Dr. Mohammed Alwosabi ECON 141 - Ch.

Notes on Chapter 5
MONEY, BANKING, AND MONETARY POLICY

WHAT IS MONEY
— Money is anything that is generally accepted as a measure of
payment and settling of debt.

FUNCTIONS OF MONEY
— Money has three main functions: (1) medium of exchange, (2) unit
of account, and (3) store of value.

Medium of Exchange:
— A medium of exchange is anything that is generally accepted in
exchange for goods and services.
— Example
When you buy a meal for lunch you are using money as a medium
of exchange
— Without money as medium of exchange, goods and services must
be exchanged directly for other goods and services. This is called
barter. Barter requires a double coincidence of wants, a situation
that rarely occurs. For example if you have CDs and you want to
get orange juice, you must find someone who has orange juice and
is looking for CDs.

Unit of Account
— A unit of account is an agreed measure for stating the prices of
goods and services (pricing mechanism). Money provides the term
in which prices are quoted and debts are recorded.

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Dr. Mohammed Alwosabi ECON 141 - Ch. 5

— The unit of account in Bahrain is Bahraini Dinar. People quote

prices in Dinar. A seller tells you the price of TV is BD150 not 30
shirts (even though they may amount to the same thing).
— Example
A BD10000 price tag on a new car is an example of money as a
unit of account.
— Example
In some countries they quote prices in the local currency but they
accept payments in US dollars. The local currency serves as the
unit of account and the US dollar serves as the medium of
exchange.

Store of Value
— A store of value is any good or asset that people can store while it
maintains its value or most of its value. Money can be held for a
time and later exchanged for goods and services.
— If money were not a store of value, it could not serve as a means of
payment. But with inflation, money might loose some of its value.
The higher the inflation the larger is the loss.
— Example
Money serves as a store of value when people keep cash on hand
for emergency or deposit money in their saving accounts.

TYPES OF MONEY:
Money consists of
— Currency: The paper notes and coins that people use in a country.
They are money because government declares them so. (legal
tender)

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Dr. Mohammed Alwosabi ECON 141 - Ch. 5

— Deposits at banks and other depository institutions are also money.

Deposits are money because they can be converted into currency
and because they are used to settle debts.
— Currently, deposits are the largest proportion of money.
— Example
Are Checks money? The answer is no. The check is only a way to
instruct your bank to transfer money from your account to another
person’s account. However, deposit accounts are money
— Example
Is credit card considered money? No. It is not. It does not make a
final payment and the debt it created must eventually be settled by
using money. Credit card is just an ID card that lets you take out a
loan at the moment you buy something.

MEASURES OF MONEY:
— There are two main official measures of money. They go from most
liquid asset to the least liquid asset. Liquidity is the ease with
which an asset can be converted into cash with little loss in value.
— M1 = currency outside banks + checking deposits owned by
individuals and business including travelers checks
— M2 = M1 + saving deposits + time deposits + money market mutual
funds and other deposits
— Currency held by banks is not included in the M2 definition of
money.
— Example
A country has $3000 million as currency outside banks, $9000 as
checking deposits, and $5000 as saving and time deposits.
Calculate M1 and M2
M1 = 3000 + 9000 =$12000 million
M2 = 12000 + 5000 = $17000 million

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Dr. Mohammed Alwosabi ECON 141 - Ch. 5

— Example
In an economy there is $100 in currency held outside banks, $50
million in traveler’s checks, $125million in currency held inside the
banks, $150 million in checking deposits, $300 million in savings
deposits, and $400 million in time deposits. The value of M1 is
$300 and M2 equals to $1000.
— Example
Suppose you have $2000 in your checking account and $5000 in
your saving account. You transferred some money from saving to
checking account. What is the impact on M1 and M2?
M1 will increase but M2 will stay the same

COMMERCIAL BANKS
— A depository institution is a firm that accepts deposits and makes
loans. They minimize the cost of obtaining funds, create liquidity
and pool risks.
— A commercial bank is a firm that is licensed by government to
receive deposits and make loans.
— The commercial bank is a financial intermediary that stands
between lenders and borrowers.
— Banks earn profits by lending the money that people deposit to the
borrowers at higher interest rates than the interest rates the bank
pays to the depositors.
— The balance sheet of a commercial bank is a summary of its
business that lists its assets, and liabilities.
o Assets are what the bank owns. Assets include reserves
and loans
o Liabilities are what the bank owes (debts and obligations to
the public). Liabilities include deposits and networth.Net
worth is the value of the bank to its stockholders.

