Money and Banking

Del Mar College, John Daly

2002 South-Western Publishing, A Division of Thomson Learning

Money and its Function

Money is any good that is widely accepted for
purposes of exchange and in the repayment of
debts.
Money reduces transaction costs because it is a
medium of exchange.
Money is a term of account. We dont have to
keep prices in oranges, apples, or computers;
money provides this role for us.
Money is a store of value, it maintains its value
over time. We accept payment for our efforts and
keep money until we spend it.

Money Vs. Barter

Making exchanges takes longer in a barter system:
not only do you have to find something you want,
but you have to have something the seller wants as
well.
Some goods are more readily accepted than other
goods.
Historically, goods that have evolved into money
are: gold, silver, copper, cattle, rocks, and shells.

Money, Leisure, and Output

A money based economy
frees up time spent
looking for someone
interested in your goods,
who has something you
want.
A persons standard of
living is, to a degree,
dependent on the number
and quality of goods he
consumes and the amount
of leisure he consumes.

What Gives Money its Value?

Our money has value because of its general
acceptability.
We accept paper dollars because we know
that other people will accept dollars later
when we try to spend them.
Money has value to people because it is
widely accepted in exchange for other
goods that are valuable.

Greshams Law: Good Money

and Bad Money
Bad money drives
good money out of
circulation.
In truth, bad money
drives out good money
if both moneys have
the same face value,
have different intrinsic
values, and are fixed at
an exchange rate of
one to one.

Defining the Money Supply

M1 is sometimes
referred to as the
narrow definition of
the money supply or as
transactions money.
M1 consists of
currency held outside
banks, checkable
deposits, and travelers
checks.

Defining the Money Supply: M2

M2 is sometimes referred to as the broad
definition of the money supply.
M2 is made up of M1 plus smalldenomination time deposits, savings
deposits, money market accounts, overnight
repurchase agreements, and overnight
eurodollar deposits held by US residents.

Where Do Credit Cards Fit In?

A credit card is an instrument or document
that makes it easier for the holder to obtain
a loan.
Credit card transactions shift around the
existing quantity of money between various
individuals and firms, but do not change to
total money available.

Q&A
Why (not how) did money evolve out of a
barter economy?
If individuals remove funds from their
checkable deposits and transfer them to
their money market accounts, will M1 fall
and M2 rise? Explain your answer.
How does money reduce the transaction
costs of making exchanges?

How Banking Developed

Early bankers used
goldsmiths warehouse
receipts.
Early bankers began to
issue receipts for more
gold than they had on
hand.
This was the
beginning of fractional
reserve banking.

The Federal Reserve System

Commonly called The Fed, this is the
central bank of the United States.
The Fed is essentially a banks bank.
The Feds chief function is to control the
nations money supply.

The Money Creation Process

The sum of bank deposits at the Fed and the
banks cash vault is total bank reserves.
The Fed mandates member commercial banks to
hold a certain fraction of their checkable deposits
in reserve form. This fraction is called the
required reserve ratio.
The difference between a banks total reserves and
its required reserves is its excess reserves.

The Banking System and The

Money Creation Process
The process starts with the Fed.
The Fed prints the funds, and Jack deposits the
funds in his bank.
The Reserves of the bank increases, while the
reserves of no other bank decreased.
The banking system made loans and in the process
created checkable deposits for the people who
received the loans.
Remember, checkable deposits are part of the
money supply. So, in effect, by extending loans,
and in the process creating checkable deposits, the
banking industry has increased the money supply.

The Banking System Creates

Checkable Deposits (Money)

The Money Expansion Process

When the $9000 that bankers created in new
checkable accounts is added to the $1000 the Fed
initially printed, we see that $10,000 has been
added to the money supply.
Maximum change in checkable deposits = (1/r) x R

Where r = the required reserve ratio and R is the

change in reserves resulting from the original
injection of funds.
In the formula, (1/r) is known as the simple
deposit ratio.

Assumptions in the Money

Expansion Process
All monies were deposited in bank
checking accounts.
Every bank lent all its excess reserves,
leaving every bank with zero excess
reserves.
Because we assumed no cash leakages and
zero excess reserves, the change in
checkable deposits is the maximum possible
change.

Who Created What?

The money expansion
process has two major
players: the Fed, and
the Banking System.
The maximum change
in bankable deposits is
equal to: (1/r) x ER,
where ER is the excess
reserves.

The Money Contraction Process

This process is the Money Creation process
in reverse

Q&A
If a banks deposits equal $579 million and the
required-reserve ratio is 9.5%, what dollar amount
must the bank hold in reserve form?
If the Fed creates $600 million in new reserves,
what is the maximum change in checkable
deposits that can occur if the required-reserve ratio
is 10%?
Bank A has $1.2 million in reserves and $10
million in deposits. The required-reserve ratio is
10%. If Bank A loses $200,000 in reserves, by
what dollar amount is it reserve deficient?