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
V. Recent Developments
VI. Fractional Reserve System/Money Creation
VII. The Monetary Multiplier
VIII. Additional Reading
Economics Internet Library
Table of Contents
Economic Video Lectures
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
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
1. 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
Hyperinflation in the
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
1 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
6. 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
10. A Brief History of U S Banking Problems and
The Essence of Money, a Medieval Tale (7:36)
provide a little
Source The Economist 4/5/14
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
B. Federal deregulation contributed to banking difficulties in the 1980's.
C. Visit History provided by the Federal Reserve Bank of St. Louis 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
| 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
5. Member commercial banks
6. Nonmember commercial banks and thrifts are regulated by other
Federal Open Market
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 BeigeBook, which is
a quarterly summary of each districts' recent economic activity.
9. Many Federal Reserve publications are free.
10.The Federal Reserve System Purposes and Functions
1. 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.
2. THEODORE ROOSEVELT took on the corporate monopoly
Trusts that control railroad rates and routes and thus destroyed
small towns and farms.
3. Nixon Shock inflationary pressure and French President De Gaulle
force the US to stops the convertibility of dollars to gold.
4. A Century of U.S. Banking: Fall 2013 Ben Bernanke
5. Federal-reserve-was-created-100-years-ago-this-is-how-it-happened 12/21/13
6. Cooperation, conflict and the emergence of a modern federal reserve 4/17/14
D. Current Events Readings
1. Philadelphia Reflections: Whither, Federal Reserve? is a well
done, concise history of banking in the United States.
2. The Real Threat to Fed Independence Henry Kaufman, Wall
Street Journal. The financial giant cuts the industry no slack.
3. Visual Guide To The Federal Reserve why we have a Fed... !
4. Phony Currency Wars
5. The Current Events Internet Library has many up-to-date economic
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.
C. 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.
1. Congress Is Politicizing the Fed Jan 25, 2010
2. Central bank independence versus inflation
This often cited  research published by Alesina and Summers (1993)
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. 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
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 Tt
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.
G. 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.
VIII. Additional reading
A. Money Creation
1. Money creation from Wiki
2. Recollections of Pine Gulch reffeconomics reviews money.
3. Banks Create Money
4. The (2nd) Deleveraging: What Economists Need to Know of Money Creation Process
B. More History
1. A Brief History of U S Banking Problems
and Dirk-bezemer-the-post-bubble-economy is a four part video explaining
credit evolution. 7/6/13
2. A 9-page summer read for historical context in understanding the history
of monetary policy: the famous Wizard of Oz book is economic allegory/satire
on who will create US money: federal government as "money" or a central bank
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
Are we getting better at controlling inflation?
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Some Central Banks Are Easing to Create Growth,
Some Are Not