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Dr. Mohammed Alwosabi ECON 141 - Ch. 5

(Net Worth = Assets – Liabilities)

— Your deposit at your bank is a liability to the bank and asset to you
because the bank must pay your deposit whenever you decide to
take your money out of the bank.
— The objective of a commercial bank is to maximize the net worth of
its stockholders.

Reserves
— Actual Reserves consist of :
a. Cash in the bank’s vault (notes and coins) to meet the
bank’s depositors’ demand for currency and to make
payments to other banks.
b. Deposits required by the Central Bank: This part of the
reserves kept at the central bank is also used to receive
and make payments to other banks
— The fraction of a bank’s total deposits that are held in reserves is
R
called reserve ratio (RR). ( RR = , where R: reserves and D:
D
deposits).
— The reserve ratio changes when a bank’s customers make deposits
or withdrawals. Making a deposit increases the reserve ratio, and
making a withdrawal decrease the reserve ratio
— Banks are required to hold a level of reserves that does not fall
below a specified percentage of total deposits. This percentage is
the required reserve ratio.
— The required reserves ratio (RRR) is the ratio of reserves to
deposits that banks are required to hold by regulations.
Re quired Reserves
RRR =
Derposits

— Note that if RRR decreases, banks will be able to give more loans

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Dr. Mohammed Alwosabi ECON 141 - Ch. 5

— Also note that the actual reserves are the reserves that banks
actually keep which could be more or equal to the required
reserves.
— If there is a difference between the actual reserves and the
required reserves, this difference is called the excess reserves.
(Excess reserve = Actual reserve - Required reserve)
— Whenever banks have excess reserves, they are able to create
money and lend out additional fund.

Loans to business and individuals:

— A loan is a commitment of a fixed amount of money for agreed
upon period of time.
— Example:
Suppose a bank has the following balance sheet (in millions of
dollars)
Assets Liabilities
Reserves 150 Deposits 500
Loans 350

Total 500 Total 500

Suppose the required reserve ratio (RRR) is 10 %, then

Actual reserves (AR) = 150
Required reserves (RR) = (RRR) (Deposits) = (0.10) (500) = 50
Excess reserves = AR – RR = 150 – 50 = 100
— Since loans are the main source of profit for the bank, the bank in
the current situation is not maximizing profit. The bank can provide
more loans that equal to $100 million (the excess reserves) and
thus increase its profit.
— The new balance sheet shows a profit-maximizing balance sheet,
after keeping only the required reserve.

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Dr. Mohammed Alwosabi ECON 141 - Ch. 5

Assets Liabilities
Reserves 50 Deposits 500
Loans 450

Total 500 Total 500

— Example:
Assets Liabilities
Reserves 100 Deposits 800
Loans 700

Total 800 Total 800

Suppose a customer deposits a $50 of currency into his current

account. If the RRR is 7% the immediate excess reserve is equal to
$46.5. This excess reserve will be loaned to some borrowers.

How Banks Create Money

— Banks create deposits by making loans. The amount of deposits
banks can create is limited by their reserves.
— To understand how banks create money we make the following
assumptions
1. Banks are able to make as much loans as they want to
2. Banks always keeps reserves equal to required reserves to
maximize profits
3. People take loans and deposit these loans back to their banks
4. If M1 = C + D, where C = currency outside banks and D =
checking deposits, then UM1 = UC + UD
— Suppose $100 million is taken from currency outside the banking
system and deposited to the banks Ö UC = – 100 (and UD = 100).

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Dr. Mohammed Alwosabi ECON 141 - Ch. 5

— The first immediate effect is the increase in deposit by $100 and

the increase in the actual reserve by $100.
— However, since banks keep only the required reserve, from this
extra $100 million deposit only 10% (equal to $10 million) must go
to reserves. The remaining $90 million is considered excess
reserves that can be loaned. Thus, the initial increase in loans is
$90 million.
— But the story does not end here. This new $90 million loans will be
deposited back in the banking system and 10% of it which is $9
million will be added to the required reserves. The remaining $81
million will be the new excess reserves that can be loaned to public.
— This new $81 million loans will be deposited back in the banking
system and 10% of it will be added to the required reserves. The
remaining amount will be the new excess reserves that can be
loaned to public.
— This process will continue until there are no more extra loans that
can be given.
— To calculate the total increase in deposits, reserves, loans and thus
the money we use the money multiplier.
— Money multiplier is the amount by which a change in the
monetary base is multiplied to determine the resulting change in
the quantity of money
1 1
— Money multiplier = m = = = 10
RRR 0.10
— If D is the initial deposit, R is the initial reserves, and L is the initial
loan then
Total increase in Deposits = D × m = 100 × 10 = 1000
Total increase in Reserves = R × m = 10 × 10 = 100
Total increase in Loans = L × m = 90 × 10 = 900

