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Chapter 11

Paul Schneiderman, Ph.D., Professor of Finance & Economics, Southern

New Hampshire University
©2008 South-Western

In This Lecture…..

Money Defined
The Money Supply
The Money Creation Process

Money vs. Barter

Money - Any good that is widely accepted
for purposes of exchange and in the
repayment of debt.
Barter - Exchanging goods and services
for other goods and services without the
use of money.

Functions of Money

Money as a Medium of Exchange -

Anything that is generally acceptable in
exchange for goods and services. Money
reduces the transactions cost of making

Functions of Money

Money as a Unit of Account - A common

measure in which relative values are
expressed. Because all goods are
denominated in money, determining
relative prices is easy.

Functions of Money

Money as a Store of Value - The ability of an

item to hold value over time. Allows us to
accept payment in money for our productive
efforts and to keep that money until we
decide how to spend it.

From Barter to a Money Economy
Money evolved out of a barter economy as
traders attempted to make exchange
In a barter economy, before a trade can be
made, a trader must find another trader
who is willing to trade what the first
trader wants and at the same time wants
what the first trader has.
A few goods that have been used as
money include gold, silver, copper, cattle,
rocks, and shells.

What Gives Money Its Value?

Our money today has value because of its

general acceptability.

Money Supply – M1
M1 = Currency held outside banks
+ Checkable deposits
+ Traveler’s checks
Currency includes coins and paper money (Federal
Reserve notes)
Checkable deposits are deposits on which checks can be
Traveler's checks are internationally redeemable drafts
purchased in various denominations from a bank or
traveler's aid company.

Money Supply – M2
M2 = M1
+Savings deposits (including money market
+ Small denomination time deposits
+ Money market mutual funds (retail)
Savings Deposit is an interest-earning account at a commercial bank
or thrift institution.
Money Market Deposit Account is an interest-earning account at a
bank or thrift institution. Most offer limited check writing privileges.
Time Deposit is an interest-earning deposit with a specified maturity
Money Market Mutual Fund is an interest-earning account at a
mutual fund company.

Money Supply Data

For current and historical data

on the money supply click either
table above

Are Credit and Debit Cards Money?

Credit card use represents loans which

must be repaid. They represent the use of
someone else's money.
Debit cards give access to checkable
deposits which are already part of the
money supply.

Self-test Questions
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 trades?

Early Banking
 Gold coin was used as a medium of
 Goldsmiths, equipped with safe storage
facilities, stored other people’s gold for
them, issuing warehouse receipts.
 Receipts, being more convenient, were used
to make purchases and pay debts.
 These paper receipts circulated as money.

Fractional Banking
 On an average day, very few people came to
redeem their gold receipts.
 Some goldsmiths began lending out some of
the stored gold, issuing additional receipts
instead of gold, and earning interest.
 This was the beginning of “fractional reserve
* A banking arrangement that
allows banks to hold reserves
equal to only a fraction of their
deposit liabilities.

The Federal Reserve System
The central bank of the United States
Chief function is to control the money

Bank Reserves
Reserves - The sum of bank deposits at the Fed
and vault cash.
Required Reserve Ratio (r) - A percentage of each
dollar deposited that must be held on reserve (at
the Fed or in the bank’s vault).
Required Reserves - The minimum amount of
reserves a bank must hold against its checkable
deposits as mandated by the Fed.
Excess Reserves - Any reserves held beyond the
required amount. The difference between (total)
reserves and required reserves.

Bank Reserves
Reserves =
Bank deposits at the Fed + Vault cash
Required reserves =
r x Checkable deposits
Excess reserves =
Reserves - Required reserves

T - Account

A simplified balance sheet that shows the

changes in a bank’s assets and liabilities.

Money Creation Process I

Fed prints $1000 in paper money and gives it
to Bill. Bill deposits the money in Bank A

The bank’s reserves have increased by $1000

as well as the bank’s obligations to Bill.

Money Creation Process II

The bank divides the $100 in reserves into 2
categories: required reserves and excess
reserves. The Fed has set required reserves at
10% of checkable deposits.

The excess reserves can be used to make new


Money Creation Process III
The bank makes a loan to Jenny of $900.

The bank gives Jenny a checking account

with a balance of $900.

Money Creation Process IV

Jenny spends the money on a new computer and
writes a check for $900. The retailer deposits the
full amount of her check in Bank B.
Bank B presents the check to Bank A and Bank A
honors it by reducing Jenny’s checking account
balance and excess reserves by $900.

Money Creation Process V

Bank B now has $900 that it didn’t have
previously, increasing its reserves (assets) by $900
and liabilities (checkable deposits) by $900

The Banking System Creates
Checkable Deposits (Money)

The required
reserve ratio is 10
Assume that there
is no cash leakage
and that excess
reserves are fully
lent out; that is,
banks hold zero
excess reserves.

Simple Deposit Multiplier

Maximum change in checkable deposits = (1/r ) x ΔR
where r = the required reserve ratio and ΔR = the
change in reserves resulting from the original
injection of funds.
In the previous example:
Maximum change in checkable deposits =
= (1 / 0.10) x $1,000
= 10 x $1,000
= $10,000
In the equation, the reciprocal of the required reserve
ratio(1/r ) is known as the simple deposit multiplier

Shrinking the Money Supply

 The Fed takes receives a check and “cashes” it at
the bank upon which it is drawn
 Those funds are not deposited in any bank and
are removed from the money supply.
 Reserves fall.
 Thus excess reserves fall.
 Fewer loans are made, and checkable deposits
 Because checkable deposits are part of the
money supply, the money supply falls.

The Money Supply Expansion and
Contraction Processes

Self-test Questions
 If a bank’s deposits equal $579 million and the
required reserve ratio is 9.5 percent, 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 percent?
 Bank A has $1.2 million in reserves and $10
million in deposits. The required reserve ratio is
10 percent. If bank A loses $200,000 in reserves,
by what dollar amount is it reserve deficient?

Wall Street Journal

The Wall Street Journal is a is a rich source
of information which provides real life
examples of micro- and macro economic
activities. Check today’s issue to see the
most current news.