and ser$ices 4and debts5.

 – Store of $alue1 can be held for futurepurchases.

 – Standard of $alue1 ser$es as a yardstick formeasurin the prices of oods and ser$ices.

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Modern 6oncepts

• 6ash is ob$iously money because it lls allthree purposes.

• 6heckin accounts perform the same marketfunctions as cash. +ebit cards act much like acheck2 so they are money.

• "nline payment systems and credit cards do

not. /hey can be a medium of exchane butdo not fulll the other purposes.

•  /he essence of money is not its physical form2but its ability to purchase oods and ser$ices.

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6omposition of the Money

Supply• Some bank accounts are better

substitutes for cash than others.

•

M%1 cash and transactions accounts – /ransactions accounts include checkin

accounts and tra$elers checks.

 – Money supply 4M%51 currency held by the

public2 plus balances in transactions accounts. – M% permits direct payment for oods and

ser$ices.

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6omposition of the Money

Supply• M*1 M% plus sa$ins accounts2 etc.

 – Sa$ins account balances and moneymarket mutual funds are almost as ood asubstitute for cash as transactionsaccounts.

 – Money supply 4M*51 M% plus balances inmost sa$ins accounts and money market

mutual funds. – M* must be turned into M% before it can be

used to purchase oods and ser$ices.

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6omposition of the Money

Supply• 6ash is about half of

the M% money supply.Most of the rest are

transactions accountbalances.

• M* is much larer thanM%. 7eople hold money

in M* accountsbecause they can earnsome interest on thesedeposits.

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 /he )conomic Importance of

Money• How much money is a$ailable 4the

si8e of the money supply5 a9ects

consumers: ability to purchase oodsand ser$ices.

•  /his directly a9ects areate

demand 43+5.

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6reation of Money

• 6ash is either printed or coined. 0ut cashis a $ery small part of M*.

•

How is the money in transactionsaccounts and sa$ins accounts created?

 – /hese bank accounts are not physical lumpsof cash. /hey are computer data entries.

 – 3 few keystrokes can increase or decreasethe money in a bank account.

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6reation of Money

• 0anks create money by makin loans.

 – ;rant a loan and increase the borrowers:

checkin account with a few keystrokes.Money is ,created.-

•  /he bank:s ability to create money islimited by the

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uired reser$es1 the minimum amount ofreser$es a bank is re>uired to hold.

 – =e>uired reser$e ratio1 the ratio of a bank:sre>uired reser$es to its total deposits.

Required reserves = Required reserve ratio x Total deposits

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uiredreser$es2 it can make loans only on the

remainder2 called excess reser$es. – )xcess reser$es1 bank reser$es in excess of

re>uired reser$es.

 – 3 minimum reser$e re>uirement directlylimits deposit creation 4lendin5 possibilities.

Excess reserves = Total reserves – Required reserves

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6hanes in the Money

Supply• When a bank makes a loan2 money is created.

 –  /he borrower spends the money the seller depositsit into the rm:s bank account.

 –  /hat bank now has more excess reser$es and canmake a loan on it2 creatin more money.

 – When the new borrower spends the loan2 this cyclecontinues to repeat itself.

 –

)ach time a new loan is made2 the money supplyincreases.

•  /here is a multiplier process oin on2 #ust likethe income multiplier process in 6hapter %(.

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 /he Money Multiplier

• Money multiplier1 the amount ofdeposit dollars thatthe bankin systemcan create from @%of excess reser$es.

  1Money multiplier =

Required  reserve ratio

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 /he Money Multiplier

•  /he potential of the money multiplier tocreate loans is summari8ed in this e>uation1

• If the re>uired reser$e ratio is (.*(2 themoney multiplier is A. 3n initial deposit of

@%(( has @B( of excess reser$es andpotentially can create @C(( of newdeposits.

Excess reserves x Money multiplier = Potential deposit creation

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)xcess =eser$es as !endin

7ower• If a bank has no excess reser$es2 it can

make no more loans.

• )ach bank may lend an amount e>ualto its excess reser$es and no more.

•  /he entire bankin system can increase

the $olume of loans by the amount ofexcess reser$es multiplied by themoney multiplier.

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0anks and the 6ircular uiredreser$es.

• 6hanes in the money supply may inturn alter spendin beha$ior and therebyshift the areate demand 43+5 cur$e.

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6onstraints on +eposit

6reation• +eposits. If people prefer to hold onto cash2 the

deposit creation process will be se$erelyhindered.

• Willinness to lend. If banks are reluctant totake risks in lendin2 they will not fully lend outtheir excess reser$es.

• Willinness to borrow. If borrowers are reluctantto take on more debt2 fewer loans will be made.

• =eulation. /he uirements.

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 /he )conomy /omorrow

• 0ank bailouts.• In *((B a ma#or bankin crisis occurred2

oriinatin in the o$erheated housin

industry. – 0anks nanced an upsure in house prices in*((*'*((D. 0ut prices bean to fall in *((E.

 – Home $alues fell below the amount left on theirmortaes2 and many home owners ceasedpayin on their mortaes.

 – 0ank assets 4mortaes5 declined2 and manybanks teetered on the brink of failin.

 – !are numbers of bank failures could lead theeconomy into a real depression.

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 /he )conomy /omorrow

•  /he federal o$ernment stepped in to,bail out- these banks. – Hundreds of billions of o$ernment dollars

were pumped into the bankin system toprop up the banks.

 – /he purpose was to ensure that credit wouldcontinue to ow in the economy tomorrow.

• When the economy reco$ered2 the banksrepaid the bailout money with interest.

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=e$isitin the !earnin

"b#ecti$es• %&'(%. )xplain what money is.

 – It is anythin enerally accepted in

exchane that ser$es as a store of $alueand acts as a standard of $alue.

 – Money supply M% includes cash plustransactions account deposits.

 – Money supply M* includes M% plus sa$insaccount and other account balances.

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=e$isitin the !earnin

"b#ecti$es• %&'(*. +escribe how banks create

money.

 – 0anks create money by makin loansusin excess reser$es.

 – )ach loan becomes a new transactionsdeposit.

 – /his enables banks to transfer moneyfrom sa$ers to spenders.

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=e$isitin the !earnin

"b#ecti$es• %&'(&. +emonstrate how the money

multiplier works. –

3s loans are spent2 they create depositselsewhere2 makin it possible for otherbanks to make additional loans.

 – /his multiplier e9ect is controlled by the

uired reser$eratio. /he money multiplier is thereciprocal of the re>uired reser$e ratio.