Chapter 13 Money, Banking and the Creation of Money

I. Functions of Money
II. The Supply and Demand for Money
III. United States Private Banking System
IV. The Federal Reserve System
VII. The Monetary Multiplier
VIII. Additional Reading
V. Recent Developments
Fractional Reserve System/Money Creation

Economic Video Lectures
review important concepts
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I. Functions of Money 
   A. Medium of exchange: facilitate exchange eliminating barter which requires people
        with mutually needs.
   B. Standard of value: allows for the pricing of heterogeneous goods.
   C. Store of value: maintains value and provides liquidity so extra spending power is
         available as needed. Maintaining money's value requires
         1. A sound fiscal policy (a reasonable federal debt)
         2. A sound monetary policy (not using inflation to pay the federal debt)
A brief history of U S dollar debasement?
    D. Standard of deferred payment: makes credit contracts possible so credit 
          transactions are possible.

Other Macro Chapters

8) Measuring Total Economic Activity 
9) The Business Cycle

10) Macro Equilibrium 
11) Competing Macro Theories and Issues
12 Keynesian Economics: Expanded View
14) Fiscal Policy
15) Monetary Policy  
16) Stagflation & Rise of Supply-Side Economics
17) Budget Deficits
See Democratic Capitalism vs. Capitalistic Democracy 
18) Economic Growth 
II. The Supply and Demand for Money
      A. Three categories of the supply of money
      1. M1 = Currency, coins, and demand deposits (checking accounts). 
           2. M2 = M1 plus near monies such as small time deposits (savings 
               accounts) and short-term government securities. 
           3. M3 = M2 plus large time deposits (over $100,000)
      B. What backs the dollar?
           1. In 1971 President Nixon took the U.S. off a partial gold standard. See
The Gold Reserve Act 
           2. It is a debt of the federal government.
           3. Backed by faith in the government's ability to control inflation.
           4. Value is determined by acceptability (it is legal tender and scarce).
5. Commodity money, such as tobacco used as money in the Virginia colony, has intrinsic
               value of its own.
           6. It's fiat (by decree of the government) money.
               a. Fiat money's first appearance in the U.S. when Congress issued Continental currency
                   with no gold backing
Gresham's Law (bad money chases good) caused it to disappear after the war.
                    2.  State issued their own money.
                    3. Ben Franklin on Paper Money Economy
               b. Greenbacks (demand notes on the Treasury) that were green in color were issued as legal
                   tender during the Civil War.
               c. An intermittent return to
Gold Standard (only gold is money) followed although the U.S.
                   left gold for good in 1971as high inflation caused a run on gold that the U.S. Treasury
                   could not satisfy.             
           7. Today, coins are called token money because they have little intrinsic value.
           9. Types of money has more information

Continental Currency

1923 Germany Hyperinflation in the Weimar Republic
A 50,000,000 (50 million) mark banknote

     C. The Demand for Money 
          1. Transaction D, Dt, results because people hold money, often in
               a money market account, to use as a medium of exchange.
          2. Asset Demand, Da, results because people accumulate money,
              often held in an investment account, to buy assets.
          3. The demand for money Dm= D t + Da
          4. Interest rates are set in the money market. more interesting history.
          5. For more information visit
Demand for money

D. History

Brief History of Money Or, how we learned to
stop worrying and embrace the abstraction          
2. 300 Years-of-financial-crises-1620-1920

3. Gold Timeline
4. The continental currency crisis of 1779 and today's
European debt crisis  4/11/14
5. Central bank crisis management during wall street's
first crash in 1792  5//14
The Slump that Shaped Modern Finance Economist 4/14
7. Infographic History of U.S. Money
8. History of the Gold Standard
9. History of Money
A Brief History of U S Banking Problems and
11. The Essence of Money, a Medieval Tale (7:36)


Source The Economist   4/5/14

III. United States Private Banking System
A. Two kinds of banks
          1. Commercial banks offer demand deposits (checking accounts)
          2. Savings and loan associations used to specialize in time
              deposits (saving accounts) and home mortgages. Now, because
              of deregulation during the early 1980's, they are similar to
              commercial banks. 
     B. Federal deregulation contributed to banking difficulties in the 1980's.

