Download Handout 7 - Jason Lee

I. Money
The term money has a different usage in economics. When economists talk about money, they
refer to something beyond the bills and coins (currency). Money is anything that is accepted
as payment for goods or services or as repayment of debts.
A. The Functions of Money
Why bother even having money? Money has three important functions, it serves as a medium of
exchange, unit of account, and a store of value. In order for something to be considered money it
must fulfill all three functions.
1. Medium of Exchange: Medium of exchange is a good that buyers can give sellers
(and sellers will accept) in exchange for a good or service. Having a medium of exchange is
much more efficient than the alternative of bartering (also known as double coincidence of
wants). Imagine that you wanted eggs for breakfast. Without money acting as a medium of
exchange, you would have to find someone with eggs that would also want something that you
are offering in exchange. An accepted medium of exchange eliminates the double coincidence
of wants problem.
2. Unit of Account: One of the functions of money is that it must serve as a way to
measure the value of goods and services. Money should serve as a consistent way of quoting
prices. For example a textbook is quoted in dollars, not 150 bananas or 6 Blu-Ray DVDs.
Having a unit of account makes it easy to quote prices.
3. Store of Value: Money also serves as a store of value—money can be used to
transport purchasing power from one time period to another. In other words, someone can hold
on to money for a period of time and use the money to make purchase at a later period. Bananas
would not be considered money because they would not have the store of value property.
Hyperinflation (very rapid inflation) destroys the function of money as a store of value. Why?
B. Liquidity
Money is not the only store of value for individuals. Many transfer their purchasing power into
the future by holding non-monetary assets such as stocks, bonds, real estate, etc… When we talk
about wealth we are referring to both money and non-money assets. One method to classify
assets is by its liquidity. Liquidity refers to the ease one can convert an asset into the accepted
medium of exchange. Since money is the medium exchange, money is the most liquid asset
available. Stocks and bonds are relatively liquid, as it is easy to sell those assets for money.
Other assets such as houses and rare paintings are less liquid as it takes a long time to sell those
assets.
C. Types of Money
1. Commodity Money: Early forms of money had intrinsic value, examples are gold and silver.
Intrinsic value means that these goods would have had value even if it were not used as money.
2. Fiat Money ($ bills, quarters, British Pound note, etc…). Fiat money is money without
intrinsic value. It has value because some authority (the government) says it has value. If the
authority behind the decree loses credibility then fiat money becomes worthless.
D. Measuring Money in the Economy


M1-The Narrowest Definition of money
o Currency (paper bills and coins)
o Traveler’s Checks
o Demand Deposits (Checking accounts)
M2-Broader Definition, Less liquid
o Small denomination time deposits (CDs) and repurchase agreements
o Saving deposits/Money Market funds
o Non-institutional money market mutual fund shares
II. Federal Reserve
The Federal Reserve is the central bank of the United States and its main objectives are to (1)
regulate the banking system (making sure the each bank is in good financial condition) and to act
as a lender of last resort to banks (lend funds to banks who cannot borrow elsewhere) and (2)
control the money supply in the economy. The Federal Reserve was created in 1913 after a
banking panic in 1907 convinced Congress that there needed to be oversight of the banking
system.
A. Structure of the Federal Reserve
1. Board of Governors- There are 7 board of governors who are appointed by the President
and confirmed by the Senate. They serve 14 year terms.
2. Chairman of the Board of Governors- The chair of the board of governors is the most
important person at the Federal Reserve. The Federal Reserve Chairman is in charge of board
meetings and Fed staffing and must testify before Congress regarding Fed policy. The President
appoints the Chairman to a 4 year term.
3. Federal Reserve Banks- The Federal Reserve system is composed of the Federal Reserve
Board in Washington D.C. and 12 regional Reserve Banks located across the country (the nearest
one is in San Francisco). Each of the regional Federal Reserve Bank is run by a president chosen
by each bank’s board of directors.
4. Federal Open Market Committee (FOMC)- This committee is composed of the 7 board of
governors and 5 out of the 12 presidents of the regional Fed banks (with the NY Fed always
getting to vote). The main objective of the FOMC is to determine the monetary policy of the
United States. The monetary policy is the decision made concerning money supply in the United
States.
III. Banking and the Creation of Money
Banks are just like any other firm in that the goal of banks is to maximize profits and minimize
risks. Banks issue out liabilities (savings and checking accounts) to obtain funds to buy assets
(make loans). Let us be a bit clear on defining liabilities and assets.
A. Liabilities (Source of Funds)

Checkable Deposits (Checking Accounts)-Typically low cost since banks usually don’t
have to pay much interest if at all. Costs are mainly due to operating and service
expenses.
 Non-Transaction Deposits (Savings)-Costs are higher since interest is higher than
checkable deposits.
o Savings Accounts
o Small Denomination CDs (< $100,000)
o Large Denomination CDs (> $100,000)
 Owners Equity: The funds put in by the owners of the bank
B. Assets (Uses of Funds)

