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ECONOMICS 5e
Michael Parkin
CHAPTER
14
Money
Chapter 31 in Economics
Learning Objectives
• Define money and describe its functions
• Explain the economic functions of banks
and other financial institutions
• Describe the financial innovations of the
1980s and 1990s
Copyright © 2000 Addison Wesley Longman, Inc.
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Learning Objectives (cont.)
• Explain how banks create money
• Explain why the quantity of money is an
important economic magnitude
• Explain the quantity theory of money
Copyright © 2000 Addison Wesley Longman, Inc.
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Learning Objectives
• Define money and describe its functions
• Explain the economic functions of banks
and other financial institutions
• Describe the financial innovations of the
1980s and 1990s
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What is Money?
Money is any commodity or token that is
generally acceptable as the means of
payment.
A means of payment is a method of settling
a debt.
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What is Money?
Other functions of Money
1) Medium of exchange
2) Unit of account
3) Store of value
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What is Money?
Medium of Exchange
A medium of exchange is an object that is
generally accepted in exchange for goods and
services.
Without money, people would have to
exchange goods for goods, or barter.
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What is Money?
Unit of Account
A unit of account is an agreed measure for
stating the prices of goods and services.
This simplifies value comparisons and
purchase decision making if all prices are
expressed using a uniform measure.
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The Unit of Account Functions of
Money Simplifies Price Comparisons
Good
Price in
money units
Price in units
of another good
Movie
$6.00 each
2 six-packs of soda
Soda
$3.00 per six-pack
2 ice-cream cones
Ice cream
$1.50 per cone
3 packs of jelly beans
Jelly beans
$0.50 per pack
2 cups of coffee
Coffee
$0.25 per cup
1 local phone call
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What is Money?
Store of Value
A store of value is any commodity or token that
can be held and exchanged later for goods and
services.
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What is Money?
Money in the United States Today
Money in the United States consists of:
• Currency
• Deposits at banks and other financial
institutions
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What is Money?
Money in the United States Today (cont.)
• Currency is the bills and coins that we use.
• Deposits are also money because they can be
converted into currency and are used to settle
debts.
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What is Money?
Official Measures of Money (cont.)
M1 consists of currency and traveler’s
checks plus checking deposits.
Includes accounts held by individuals and
businesses, but does not include currency
held by banks, or currency and checking
deposits owned by the U.S. government.
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What is Money?
Official Measures of Money (cont.)
M2 consists of M1 plus saving deposits
and time deposits.
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What is Money?
Official Measures of Money (cont.)
M3 consists of M2 plus large-scale time
deposits and term deposits
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Two Measures of Money
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What is Money?
Are M1 and M2 Really Money?
The test of whether an asset is money is
whether it serves as a means of payment.
• Currency does.
• Checking deposits are money because they
can be transferred by writing a check.
M1 is money
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What is Money?
Are M1 and M2 Really Money?
• Some savings deposits are readily accessible
and can be used as a means of payment.
• Other deposits are less liquid.
Liquidity is the property of being instantly
convertible into a means of payment with
little loss in value.
M2 is money
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What is Money?
Other Points Regarding Money
1) Deposits are money but checks are not.
2) Credit cards are not money.
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Learning Objectives
• Define money and describe its functions
• Explain the economic functions of banks
and other financial institutions
• Describe the financial innovations of the
1980s and 1990s
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Financial Intermediaries
Financial intermediaries are firms that take
deposits from households and firms and
makes loans to other households and firms.
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Financial Intermediaries
Four Types of Financial Intermediaries
1) Commercial banks
2) Savings and loan associations
3) Savings banks and credit unions
4) Money market mutual funds
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Financial Intermediaries
Commercial Banks
A commercial bank is a firm, licensed by the
Comptroller of the Currency or by a state
agency to receive deposits and make loans.
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Financial Intermediaries
Commercial Banks
Their balance sheet lists their assets, liabilities,
and net worth.
• The assets are what the bank owns.
• The liabilities are what the bank owes
• These include deposits.
