CHAPTER 12
(MACRO CHAPTER 12)
Money and Banking
FUNDAMENTAL QUESTIONS
1. What is money?
2. How is the U.S. money supply defined?
OVERVIEW AND OBJECTIVES
The primary purpose of this chapter is to introduce the principles of money and banking in the domestic
and the global economies.
The unique features of the chapter include discussion of the functions of money and the definition of the
After reading and reviewing this chapter, the student should be able to:
1. Define money.
2. List the functions of money.
3. Define the U.S. money supply in terms of M1 and M2.
86 Chapter 12: Money and Banking
KEY TERM REVIEW
money
liquid asset
currency substitution
credit
M1 money supply
special drawing right (SDR)
Federal Deposit Insurance Corporation (FDIC)
Eurocurrency market or offshore banking
international banking facility (IBF)
LECTURE OUTLINE AND TEACHING STRATEGIES
I. What Is Money?
Money is anything that is generally accepted in exchange for goods and services.
A. Functions of money
1. Medium of exchange: Money increases the efficiency of the economy by minimizing
transaction costs.
Chapter 12: Money and Banking 87
B. The U.S. money supply: The money supply includes assets that serve the functions of
money. Economists have found it difficult to determine whether an asset is a monetary asset.
Teaching Strategy: Point out that because many assets can serve as monetary and
nonmonetary assets, it is difficult to measure the true supply of money.
1. M1 money supply: Currency accounts for 54 percent of the M1 money supply.
Travelers’ checks account for less than 1 percent of the M1 money supply.
C. Global money: The money supplies of different nations are linked through the foreign
exchange market.
1. International reserve currencies: The role of the dollar as a reserve currency has
diminished. Composite currencies: The ECU was an accounting entity that was a
composite of European currencies. The euro replaced the ECU.
II. Banking
A. Financial intermediaries: These are the links between savers and borrowers in the economy.
B. U.S. banking
1. Current structure: Banking went through many changes in the 1980s.
C. International banking: Because of less restrictive regulations, international banks are highly
competitive with domestic banks.
1. Eurocurrency market: Eurocurrencies are deposits that are denominated in the
III. Banks and the Money Supply
Banks create money by simply carrying out their normal business.
A. Deposits and loans: An example of how banks create money by lending money.
88 Chapter 12: Money and Banking
Teaching Strategy: Draw parallels between the deposit expansion multiplier and the
spending multiplier to build on ideas with which your students are already familiar.
OPPORTUNITIES FOR DISCUSSION
1. Are credit cards considered to be money? What about unused limits on credit cards? 2. What
forces have led to the development of composite currencies?
ANSWERS TO EXERCISES
1. Money is a medium of exchange, which means that money is used to carry out transactions. I take
dollars to the grocery store to buy food. Money is a unit of account, which means that goods are
2. Cigarettes could serve as money among prisoners because they can satisfy all the functions of
money. Because transactions could be carried out with cigarettes, they serve as a medium of
3. A financial intermediary is a business firm like a bank, credit union, or savings and loan
institution that accepts deposits and makes loans. My bank accepts my deposits, which I may need
4. The Eurocurrency market is where deposits and loans are denominated in currencies other than
5. IBFs are on-shore international banks. These are not actually banks but are separate bookkeeping
systems that record a bank’s international deposits and loans. IBFs were probably legalized to
capture some of the international banking business that was going offshore.
6.
a.
Assets
Liabilities
Chapter 12: Money and Banking 89
7.
8. Because M2 includes assets that incorporate potential spending and that are still quite liquid, it is a
9. If people choose to hold cash rather than checkable deposits, the deposit multiplier will be
smaller. Also, if banks choose to hold excess reserves, they will not lend as much at each stage in
the multiplier process. Consequently, the deposit multiplier will be smaller.
10. The liquidity of an asset is how easily the asset can be exchanged for goods and services. In order
13.
a.
1 .1 10=
b.
15
(.1 .1) =
+
ANSWERS TO STUDY GUIDE HOMEWORK
1. Anything that is generally acceptable to sellers in exchange for goods and services.
5.
a.
Excess reserves $9,500=
: the
$10,000 deposit $500−
required reserves (5 percent of
$10,000). The bank can loan up to $9,500.
90 Chapter 12: Money and Banking
ACTIVE LEARNING EXERCISE
This exercise will have students explore the creation of money and the deposit expansion multiplier. It
can also serve as a tool to explore the impact of a change in the reserve requirement if the instructor
desires to repeat the project using a higher or lower reserve requirement.
Split the class into groups of four. The students in each group count off 1 through 4. The 1s will be
bank 1; the 2s, bank 2; the 3s, bank 3; and the 4s, bank 4. The exercise starts with each bank having
zero deposits and zero excess reserves. Assume the reserve requirement is 20 percent. Bank 1 then
receives a deposit of $1,000. Each group will simulate the money creation process by having bank 1
make the maximum loan possible, with the loaned money being deposited in bank 2. Bank 2 then
makes the maximum loan possible, and the loaned funds go to a deposit in bank 3. Bank 3 makes the
maximum loan possible with the funds going to bank 4. Finally, bank 4 makes the maximum loan
possible. Including the initial deposit of $1,000, how much money has been created in this exercise by
all the banks?