     C. Visit  brief history provided by the Federal Reserve Bank for
          a time line of the U.S. banking System. Be sure to point at each date
          to see what happens during that period.
IV. The Federal Reserve System    
      A. Organization Chart






            1. Board of Governors oversee the Federal Reserve System
                a. Seven governors
                b. Governors are appointed by the President and confirmed by the Senate.
                c. The chair is appointed by the President for a four-year term.
                    1)  To foster independence, the term does not coincide with the President's
                    2) Other board members are appointed to 14-year terms on a staggered
                       basis to insure an experienced board.
            2. Federal Open Market Committee
                 a. Membership consists of the Board of Governors and 5 of the 12 Federal
                     Reserve bank presidents with the N.Y. president always a member 
                     because N.Y. City is the financial center for U.S. international trade.
                 b. The Committee tries to affect interest rates by affecting the supply of
                     money by buying and selling U.S. government bonds (See Chapter 15).
           3. Federal Advisory Council 12 prominent commercial bankers, one from
               each district, who advise the Board of Governors
           4. Twelve Federal Reserve Banks 
a. The United States is divided into 12 homogenous districts and each 
                    has its own bank
               b. Bank for the federal government
               c. Bank for member banks
               d. Graphic is complements of the Board of Governors of the Federal
                   Reserve System.
           5. Member commercial banks
           6. Nonmember commercial banks and thrifts are regulated by other
               government agencies.

           Federal Open Market Committee
meeting at the Federal Reserve in Washington, DC

20th Century
U.S. Political Economy

Interaction of Politics and Economics
19th Century Ended with Monarchs in control and liberal economic thought expanding.
1900-09 A sever recession brings the need government take-over of central banking.
1910-19 FED becomes the Lender of Last Resort, few labor gains and war.
1920-29 Recession then economy and Wall Street dominates with loans to war-torn to nations.
1930-39 Great Depression dominates, Keynes Wins, communism affects Western economies.
1940-49 U.S. dominates world after WWII and Marshal Plan hopes to defeated communism.
1950-59 U.S. vs. with communists, labor power, and segregationists don't slow economy.
1960-69 OPEC oil slows manufacturing and Vietnam enrages many.
1970-79 Nixon starts inflation, closes gold door, opens China, and lies.
1980-89 FED recession solve inflation, RR cuts taxes and regulation.
1990-99 Tax increase hurts Bush, free trade and capital markets expands.
2000-09 Two tax cuts, three wars and one health care acts expand government
2010-04 Government expands to end Great Recession and expand health care.

       B. Functions of the Federal Reserve 
            1. Regulate the money supply
            3. Oversea the financial system
            4. Check collection and clearing
            5. Fiscal agent for the government
            6. Supervise (audit) member banks 
            7. Hold reserves (deposits) for member banks
            8. Compile economic statistics such as the 2010
Beige Book, which is
a quarterly summary of each districts' recent economic activity.
            9. Many Federal Reserve publications are free.
The Federal Reserve System Purposes and Functions
C.  History
1. The bank that Hamilton built
              2. ANDREW JACKSON took on the eastern bankers, vetoed 
                  the charter extension of the Second Bank of the United States
                  because he felt it had excessive power over farmers.
THEODORE ROOSEVELT took on the corporate monopoly
                  Trusts that control railroad rates and routes and thus destroyed
                  small towns and farms. 
             4. Nixon Shock inflationary pressure and French President De Gaulle
                 force the US to stops the convertibility of dollars to gold.
             5. A Century of U.S. Banking: Fall 2013 Ben Bernanke
             6. Federal-reserve-was-created-100-years-ago-this-is-how-it-happened
             7. Cooperation, conflict and the emergence of a modern federal reserve
Current Events Readings
Philadelphia Reflections: Whither, Federal Reserve?
is a well
   done, concise history of banking in the United States.
The Real Threat to Fed Independence Henry Kaufman, Wall 
                 Street Journal. The financial giant cuts the industry no slack.
Visual Guide To The Federal Reserve why we have a Fed... !
Phony Currency Wars
5. The Current Events Internet Library has many up-to-date
              economic articles.
Figure of 'Federal Reserve Distributions to the U.S. Treasury, 2004-2013'. Bar chart. Federal Reserve distributions to the Treasury displayed annually: 2004, $18.1 billion; 2005, $21.5 billion; 2006, $29.1 billion; 2007, $34.6 billion; 2008, $31.7 billion; 2009, $47.4 billion; 2010, $79.3 billion; 2011, $75.4 billion; 2012, $88.4 billion; 2013, $77.7 billion.