• Net worth is the difference between assets
and liabilities.
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Financial Intermediaries
Commercial Banks
Their balance sheet is described by the
following formula:
Liabilities + Net Worth = Assets
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Financial Intermediaries
Profit and Prudence: A Balancing Act
Banks attempt to maximize the net worth of
their stockholders:
• They earn profit by lending at a higher
interest rate than they borrow.
• Lending is risky.
Banks must be prudent in how they use their
deposits.
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Financial Intermediaries
Reserves and Loans
Banks divide their funds into two parts:
• Reserves are cash in a bank’s vault plus its
deposits at Federal Reserve banks
• Loans
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Financial Intermediaries
Three Types of Assets Held by Banks
1) Liquid assets are U.S. government Treasury
bills and commercial bills.
2) Investment securities are longer-term
U.S. government bonds and other bonds.
3) Loans are commitments of fixed amounts of
money for agreed- upon periods of time.
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Financial Intermediaries
Savings and Loan Associations
A savings and loan association is a financial
intermediary that receives checking deposits
and savings deposits and that makes personal,
commercial, and home-purchase loans.
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Financial Intermediaries
Savings Banks and Credit Unions
A savings bank (mutual savings bank) is a
financial intermediary owned by its depositors
that accepts deposits and makes mostly homepurchase loans.
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Financial Intermediaries
Savings Banks and Credit Unions
A credit union is a financial intermediary owned
by its depositors that accepts savings deposits
and makes mostly consumer loans.
The key difference between savings banks
and credit unions is that credit unions are
owned by a social or economic group such
as a firm’s employees.
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Financial Intermediaries
Money Market Mutual Funds
A money market mutual fund is a financial
institution that obtains funds by selling shares
and uses these funds to buy highly liquid assets
such as U.S. Treasury bills
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Financial Intermediaries
The Economic Functions of Financial
Intermediaries
1) Creating Liquidity
2) Minimizing the cost of borrowing
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Financial Intermediaries
The Economic Functions of Financial
Intermediaries
3) Minimizing the cost of monitoring
borrowers
4) Pooling Risk
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Financial Regulation,
Deregulation, and Innovation
Financial Regulation
Two types of regulation faced by financial
intermediaries:
• Deposit insurance
• Balance sheet rules
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Financial Regulation,
Deregulation, and Innovation
Deposit Insurance
The deposits of most financial intermediaries
are insured by the Federal Deposit Insurance
Corporation.
• Receives its income from compulsory
premiums paid by financial intermediaries
• Protects depositors
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Financial Regulation,
Deregulation, and Innovation
The balance sheet regulations faced by
financial intermediaries include:
1) Capital requirements
The minimum amount of an owner’s own
financial resources that must be put into an
intermediary.
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Financial Regulation,
Deregulation, and Innovation
The balance sheet regulations faced by
financial intermediaries include:
2) Reserve requirements
Rules setting out the minimum percentages
of deposits that must be held in currency or
other safe, liquid assets.
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Financial Regulation,
Deregulation, and Innovation
The balance sheet regulations faced by
financial intermediaries include:
3) Deposit rules
Restrictions on the different types of deposits
that an intermediary can accept.
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Financial Regulation,
Deregulation, and Innovation
The balance sheet regulations faced by
financial intermediaries include:
4) Lending rules
Restrictions on the proportions of different
types of loans that an intermediary may
make.
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Financial Regulation,
Deregulation, and Innovation
Deregulation in the 1980s
The Depository Institutions’ Deregulation and
Monetary Control Act (DIDMCA), passed in
1980, removed many of the distinctions
between commercial banks and other financial
intermediaries.
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Financial Regulation,
Deregulation, and Innovation
Deregulation in the 1980s
Other actions affecting financial intermediaries
include:
• The passage of the Garn-St. Germain
Depository Institutions Act in 1982.
• The abolition of Regulation Q in 1985.
