Unit Four

A. Money and the Banking System

1. Definitions of money and its creation

Money is defined in general terms as anything widely accepted as the medium of exchange.
There are two types of money: commodity money and fiat money.
1. Commodity money any commodity that has intrinsic value, such as precious metals (gold),
animal pelts, or cigarettes.
2. Fiat money Tokens that are intrinsically valueless and therefore have value by government
decree, such as the U.S. dollar or the euro.
The Fed, however, defines the money supply as three monetary aggregates: M1, M2, and M3.
Money Definition M1
1. Currency coins and paper money in the hands of the public
a. Coins token money
b. Paper money Form of Federal Reserve Notes issued by the Federal Reserve System with the
authorization of congress.
2. All Checkable Deposits all deposits in commercial banks and thrifts
a. Convenient, facilitate bill payment and the transfer of ownership of bank deposits
b. Require endorsement to protect against theft
c. Institutions that offer checkable deposits: commercial banks, savings and loan associations,
mutual savings banks, credit unions, and thrifts.
3. Note: Currency and checkable deposits owned by the U.S. government, commercial banks,
Federal Reserve banks, etc. are excluded from M1 to avoid double counting.
Money Definition M2
1. M2 consists of all the components of M1 plus near-monies.
2. Near-monies Liquid financial assets that may be readily converted into M1 money
a. Savings deposits, including money market deposit accounts
b. Small-time deposits (less than $100,000) that become readily available at maturity
c. Money market mutual funds

Money Definition M3
1. M3 consists of all the components of M2 plus large-time deposits
2. Large-time deposits (greater than $100,000) are usually used for saving and owned by
businesses.
Quiz on U.S. Currency!

2. Functions of money
1. A medium of exchange that is usable for buying and selling goods and services.
2. A monetary unit of account that serves as a tool for measuring the relative worth of goods and
services. Money facilitates comparison and taxation, and defines debt and GDP.
3. The most liquid store of value that allows people to transfer their purchasing power from
the present into the future.
In order to function, money must be accepted by the people, portable, divisible, uniform,
familiar, and durable. Without money, people would resort to bartering, which requires a double

coincidence of wants.

3. Relationship of money supply to nominal gross domestic product (GDP)

The money supply is directly proportional to the nominal gross domestic product (GDP), based
on the monetary equation of exchange that was made famous by Irving Fisher. Nominal GDP is
equal to all final transactions that take place within a year.
Equation: MV = PQ
M: Amount of money in circulation (money supply M1)
V: Income velocity of money (also, the number of times $1 changes hands from final consumer
to final consumer.
P: The average price level (Price Index)
Q: Real GDP (value of final goods and services)
Note: Real GDP (Q) times the Price Index (P) is equal to nominal GDP. In other words, PxQ =
nominal GDP.
Therefore, a larger money supply corresponds to a larger nominal GDP, but also to higher
inflation (larger Price Index).
Buckle Up, It Could be a Bumpy 2008

4. Creation of money and the deposit expansion multiplier

The growth of the money supply is determined by the actions of the Fed, the commercial
banking system, and the public. The Fed sets the reserve requirement and the discount rate, and
conducts open market operations. The commercial banking system loans money and accepts
deposits, and determines the use of excess reserves. The public hold deposits and cash.
Banks do not try to create money, but the nature of their normal profit-seeking activities result in
money creation because of the fractional-reserve banking system. Banks must hold a fraction of
their money as reserves. The required amount is set by the Fed and is called the reserve
requirement. The rest of their money is called excess reserves, and may be loaned out. New
deposits are created as a result of the loans, and money is created.
The demand deposits that are created are a multiple of the required reserves, as shown by the
equation R = rD, where R is the required reserves, r is the percent reserve requirement, and D is
the demand deposits that are created.

