Chapter 12: Money and Banking

1
Chapter 12 Money and Banking

• Money--anything widely accepted in exchange for
  goods payments
• Functions
• Medium of Exchange
• Unit of Account
• Store of Value
• Acceptability as medium of exchange gives its
  value

2
Two Definitions of Money Supply

• M1 Currency outside banks Demand Deposits
  and Other Checkable Deposits Travelers checks
  
• Checkable Deposits Funds against which checks
  can be written
• M1 measures actual medium of exchange

3

• M2 M1 Small Denomination Time Deposits
  Savings Deposits -Market Accts. Overnight
  Repo Agreements Overnight Euro- Deposits
• Time Deposits Interest-earning Deposits lt 100K
  with specific maturity date
• Savings Deposits Interest-earning deposits
  without specific maturity or maximum value
• Money Market Accts Invest savings in
  short-term instruments can write checks
• M2 more broadly defines money supply
• Highly liquid assets public holds

4
Banking System and Money Creation

• Federal Reserve System
• US central bank, controls -supply
• Fractional Reserve Banking System
• Banks create money by holding only portion of
  deposits on reserve
• Bank Reserves
• Cash in vault plus funds on account at Fed
  (neither earn interest)

5
Banking System and Money Creation (cont.)

• Required Reserves
• Amount Fed requires banks hold on reserve
• Required-Reserve Ratio ( r ) deposits
  required on reserve
• Required Reserves (r) x (total deposits)
• Excess Reserves
• Bank reserves excess of required reserves
• Banks may lend excess reserves, increasing
  -stock and thus creating money

6
Money Creation Process(e.g., required-reserve
ratio is 10)

• Person 1 deposits 100 at Bank A
• Bank As assets
• 10 of deposit required- reserve
• Remaining 90 it can loan
• Liabilities
• 100 obligation to depositor

Bank As T-account
Assets
Liabilities
Deposits 100
Reserves 10
Excess Reserves 90
7
Money Creation Process (cont.)
Bank As T-account

• Bank A loans 90 (excess reserves) to Person 2,
  who deposits it at Bank B
• Bank B keeps 9 on required-reserve, and loans
  81 excess reserves

Assets
Liabilities
Deposits 100
Reserves 10
Excess Reserves 90
Bank Bs T-account
Assets
Liabilities
Reserves 9
Deposits 90
Excess Reserves 81
8
Money Creation Process (cont.)
Bank Bs T-account

• Bank B loans 81 (excess reserves) to Person 3,
  who deposits it at Bank C
• Bank C keeps 8.10 on reserve, loans 72.90
• Process continues
• Each time deposited, more created

Assets
Liabilities
Deposits 90
Reserves 9
Excess Reserves 81
Bank Cs T-account
Assets
Liabilities
Reserves 8.10
Deposits 81
Excess Reserves 72.90
9
How Much Money is Created in Economy?
Sum of Checkable Deposits Created
Original Deposit 100.00

• Bank As Lending 90.00 ( 0.9x100)

Bank Bs Lending 81.00 ( 0.9x90)
Bank Cs Lending 72.90 ( 0.9x81)

Total Money Created 1,000
10
Money (Simple-Deposit) Multiplier

• Money Multiplier
• Amount of system creates with extra
  reserves
• 100 of extra reserves created 1,000 of money
• Money multiplier 1/(r)
• Higher the r, lower the money multiplier
• If banking system has 1,000 deposits, then 10
  reserve ratio means banks must have 100 reserves
• Or, if banking system has 100 in reserves, it
  can have up to 1,000 in deposits