is whatever is generally accepted in exchange for goods and services — accepted not as an object to be consumed but as an object that represents a temporary abode of purchasing power to be used for buying still other goods and services.”

— Milton Friedman (1992)

What is Money?1. A medium of exchange:

Used to buy and sell goods and services.Avoids barter

2. A store of value: Allows transfer of purchasing power from one period to another.

3. A measure of value:Converts worth to a monetary value.

4. A standard of deferred payment:Makes future payments possible.

1. Commodity Money:

has value itself, deer skins2. Fiat money:

just because

1. Acceptable:

used by most people2. Standardized quality :

all looks the same3. Durable:

goes through the wash4. Valuable

large enough and portable5. Divisible

allows impulse buying

• Two basic measurements of the money supply are M1 and M2:• The components of M1 are:

•Currency•Checking Deposits

(including demand deposits and interest-earning checking deposits)

•Traveler's checks • M2 (a broader measure of money)

includes:•M1,•Savings,•Time deposits under $100,000,

and,•Money mutual fundsThe Supply of Money

6 of 61© 2013 Pearson Education, Inc. Publishing as Prentice Hall

Measuring the Money Supply, August 2011

M1 = $9,545 billion M2= $2,108.8 billion

The Composition of Money in the U.S.

• The size and composition of the two most widely used measures of U.S. money supply (M1 & M2)

are shown above.

Money Supply, M1 (in billions)

Currency (in circulation)Demand deposits

Other checkable depositsTraveler’s checks

Total M1

$850407334

5

$1,596

Money Supply, M2 (in billions)

M1Savings deposits aSmall time deposits

Money market mutual funds

Total M2

$1,5964,4451,308

979

$8,328

$1,596

$8,328

a Including money market deposit accounts. Source: http://www.federalreserve.gov.

The M1 and M2 Money Supply of the U.S –––––––––– (as of May 2009) ––––––––––

1. __ A $100 bill

4. __ A $50 traveler’s check

10. __ A $10,000 treasury bill

6. __ A quarter

2. __ A 6-month certificate of deposit

5. __ A $5,000 American Express credit line

7. __ A $1 off coupon clipped from the paper 8. __ A $100 balance in a checking account

3.__ A $10,000 retirement account invested in stocks

9. __ A $200 balance in a savings account

a b cbaaa ccc

The Changing Nature of M1

• In the 1980s, interest-earning checking accounts M1

• In the 1990s, money market mutual funds M1

150

300

450

600

750

900

1,050

1,350Billions of $

Interest-earningcheckable deposits

1970 1975 1980 1985 1990 1995 2000 2003

$309

$312

$672

Total $1,293

1,200

Demand deposits

Currency

M1

Currency

Interest-earningcheckable deposits

The Changing Nature of M1Billions of $

Total $1,388

150

300

450

600

750

900

1970 1975 1980 1985 1990 1995 2000 2005

$761

$309

$318Demand deposits

M1

• In the 1980s, interest-earning checking accounts M1

• In the 1990s, money market mutual funds M1

Function:1. accept and maintain deposits.2. make loans.

Types:.1. Commercial Banks.2. Savings and Loans3. Credit Unions4. Savings Banks.

The Functions of Commercial Banking Institutions

Assets

Vault cash Reserves at the Fed Loans outstanding

U.S. government securities Other securities Other assets

Total

Checking deposits Savings and time deposits

Borrowings Other liabilities Net worth

Consolidated Balance Sheet of Commercial Banking InstitutionsApril 2009 (billions of $)

Liabilities

$ 40 672 7,051 1,265 1,412 1,630

$ 12,070

$ 600 6,851 2,400

928 1,291

$ 12,070

• Banks provide services and pay interest to attract checking, savings, and time deposits (liabilities).

• Most of these deposits are invested and loaned out, providing interest income for the bank.

• Banks hold a portion of their assets as reserves (either as cash

or deposits with the Fed) to meet their daily obligations toward their depositors.

14 of 61© 2013 Pearson Education, Inc. Publishing as Prentice Hall

Balance Sheet for a Large Bank, 12/31/10

The items on a bank’s balance sheet of greatest economic importance are its reserves, loans, and deposits.

. The left side of the balance sheet always equals the right side.

• Banks maintain only a fraction of their assets (deposits) as reserves to meet the requirements of depositors.

• an decrease in required reserves lets banks make more loans, expand the money supply

1. Printing Money2. Making Loans

a. Key Ingredients: • Deposits – Household savings• Required Reserves – money

held at the bank or at the FRS (around 10%)

• Excess Reserves – loan able funds = Deposits – Required ReservesA depository institution can

make loans up to the value of its excess reserves

A depository institution can make loans up to the value of

its excess reserves

Main Street Bank Situation:Demand deposits = $50,000Reserve requirement = 10 %Actual reserves at bank = $10,000Excess Reserves:Demand deposits = $50,000Reserve requirement= 10 %Actual reserves = $10,000- Required reserves = $5,000

= Excess reserves = $5,000

Excess Reserves ($5,000) can be loaned

By making a loan, the bank has created money.

The original deposits are still in Main Street Bank, but now there is an additional $5,000 out floating around.

