By: Hussain Shiyam.

What Makes Money

Money?
Can exchange occur in economy without money?
It can, using a traditional system called barter.
 Barter is the direct exchange of one good for
another good, rather than for money.
The problem with barter is that it requires a
coincidence of wants.
The use of money simplifies and therefore
increases market transactions.
Money also prevents wasting time that can be
devoted to production, thereby promoting
economic growth by increasing a nation’s
production possibilities
The three function of
money
Money is anything that serves as a medium of exchange,
unit of account, and store of value.
1. Money as a medium of exchange. The most important
function of money is to serves as a medium of exchange
2. Money as a unit of account. Unit of account is the function of
money to provide a common measurement of the relative value
of goods and services.
3. Money as a store of value. Store of value is the ability of
money to hold value over time
Conclusion: Money is a useful mechanism for transforming
income in the present into future purchases
The key property of money is that it is completely liquid.
Money is the most liquid form of wealth because it can be spent
directly in the marketplace
Other desirable properties
of money
 Once something has passed the three basic
requirements to serves as money, there are
additional hurdles to clear.
 First, an important consideration is scarcity.
Money must be scarce, but not too scarce.
(Counterfeiting threatens the scarcity of money)
 Second, money should b portable and divisible.
 Finally, money must be uniform.
What stands behind our
money
Historically, money played two roles.
Commodity money is anything that serves as
money while having market value in other uses.
 Money itself has intrinsic worth.
Money can be pure gold or silver, both of which
valuable for non-money uses, such as making
jewelry and serving other industrial purposes
Fiat money is money accepted by the law, and
not because of its redeemability or intrinsic value.
An item’s ability to serve as money does not
depend on its own market value or the backing of
precious metal
The three money supply definitions
 M1 - The most narrowly defined money supply
 This money definition measures purchasing power immediately available to the
public without borrowing or having to give notice.
 M1 measures the currency, traveler's checks, and checkable deposits held by the
public at a given time, such as a given day, month, or year.
 M1 does not include the money held by the government, Federal Reserve Banks,
or depository institutions.
M1= currency + traveler’s checks + checkable deposits
 Currency= money include coins and paper money
 Checkable deposits= Most ‘big tickets’ purchases are paid for with checks or credit
cards (which are not money), rather than currency.
 Checkable deposits are the total of checking account balances in financial
institutions that are convertible to currency ‘on demand’ by writing a check
without advance notice
The three money supply definitions
 M2 = M1 + near monies
 M2 = M1 + saving deposits + small time deposits of less than
$100,000
 M2 = Adding near monies to M1
 Near money include passbook savings accounts, money market mutual
funds, and time deposits of less than $100,000.
Saving deposits
 Interest bearing accounts that can be easily withdrawn. These deposits
include passbook savings accounts, money market mutual funds
Small time deposits
 Distinction between a checkable deposit and a time deposit. A time deposit
is an interest bearing account in a financial institution that requires a
withdrawal notice or must remain on deposit for a specified period unless
an early withdrawal penalty is paid.
The three money supply definitions
M3 = M2 + large deposits of $100,000 or more
 M3 = Adding large time deposits to M2
 The large time deposits included in M3 are any CDs with a value of
$100,000 or more.
 Why M2 and M3 include the savings and time deposits excluded
from M1?
 The traditional reason is that these accounts are less liquid than
the items included in the narrow definition of money.
 Currency plus traveler’s checks plus checkable deposits constitute
the public’s most immediately spendable forms of money
 M1 is more liquid than M2 or M3
 The boundary lines for any definition of money are somewhat
arbitrary
The Federal reserve system
The Fed is the central banker for the nation and
provides banking services to commercial banks, other
financial institutions, and the federal government.
The Fed regulates, supervises, and is responsible for
policies concerning money.
Congress and the president consult with the Fed to
control the size of the money supply and thereby
influence the economy’s performance.
The desire for more safety in banking led to the
creation of the Federal reserve System by the Federal
Reserve Act of 1913.
The Fed’s Organizational
Chart.
The Federal Reserve system is an independent
agency of the Federal government.
Congress oversees the Fed.
The Chair reports twice a year.
Coordinates it’s actions with the US treasury
and the president.
Congress can abolish the Fed if it’s policies are
contrary to the national interests.
The Fed’s organizational
chart

