Understanding Money: The Supply Process and Its Role in the Economy

1. Ec 123 Section 1 • THIS SECTION • Course Introduction • The Money Supply Process • The Price of Money • NEXT • Case: The U.S. Financial Crisis of 1931 Purchase from Edith Quintanalla for $3 in Baxter 301. Read before class and prepare money worksheets (on website) and short response. Ec 123 Section 1

2. Money: What is it? Money is anything that has the following three functions: • a medium of exchange • the unit of account • a store of value • The last two features are not unique to money. Almost any durable commodity or asset could fulfill these roles. • Medium of exchange is the unique, and most important, feature. What makes for a good medium of exchange? • Cigarettes were Poland’s unofficial currency in the early ‘80’s. • The key is liquidity. Ec 123 Section 1

3. Money: What is it? Liquidity is the degree of ease and speed with which a commodity can be used to purchase goods and services. • Most all commodities are liquid to some extent. Hence what we label as “money” is a matter of degree. • Rank the following from most liquid to least liquid: • a check drawn on a standard demand deposit • cash • bank certificate of deposit • money market mutual fund • mortgage backed security Ec 123 Section 1

4. The M1 definition of money We will temporarily adopt a narrow definition of money known as M1: M1 = currency + demand deposits There is also M2, M3, L. Why focus on M1? Ec 123 Section 1

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7. Money: Where does it come from? • In modern economies, the creation of money begins with a central bank. • The central bank in the U.S. is the Federal Reserve. Like all banks, it keeps a balance sheet. • The liability side of the balance sheet is known as the monetary base (or high powered money or reserve money). • The Fed expands the money supply by adding to the monetary base Ec 123 Section 1

8. Source: Federal Reserve “The Federal Reserve System: Purposes & Functions” 2005. Ec 123 Section 1

9. Money Supply Example Suppose the Fed buys $113.50 in Treasury bills from a private investor. The investor keeps $13.50 in his pocket (12%), and puts $100 into a checking account (a demand deposit) at Bank 1: $100 $100 $100 $100 Ec 123 Section 1

10. Money Supply Example 2 Bank 1 keeps 15% of the $100 in reserve and makes an $85 loan to a farmer. $100 $100 $15 $85 $85 $100 $100 Ec 123 Section 1

11. Money Supply Example 3 The farmer uses the $85 to buy fertilizer. The dealer keeps $10 (12%) in cash and deposits $75 in his bank. $75 $75 $75 $75 Ec 123 Section 1

12. Money Supply Example 4 Bank 2 keeps 15% of the $75 in reserve and has $63.75 to lend to a customer–$63.75 that did not previously exist. Money creation continues in this manner. $75.00 $75.00 $11.25 $63.75 $63.75 $75.00 $75.00 Ec 123 Section 1

13. The Money Supply Process How much money will ultimately be created? • Must consider the leakages out of the system. • 2 main types: • Cash Leakage • Reserve Leakage • Total Proportion of leakages: R = cash + reserve(1-cash) Ec 123 Section 1

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15. What is the price of money? Two answers! Ec 123 Section 1

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17. How banks make money: Summary • The key characteristic of money is liquidity. • Central banks influence the money supply through changes in the monetary base and reserve requirements. Private banks influence the money supply through the money multiplier process. • Money is a commodity it usually trades on price. Ec 123 Section 1