13e

Chapter 13:
Money and Banks

McGraw-Hill/Irwin

Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Money
In this chapter we examine the role
of money in the economy. Specifically
What is money?
How is money created?
What role do banks play in the circular
flow of income and spending?

13-2

Learning Objectives
13-01. Explain what money is.
13-02. Describe how banks create
money.
13-03. Demonstrate how the money
multiplier works.

13-3

What Is Money?
Money is a tool that greatly simplifies
market transactions.
No money? Transactions would be made
using a barter system.
Barter: the direct exchange of one good for
another, without the use of money.

Money acts as a medium of exchange.

Sellers will accept it as payment for goods
and services.
Money: anything generally accepted as a
medium of exchange.
13-4

The Money Supply

Anything that serves all the following
purposes can be thought of as money:
Medium of exchange: accepted as payment
for goods and services (and debts).
Store of value: can be held for future
purchases.
Standard of value: serves as a yardstick for
measuring the prices of goods and services.

13-5

Modern Concepts
Cash is obviously money because it fills all
three purposes.
Checking accounts perform the same market
functions as cash. Debit cards act much like a
check, so they are money.
Online payment systems and credit cards do
not. They can be a medium of exchange but
do not fulfill the other purposes.
The essence of money is not its physical form,
but its ability to purchase goods and services.
13-6

Composition of the Money

Supply
Some bank accounts are better
substitutes for cash than others.
M1: cash and transactions accounts
Transactions accounts include checking
accounts and travelers checks.
Money supply (M1): currency held by the
public, plus balances in transactions accounts.
M1 permits direct payment for goods and
services.
13-7

Composition of the Money

Supply
M2: M1 plus savings accounts, etc.
Savings account balances and money
market mutual funds are almost as good a
substitute for cash as transactions
accounts.
Money supply (M2): M1 plus balances in
most savings accounts and money market
mutual funds.
M2 must be turned into M1 before it can be
used to purchase goods and services.
13-8

Composition of the Money

Supply
Cash is about half of
the M1 money supply.
Most of the rest are
transactions account
balances.
M2 is much larger than
M1. People hold money
in M2 accounts
because they can earn
some interest on these
deposits.
13-9

The Economic Importance of

Money
How much money is available (the
size of the money supply) affects
consumers ability to purchase goods
and services.
This directly affects aggregate
demand (AD).

13-10

Creation of Money
Cash is either printed or coined. But cash
is a very small part of M2.
How is the money in transactions
accounts and savings accounts created?
These bank accounts are not physical lumps
of cash. They are computer data entries.
A few keystrokes can increase or decrease
the money in a bank account.

13-11

Creation of Money
Banks create money by making loans.
Grant a loan and increase the borrowers
checking account with a few keystrokes.
Money is created.

The banks ability to create money is

limited by the Federal Reserve System
(the Fed).
Thus the Fed controls the basic money
supply.
13-12

Fractional Reserves
The Fed controls a banks ability to create
money by making loans.
Each bank is required to maintain a minimum
reserve ratio.
Bank reserves: assets held by a bank to fulfill its
deposit obligations.
Required reserves: the minimum amount of
reserves a bank is required to hold.
Required reserve ratio: the ratio of a banks
required reserves to its total deposits.
Required reserves = Required reserve ratio x Total deposits
13-13

Fractional Reserves
Since the bank must set aside some of
its deposits to satisfy its required
reserves, it can make loans only on the
remainder, called excess reserves.
Excess reserves: bank reserves in excess of
required reserves.
Excess reserves = Total reserves Required reserves

A minimum reserve requirement directly

limits deposit creation (lending) possibilities.

13-14

Changes in the Money

Supply
When a bank makes a loan, money is created.
The borrower spends the money; the seller deposits
it into the firms bank account.
That bank now has more excess reserves and can
make a loan on it, creating more money.
When the new borrower spends the loan, this cycle
continues to repeat itself.
Each time a new loan is made, the money supply
increases.

There is a multiplier process going on, just like

the income multiplier process in Chapter 10.
13-15

The Money Multiplier

Money multiplier:
the amount of
deposit dollars that
the banking system
can create from $1
of excess reserves.
Money multiplier =

Required
reserve ratio

13-16

The Money Multiplier

The potential of the money multiplier to
create loans is summarized in this equation:
Excess reserves x Money multiplier = Potential deposit creation

If the required reserve ratio is 0.20, the

money multiplier is 5. An initial deposit of
$100 has $80 of excess reserves and
potentially can create $400 of new
deposits.
13-17

Excess Reserves as Lending

Power
If a bank has no excess reserves, it can
make no more loans.
Each bank may lend an amount equal
to its excess reserves and no more.
The entire banking system can increase
the volume of loans by the amount of
excess reserves multiplied by the
money multiplier.
13-18

Banks and the Circular Flow

Banks perform two essential functions
for the macro economy:
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 required
reserves.

Changes in the money supply may in

turn alter spending behavior and thereby
shift the aggregate demand (AD) curve.
13-19

Constraints on Deposit
Creation
Deposits. If people prefer to hold onto cash, the
deposit creation process will be severely
hindered.
Willingness to lend. If banks are reluctant to
take risks in lending, they will not fully lend out
their excess reserves.
Willingness to borrow. If borrowers are reluctant
to take on more debt, fewer loans will be made.
Regulation. The Fed may limit deposit creation
by changing reserve requirements.
13-20

The Economy Tomorrow

Bank bailouts.
In 2008 a major banking crisis occurred,
originating in the overheated housing
industry.

Banks financed an upsurge in house prices in

2002-2006. But prices began to fall in 2007.
Home values fell below the amount left on their
mortgages, and many home owners ceased
paying on their mortgages.
Bank assets (mortgages) declined, and many
banks teetered on the brink of failing.
Large numbers of bank failures could lead the
economy into a real depression.
13-21

The Economy Tomorrow

The federal government stepped in to
bail out these banks.
Hundreds of billions of government dollars
were pumped into the banking system to
prop up the banks.
The purpose was to ensure that credit would
continue to flow in the economy tomorrow.

When the economy recovered, the banks

repaid the bailout money with interest.

13-22

Revisiting the Learning

Objectives
13-01. Explain what money is.
It is anything generally accepted in
exchange that serves as a store of value
and acts as a standard of value.
Money supply M1 includes cash plus
transactions account deposits.
Money supply M2 includes M1 plus savings
account and other account balances.

13-23

Revisiting the Learning

Objectives
13-02. Describe how banks create
money.
Banks create money by making loans
using excess reserves.
Each loan becomes a new transactions
deposit.
This enables banks to transfer money
from savers to spenders.
13-24

Revisiting the Learning

Objectives
13-03. Demonstrate how the money
multiplier works.
As loans are spent, they create deposits
elsewhere, making it possible for other
banks to make additional loans.
This multiplier effect is controlled by the
Fed when it sets the required reserve
ratio. The money multiplier is the
reciprocal of the required reserve ratio.
13-25