The Federal Reserve system consists of

12 central banks that service banks and
other financial institution within each
district.
The board of governors administer the
Federal Reserve System.
The Board of governors is made up of 7 members appointed by
the president and confirmed by the senates.
They served for 1 non renewable 14 year terms.
The Chair is the principle spokesperson for the Fed and has
considerable power over policy decisions.
The Federal Reserve System receives no
funding from congress.
This creates financial autonomy for the
Fed.
The Fed earns interest income from the
government security it holds, and the loans
it makes to depository institutions.
The board of governors is the independent
self supporting authority of the Federal
Reserve system.
Federal Open Market
Committee
The FOMC consists of the 7 members of the board
of governors, the president of the New York
Federal reserve Bank, and the president of 4
others Federal Reserve district banks.
The FOMC directs the buying and selling of US
government securities.
FOMC expresses opinions and implementing
monetary policies and issue policy statements
known as FOMC directives.
Federal advisory councils consists of 12 prominent
commercial banks. They meet periodically, to
advise the board of governors.
What Federal Reserve Bank
does
Controlling the money supply
Clear checks
Supervising and regulating banks. Works with the
FDIC to insure commercial bank deposits upto a
specified limit.
Maintain and circulating currency
Protect consumers. (Enforces laws enacted by
congress, most notably Equal Credit Opportunity
Act)
Maintain Federal government checking accounts
and gold
The US Banking
Revolution
THE MONETARY CONTROL ACT of 1980
The acts for major provisions are:
1. The authority of the fed over non-member depository institutions
was increased.
2. All depository institutions are able to borrow loan reserves from
the Federal Reserve banks.
3. The act allowed commercial banks, thrifts, money market mutual
funds, stock brokerage firms, and retailers to offer a wide variety
of banking services.
4. The act eliminated all interest rate ceilings. Before this act S&L’s
were allowed to pay depositors a slightly higher interest rate on
passbook savings deposits than those paid by commercial banks.
 Finally, deregulation continued with the signing of the Financial
Services Modernization Act of 1999 which allowed banks,
securities firms, and insurance companies to merge and sell each
others products.
The Savings and Loan Crisis.
Monetary Control Act removed interest rate ceiling
on deposits, forcing S&L’s to pay higher interest on
short term loans.
S&L’s earned incomes from long-term mortgages at
fixed interest rates below the rate required to keep
or attract new deposits. Which forced them to seek
high-interest but riskier commercial and consumer
loans. Which resulted in losses and defaults.
Similar to FDIC the FSLIC (Federal Savings and Loan
Insurance Corporation) insured the deposits of the
S&L’s. The magnitude of the losses were so high
that the FSLIC ran out of funds.
Congress placed FSLIC under FDIC and enacted the
Financial Institutions Reform, Recovery, and
Enforcement Act of 1989 (FIRREA), better known as
the Thrift Bailout Bill.
One of the provisions in the act required
thrifts to invest a higher minimum percentage
of their assets in long-term housing loans to
divest themselves of certain risky assets.
Another provision created the Resoultion
Trust Corporation (RTC) to carry out a massive
bailout of failed institutions . It bought the
assets and deposits of the failed insitiutions
and sold them to offset the cost borne by
taxpayers.
The RTC closed in 19995 and the final cost to
taxpayers at over $300 Billion.
In the middle ages Gold was the money of
choice in most European countries.
Gold is heavy, difficult to transact and difficult
to hide from thieves.
To keep it safe people deposited their gold
with Goldsmiths.
This inspired goldsmiths' to become the
founder of modern-day banking.
•Fractional Reserve Banking.
oA system in which banks keep only a
percentage of their
odeposits on reserve as vault cash and
deposits at the Fed.
Typical bank. BALNCE SHEET 1
Assets Liabilities
Required Reserves 5 Checkable Deposits 50
Million Million
Excess Reserves 0
Loans 45
Million
Total 50 Total 50
Million Million
BANKER BOOKKEEPING
•Liabilities are the amounts the bank owes to others.
•Assets are amounts the bank owns.
•Required Reserves are the minimum balance that the Fed requires
a bank to hold in vault cash or on deposit with the Fed.
•Required Reserve Ratio is the percentage of deposits that the fed
requires a bank to hold in vault or cash on deposit with the fed.
• Excess Reserves are potential loan balance
held in vault cash or on deposit with the Fed
in excess of required reserve.
Total Reserves = Required Reserves + Excess
Reserves
Or
Excess Reserves = Total Reserves – Required
Reserves.
Best Nation Bank BALNCE SHEET 2
Assets Liabilities Change in M1

Required 10,000 Andreas Acc 100,000 0

Reserves
Excess 90,000
Reserves
Total 100,000 Total 100,00

STEP ONE: Accepting A New Deposit.

Assume Required ratio is 10%.

If Andreas deposits 100,000. The bank would mark the
entry as liabilities for them and increases its excess
reserves to 90,000 which would allow it to make loans.
Step 2: Making a Loan

Actual money creation occurs.

