6  Money and banking

6.1 What money is

A medium of exchange, a store of value, a unit of account. Its key property is liquidity.

type example
Commodity money Gold
Fiat money U.S. dollar — value by government decree, intrinsically worthless
Legal tender Money the government requires accepted in settlement of debts

6.2 M1 and M2

measure what’s in it
M1 Currency held by public + checkable deposits + travelers’ checks + NOW accounts
M2 M1 + savings deposits + small time deposits + money market mutual funds + near-monies

Both are stock measures (point in time). M2 is broader and more stable.

6.3 The bank balance sheet

\text{Assets} = \text{Liabilities} + \text{Net Worth}

Assets Liabilities + Net Worth
Reserves (vault cash + deposits at Fed) Demand deposits (DD_p)
Loans Other deposits
Securities Net worth

6.4 Reserves

RR = rrr \cdot DD_p \qquad ER = TR - RR

Banks earn nothing on ER, so they want ER = 0. They make loans until ER is exhausted. The act of lending creates new deposits at other banks. That is how money is created.

6.5 The money creation chain

Suppose rrr = 20\% and the Fed buys $100 in bonds from Bank A.

  • Bank A receives $100 in reserves. RR = 20, ER = 80. Lends $80.
  • Borrower spends; receiver deposits at Bank B. Bank B has $80 in reserves. RR = 16, ER = 64. Lends $64.
  • Bank C: lends $51.20.
  • Continue.

Sum of new deposits: 100 + 80 + 64 + 51.2 + \ldots = 100 \cdot \frac{1}{1 - 0.8} = \$500.

Money creation chain. Geometric series, ratio = (1 - rrr) = 0.80. Sum = K_S \times \Delta R = 5 \times 100 = 500. New money created = 500 - 100 = 400.

6.6 The money multiplier

K_S = \frac{1}{rrr} \qquad \Delta M^S = K_S \cdot \Delta\text{Reserves}

Warning

This is an upper bound. It assumes (1) banks lend until ER = 0, and (2) no leakage out of the banking system (no cash held outside banks). Real-world K_S is smaller.

6.7 The Fed

body role
Board of Governors Sets policy direction. 7 presidentially-appointed members.
FOMC Sets money-supply and interest-rate targets.
Open Market Desk (NY Fed) Executes the trades daily.

6.8 The three Fed tools

tool how it works direction
rrr Lower → banks have more ER to lend \downarrow rrr \Rightarrow \uparrow M^S
Discount rate Lower → banks borrow more from Fed \downarrow discount \Rightarrow \uparrow M^S
OMO (most-used) Buying bonds injects reserves OMO purchase \Rightarrow \uparrow M^S

6.9 Try it

The money creation tool lets you pick rrr and OMO size, and shows the iterative deposit chain plus the geometric sum.