The deposit expansion multiplier measures the amount of demand deposits created as a multiple
of the reserve requirement. This is given by the equation 1/r, where r is the reserve requirement.
In sum, the deposit creation process is based on the fact that banks only keep a fraction of what
the receive as reserves, and lend the excess out again. Smaller reserves lead to the creation of a
larger number of checkable deposits, and vice versa. In the real world, the multiplier is less than
1/r because banks hold excess reserves, and the public holds cash.
The Money Has to Come From Somewhere
Economics resources (topic: money):
The Library of Economics and Liberty - Money
An interesting connection:
The Economics of the Wizard of Oz

Works Cited
http://wfhummel.cnchost.com/index.html#10
www.dollardaze.org
Yahoo Finanace
Notes from class and the textbook

B. Monetary Policy and Aggregate Demand

1. Tools of the central bank
1. Open Market Operations (OMOs) are the buying and selling of bonds by the
Federal Reserve to manipulate the economy. A bond is the government's promise
that if you hand over your money for a slip of paper, they will repay you in full
later on in life.
2. Change the reserve requirement is another effective tool of the Federal Reserve.
By increasing the reserve requirement, the Federal Reserve is dictating that banks
must send a larger amount of money to the Federal Reserve as an insurance.
3. Change the discount rate acts as a signalling move. The discount rate is the rate
at which the Federal Reserve loans out to banks. While banks are hesitant to
borrow from the Federal Reserve, the act of lowering or raising the reserve
requirement acts as a signal to other banks. Banks will follow suit when the
Federal Reserve manipulates the discount rate.

2. How the Federal Reserve's tools change the money supply

1. Open Market Operations: When the Reserve sells bonds, they are enforcing a
contractionary policy by taking money away from the public and investing it into
bonds. When the Reserve buys bonds, they are forcing an expansionary policy by
giving the public money and taking it out of the government.
2. Change the reserve requirement: When the Federal Reserve increases the
reserve requirement, there are less funds available to loan out to the public, so a
contractionary policy is enacted. When the Federal Reserve lowers the reserve
requirement, they increase the amount of funds available to loan out, and enforce
an expansionary policy.
3. Change the discount rate: When rates increase, a contractionary policy begins.
When the rate decreases, an expansionary policy begins.
3. How the interest rate is determined in the money market
1. The loanable funds graph determines the interest rate of money given a money
supply and demand. As supply increases with a constant demand, the interest rate
will decrease.
2.

4. The transmission mechanisms of changes in the money supply to output and the price
level
5. The idea of the transmission mechanisms of changes explains the ripple effect in our
economy. For example, the Fed could begin the ripple by buying bonds. When they buy
bonds, the money supply increases. With a larger amount of money available, interest
rates will fall. With lower interest rates, the Aggregate Demand curve will shift to the left.
With that shift, the real GDP will increase. Price level will lower as an overall effect as
the interest rates lower. The exact opposite of this ripple could also occur, if the
Federal Reserve sells bonds instead of buying them.

C. Real versus Nominal Interest Rates

1. Definition of real and nominal interest rates- A real interest rate is adjusted for inflation. The
formula for a real interest rate is (1+r)/(1+i)-1. Where "r" stands for nominal interest rate and "i"
is inflation. A nominal interest rate is the interest rate that hasn't been changed for inflation.
2. Fisher equation- This equation is 1+n=(1+i)(1+r), where "i" equals inflation and "r" stands for
the real interest rate. "n" also stands for the nominal interest rate. The hypothesis that goes along
with the equation states that "i" and "n" move together, therefore "r" will always be relatively
stable in the long-run. The equation and hypothesis were formulated by Irving Fisher.
3. Short-run effects of monetary policy on real and nominal interest rates- Monetary policies that
try to keep short-run, real interest rates low will actually cause higher nominal interest and a
sharp increase in inflation. This policy will also reduce the value of the dollar which causes the
U.S. to spend more on imports.
4. Long-run effects of monetary policy on real and nominal interest rates- These interest rates
reflect what the public thinks the Fed will do in the future. For example, if the Fed chooses not to
contain inflation, the general public will be concerned about increased inflation rates. So, they
will add premiums to long-run rates, which will increase the interest rates. If the Fed focuses on
keeping inflation under control, then interest rates will be cheaper because people will feel
confident that they will be paid back in full.
http://moneyterms.co.uk/
http://www.frbsf.org/publications/federalreserve/monetary/affect.html
user-14387

Fed Fearas Worsening Credit Market

christinabins Jan 2, 2008
http://biz.yahoo.com/ap/080102/fed_minutes.html

christinabins Jan 2, 2008

This article illustrates exactly how difficult monetary policy is. The Fed responded as logically as
possible by cutting rates, yet the economy continues to slump.

