1. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Money and Banks

2. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. The Uses of Money Imagine that there was no money. –Barter is the direct exchange of one good for another, without the use of money.

3. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. The Uses of Money Anything that serves all of the following purposes can be thought of as money: –Medium of exchange –Store of value –Standard of value

4. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. The Uses of Money Medium of exchange — accepted as payment for goods and services (and debts).

5. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. The Uses of Money Store of value — can be held for future purchases. Standard of value — measures price of goods and services

6. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. The Uses of Money Money facilitates market exchanges and specialization in production.

7. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Many Types of “Money” In history of the U.S. many things have been used as money. There were no U.S. dollars in the early days of Colonial America.

8. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Many Types of “Money” Greenbacks were issued in 1861 by the U.S. Federal government. Confederate states also issued paper money to finance their side of the U.S. Civil War.

9. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Cash vs. “Money” The concept of money includes more than dollar bills and coins. Checking accounts can and do perform the same market function as cash.

10. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Cash vs. “Money” Money is anything generally accepted as a medium of exchange.

11. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Transactions Accounts A bank account that permits direct payments to a third party (e.g., with a check).

12. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Transactions Accounts The balance in your transactions account substitutes for cash, and is, therefore, a form of money.

13. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Basic Money Supply The basic money supply is referred to by the abbreviation M1. M1 is currency held by the public, plus balances in transactions accounts.

14. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Basic Money Supply Cash is a small part of the money supply. Currency and coins account for less than a third of the basic money supply.

15. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Basic Money Supply Most money consists of balances in transactions accounts.

16. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Total money supply ($1,090 billion) Currency in circulation$537 Transactions-account balances $545 Travelers checks $8 BILLIONS OF DOLLARS Composition of the Basic Money Supply

17. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Composition of M1 Transaction-account balances Traveler’s checks Currency in circulation Credit cards are NOT money

18. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Near Money Savings accounts Certificates of deposit Money market mutual fund

19. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Aggregate Demand How much money people have may be one of the determinants of aggregate demand. –Aggregate demand is the total quantity of output demanded at alternative price levels in a given time period, ceteris paribus.

20. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Creation of Money The Bureau of Printing and Engraving and the U.S. Mint play only a minor role in creating money. Most of what we call money is not cash but bank balances.

21. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Deposit Creation A bank effectively creates money when it makes a loan. Transactions-account balances are counted as part of the money supply.

22. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Deposit Creation Transactions-account balances are the largest part of the money supply.

23. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Deposit Creation Banks create transactions-account balances by making loans.

24. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Deposit Creation Deposit creation — creation of transaction deposits by bank lending.

25. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. A Monopoly Bank To keep things simple, assume one bank in a town, and nobody regulates bank behavior.

26. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. A Monopoly Bank You deposit $100 from your piggy bank into the monopoly bank and receive a new checking account.

27. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. A Monopoly Bank When cash or coins are deposited in a bank, the composition of the money supply changes, not its size.

28. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. An Initial Loan The monopoly bank loans $100 to Campus Radio. It deposits $100 into Campus Radio’s checking account.

29. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. An Initial Loan The loan is accomplished by a simple bookkeeping entry. Money has been created because the checking account is considered to be money.

30. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. An Initial Loan Total bank reserves have remained unchanged. –Bank reserves are assets held by a bank to fulfill its deposit obligations.

31. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Using the Loan The money supply does not contract when Campus Radio spends the $100. The ownership of the deposit changes.

32. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Fractional Reserves Bank reserves are only a fraction of total transactions deposits.

33. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Fractional Reserves The reserve ratio is the ratio of a bank’s reserves to its total deposits.

34. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Fractional Reserves Ability of a monopoly bank to hold fractional reserves is based on two facts: –People use checks for most transactions. –There are no other banks.

35. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Reserve Requirements If a bank could create money at will, it would have a lot of control over aggregate demand. In reality, no private bank has that much power.

36. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Reserve Requirements The power to create money resides in the banking system, not in any single bank.

37. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Reserve Requirements The Federal Reserve System requires banks to maintain some minimum reserve ratio.

38. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Required Reserves Required reserves are the minimum amount of reserves a bank is required to hold by government regulation

39. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Required Reserves Required reserves are equal to the required reserve ratio times transactions deposits.

40. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Required Reserves The minimum reserve requirement directly limits deposit-creation possibilities.

41. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Excess Reserves Excess reserves are bank reserves in excess of required reserves.

42. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Excess Reserves The ability of banks to make loans depends on access to excess reserves.

43. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Excess Reserves If a bank currently has $100 in reserves and is required to hold $75, it can lend out the $25 excess.

44. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Excess Reserves

45. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Excess Reserves So long as a bank has excess reserves it can make loans.

46. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. A Multi-Bank World In reality there is more than one bank in town. The key issue is not how much excess reserves any specific bank holds. It is how much excess reserves exist in the entire banking system.

47. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. The Money Multiplier Excess reserves are the source of bank lending authority. The cumulative amount of new loans is determined by the money multiplier.

48. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. The Money Multiplier The money multiplier is the number of deposit (loan) dollars that the banking system can create from $1 of excess reserves.

49. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. The Money Multiplier Process Initial deposit of $100 made at University Bank.

50. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. The Money Multiplier Process University Bank keeps $75 (75% of the $100 new deposit) on reserve and loans out $25 which is deposited in Bank Two.

51. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. The Money Multiplier Process Bank Two keeps 75% of the new deposit on reserve ($18.75) and loans out $6.25.

52. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. The Money Multiplier Process Bank three keeps 75% of the new deposit on reserve ($4.69) and loans out $1.56. Etc., etc., etc.

53. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. The Money Multiplier Process Initial deposit ($100) Bank #2 Bank #4 Bank #3 University Bank Loan $25Loan $6.25Loan $1.56 Deposit etc.

54. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Limits of Deposit Creation The potential of the money multiplier to create loans is summarized by the equation:

55. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Limits of Deposit Creation If the required reserve ratio =.75: –The multiplier = 1.33 If the banking system has $25 in excess reserves: –Potential deposit creation is $25 x 1.33 = $33.25

56. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Excess Reserves as Lending Power Each bank may lend an amount equal to excess reserves and no more.

57. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Excess Reserves as Lending Power The entire banking system can increase the volume of loans by the amount of the system’s excess reserves multiplied by the money multiplier.

58. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. The Macro Role of Banks Since virtually all market transactions involve the use of money, banks must have some influence on macro outcomes.

59. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Financing Aggregate Demand Banks perform two functions: –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 total reserves.

60. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Financing Aggregate Demand Increases in money supply tend to increase aggregate demand. Aggregate demand declines when the money supply shrinks.

61. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Financing Aggregate Demand The banking system can create any desired level of money supply if allowed to expand or reduce loan activity at will.

62. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Loans Saving Investment expenditures Sales receipts Wages, dividends, etc. Incom e Domestic consumption Banks in the Circular Flow Business firms Consumers BANKS Factor markets Product markets

63. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Constraints on Lending Activity There are four major constraints on the ability of banks to make loans.

64. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Bank Deposits Willingness of consumers and businesses to continue using and accepting checks rather than cash.

65. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Willing Borrowers Willingness of consumers and businesses and governments to borrow money from banks.

66. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Willing Lenders Banks may not be willing to satisfy credit demands choosing instead to hold excess reserves.

67. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Government Regulation The Federal Reserve regulates bank lending practices.

68. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Digital Money The most common forms of money cannot be used as a medium of exchange in electronic malls.

69. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Credit Cards Almost all Internet purchases are completed with a credit card.

70. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Credit Cards Dependence on credit cards limits the potential of e-commerce because of: –Security issues such as credit card number theft. –Use and sale of credit card databases by e-retailers for undisclosed purposes.

71. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. E-Payments Some companies offer a quasi-banking service by storing purchasing power that consumers and e-retailers can access.

72. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. E-Payments Consumers must "deposit" e-cash with credit card advances.

73. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Speed of Spending Consumers still need cash and checking-account balances to pay for their e-purchases.

74. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Speed of Spending Virtual malls allow consumers to spend money balances faster, thereby boosting aggregate demand.

75. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Money and Banks End of Chapter 13