Now, Ricky applies for a loan to purchase
equipment to open a Spa worth 90,000 and
the bank agrees after accepting Ricky’s IOU.
Best National Bank Balance Sheet 3

Assets Liabilities Change in M1

Required 19,000 Andres Acc 100,000

Reserves
Excess 81,000 Ricky Acc 90,000 90,000
Reserves
90,00

Total 190,000 Total 190,000

Step 3: Clearing the Loaning Check
Now Ricky buy’s equipment from Better
Health Spa and pays thorough check. Better
Health Spa then deposits the amount into
their account at Yazoo National Bank.
BEST NATIONAL BANK Balance Sheet 4
Assets Liabilities Cahnge in
M1
Required 10,000 Andreas Acc100,000 0
Reserves
Excess 0 Ricky Acc 0
Reserves
Loans 90,000
Total 100,000 Total 100,000
The Fed, Clears the check by debiting the reserve
account of Best National Bank and then crediting
the reserve account of Yazoo National Bank
YAZOO NATIONAL BANK Balance Sheet 5

Assets Liabilities

Required 9,000 Better Health 90,000

Reserves Spa Acc

Excess Reserves 81,000

Total 90,000 Total 90,000

Multiplier Expansion of
Money by the Banking
System
Exhibit 2, EXPANSION OF THE MONEY SUPPLY
Round Bank Increase in Increase in Increase in
Checkable Required Excess Reserves
Deposits Reserves
Rnd1 Best National Bank 100,000 10,000 90,000
Rnd 2 Yazoo National Bank 90,000 9,000 81,000

Rnd 3 Bank A 81,000 8,100 72,000

Rnd 4 Bank B 72,000 7,290 65,610
Rnd 5 Bank C 65,610 6,561 59,049
Rnd 6 Bank D 59,049 5,905 53,144
Rnd 7 Bank E 53,144 5,314 47,830
. … … … …
.. … … … …
Total All other Banks 578,297 47,830 430,467
Total Increase $ 1,000,000 $ 100,000 $ 900,000
The Money Multiplier
Money Multiplier us the maximum change in the money
supply (checkable deposits) due to an initial change in the
excess reserves banks hold.
Money Multiplier is Equal to 1 divided by the required ratio
Money Multiplier = 1÷ Required Ratio
 = 1÷(1/10) =10
Actual Money supply change= Initial Change in Excess
Reserve (ER) × Money Multiplier
 ΔM1 = ΔER × MM
$ 900,000 = $ 90,000 × 10
How Monetary Policy Creates
Money
Monetary policy is the federal Reserve’s use
of:
 open market operations
changes in the discount rate, and
changes in the required reserve ratio to change
the money supply (M1).
OPEN MARKET
OPERATIONS.
The FOMC determines the money supply through Open
Market Operations.
Open Market Operations is the buying and selling of
government securities by the Federal Reserve System.
The NY Fed’s trading desk executes these orders.
A purchase of government securities by the fed injects
reserves into the banking system and increases the money
supply. A sale of government securities by the Fed reduces
reserves in the banking system and decreases the money
supply.
The Discount Rate
Discount rate is the rate the Fed charges on
loans of reserves to banks.
A higher discount rate discourages banks
from borrowing reserves andmaking loans. If
the Fed wants to expand the money supply, it
reduces the discount rate. If the objective is to
contract the money supply, the Fed raises the
discount rate.
Banks can also turn to the Federal Funds
Market to seek profitable loan opportunities.
Federal Fund Market is a private market in
which banks lend reserve to each other for
less than 24 hours.
Banks short on reserves can borrow excess
reserves of another bank to pay the Federal
Funds Rate.
Federal Funds Rate is the interest rate banks
charge for overnight loans of reserves to other
banks.
The Required Reserve
Ratio
The Fed can set reserve requirements by law for
all banks and savings and loans associations.
There is an inverse relationship between the size
of the required reserve ratio and the money
multiplier.
If the fed wishes to increase the money supply, it
decreases the required reserve ratio.
If the objective is to decrease the money supply,
the Fed increases the required reserve ratio.
Changing the required reserve ratio is considered
a heavy handed approach that is an infrequently
used too to monetary policy.
Monetary Policy
Shortcomings.
MONEY MULTIPLIER INACCURACY
The value of the Money Multiplier can be uncertain and
subject to decisions independent of the fed. Such as the
public’s decision to hold cash and the willingness of
banks to make loans.
NONBANKS
Nonbanks are not directly under the Fed’s jurisdiction.
Nonbanks provide financial services but do not offer
checkable depositis included in M1.
Example of nonbanks are brokerage firms, finance
companies etc
WHICH MONEY DEFINITION SHOULD THE FED
CONTROL?
What if the Fed controls M1 but the public
transfers its deposits to M2?
What if the Fed responds and focuses more
on M2?
In recent years the Fed has focused more on
M2 because it more closely correlates with
changes to GDP.
LAGS IN MONETARY POLICY VERSUS FISCAL POLICY.
Firstly and Inside Lag exists.
An Inside lag exists between the time a policy change
is need and the time the Fed identifies the problem
and decides which policy tool to use.
Inside lag is fairly short.
Financial data is available daily.
Data on inflation and unemployment are available
monthly.
GDP data is available every three months.
Once data is available the Fed can decide which
policies need to be changed and adjusted.
The inside lag for monetary policy is shorter than for
fiscal policy because the fiscal policy is the result of a
long political budget process.
Second, there is an outside lag.
This lag refers to the length of time it takes
the money multiplier or spending multiplier to
have its full effect on aggregate demand and,
in turn, employment, the price level, and real
GDP.