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Macroeconomics - ECO 2013
Fall 205 – 1 Term
August 24 – December 16, 2005
Chapter 13: Money & Banking
When working properly, the monetary system
provides lifeblood of the circular flows of
income & expenditure.
Well-operating monetary system helps
economy achieve full employment & efficient
use of resources.
Malfunctioning monetary system creates
severe fluctuations in the economy’s levels of
output, employment & prices, distorting the
allocation of resources
The Functions of Money
1. Mediums of Exchange for buying & selling
goods & services
2. Unit of Account, yardstick for measuring
the relative worth of a variety of goods,
services & resources.


Price of each item stated only in terms of the
monetary unit
Money aids rational decision making by enabling
buyers & sellers to easily compare the prices of
various goods, services, and resources.
3. Store of value enables transfer of
purchasing power from present to future

Store some of wealth as money
The Supply of Money
Money Definition M1
Money Definition M2
Money Definition M3
Money Definition M1
Narrowest definition
Consists of:

Currency (coins & paper money) in hands of public
 Coins are token money: Intrinsic value (of the metal
contained in the coin) < face value

All checkable deposits (in commercial banks &
“thrifts” or savings on which checks can be drawn)
Money, M1 = Currency + Checkable Deposits
Money Definition M2
Broader definition

Near-monies are certain highly liquid financial
assets that do not function directly or fully as a
medium of exchange but can be readily converted
into currency or checkable deposits
Savings deposits, including money market
deposit accounts (MMDA)
Small time deposits (<$100,000)
Money market mutual funds (MMMF)
Money, M2 = M1 + Savings Deposits
including MMDAs + Small time Deposits
(<$100,000) + MMMFs)
Money Definition M3
Includes large time deposits
(>$100,000)

Certificates of deposit
Money, M3 = M2 + large time deposits
(>$100,000)
Credit Cards
Not really money
Means of obtaining a short-term loan
from commercial bank or other financial
institution that issued the card
Means of deferring or postponing
payment for a short period
What “backs” the money
supply?
Government’s ability to keep its value stable
provides the backing
Money is debt; paper money is a debt of
Federal Reserve Banks & checkable deposits
are liabilities of banks & thrifts b/c depositors
own them
Value of money arises not from intrinsic
value, but its value in exchange for goods &
services
Value of Money
Acceptable as a medium of exchange
Currency is legal tender or fiat money; must
be accepted by law
Relative scarcity of money compared to goods
& services will allow money to retain its
purchasing power
Money’s purchasing power determines its
value. Higher prices mean less purchasing
power.
Inflation & Acceptability
Excessive inflation may make money
worthless & unacceptable
Worthless money leads to use of other
currencies that are more stable
Worthless money may lead to barter
exchange system.
Stabilization of Money’s Value
The government tries to keep supply
stable w/ appropriate fiscal policy
Monetary policy tries to keep money
relatively scarce to maintain its
purchasing power, while expanding
enough to allow the economy to grow
The Demand for Money:
Two Components
Transactions demand, Dt is money kept for
purchases, will vary directly w/ GDP
Asset demand, Da is money kept as store of
value for later use, varies inversely w/
interest rate, since that is price of holding idle
money
Total demand, Dm will equal quantities of
money demanded for assets & transactions
The Money Market
Sm represents money supply

Vertical line b/c monetary authorities &
financial institutions have provided the
economy w/ particular stock of money
Intersection of demand & supply
determines equilibrium price
The Federal Reserve Bank &
The Banking System
Board of Governors of the Federal Reserve
System (“the Fed”)
Board directs 12 Federal Reserve Banks which
control lending activity of nation’s banks &
thrift institutions
Federal Open Market Committee (FOMC)

Sets Fed’s monetary policy & directs purchase &
sale of government securities in the open market,
“open-market operations”
Fed Functions &
The Money Supply
Issuing currency
Setting reserve requirements & holding
reserves
Lending money to banks
Providing for check collection
Acting as fiscal agent
Supervising banks
Controlling money supply
Federal Reserve Independence
Protects Fed from political pressures to
effectively control money supply & maintain
price stability
Political pressures on Congress & Executive
Branch result in inflationary fiscal policy,
including tax cuts & special-interest spending,
but Fed can take actions to increase interest
rates when higher rates are needed to stem
inflation
Countries w/ independent central banks have
lower rates of inflation, on average, than
countries w/ little or no independence
Recently Developments in
Money & Banking
Relative decline of banks & thrifts
Consolidation among banks & thrifts
Convergence of services provided by
financial institutions
Globalization of financial markets
Electronic transactions
Last Word: The Global
Greenback
Two-thirds of all U.S. currency is circulating
abroad
U.S. profits when dollars stay overseas
Black markets & illegal activity overseas are
usually conducted in dollars b/c are such a
stable form of currency
The dollar is a reliable medium of exchange,
measure, & store of value that facilitates
transactions everywhere
All dollars will not return to the U.S.
Chapter 13 Study Questions
1: Functions of Money
5: Backing Money
Next Class
Chapter 14: How Banks and Thrifts
Create Money
Chapter 15: Monetary Policy
Quiz on Ch. 9 – 12, 16