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Learning Objectives
• Define money and describe its functions
• Explain the economic functions of banks
and other financial institutions
• Describe the financial innovations of the
1980s and 1990s
Copyright © 2000 Addison Wesley Longman, Inc.
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Financial Regulation,
Deregulation, and Innovation
Financial Innovation
Financial innovation is the development of new
ways of borrowing and lending.
Primary aim is to increase the profit from
financial intermediation.
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Financial Regulation,
Deregulation, and Innovation
The three main influences on financial
innovation are:
1) Economic environment
2) Technology
3) Regulation
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Financial Regulation,
Deregulation, and Innovation
Financial Innovations
• Variable interest rate mortgages
• Widespread credit card usage
• Rise in the importance of the Eurodollar
• Paying interest on checkable deposits
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Learning Objectives
• Explain how banks create money
• Explain why the quantity of money is an
important economic magnitude
• Explain the quantity theory of money
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How Banks Create Money
Reserves: Actual and Required
• The reserve ratio is the fraction of a bank’s total
deposits that are held in reserves.
• The required reserve ratio is the ratio of
reserves to deposits that banks are required, by
regulation, to hold.
• Excess reserves are actual reserves minus
required reserves.
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How Banks Create Money
Creating Deposits by Making loans in a
One-Bank Economy
Let’s see an example of how
banks create money.
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Creating Money at the
One-and-Only Bank
Balance sheet on January 1
Assets
(millions of dollars)
Liabilities
(millions of dollars)
Reserves
$100
Loans
$300
Total
$400
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Deposits
$400
Total
$400
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Creating Money at the
One-and-Only Bank
Balance sheet on January 2
Assets
(millions of dollars)
Liabilities
(millions of dollars)
Reserves
$101
Loans
$300
Total
$401
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Deposits
$401
Total
$401
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Creating Money at the
One-and-Only Bank
Balance sheet on January 3
Assets
(millions of dollars)
Liabilities
(millions of dollars)
Reserves
$101
Loans
$303
Total
$404
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Deposits
$404
Total
$404
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How Banks Create Money
The Deposit Multiplier
Change in deposits
Deposit multiplier 
Change in reserves
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How Banks Create Money
Creating Deposits by Making Loans with
Many Banks
Let’s see how the
banking system creates money.
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The Multiple Creation of Bank Deposits
The sequence
The running tally
Reserves
Loans
Deposits
Deposit
$100,000
Reserve
$25,000
Loan
$75,000
$25,000
$75,000
$100,000
$43,750
$131,250
$175,000
Deposit
$75,000
Reserve
$18,750
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Loan
$56,250
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The Multiple Creation of Bank Deposits
The sequence
The running tally
Reserves
Deposit
$56,250
Reserve
$14,063
Loan
$42,187
$43,750
$57,813
Loans
$131,250
$173,437
Deposits
$175,000
$231,250
Deposit
$42,187
Reserve
$10,547
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Loan
$31,640
$68,360
$205,077
$273,437
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The Multiple Creation of Bank Deposits
The sequence
The running tally
Reserves
Reserve
$10,547
Loan
$31,640
Loans
Deposits
$68,360
$205,077
$273,437
$100,000
$300,000
$400,000
and
so on...
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How Banks Create Money
The Deposit Multiplier in the United States
• The actual deposit multiplier in the U.S. works
the same as the one presented.
• However, it does differ in some aspects.
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How Banks Create Money
The deposit multiplier in the United States
differs from our model economy’s for three
main reasons:
1) The actual required reserve ratio is
smaller than the 25 percent used here.
2) Banks sometimes choose to hold excess
reserves.
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How Banks Create Money
The deposit multiplier in the United States
differs from our model economy’s for three
main reasons:
3) Not all loans made by banks return to
them in the form of reserves.
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Learning Objectives
• Explain how banks create money
• Explain why the quantity of money is an
important economic magnitude
• Explain the quantity theory of money
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Money, Real GDP, and
the Price Level
We are going to study the effect the money
supply has on real GDP, the price level, and
the inflation rate.
