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Chapter 13
Money and the Banking System
OUTLINE
I. What is Money?
A. Medium of Exchange
B. Store of Value
C. Unit of Account
II. How the Supply of Money Affects Its Value
A. The main thing that makes money valuable is the same thing that generates value for
other commodities: Demand relative to supply.
B. People demand money because it reduces the cost of exchange. When the supply of
money is limited relative to the demand, money will be valuable.
III. How is the Money Supply Measured?
A. Components of M1 Money Supply
2. Checking Deposits (including demand deposits and interest-earning checking
deposits)
3.
B. M2 money supply: broader measure that includes savings and time deposits and money
market mutual funds
C. Credit Cards versus Money
1. Money is an asset; credit card balances are a liability. Thus, credit card purchases
are not money.
IV. The Business of Banking
A. The banking industry includes savings and loans and credit unions as well as
commercial banks.
B. Banks accept deposits and use part of them to extend loans and make investments.
C. Banks are profit-seeking institutions
D. Banks play a central role in the capital (loanable funds) market. They help to bring
together people who want to save for the future with those who want to borrow in
order to undertake investment projects.
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V. How Banks Create Money by Extending Loans
A. Under a fractional reserve system, an increase in reserves will permit banks to extend
additional loans and thereby expand the money supply (create additional checking
deposits)
B. The lower the percentage of the reserve requirement, the greater is the potential
VI. The Federal Reserve System
A. The Fed is a central bank responsible for the conduct of monetary
policy
D. Independence of the Fed
1. Stems from the lengthy terms 14 years of members of the Board of Governors
E. How the Fed Controls the Money Supply
1. Reserve requirements.
2. Open Market operations.
a. The buying and selling of bonds in the open market.
b. Primary tool used by Fed.
3. Extension of Loans
a. Historically, member banks have borrowed from the Fed primarily to meet
temporary shortages of reserves..
Chapter 13/Money and the Banking System 131
d. Discount Rate and Federal Funds Rate
(1) The discount rate is closely related to the interest rate in the federal funds
e. Controlling the Federal Funds Rate
(1) Announcements after the regular meetings of the Federal Open Market
(3) The Fed can increase the fed funds rate by selling bonds, which will darin
reserves from the banking system.
f. Longer Term Loans Extended by the Fed
(1) Prior to 2008, the Fed extended only short-term discount rate loans, and
they were extended only to member banks.
(2) In 2008, the Fed established several new procedures for the extension of
(3) In 2008, the Fed also began making loans to non-bank financial
(4) Like the discount rate loans, these new types of loans inject additional
4. Interest Rate Fed Pays on Reserves.
a. The Fed began paying banks interest on their reserves in October 2008.
b. As of June 2011, the Fed was paying member banks an interest rate equal to the
target federal funds rate on both required and excess reserves.
F. Recent Fed Policy, the Monetary Base, and the Money Supply
1. Recent Fed Policy
a. Prior to the financial crisis of 2008, the Fed controlled the money supply
almost exclusively through open market operations the buying and selling of
Treasury Securities.
132 Chapter 13/Money and the Banking System
2. Monetary Base
a. The monetary base is equal to the currency in circulation plus the reserves of
commercial banks (vault cash and reserves held at the Fed).
3.
a. Because of the recession and sluggish growth, the demand for loans was weak.
G. The Difference Between the Fed and the Treasury
1. U.S. Treasury.
a. Concerned with the finance of the Federal Government
2. Federal Reserve.
a. Concerned with the monetary climate for the economy.
VII. Ambiguities in the Meaning and Measurement of the Money Supply
A. Interest Earning Checking Deposits
B. Widespread Use of the U.S. Dollar Outside of the United States
2. This reduces the reliability of the M1 money supply measure.
C. Sweeping of various interest-earning checking accounts into Money Market Deposit
Accounts.
Chapter 13/Money and the Banking System 133
E Summary:
1. Historically, the rate of change of the money supply has been used to judge the
OBJECTIVES
This chapter focuses on the supply of money how it is defined and what determines its value. The
heart of this chapter is an outline of the monetary institutional arrangements for the United States
that explains how monetary planners control the money supply. This material lays the foundation
for Chapter 14, which analyzes how changes in the money supply affect economic activity.
It is important that the student gain an understanding of a fractional reserve banking system
and how the actions of the central bank (the Federal Reserve System in the United States) can alter
the deposit levels of member banks (and the money supply). However, this is not a text on money
and banking. Historical information about banking institutions and endless detail about the banking
material of this sort, often included in introductory texts, was kept to a minimum.
IMPORTANT POINTS AND TEACHING SUGGESTIONS
1. It is advisable to let students know what lies ahead. Therefore, you may want to explain that
2. Students often tend to believe that money has intrinsic value. Others may feel that the value of
3. The M1 concept of money incorporates the idea that money is what a society generally uses as
a means for payment. Since both currency and checks are broadly used for payment in the United
4. In addition to the narrowly defined money supply (M1), we have chosen to emphasize the
5. Deregulation and the growth of interest-earning checkable deposits has changed the nature of
money significantly in recent years. As Exhibit 1 illustrates, interest-earning deposits now
6. Deregulation legislation has, in effect, eliminated the meaningful distinctions between: (a)
7. Our past experience suggests that an explanation of how the goldsmiths of the past altered the
8. Exhibit 2 illustrates that the creation of $1,000 of new reserves can potentially expand the money
9. Be sure to explain that profit-maximizing banks have an incentive to minimize their idle reserves
10. f
11. Students invariably confuse the U.S. Treasury and the Federal Reserve System. Carefully
explain the distinction between these two institutions of the government.
