1. Money and the Banking System
8-1
What Makes Money Money?
8-2
How Banks Create Money

2. What Makes Money Money? 8-1 LO1-1
Identify the three functions of money.
LO1-2
Explain two definitions of the money supply.

3. What Makes Money Money? 8-1 Exactly What Is Money? money
medium of exchange
unit of account
store of value
commodity money
fiat money
Money Supply Definitions
checkable deposits
time deposit

4. Exactly What Is Money?
Money is anything that people accept as payment for goods and services.
Money is not limited to dimes, quarters, and dollar bills.
Precious metals, beaver skins, and wampum (shells strung in belts) have all served as money.
8-1 What Makes Money Money?

5. Exactly What Is Money?
The most important function of money is to be widely accepted in trade for goods and services and thus serve as a medium of exchange.
In a simple society, barter is a way for participants to exchange goods and services to satisfy wants.
Money removes the problems of barter because everyone is willing to accept it as payment.
Money increases trade by providing a much more convenient method of exchange than a cumbersome barter system.
8-1 What Makes Money Money?

6. Exactly What Is Money?
The unit of account function of money provides a common measurement of the value of goods and services.
You can compare the value of two items using money.
In the United States, the monetary unit is the dollar. In Japan, the monetary unit is the yen. Mexico has a unit of a peso.
All these monetary units serve as a unit of account.
8-1 What Makes Money Money?

7. Store of value is the ability of money to hold value over time.
Exactly What Is Money?
Store of value is the ability of money to hold value over time.
Money serves as a store of value because it can be exchanged for some time in the future.
Money can be saved and spent in the future. However, the value will not necessarily remain constant.
Over time prices often rise, and the value of money declines.
8-1 What Makes Money Money?

8. Exactly What Is Money?
Commodity money is anything that serves as money that has market value based on the material from which it is made.
Fiat money is money accepted by law, and not because of its tangible value.
8-1 What Makes Money Money?

9. The Methodology of Economics
money
medium of exchange
unit of account
store of value
commodity money
fiat money
Debit cards are used to pay for purchases, and the money is automatically deducted from the user’s bank account. Are debit cards money?
Debit cards serve as a means of payment, and debit card statements serve as a unit of account. Debit cards serve as a store of value because they are a means of accessing checkable deposits and not an extension of credit. Debit cards are money because they serve all three functions required for money.
8-1 What Makes Money Money?

10. Money Supply Definitions
Checkable deposits are the total money in financial institutions that can be withdrawn by writing a check.
Checks eliminate trips to the bank, and they are safer than cash. If lost or stolen, checks can be replaced at little cost—currency cannot.
Checkable deposits and currency are considered M1.
A checking account balance is a bookkeeping entry. It is often called a demand deposit because it can be converted into cash “on demand.”
8-1 What Makes Money Money?

11. Money Supply Definitions
A time deposit is an account with guaranteed interest for a period of time.
M2, the broader definition of money, includes small time deposits. M2 is M1, savings deposits, and small time deposits of less than $100,000.
A small time deposit is less than $100,000. Time deposits over $100,000 are large time deposits.
Certificates of deposit (CDs) are deposits for a specified time, with a penalty charged for early withdrawal.
8-1 What Makes Money Money?

12. Money Supply Definitions
checkable deposits
time deposit
MI consists of coins, paper money, and checkable deposits. Does M2 also include these components?
The amount of M2 includes M1. Therefore, all components of M1 are part of M2.
8-1 What Makes Money Money?

13. Money Supply Definitions
checkable deposits
time deposit
Debt and credit cards are called “plastic money.” So are debit cards or credit card bal-ances included in the defin-ition of the money supply?
A debit card simply withdraws money from checkable deposits which are included in M1 and M2. Credit card balances are loans and not included in M1 and M2. Debit cards can be considered plastic money, but credit cards can’t.
8-1 What Makes Money Money?

14. How Banks Create Money 8-2 LO2-1 Explain how banks create money. LO2-2
Understand the calculation of the money multiplier.

15. How Banks Create Money 8-2 The Money Creation Process
fractional reserve banking
required reserves
Federal Reserve System
required reserve ratio
excess reserves
Multiplier Expansion of Money by the Banking System
money multiplier

16. The Money Creation Process
Fractional reserve banking is a system in which banks keep only a percentage of their deposits on reserve and lend out the remainder.
The medieval goldsmiths were the first to practice fractional reserve banking.
In a 100 percent reserve banking system, banks would be unable to create money by making loans. However, holding less than 100 percent on reserve allows banks to make loans. These loans create money in the economy.
8-2 How Banks Create Money

17. The Money Creation Process
Required reserves are the minimum balance of money that the Fed requires a blank to hold in cash or on deposit with the Fed.
The Federal Reserve System is the central banking system of the United States.
The Fed is the popular name for the Federal Reserve System.
8-2 How Banks Create Money

18. The Money Creation Process
The required reserve ratio (RRR) is the percentage of deposits the Fed requires a bank to hold in cash or on deposit with the Fed rather than being loaned.
Excess reserves are potential loan balances of reserves held on deposit with the Fed in excess of required reserves.
Excess reserves play a starring role in the banking system’s ability to change the money supply.
8-2 How Banks Create Money

19. The Methodology of Economics
fractional reserve banking
required reserves
Federal Reserve System
required reserve ratio
excess reserves
The key to banks creating money is that they make loans from their excess reserves. Do banks have to create loans with excess reserves? What reserves must banks not lend out?
Banks are not forced by the Fed to make loans. If banks do not make loans with excess reserves, they miss the opportunity to earn interest income. The Fed by law requires banks to hold required reserves in cash or with the Fed.
8-2 How Banks Create Money

20. Money Supply Definitions
The money multiplier gives the maximum change in the money supply (checkable deposits) due to an initial change in the excess reserves held by banks.
Economists use the money multiplier, or deposit multiplier, to derive the change in the money supply initiated by an initial deposit or withdrawal.
The money multiplier is equal to 1 divided by the required reserved ratio.
8-2 How Banks Create Money

21. Money Supply Definitions
money multiplier
If during a financial crisis, people lose confidence in the banking system and keep their cash on hand rather than depositing it in a bank, what happens to the money multiplier?
People make large account withdrawals. Banks hold less excess reserves to lend. During an economic downturn, more people are unemployed. Banks can hold excess reserves because they lack enough worthy loan applications. This causes the size of the money multiplier falls.
8-2 How Banks Create Money