1. Chapter 23
The Money Supply

2. Topics to be covered What is money Commodity Vs Fiat Money
Measuring the supply of money
How banks create money
-Goldsmiths
-Modern Banking System
-The Creation of Money
-The Money Multiplier

3. An Overview of Money
Money is anything that is generally accepted as a medium of exchange.
Money is not income, and money is not wealth. Money is:
a means of payment,
a store of value, and
a unit of account.

4. Money: A means of payment
Money as a means of payment, or medium of exchange, is more efficient than barter.
Barter is 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. Money eliminates this problem.
Money is a lubricant in the functioning of a market economy.

5. Money: A store of value
Money as a store of value refers to money as an asset that can be used to transport purchasing power from one time period to another.
Money is easily portable, comes in convenient denominations and easily exchanged for goods at all times. The liquidity property of money makes money a good medium of exchange as well as a store of value.
The main disadvantage of money as a store of value is that the value of money falls when price of goods and services rise

6. Money: A unit of account
Money also serves as a unit of account, or a standard unit that provides a consistent way of quoting prices.
1 loaf of bread = 2 Dairy Milk Chocolates !!!!!!

7. Commodity Money Vs Fiat Money
Commodity monies are items used as money that also have intrinsic value in some other use. E.g.- Gold, candy bars, cigarettes, etc
Fiat, or token, money is money that is intrinsically worthless.
Legal tender is money that a government has required to be accepted in settlement of debts –it does this by fiat.
Currency debasement- the decrease in the value of money that occurs when its supply is increasing rapidly.

8. Measuring the Supply of Money
The two most common measures of money are M1 and M2.
M1, or transactions money is money that can be directly used for transactions. It includes:
M1= currency held outside banks + demand deposits + traveler’s checks+ other checkable deposits
A checkable deposit is any deposit with a bank or any financial institution on which a check can be drawn.
M1 is a stock measure—it is measured at a point in time—on a specific day.

9. Measuring the Supply of Money
M2, or broad money, includes near monies, or close substitutes for transactions money.
M2 = M1 + savings accounts + money market accounts + other near monies
The main advantage of looking at M2 instead of M1 is that M2 is sometimes more stable.
Beyond M2…..credit cards!!!!
However there is no specific rule to decide what is money and what is not

10. The Private Banking System
Financial intermediaries are banks and other financial institutions that act as a link between those who have money to lend and those who want to borrow money.
E.g.- commercial banks, insurance companies, pension funds, etc.

11. How Banks Create Money
To see how banks create money, consider the origins of the modern banking system:
Goldsmiths functioned as warehouses where people stored gold for safekeeping.
Upon receiving the gold, a goldsmith would issue a receipt to the depositor. After a time, these receipts themselves, rather than the gold that they represented, began to be traded for goods.
At this point, all the receipts issued were backed 100 percent by gold.

12. How Banks Create Money
Goldsmiths realized that people did not come often to withdraw gold and, as a result, they had a large stock of gold continuously on hand. They could lend out some of this gold without any fear of running out.
There were thus more claims than there were ounces of gold.

13. How Banks Create Money
Knowing there were more receipts outstanding than there were ounces of gold, people might start to demand gold for receipts.
A run on a goldsmith (or a modern-day bank) occurs when many people present their claims at the same time.

14. The Modern Banking System
A brief review of accounting:
Assets – liabilities = Net Worth, or
Assets = Liabilities + Net Worth
A bank’s most important assets are its loans. Other assets include cash on hand (or vault cash) and deposits with the Central Bank.
The Federal Reserve System (the Fed) is the central bank of the United States.
A bank’s liabilities are the promises to pay, or IOUs, that it has issued. A bank’s most important liabilities are its deposits.

15. Reserves
Reserves are deposits that banks keep with the Central Bank plus its cash in hand.
Required Reserve Ratio- the % of the total deposits that a bank must keep as reserves with its Central Bank.

16. T-Account for a Typical Bank
The balance sheet of a bank must always balance, so that the sum of assets (reserves and loans) equals the sum of liabilities (deposits and net worth).
T-Account for a Typical Bank (millions of dollars)
ASSETS
LIABILITIES
Reserves 20
100
Deposits
Loans 90 10
Net worth
Total
110

17. 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 (or up to the point where their excess reserves are zero).
Banks can make loans only when they have excess reserves.
When bank has no excess reserves and thus cannot make any further loan, it is said to be loaned up.

18. The Creation of Money
When someone deposits $100, and the bank deposits the $100 with the central bank, it has $100 in reserves.
If the required reserve ratio is 20%, the bank has excess reserves of $80. With $80 of excess reserves, the bank can lend $400 and have up to $400 of additional deposits. The $100 in reserves plus $400 in loans equal $500 in deposits.

19. The Creation of Money
Balance Sheets of a Bank in a Single-Bank Economy
Panel 1
Panel 2
Panel 3
ASSETS
LIABILITIES
Reserves 0
0 Deposits
Reserves 100
100 Deposits
500 Deposits
Loans 400

20. The Creation of Money
The Creation of Money: Balance Sheets of Three Banks
Panel 1
Panel 2
Panel 3
ASSETS
LIABILITIES
Reserves 100
100 Deposits
Reserves 100 Loans 80
180 Deposits
Reserves 20 Loans 80
Reserves 80
80 Deposits
Reserves 80 Loans 64
144 Deposits
Reserves 16 Loans 64
Reserves 64
64 Deposits
Deposits
Reserves 12.80
Summary:
Deposits
Bank 1
100
Bank 2 80
Bank 3 64
Bank 4 51
.20
. . .
Total
500
.00

21. The Money Multiplier
The money multiplier is the multiple by which deposits can increase for every dollar increase in reserves.
If the required reserve ratio is 10%, then an increase in reserves of $1 could cause an increase in deposits of $10 if there were no leakage out of the system.

22. Functions of the Fed
The Fed performs important functions for banks including:
Clearing interbank payments.
Regulating the banking system.
Assisting banks in a difficult financial position.
Managing exchange rates and the nation’s foreign exchange reserves.
Control of mergers between banks.
Examination of banks to ensure that they are financially sound.
Setting of reserve requirements for all financial institutions.
Lender of last resort.

23. How the Fed Controls the Money Supply
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.
If the Fed wants to increase the money supply, 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.

24. The Discount Rate
Banks may borrow from the Fed. The interest rate they pay the Fed is the discount rate.
Bank borrowing from the Fed leads to an increase in the money supply. The higher the discount rate, the higher the cost of borrowing, and the less borrowing banks will want to do.
In practice, the Fed does not often use the discount rate to control the money supply.
The discount rate cannot be used to control the money supply with great precision, because its effects on banks’ demand for reserves are uncertain.
Moral suasion is the pressure exerted by the Fed on member banks to discourage them from borrowing heavily from the Fed.

25. Open Market Operations
Open market operations is the purchase and sale by the Fed 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.
Open market operations is by far the most significant tool of the Fed for controlling the supply of money.

26. Open Market Operations
An open market purchase of securities by the Fed 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 Fed 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.