13. It is often helpful to use a money multiplier formula to help students understand how the Fed
controls the money supply. You can show them that in a highly simplified world, the money
14. It is helpful to use several illustrations about money to make sure students understand money
and the functions it performs. For instance, you can discuss with students whether rubles or any
15. In introducing the measurement and analysis of money, it is important for students to see that
money is valuable to a society because the presence of a reliably valued money allows a
dramatic reduction in transaction costs, leading to greatly increased levels of mutually beneficial
16. Emphasize that while credit cards are not part of the supply of money, their degree of availability
17. It is useful to show students why a change in reserve requirements is a blunt instrument for
18. It is useful to tell students that while discount rate changes have little direct effect on the money
19. The issue of foreign holdings of U.S. currency can be illustrated by the Federal
20. Game 1 examines how the fractional reserve system was developed. Game 2 shows students an
RELATED MATERIALS AVAILABLE FREE TO INSTRUCTORS
1. Federal Reserve District Bank Publications. The regional Federal Reserve banks publish
monthly and quarterly reviews available to instructors upon request. For those particularly
interested in money supply and related economic data, the following publications from the
Federal Reserve Bank of St. Louis, P.O. Box 442, St. Louis, MO 63166, are recommended.
a. Review. Published monthly; contains articles and analyses on current monetary topics.
b. Monetary Trends. Issued monthly. Presents current data on member bank reserves and the
c. International Economic Conditions. Issued monthly. Contains monetary and aggregate
136 Chapter 13/Money and the Banking System
GAMES
1. Gold and Knights
Type: In-Class demonstration
Topics: Money, fractional reserve banking
Textbook: Chapter 13 Money and the Banking System
Materials Needed: 3 coins, a receipt, a volunteer
Time: 10 minutes
Class limitations: works in any size class
Purpose
This activity illustrates the development of paper currency and the modern banking system.
Instructions
Explain to the class that they are going back in time, back to a time when knights roamed the
countryside and money was gold. Since gold was so important, the student volunteer will play the
role of a goldsmith.
days, putting money away for safe-keeping was like a coat check: your coins were
stored and the same exact coins would be returned. Eventually the goldsmiths came up with an
k, as long as they
Points for discussion
Fractional reserve banking has many economic benefits. Depositors could now earn interest on
their money, encouraging savings. Bank funding allowed borrowers to create new factors of
production. This increased investment allows faster economic growth.
The main problem with fractional reserve banking is the inability to pay all depositors at a given
time. Bank runs can lead to bank failures. Even healthy banks will not survive a bank run. This
makes a good introduction to Federal deposit insurance as a way to prevent bank runs.
2. Money Creation
Type: In-Class demonstration
Topics: The banking system and deposit expansion
Textbook: Chapter 13 Money and the Banking System
Materials Needed:
Time: 25 minutes
Class limitations: works in any size class
Purpose
This activity demonstrates the role of the banking system in expanding the money supply.
Instructions
The two volunteers are bankers. Have each of them draw a balance sheet on the board.
BankTwo AmerBankCorp
138 Chapter 13/Money and the Banking System
BankTwo AmerBankCorp
Assets Liabilities Assets Liabilities
If the process continued indefinitely the banks balance sheets would look something like this:
BankTwo AmerBankCorp
Assets Liabilities Assets Liabilities
Points for discussion
Banks are important to the process of money creation. The banking system, as a whole, literally
expands the money supply.
3. What Can Be Learned from a Dollar?
Type: In-Class demonstration
Topics: Money, Federal Reserve
Textbook: Chapter 13 Money and the Banking System
Materials Needed: none
Time: 5 minutes
Class limitations: works in any size class
Purpose
This activity introduces the role of the Federal Reserve in controlling the money supply.
Instructions
Ask the class to take a dollar bill from their wallets (or a $5, $10, $20, or $100). Students without
any currency can share with someone who does. Ask the class to read the bill.
After a minute, ask them what they have learned.
Common answers and points for discussion
the note is not convertible into gold or
silver. This can be used to introduce the difference between fiat money and commodity money.
Someone w
140 Chapter 13/Money and the Banking System
HINTS FOR ANSWERING CRITICAL ANALYSIS QUESTIONS
2. The narrowly defined money supply M1 includes only assets that are widely used as a means
5. While the customers of a bank are constantly making deposits and withdrawals, these will
tend to roughly balance out. Therefore, at any point in time, the bank will be able to satisfy
9. Challenge students to think about the following questions: Is printing more paper money the
usual way in which the U.S. government alters the money supply? Does a budget deficit always
increase the money supply? Is an increase in the money supply always inflationary?
11. In federal funds market, banks with excess reserves extend short-term loans to other banks
13. a. False; from time to time, individuals might want to reduce their money balances and hold
wealth (or income).
15. a. The currency outstanding is included in both the M1 and M2 money supply, regardless of
whether it is held domestically or abroad. Thus, this will not directly impact either M1 or M2.
b. M1 will decline because money market mutual funds are not included in the M1 money
17. a. Required reserves = $20,000; excess reserves = $30,000.