13-1 Money  In this chapter we examine the role of money in the economy. Specifically  What is money?  How is money created?  What role do banks play in the circular flow of income and spending?

13-2 What Is “Money”?  Money is a tool that greatly simplifies market transactions.  No money? Transactions would be made using a barter system.  Barter: the direct exchange of one good for another, without the use of money.  Money acts as a medium of exchange. Sellers will accept it as payment for goods and services.  Money: anything generally accepted as a medium of exchange.

13-3 The Money Supply  Anything that serves all the following purposes can be thought of as money:  Medium of exchange: accepted as payment for goods and services (and debts).  Store of value: can be held for future purchases.  Standard of value: serves as a yardstick for measuring the prices of goods and services.

13-4 Modern Concepts  Cash is obviously money because it fills all three purposes.  Checking accounts perform the same market functions as cash. Debit cards act much like a check, so they are money.  Online payment systems and credit cards do not. They can be a medium of exchange but do not fulfill the other purposes.  The essence of money is not its physical form, but its ability to purchase goods and services.

13-5 Composition of the Money Supply  Some bank accounts are better substitutes for cash than others.  M1: cash and transactions accounts  Transactions accounts include checking accounts and travelers checks.  Money supply (M1): currency held by the public, plus balances in transactions accounts.  M1 permits direct payment for goods and services.

13-6 Composition of the Money Supply  M2: M1 plus savings accounts, etc.  Savings account balances and money market mutual funds are almost as good a substitute for cash as transactions accounts.  Money supply (M2): M1 plus balances in most savings accounts and money market mutual funds.  M2 must be turned into M1 before it can be used to purchase goods and services.

13-7 Composition of the Money Supply  Cash is about half of the M1 money supply. Most of the rest are transactions account balances.  M2 is much larger than M1. People hold money in M2 accounts because they can earn some interest on these deposits.

13-8 The Economic Importance of Money  How much money is available (the size of the money supply) affects consumers’ ability to purchase goods and services.  This directly affects aggregate demand (AD).

13-9 Creation of Money  Cash is either printed or coined. But cash is a very small part of M2.  How is the money in transactions accounts and savings accounts created?  These bank accounts are not physical lumps of cash. They are computer data entries.  A few keystrokes can increase or decrease the money in a bank account.

13-10 Creation of Money  Banks create money by making loans.  Grant a loan and increase the borrowers’ checking account with a few keystrokes.  Money is “created.”  The bank’s ability to create money is limited by the Federal Reserve System (the “Fed”).  Thus the Fed controls the basic money supply.

13-11 Fractional Reserves  The Fed controls a bank’s ability to create money by making loans.  Each bank is required to maintain a minimum reserve ratio.  Bank reserves: assets held by a bank to fulfill its deposit obligations.  Required reserves: the minimum amount of reserves a bank is required to hold.  Required reserve ratio: the ratio of a bank’s required reserves to its total deposits. Required reserves = Required reserve ratio x Total deposits

13-12 Fractional Reserves  Since the bank must set aside some of its deposits to satisfy its required reserves, it can make loans only on the remainder, called excess reserves.  Excess reserves: bank reserves in excess of required reserves.  A minimum reserve requirement directly limits deposit creation (lending) possibilities. Excess reserves = Total reserves – Required reserves

13-13 Changes in the Money Supply  When a bank makes a loan, money is created.  The borrower spends the money; the seller deposits it into the firm’s bank account.  That bank now has more excess reserves and can make a loan on it, creating more money.  When the new borrower spends the loan, this cycle continues to repeat itself.  Each time a new loan is made, the money supply increases.  There is a multiplier process going on, just like the income multiplier process in Chapter 10.

13-14 The Money Multiplier  Money multiplier: the amount of deposit dollars that the banking system can create from $1 of excess reserves. 1 Money multiplier = Required reserve ratio

13-15 The Money Multiplier  The potential of the money multiplier to create loans is summarized in this equation:  If the required reserve ratio is 0.20, the money multiplier is 5. An initial deposit of $100 has $80 of excess reserves and potentially can create $400 of new deposits. Excess reserves x Money multiplier = Potential deposit creation

13-16 Excess Reserves as Lending Power  If a bank has no excess reserves, it can make no more loans.  Each bank may lend an amount equal to its excess reserves and no more.  The entire banking system can increase the volume of loans by the amount of excess reserves multiplied by the money multiplier.

13-17 Banks and the Circular Flow  Banks perform two essential functions for the macro economy:  Banks transfer money from savers to spenders by lending funds held on deposit.  The banking system creates additional money by making loans in excess of required reserves.  Changes in the money supply may in turn alter spending behavior and thereby shift the aggregate demand (AD) curve.

13-18 Constraints on Deposit Creation  Deposits. If people prefer to hold onto cash, the deposit creation process will be severely hindered.  Willingness to lend. If banks are reluctant to take risks in lending, they will not fully lend out their excess reserves.  Willingness to borrow. If borrowers are reluctant to take on more debt, fewer loans will be made.  Regulation. The Fed may limit deposit creation by changing reserve requirements.

13-19 The Economy Tomorrow  Bank bailouts.  In 2008 a major banking crisis occurred, originating in the overheated housing industry.  Banks financed an upsurge in house prices in But prices began to fall in  Home values fell below the amount left on their mortgages, and many home owners ceased paying on their mortgages.  Bank assets (mortgages) declined, and many banks teetered on the brink of failing.  Large numbers of bank failures could lead the economy into a real depression.

13-20 The Economy Tomorrow  The federal government stepped in to “bail out” these banks.  Hundreds of billions of government dollars were pumped into the banking system to prop up the banks.  The purpose was to ensure that credit would continue to flow in the economy tomorrow.  When the economy recovered, the banks repaid the bailout money with interest.