Profit isn't usually listed as a function of the FED but $325 from 20010 -13 isn't chicken feed.



V. Recent Developments
        A. Banks and thrifts are the only institutions whose checking accounts are not
             restricted as to check size and number
            1. The
Financial Institutions Reform, Recovery and Enforcement Act of 1989
                liberalized banking laws, caused a declined in their importance although 
                reforms resulting from the Great Recession of 2008 cold change this.
            2. Consolidation has caused their numbers to decline and their size to increase.
            3. Many bank/thrift services are now performed by insurance companies, 
                pension, and securities companies.
        B. Globalization of financial markets.
Shadow Banking System
  1. Rise of the Shadow-Banking System
             2. Long Term Capital Management collapsed in the late 1990s
       D.  Some politicians think the Federal Reserve system is too independent.   
Congress Is Politicizing the Fed Jan 25, 2010
             2. Central bank independence versus inflation
                 This often cited
  [49] research published by Alesina and Summers (1993)[50]
                 is used to show why it is important for a nation's central bank (i.e.-monetary
                 authority) to have a high level of independence. This chart shows a clear
                 trend towards a lower inflation rate as the independence of the central bank
                 increases. The generally agreed upon reason independence leads to lower
                inflation is that politicians have a tendency to create too much money if given
                 the opportunity to do it.
[50] The Federal Reserve System in the United States
                 is generally regarded as one of the more independent central banks.
             3. Presidential Elections of 1828 and 1832 were about the need for a  strong
                central bank
        E. Former FED Chairman Ben Bernanke defined the FED economic roll as follows
             1. Inflation targeting i.e. macro stabilization
             2. Financial Oversight
             3. Unlimited crisis intervention See
Lombard Street for historical creation
                 a. Macro prudential regulation used by FED to regulates and controls the
                     financial system (investment banks) as FED does  banking syste
                 b. Lombard Street: A Description of the Money Market from Project Gutenberg
                 c. Text at Library of Economics and Liberty
             4. Maximum employment given inflation target


  VI. Fractional Reserve System/Creation of Money
         A. Commercial banks are required to keep a reserve (cash) of about 12% of their
              demand deposits (checking accounts) at their bank or on deposit with the 
              Federal Reserve (required reserves). The remainder, (Excess Reserves)  
              may be loaned out even though they support deposits.
         B. Money is created by these loans as long as the demand deposits (DD) created
              by them stay within the banking system, that is, the money loaned is redeposit
              as a DD into a bank within the system. The banks owe the demand deposits
              created by the loans to each other. These inter-brain debts  are canceled with
              a bookkeeping entry. It should be pointed out that the demand deposits 
              created by such loans are spent, and goods transferred, just as if the 
              transaction involved   currency.
         C. Example: Bank A has $50,000 in demand deposits. A reserve requirement of 
             10% would yield required reserves of .10 x $50,000 = $5,000. If Bank A 
              had $7,000 in reserve, it could loan up to $2,000 in the form of demand 
              deposits. Suppose Bank B does exactly the same with both banks' customers
              depositing their DD in the other bank. Banks would owe cashed checks to 
              each other, would cancel interbank debts, and money  has been created.
         D. The system works in reverse with money destroyed if reserves leave the system.
         E. Required reserves, reserves not loaned, and loans of cash (reserves) represent
              a leakage which eventually stops money supply growth.
         F. Readings and Video
1. The Truth is Out: Money is Just an IOU and the Banks are Rolling In It
             2. Money Creation in the Modern Economy
             3. Money Creation Video 13.03 minutes is well done
















