Macroeconomics

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Macroeconomics

• Chapter 10
• Money and Money Creation
• Spring 2007

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Money

• Whatever is generally accepted as a medium of
  exchange.
• Example Castaways on Gilligans Island decide
  to use Monopoly money as their medium of
  exchange. As long as they are willing to accept
  Monopoly money in trade, it will be money for
  them.
• Historically, various commodities have been used
  as money.
• The money we use today is fiat money and has no
  intrinsic value.
• Without money, we would have to make exchanges by
  barter.

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Barter

• Direct exchange of goods.
• To make a trade by barter requires a double
  coincidence of wants.
• Using money eliminates the need for a double
  coincidence of wants and thus reduces the
  transaction costs of making exchanges.

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Functions of Money

• Medium of exchange.
• Using money as a medium of exchange reduces the
  transaction costs of making exchanges.
• This enables people to make more exchanges and to
  specialize in producing according to comparative
  advantage.

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Functions of Money (continued)

• Measure of value.
• The value of goods, services, and resources is
  expressed in terms of the monetary unit.
• Having a measure of value makes it easier to
  discover mutually beneficial exchanges.
• Store of value.
• When we receive money, we dont have to spend it
  immediately.
• This allows us to use our buying power when it is
  most valuable to us.

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Why Money Is Valuable

• Money does not have intrinsic value and is not
  backed by gold.
• Money has value because it is generally accepted
  as a medium of exchange.
• The goods and services we produce make our money
  valuable, because we can trade the money for the
  goods and services.

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Measures of the Money Supply

• Currency
• coins and paper money.
• M1
• currency in circulation (held outside banks) plus
  checkable deposits.
• Checkable deposits are deposits in banks or other
  financial institutions on which checks can be
  written.

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Checks and Credit Cards

• Checks are not money.
• Checks are a way to transfer the money held in a
  checkable deposit.
• Credit cards are not money.
• When a purchase is made through the use of a
  credit card, the purchaser is not spending money,
  he or she is taking out a loan.

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Money Creation

• Our banking system is a fractional reserve
  system.
• In a fractional reserve system, banks are able to
  create money.
• Money creation arises from increases in checkable
  deposits made possible by fractional reserve
  banking.
• In a fractional reserve system, banks hold
  reserves equal to only a fraction of their
  deposits.
• The required reserve ratio is set by the Federal
  Reserve System.

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Bank Reserves

• Required reserves
• the minimum amount of reserves a bank is legally
  required to hold against its deposits.
• To meet its reserve requirement, a bank must hold
  reserves.
• Reserves
• Vault cash plus bank deposits with the Fed.
• Excess reserves
• Excess of reserves over required reserves.
• Excess reserves may be loaned out.

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A Simplified Bank Balance Sheet

• Since a bank earns no revenue from its reserves,
  a bank will usually try to hold only enough
  reserves to meet its reserve requirement.
• See Balance Sheet for Bank X on page 10-6.
• Assets Loans receivable from borrowers
• Liabilities Deposits due to customers

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U.S. Government Securities

• U.S. government securities (bonds) are debt
  instruments issued by the federal government.
• See Example 9 on page 10-6.
• U.S. government securities are an attractive
  asset for banks to hold because
• they pay interest.
• they are risk free.
• they are highly liquid.

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Example of Money Creation

• An initial deposit into a checking account sets
  off a chain of lending and depositing which leads
  to a multiplied increase in checkable deposits.
• The maximum possible change in the money supply
  can be calculated by using the potential deposit
  multiplier.
• Potential deposit multiplier 1 reserve ratio

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Financial Intermediation

• The primary function of banks today is financial
  intermediation.
• Process by which banks make depositors savings
  available to borrowers.
• Advantages of financial intermediation
• Savers reduce their risk of loss.
• Savers do not have to evaluate the ability of
  borrowers to repay a loan.
• Borrowers do not have to seek out numerous savers
  in order to borrow a large sum.