Chapters 14 & 15: Money, Banking, and Financial Institutions & Money Creation

Chapters 14 & 15: Money, Banking, and Financial Institutions & Money Creation


• What is money? • Measuring the money supply • Commercial Bank Balance Sheet • Federal Reserve System • Banking & Money Creation • How does the Fed control the money supply

What is Money?

Money is whatever is generally accepted in exchange for goods and services — accepted not as an object to be consumed but as an object that represents a temporary abode of purchasing power to be used for buying still other goods and services.

— Milton Friedman (1992)

Three Functions of Money

A medium of exchange

A store of value

A unit of account

Functions of Money

A medium of exchange:

Money is an asset used to buy and sell goods and services.

Does not have to be currency.

Any commonly accepted good will serve as money.

Why is the Medium of Exchange Useful?

• Often, you have good A, and want good B. • To successfully trade, you must find someone with B who wants to trade for A.

This is called a double coincidence of wants, and doesn’t occur very often.

Having an accepted currency reduces transaction costs and greatly increases trade.

Functions of Money

A medium of exchange: Money is an asset used to buy and sell goods and services.

A store of value: Money is an asset that allows people to transfer purchasing power from one period to another.

Why is Having a Store of Value Important?

Easier and more convenient to hold wealth in money rather than a large amount of goods

The “store of value” role of money has declined recently due to many other options to store wealth:



Savings accounts

Functions of Money

A medium of exchange: Money is an asset used to buy and sell goods and services.

A store of value: Money is an asset that allows people to transfer purchasing power from one period to another.

A unit of account: Money is a unit of measurement used by people to post prices and keep track of revenues and costs

Why is Having a Unit of Account Useful?

Creates a common language by placing a value on a good that everyone can understand

Creates a “measuring stick” by which we can compare purchases

Creates a consistent method of record keeping (think about debits and credits in a ledger)

Commodity vs Fiat Money

Commodity money

Money that is an actual physical commodity, such as gold or silver.

Ties the value of money to something real, which limits inflation

Changes in the commodity value affect the whole economy (think

about the discovery of gold or silver)

Fiat money

Has no intrinsic value except as the medium of exchange

Value comes from government mandate that money can be used as “legal tender”

All modern money is fiat money –> does not have intrinsic value

Yet, money derives its value because of the demand relative to the


People demand money because it reduces the cost of exchange

But supply of money is limited relative to demand … that’s what makes money valuable

If the supply of money rises too much, what happens to prices?

With inflation, the purchasing power of money declines and money looses its value

How is Money Supply Measured?



checking deposits (including demand deposits and interest-earning checking deposits)



Savings deposits

time deposits

money market mutual funds.

The Composition of Money Supply in the U.S. (As of April 2013)

How Does Money Derive its Value?

Acceptability: Everyone accepts paper money in exchange for G&S.

Legal Tender: We are confident in money because the government had designated currency as legal tender

• Relative Scarcity: Money derives its value from its scarcity relative to the utility it creates (as it has the capacity to be exchanged for G\&S).

What are Banks?

Profit-seeking institutions that accept deposits and use part of them to extend loans and make investments.

Income from these activities is their major source of revenue.

They play a central role in the loanable funds market)

They help bring together people who want to save for the future with those who want to borrow for current investment.

Types of Banks

◦ Commercial banks

◦ Savings & loans ◦ Credit unions.

The Functions of Commercial Banks

The banks’ major function is (Financial Intermediation)

Banks provide services and pay interest to attract checking, savings,

and time deposits (liabilities).

Most of these deposits are invested and loaned out, providing interest income for the bank.

Banks hold a portion of their assets as reserves (either as cash or deposits with the Fed) to meet their daily obligations toward their depositors.

Commercial Bank’s Balance Sheet

Fractional Reserve Banking

The U.S. banking system is a fractional reserve system. ◦ Banks are required to maintain only a fraction of their assets as reserves against their customers’ deposits (required reserves).

Excess reserves (actual reserves in excess of legal requirement) can

be used to extend new loans and make new investments.

Under a fractional reserve system, an increase in deposits will provide the bank with excess reserves and place it in a position to extend additional loans, and thereby expand the money supply.

Fractional Reserve Banking

Bank Reserves

To determine the dollar amount of required reserves:

Required reserves = rr ratio × deposits Any reserves above the required level are called “excess reserves.”

They can be used to extend loans and generate revenue for the bank.

Excess reserves = total reserves – required reserves

The Bank’s reserve ratio is the fraction of the deposits that is kept in reserves (whether required or excess reserves)

Reserve Ratio = total reserves / deposits

How Do Banks Create Money?

From new reserves

By extending loans

How Do Banks Create Money?

Start off with two simplifying (although unrealistic) assumptions

1. All currency is deposited in a bank.

2. Banks hold no excess reserves (rr = .20).


Alex gets a $1000 loan to pay for college tuition.

The college deposits this money in its bank.

This bank then lends out the money as well.

We can examine the balance sheets of each bank.

Creating Money from New Reserves

How Banks Create Money by Extending Loans

The lower the percentage of the reserve requirement, the greater the potential expansion in the money supply resulting from the creation of new reserves.

Deposit Multiplier (money multiplier)

Rate at which banks multiply money when all currency is deposited into banks and they hold no excess reserves

𝑫𝒆𝒑𝒐𝒔𝒊𝒕 𝒎𝒖𝒍𝒊𝒑𝒍𝒊𝒆𝒓 = 𝟏/ 𝒓𝒓

Actual money multiplier will be less than the potential because: ◦ some persons will hold currency rather than bank deposits ◦ some banks may not use all their excess reserves to extend loans.

The Federal Reserve

The Federal Reserve is the central bank for the United States.

Created in 1913.

Responsible for the creation of a stable monetary climate for the entire U.S. economy.

i) It controls the money supply of the U.S., ii) serves as a “banker’s bank” or “bank of last resort” for U.S. banks, and, iii) regulates the banking sector.

Responsible for the conduct of U.S. monetary policy.

The Federal Reserve System

Board of Governors

7 members

Appointed by the president, with the confirmation of the Senate

The president selects the Chairperson & the Vice Chairperson of the board from among those members.

The Federal Reserve Banks


Assists the board of governance in conducting monetary policy

Made up of 12 members

Makes decisions about buying and selling government securities in the open market.

Functions and Responsibilities of the Fed

Issuing currency

Setting reserve requirements and holding reserves

Serving as lender of last resort

Acting as fiscal agent

Supervising banks

Controlling money supply

Think about the Fed as the “Bank of the Banks”

Comments are closed.