If the Excess Reserves are loanedThe borrowed money is spent and

deposited at another bank.The second bank’s reserves are now up

$5,000- it must keep 10% or $500- it can then loan out $4,500 ($5,000 – $500)

This process can be repeated at each step. 10% of the money is lost at each stepThe more that is required to be held in reserve, the less money can be created

The lower the reserve requirement, the greater the amount of money that can be created

Bank

New cash deposits:

Actual Reserves New

Required Reserves

Potential demand deposits created by

extending new loans

Initial deposit (bank A) Second stage (bank B) Third stage (bank C) Fourth stage (bank D) Fifth stage (bank E) Sixth stage (bank F) Seventh stage (bank G)

$1,000.00 $200.00 160.00

102.40 81.92 65.54 52.43

800.00 $800.00

512.00 128.00 640.00

640.00 512.00

409.60 409.60

327.68 327.68

262.14 262.14 209.71

Total $5,000.00 $1,000.00 $4,000.00

All others (other banks) 1,048.58 209.71 838.87

Creating Money from New Reserves

• When banks are required to maintain 20% reserves against demand deposits, the creation of $1,000 of new reserves will potentially increase the supply of money by $5,000.

From the table a deposit of $1000, with a 20% reserve requirement led to a $4000 expansion of the money supply

Is there a pattern here?

It just takes 3 easy steps

2. Multiply the initial change in the excess reserves by the money multiplier

$1000 * 5 = $5000

1. Find the reciprocal of the required reserve1/20% = 1/1/5= 5

3. Subtract out the initial change$5000 - $1000 = $4000

1. Deposit of $10,0002. Required reserve 10%3. Increase in the money

supply?

How about if the reserve requirement was 20%?

1. ________2. ________3. ________

1. ________2. ________3. ________

a. 10,000 c. 100,000b. 9,000 d. 90,000

a. 200,000 c. 100,000b. 40,000 d. 50,000

1. Deposit of $16,0002. Required reserve 25%3. Increase in the money

supply?

How about if the reserve requirement was 20%?

How about if the reserve requirement was 10%?

1. ________2. ________3. ________

1. ________2. ________3. ________1. ________2. ________3. ________

a. 144,000 c. 80,000b. 48,000 d. 64,000

1. Loan making changes the money supply

2. Increases in loans leads to increased spending which increases the money supply.

3. BUT, decreases in loan making, or even paying back a loan decreases the money supply.

Type of Deposit Current Requirement Limits

Checkable Deposits

$0 - $6 million 0 % 3%

$6 - $42.1 million 3 3

Over 42.1 million 10 8-14

Non-checkable non-personal

savings and time deposits 0 0-9

1. Created in 19132. Responsible for:

a. overseeing the money supplyb. coordinating commercial bank operationsc. regulating depository institutions

The Public: Households & businesses

Commercial BanksSavings & Loans

Credit UnionsMutual Savings Banks

• The Board of Governors is at the center of the banking system in the U.S.

• The seven members of the Board of Governors also serve on the Federal Open Market Committee

• The FOMC is a 12-member board that establishes Fed policy regarding the buying and selling of government securities.

Federal ReserveBoard of Governors

7 members appointed by the president,with the consent of the U.S. Senate

12 Federal ReserveDistrict Banks (25 branches)

Open MarketCommittee

Board of Governors &5 Federal Reserve Bank

Presidents (alternating terms, New York Bankalways represented).

                                         

                                         

                                         

                                         

                                         

                                         

                                         

2000

2014

2012

2010

2008

2006

2004

2002

1. Board of Governors –7 members appointed by President

- 14 yr terms at 2 yr intervals for continuity & independence

-not more than one from each district

http://www.federalreserve.gov/http://www.federalreserve.gov/

312

1

4

9

11

. (Board of Governors)10

7

5

2

6

8

• Each district bank monitors the commercial banks in their region and assists them with the clearing of checks.

• The Board of Governors of the Federal Reserve System is located in Washington D.C.

312

1

4

9

11

. 10

7

5

2

6

8

1.____________________2.____________________, ____________________3.____________________4._________________, _________________, _________________5.________________, _________________, _________________, 6._________________, ________________, _________________, _________________, _________________, _________________7._________________, _________________8._________________, ________________, _________________, _________________9._________________, _________________10._________________, ________________, ________________, __________________11._________________, _________________, _______________, 12._________________, ________________, _________________, _________________, _________________, _________________

1 Boston2 New York City, Buffalo3 Philadelphia4 Cleveland, Pittsburgh, Cincinnati5 Richmond, Baltimore, Charlotte6 Atlanta, Nashville, Birmingham, Miami, Jacksonville, New Orleans7 Chicago, Detroit8 St. Louis, Louisville, Memphis, Little Rock9 Minneapolis, Helena10 KC, Denver, Omaha, Oklahoma City11 Dallas, San Antonio, El Paso12 SF, Salt Lake City, LA, Port., Seattle, Honolulu

2. Federal Open Market Committee -12 members = 7 Governors (for majority) plus

5 Pres or VP from 1 NY

2 Bost, Phila, or Richmond,3 Atl, Dallas, or StL 4 Minn, KC, or SF, LA

5 Clev, or Chicago

set policy on buying & selling bonds on open mkt

3. Federal Advisory Council outsiders 12 members - 1 each selected by

Board of each Region

Make sure they are following the rules

Makes clearing check easier

Replace money or increase or decrease money in circulation

Moves checks from region to region

Borrows, writes checks, takes deposits

=* *M V P Y

Velocity Price

Output

- the amount of money in circulation- the number of times each $ is spent in a year (considered to be stable)

- the actual output of goods and services

- the level of prices

Money

MV P

Y

=* *M V P Y

MoneyVelocity Price

Y =output

• If V and P are constant, then an increase in M will lead to a proportional increase in Y GDP increases.

• but if V and Y are constant (at full employment), then an increase in M will lead to a proportional increase in P =Inflation.

• P Y Total Sales (GDP)

=*