1. Ec 123 Section 11 THIS SECTION –Course Introduction –The Money Supply Process –The Price of Money NEXT –Case: The U.S. Financial Crisis of 1931 Purchase from Edith Quintanalla for $3 in Baxter 301. Read before class and prepare money worksheets (on website) and short response.

2. Ec 123 Section 12 Money: What is it? Money is anything that has the following three functions: 1.a medium of exchange 2.the unit of account 3.a store of value The last two features are not unique to money. Almost any durable commodity or asset could fulfill these roles. Medium of exchange is the unique, and most important, feature. What makes for a good medium of exchange? –Cigarettes were Poland’s unofficial currency in the early ‘80’s. –The key is liquidity.

3. Ec 123 Section 13 Money: What is it? Liquidity is the degree of ease and speed with which a commodity can be used to purchase goods and services. Most all commodities are liquid to some extent. Hence what we label as “money” is a matter of degree. Rank the following from most liquid to least liquid: –a check drawn on a standard demand deposit –cash –bank certificate of deposit –money market mutual fund –mortgage backed security

4. Ec 123 Section 14 The M1 definition of money We will temporarily adopt a narrow definition of money known as M1: M1 = currency + demand deposits There is also M2, M3, L. Why focus on M1?

5. Ec 123 Section 15

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7. 7 Money: Where does it come from? In modern economies, the creation of money begins with a central bank. The central bank in the U.S. is the Federal Reserve. Like all banks, it keeps a balance sheet. –The liability side of the balance sheet is known as the monetary base (or high powered money or reserve money). The Fed expands the money supply by adding to the monetary base

8. Ec 123 Section 18 Source: Federal Reserve “The Federal Reserve System: Purposes & Functions” 2005.

9. Ec 123 Section 19 Money Supply Example Suppose the Fed buys $113.50 in Treasury bills from a private investor. The investor keeps $13.50 in his pocket (12%), and puts $100 into a checking account (a demand deposit) at Bank 1: Bank 1 AssetsLiabilities CashDemand Deposits Required Reserves Excess Reserves Loans Total $100

10. Ec 123 Section 110 Money Supply Example 2 Bank 1 keeps 15% of the $100 in reserve and makes an $85 loan to a farmer. Bank 1 AssetsLiabilities CashDemand Deposits Required Reserves Excess Reserves Loans Total $100 $15 $85 $100 $85

11. Ec 123 Section 111 Money Supply Example 3 The farmer uses the $85 to buy fertilizer. The dealer keeps $10 (12%) in cash and deposits $75 in his bank. Bank 2 AssetsLiabilities CashDemand Deposits Required Reserves Excess Reserves Loans Total $75

12. Ec 123 Section 112 Money Supply Example 4 Bank 2 keeps 15% of the $75 in reserve and has $63.75 to lend to a customer–$63.75 that did not previously exist. Money creation continues in this manner. Bank 2 AssetsLiabilities CashDemand Deposits Required Reserves Excess Reserves Loans Total $11.25 $63.75 $75.00

13. Ec 123 Section 113 The Money Supply Process How much money will ultimately be created? –Must consider the leakages out of the system. –2 main types: Cash Leakage Reserve Leakage –Total Proportion of leakages: R = cash + reserve(1-cash)

14. Ec 123 Section 114 The Money Supply Process

15. Ec 123 Section 115 What is the price of money? Two answers!

16. Ec 123 Section 116

17. Ec 123 Section 117 How banks make money: Summary The key characteristic of money is liquidity. Central banks influence the money supply through changes in the monetary base and reserve requirements. Private banks influence the money supply through the money multiplier process. Money is a commodity it usually trades on price.