Reserves (No Interest)/Cash Items
o Required Reserves: Currency physically stored in the bank or at the Federal
Reserve that earn no interest. Reserves are needed because of the required reserve
rule (required reserve ratio) for deposits. Banks must set aside a fraction of
their deposit so it can meet its obligations.
o Excess Reserves: Currency held in the bank beyond what is required by the
required reserve ratio
 Loans: Interest provides income for the bank
It is always the case in accounting that assets = liabilities
Bank Balance Sheet
Assets
1
Reserves:
(a) Required Reserves
Liabilities and Net Worth
1
Checkable Deposits
(b) Excess Reserves
2
2
Loans
(a) Commercial and Industrial
Loans
Non-Transaction
Deposits
(a) Small Denomination
CD
(b) Savings Deposits
(C) Large Denomination
CD
3.
(b) Real Estate Loans
(c) Consumer Loans
Owner’s Equity
Basic Banking Examples (Simpsons Style)
Example #1: Mr. Burns goes to the First Bank of Springfield and opens a checking deposit
account with $10,000 in cash. Show this transaction on the balance sheet
First Bank of Springfield
Assets
Reserves
Loans and Net Worth
+$10,000
Checkable Deposit
+$10,000
When the Bank receives the money it initially placed in its reserves (either its vault or is sent to
its account at the Fed). Checkable accounts are subject to the reserve requirement ratio.
Assume that the required reserve ratio is 8%. Show this on the balance sheet
Assets
Loans and Net Worth
Required Reserve
+$800
Excess Reserve
$9200
Checkable Deposit
+$10,000
The bank by law must hold $800 of Mr. Burn’s deposit in reserve. What it does with the rest of
the money is to the discretion of the bank. Why would the bank not want to keep the excess
reserve at $9200? The answer is it earns no interest from the reserve, while it has to pay for
servicing the checking account (and maybe pay some interest), thus it would be losing money by
keeping all the funds in reserve. What if they used the funds to issue out a loan to Bumblebee
Man. Show this transaction on the balance sheet
Assets
Required Reserve
Loans
Loans and Net Worth
+$800
+$9200
Checkable Deposit
+$10,000
Key Lessons so far:
Lesson #1: When someone deposits money, total reserves increases by the same amount
initially.
Lesson #2: By law the bank has to keep a fraction of checkable and time deposits in
reserve.
Note that the First Bank of Springfield has made a loan to Bumblebee Man for $9200.
Bumblebee man is going to take that money and deposit it into his checking account at the
Second Bank of Springfield.
Second Bank of Springfield
Assets
Loans and Net Worth
Required Reserve
+$736
Loans
+$8464
Checkable Deposit
+$9200
The 2nd Bank of Springfield will have to keep $736 of the deposit as required reserves (since the
reserve requirement ratio is 8%). That will leave $8464 the bank could lend out. Suppose it
lends that money to Mr. Smithers who will deposit the money at the 3rd Bank of Springfield.
Third Bank of Springfield
Assets
Loans and Net Worth
Required Reserve
Loans
+$677.12
+$7786.88
Checkable Deposit
+$8464
Again because the reserve requirement ratio is 8%, the Third Bank of Springfield will have to
keep $677.12 out of the $8464 as reserves, but it will be able to loan out the balance of $7786.88.
We can continue this analysis. Note that at each step “new” money is being created as banks are
able to loan out their excess reserves. How much money was created by the original deposit of
$10,000?
$10,000 + $9200 + $8464 + 7786.88 + ….
Instead of calculating each step of the process we can use a simple formula called the moneymultiplier to see what the total money created in the economy from the single deposit
M Dx
1
rr
Where rr= required reserve ratio
D = original deposit
M = money created
In this case the $10,000 deposit by Mr. Burns will create $125,000 in new money in the
economy.
M = $10000 X (1/0.08) = $125,000
IV. Fed Tool’s of Money Supply
We saw earlier in the chapter that one of the objectives of the Federal Reserve is to control the
money supply in the economy through the FOMC. In this section we discuss how that control of
money supply works. If the FOMC decides to increase money supply how do they go about
injecting more money into the economy? Conversely if they decide to decrease money supply
how do they remove money from the system?
1. Open Market Operations: The principal tool at the disposal of the Federal Reserve is
something called open market operations. Open market operations is nothing more than the
buying and selling of U.S. government securities (bonds). There are two open market
operations: Open-market purchases and open-market sales
(a) If the Federal Reserve wishes to increase money supply they conduct an open market
purchase. In an open market purchase the Federal Reserve prints money and goes out to the
bond market and purchases government bonds from the public. The public (individuals and
banks) sell their bonds to the government in exchange for money. Individuals will then deposit
this money in the banks and create money in the system (as outlined in the last section).
(b) If the Federal Reserve wishes to decrease money supply they conduct an open market
sale. In an open market sale the Federal Reserve sells US. Government bonds to the public in
the bond market. The public purchases these bonds by giving money to the Government in
exchange for these bonds. In order to get the money to purchase the bonds, the public will have
to pull money out of their bank accounts, which reduces the amount that banks have to lend, and
the process of money creation reverses itself. The Fed has effectively reduced the amount of
money circulating in the economy by conducting an open market sale.
2. Changing the Reserve Requirement Ratio: A tool that is rarely used to change the money
supply is to change the reserve requirement ratio. Think about how changing the ratio will affect
money supply. Suppose that the Fed decides to increase the reserve requirement ratio. The
result would be that the banks will have to hold more of the deposits as reserves and thus will
have less to lend out in loans. Thus increasing the reserve requirement ratio will decrease the
supply of money. Conversely by decreasing the reserve requirement ratio will increase the
supply of money.
3. Changing the Discount Rate: When banks want to borrow from the Federal Reserve the
Fed charges them a special interest rate called the discount rate. The discount rate is the interest
that the banks have to pay to the Fed. Decreasing the discount rate will increase the supply of
money. If the Fed decreases the interest rate it charges banks, banks will be more willing to
borrow the money from the Fed. They can then use the money to issue out loans and thus more
money is created through the system. An increase in the discount rate will have the opposite
effect.