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Dr. Mohammed Alwosabi ECON 141 - Ch. 5

— The change in quantity of money = change in currency + the final

change in deposits. UM1 = U C +UD = – 100 + 1000 = 900
— Note the change in quantity of money is equal to the total change in
loans. Quantity of money increases by $900 million as a result of
the total increase in loans by that amount.
— The banks can increase their loans as deposits increase

THE CENTRAL BANK AND THE MONETARY POLICY

— The central bank of any country is a government authority in charge
of regulating the country’s financial institutions and controlling the
quantity of money.
— The central bank is the bank of the banks and the bank of
government. It does not provide general banking services to
individual citizens and business firms.
— There is only one central bank for each country.
— The central bank’s goals are to keep low rate of inflation, maintain
full employment, and contribute toward achieving long-term growth.
— To help achieving these goals the central bank conducts the
country’s monetary policy through adjustments of the quantity of
money in circulation and the interest rates.
— The central bank uses three main tools to conduct the monetary
policy: required reserve ratios, discount rate, and open market
operations

Required Reserve Ratio

— All depository institutions in the country are required to hold a
minimum percentage of deposits as reserves. This minimum
percentage is known as a required reserve ratio.

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Dr. Mohammed Alwosabi ECON 141 - Ch. 5

— To reduce inflation, the central bank conducts a contractionary

monetary policy using the required reserve ratio. It requires
depository institutions to hold more reserves which results in
increasing the reserves and thus reducing the amount they are able
to lend Ö Loans decrease Ö money supply (Ms) decreases Ö AD
decreases Ö AD curve shifts leftward.
— To reduce unemployment, the central bank conducts an
expansionary monetary policy using the required reserve ratio.
Required reserves decrease Ö loans increase Ö Ms increase Ö
AD increase Ö AD curve shifts rightward.

Discount Rate
— The discount rate is the interest rate the central bank charges the
commercial banks and other depository institutions when they
borrow reserves from it.
— To reduce inflation, the central bank conducts a contractionary
monetary policy using the discount rate. It increases the discount
rate Ö higher cost of borrowing reserves Ö banks borrow less
reserves from central bank Ö but with a given required reserves
banks decrease their lending to decrease their borrowed reserves
Ö Loans decrease Ö money supply (Ms) decreases Ö AD
decreases Ö AD curve shifts leftward.
— To reduce unemployment, the central bank conducts an
expansionary monetary policy using the discount rate. It decreases
the discount rate Ö lower cost of borrowing reserves Ö banks
borrow more reserves from central bank Ö banks increase their
lending Ö Loans increase Ö money supply (Ms) increases Ö AD
increases Ö AD curve shifts rightward.

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Dr. Mohammed Alwosabi ECON 141 - Ch. 5

Open Market Operations (OMO)

— An open market operation is the purchase or sale of government
securities by the central bank in the open market.
— To reduce inflation, the central bank conducts a contractionary
monetary policy using the open market operation. Central bank
sells government securities Ö people pay money to buy
government securities from the central bank Ö banks deposit
decreases Ö banks reserves decrease Ö Loans decrease Ö
money supply (Ms) decreases Ö AD decreases Ö AD curve shifts
leftward.
— To reduce unemployment, the central bank conducts an
expansionary monetary policy using the open market operation.
Central bank buys government securities Ö people receive money
from the central bank Ö banks deposit increases Ö banks
reserves increase Ö Loans increase Ö money supply (Ms)
increases Ö AD increases Ö AD curve shifts rightward.

— In conclusion,
— To increase commercial bank lending the central bank can lower
the required reserve ratio, lower the discount rate, or buy
government securities.
— To decrease commercial bank lending the central bank can raise
the required reserve ratio, raise the discount rate, or sell
government securities.

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