CHAPTER OUTLINE

25

THE MONEY SUPPLY AND THE BANKING SYSTEMAn Overview of Money

What Is Money?Commodity and Fiat MoniesMeasuring the Supply of MoneyThe Private Banking System

How Banks Create MoneyThe Modern Banking SystemThe Creation of MoneyThe Money Multiplier

How the Central Bank Controls the Money Supply

Money anything that is generally accepted in payment for

goods or services or in the repayment of debts

For economists:

Money is the set of assets in the economy that people regularly use

to buy goods and services from each other.

Money is anything that can perform the functions:

Medium of exchange (used to pay for goods and services)

Unit of account (used to measure value in the economy)

Store of value (used as a repository of purchasing power over time)

AN OVERVIEW OF MONEY

The three basic functions of money are:

medium of exchange or means of payment

What sellers generally accept and buyers generally use to pay for goods

and services.

store of valueAn asset that can be used to

transport purchasing power from one time period to another.

unit of account A standard unit that provides a

consistent way of quoting prices.

FUNCTIONS OF MONEY

Barter - the direct exchange of goods and services for other goods

and services.

Liquidity Property Of Money

The property of money that makes it a good

medium of exchange as well as a store of value: It is portable and readily accepted and thus easily

exchanged for goods.

THE KINDS OF MONEY

Commodity monies Items used as money that also have intrinsic value

in some other use.

Fiat, or token, money Items designated as money that are intrinsically

worthless.

legal tender Money that a government has required to be

accepted in settlement of debts.

currency are the paper bills and coins in the hands of the

public.

currency debasement The decrease in the value of money that occurs when

its supply is increased rapidly.

Which of these are money?

a. Currency

b. Checks

c. Deposits in checking accounts

(called demand deposits)

d. Credit cards

DISCUSSION QUESTION:

MEASURING THE SUPPLY OF MONEY

Central Bankan institution designed to oversee the

banking system and regulate the quantity of money in the economy.

The two most common measures of money are :

transactions money, also called M1, andbroad money, also called M2.

Exact classifications of M1 and M2 depend on the country.

M1 - Money that can be directly used for transactions.

M2 - M1 plus savings accounts, money market accounts, and other near monies.

near monies Close substitutes for transactions money, such as savings accounts and money market accounts.

MEASURING THE SUPPLY OF MONEY

M1 ≡ currency held outside banks + demand deposits + traveler’s checks + other checkable deposits

M2 ≡ M1 + savings accounts + money market accounts +other near monies

MONETARY AGGREGATES

TURKEY:

M1 = Currency in circulation + Demand deposits

M2= M1 + Time deposits

financial intermediaries Banks and other institutions that act as a link

between those who have money to lend and those who want to borrow money.

THE PRIVATE BANKING SYSTEM

The main types of financial intermediaries are

commercial banks, followed by savings and loan

associations, life insurance companies, and pension

funds.

HOW BANKS DO BUSINESS

THE MODERN BANKING SYSTEMA BRIEF REVIEW OF ACCOUNTING

Central to accounting practices is the statement that

“the books always balance” Assets − Liabilities ≡ Net

Worthor

Assets ≡ Liabilities + Net WorthAssets

Any item of economic value owned by an individual or corporation, especially that which could be converted to

cash.Liabilities

Obligations of a company or organization.Net Worth

Difference between what it owns and what it owes.

T-ACCOUNT FOR A TYPICAL BANK (millions of dollars)

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).

reserves The deposits that a bank has at the Central bank plus its

cash on hand. required reserve ratio

The percentage of its total deposits that a bank must keep as reserves at the Central bank.

THE CREATION OF MONEY

excess reserves ≡ actual reserves − required reserves

Excess reserves bank reserves in excess of the reserve

requirement.

Required reserves the amount of reserves that banks are required to hold, determined by the central bank as a function

of a bank's deposit liabilities.

THE CREATION OF MONEY WHEN THERE ARE MANY BANKS

In panel 1, there is an initial deposit of $100 in bank 1. In panel 2, bank 1 makes a loan of $80 by creating a deposit of $80. A check for $80 by the borrower is then written on bank 1 (panel 3) and deposited in bank 2 (panel 1). The process continues with bank 2 making loans and so on. In the end, loans of $400 have been made and the total level of deposits is $500.

BALANCE SHEETS OF A BANK IN A SINGLE-BANK ECONOMY

In panel 2, there is an initial deposit of $100. In panel 3, the bank has made loans of $400.

THE MONEY MULTIPLIER

An increase in bank reserves leads to a greater than one-for-one increase in the money supply.

Economists call the relationship between the final change in deposits and the change in reserves that

caused this change the money multiplier.

money multiplier

The multiple by which deposits can increase for every dollar increase in reserves; equal to 1 divided

by the required reserve ratio.

ratio reserve required

1 multiplier money

HOW THE CENTRAL BANKS (CB) CONTROLS THE MONEY SUPPLY

Central banks in different countries (Fed in USA) control the money supply (M1): If the Fed wants to

increase the supply of money, 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.

Three tools are available to the Fed for changing the money supply:

(1) Changing the required reserve ratio.

(2) Changing the discount rate.

(3) Engaging in open market operations.

Decreases in the required reserve ratio allow banks to have more deposits

with the existing volume of reserves.

As banks create more deposits by making loans, the supply of money

(currency + deposits) increases.

The reverse is also true: If the Central bank wants to restrict the supply of money, it can raise the required reserve ratio, in which case banks will find that they have insufficient reserves and must therefore reduce

their deposits by “calling in” some of their loans.

The result is a decrease in the money supply.

THE REQUIRED RESERVE RATIO

THE DISCOUNT RATE

discount rate The interest rate that banks pay to the Central

bank to borrow from it.

moral suasion The pressure that in the past the Fed exerted on

member banks to discourage them from borrowing heavily from the Fed.

OPEN MARKET OPERATIONS

open market operations The purchase and sale by the Central bank 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.

TWO BRANCHES OF GOVERNMENT DEAL IN GOVERNMENT SECURITIES

The Treasury Department is responsible for collecting taxes and paying the federal government’s bills.

THE MECHANICS OF OPEN MARKET OPERATIONSWe can sum up the effect of these open market operations this way: 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.