Source and prediction of coming inflation A. Laffer, 6/11/14

VII. The Monetary Multiplier
       A. An infusion of reserves into the system by the Treasury as directed by the 
           Federal Reserve can be loaned a number of times by the commercial 
           banking system. For example, the Federal Reserve may buy a $100 
           Treasury bond from Ms. A who deposits the Federal Reserve check
           (reserves) into Bank A. 
       B. Bank A's new DD of $100 requires them to keep $10 (10%) in reserve
            leaving $90 excess to loan to Mr. B who deposits it in Bank B.
       C. Bank B needs to keep only $9 ($90 x .1) in reserve and may loan out $81. 
       D. This process continues and as long as the demand deposits being created
            by the loans stay within the commercial 
            banking system, interbank debts are canceled and money has been created
       E. Monetary multiplier (M) sets the upper limit of the expansion
           1. R = reserve requirement = 10% = .1
           2. M = 1/R = 1/.1 = 10
       F. In the above example the total amount of DD created beginning with Bank
           A's $90 in excess reserves would equal 
           Excess Reserves x M = $90 x 10 = $900. If the $100 infusion by the 
           Federal Reserve is included, the increase is 10 x 100 = $1,000.
Video 2.43 minute Practice Problems Video 3.02
      H. Visit
The Banking System and the Money Multiplier
from Jay Kaplan
            of the University of Colorado at Boulder for more information.

Are we getting better at controlling inflation?



VIII. Additional reading

A. Money Creation
Money creation from Wiki
Recollections of Pine Gulch
reviews money.
Banks Create Money
  4. The (2nd) Deleveraging: What Economists Need to Know of Money Creation
B. More History 
1. A Brief History of U S Banking Problems 
Dirk-bezemer-the-post-bubble-economy is a four part video explaining
    credit evolution. 7/6/13

. A 9-page summer read for historical context in understanding the history
     of monetary policy: the famous Wizard of Oz, an economic allegory/satire
     on who will create US money: federal government as "money" or a central
as "debt." This issue was the foundation for the "Greenback Party,"
   "Populist Party," "free silver," and William Jennings Bryan's three
     presidential campaigns (and "Cross of Gold" speech): or a film version
     of this allegory
The Secret of Oz can be viewed online (winner of
    two 2010 international Best Documentary awards).
 3. The Nixon Shock
from Business Week 8/14/11 How Nixon stopped backing
    the dollar with gold and changed global finance,

a 40-year-old decision that still echoes in Greece, Ireland, and the U.S.
4. Buttonwood, Forty years on from 8/11 of Economist Magazine
5. Mississippi-bubble of 1720 and the-European Debt Crisis

Last Chapter 

Free Political Science Book Summaries

Presidential Courage
Brave Leaders and How They Changed America 1789-1989

by Michael Beschloss , 8 pages, or  Buy this Book 

Second Chance
Three Presidents and the Crisis of America Superpower, 
by Zbigniew Brzezinski,
 6 pages, or Buy this Book
 6 pages, or Buy this Book

American Dynasty
Aristocracy, Fortune, and the Politics of Deceit in the House of Bush
by Kevin Phillips
5 pages, or  Buy the Book

Don't Know Much About History
Everything You Need To Know About American History But Never Learned, 5 pages, or
Buy the Book

Chapter 13 Class Discussion   Questions

Chapter 13 Homework Questions

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Table of Contents

Economics Internet Library




Some Central Banks Are Easing to Create Growth,

Some Are Not  



Source 2014/09/28/