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Money, Real GDP, and
the Price Level
The Short-Run Effects of a Change in the
Quantity of Money
Let’s study how a change in the quantity of
money effects these factors by examining the
aggregate supply-aggregate demand model.
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Price level
(GDP deflator, 1992 = 100)
Short-Run Effects of
Change in Quantity of Money
140
LAS
130
SAS
120
110
107
100
AD0 AD1
0
6.6 6.8 7.0 7.2 7.4 7.6
Real GDP (trillions of 1992 dollars)
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Price level
(GDP deflator, 1992 = 100)
Long-Run Effects of
Change in Quantity of Money
140
130
LAS
SAS2
SAS1
121
113
110
100
AD2
AD1
0
6.6 6.8 7.0 7.2 7.4 7.6
Real GDP (trillions of 1992 dollars)
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Learning Objectives
• Explain how banks create money
• Explain why the quantity of money is an
important economic magnitude
• Explain the quantity theory of money
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Money, Real GDP, and
the Price Level
The Quantity Theory of Money
• The quantity theory of money is the proposition
that in the long run, an increase in the quantity
of money brings an equal percentage increase
in the price level.
• This theory is based upon the velocity of
circulation and the equation of exchange.
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Money, Real GDP, and
the Price Level
The Quantity Theory of Money
The velocity of circulation is the average
number of times a dollar of money is used
annually to buy goods and services that make
up GDP.
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Money, Real GDP, and
the Price Level
GDP equals the price level (P) times real
GDP (Y), or:
GDP = PY
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Money, Real GDP, and
the Price Level
Make the quantity of money M, and the
velocity of circulation V is determined by:
V = PY/M
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The Velocity of Circulation in the
United States: 1930–1999
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Money, Real GDP, and
the Price Level
The equation of exchange states that the
quantity of money (M) multiplied by the
velocity of circulation (V) equals GDP, or
MV=PY
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Money, Real GDP, and
the Price Level
We can convert the equation of exchange
into the quantity theory of money by
making two assumptions:
1) The velocity of circulation is not
influenced by the quantity of money.
2) Potential GDP is not influenced by the
quantity of money.
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Money, Real GDP, and
the Price Level
Assuming this is true, the equation of
exchange tells us that a change in the
quantity of money causes an equal
proportional change in the price level.
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Money, Real GDP, and
the Price Level
This can be shown by using the equation of
exchange to solve for the price level.
P = (V/Y)M
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Money, Real GDP, and
the Price Level
In the long run, real GDP equals potential
GDP, so the relationship between the
change in the price level and the quantity of
money is:
P  (V / Y )M
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Money, Real GDP, and
the Price Level
Dividing this equation by an earlier one,
P = (V/Y)M, gives us
P / P  M / M
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Money, Real GDP, and
the Price Level
This equation shows that the proportionate
change in the price level equals the
proportionate change in the quantity of
money.
This gives us the quantity theory of money:
In the long run, the percentage increase in the
price level equals the percentage increase in the
quantity of money.
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Money, Real GDP, and
the Price Level
The AS-AD model predicts the same
outcome as the quantity theory of money.
It also predicts a less precise relationship
between the quantity of money and the price
level in the short run than in the long run.
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Money, Real GDP, and
the Price Level
Historical Evidence on the Quantity Theory
of Money
• The data are broadly consistent with the
quantity theory of money, but the relationship is
not precise.
• The relationship is stronger in the long run than
in the short run.
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Money Growth and
Inflation in the United States
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Money Growth and
Inflation in the United States
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Money Growth and
Inflation in the World Economy
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Money Growth and
Inflation in the World Economy
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Money, Real GDP, and
the Price Level
Correlation, Causation, and Other Influences
The evidence shows that money growth and
inflation are correlated.
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Money, Real GDP, and
the Price Level
Correlation, Causation, and Other Influences
This does not represent causation.
• Does money growth cause inflation, or does
inflation cause money growth?
• Does some other factor cause inflation
(deficit spending)?
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The End
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