The Money Has to Come From Somewhere (Unit 4A)

kristin_w Jan 2, 2008
http://dollardaze.org/blog/?post_id=00249&cat_id=7
This article is a unique view of various criticisms of the actions of the Federal Reserve. In class,
we learn economic theories, and we often read articles criticizing the economy, but articles
against the actions of the Fed force students to think. The Fed is in an uncertain position, as they
have a new chairman who needs to prove himself in monetary and fiscal policy. The author of
this particular article expresses concern for the current Fed chairman and board, and cites several
statistics about the current state of the economy. He sites increasing foreign debt, reduced
demand for United States Treasury bonds, and a very expensive war overseas as drains on the
current United States economy. The author states that a general remedy would be to print more
money, which, as we learned in AP Economics, is always risky. The United States are now facing
inflation, and the author discusses several theories about shifty things that may be going on in the
government. Of course, the article represents the opinions of the author, and many of the
projections cannot be verified. The author also questions many decisions of the popular chairman
Alan Greenspan, and seems to be a bit paranoid about the actions of the government. Again, it is
necessary to consider the source of the article. That said, however, it does raise many interesting
questions about the way that our nation views monetary policy, and how future decisions will
affect the economic health of our nation. (248 words)

Buckle Up, it Could be a Bumpy 2008 (Unit 4A)

kristin_w Jan 2, 2008

http://biz.yahoo.com/cnnm/080101/122807_2008_predictions.html?.v=4
The start of the New Year always gives analysts the opportunity to discuss their predictions.
Based on the numbers, any non-economist might assume that 2008 is going to be a scary year,
financially speaking. The integration of a few key economic concepts, however, reveals that this
is not necessarily true. According to economic analysts, 2008 will have a rough start, based
strictly on the headlines. By the end of the year, however, the economy will have surpassed these
predictions. On the outset, falling house prices, rising unemployment, and dangerous mortgage
conditions point to economic slump. Stocks are on the rise, however, and economists predict that
2008 could finish in the positive. Consumers will also benefit this year. Compared to previous
years with comparable rates of inflation, the market appears to be relatively affordable. To avoid
a potential recession, the Fed is taking action. Economists anticipate that, according to policy, the
Fed will reduce interest rates and the federal funds rate in order to boost the economy. This will
increase consumer investment and money creation, and illustrates the concepts discussed in Unit
4A. In sum, although the economy will be in a generally precarious position over the course of
2008, it will largely resemble 2007. This article was of interest mainly because it discusses many
economic concepts that we discuss on the AP Macroeconomics class. This includes how the
rising unemployment rate, falling house prices, and sluggish stock market cause the Fed to lower
interest rates and the federal funds rate in order to create an expansionary fiscal policy. (258
words)

peytonrocks Jan 2, 2008

This article is cause for my parents to feel depressed. My parents bought a beach house on Tybee
Island a few years back right before the hosue market started to recede. So they paid a the peak
which means they paid much more than anyone else. The realtor told them that the house would
keep going up in value and so they would just make money. Little did they know their house is
now worth a lot less. While it is nice have a beach house on the quaint island of Tybee, where on
new years my brother and I went to a bar called Scandals and witness and atrocious obese girl
dancing all over her boyfriend, it still isn't making money. With this prediction that the housing
market will continue to fall my parents are wondering if it will ever rise again. Perhaps this little
Tybee investment went bust. Which sucks for me because I might get stuck having to spend
every New Years like I did this year: witnessing the glory of American obesity dancing around in
drunken insanity. Sick.

Cutting the Interest Rate

danielarudman Jan 1, 2008
Okay so the Fed has cut the interest rate a total of one percent just between August and
December of 2008. Why are things not able to pick up? In theory, people should be jumping at

this opportunity to invest in property and stocks and bonds because the interest rate is declining,
and thus, the cost of borrowing money is declining as well. With the real estate market in an
obvious buyers market cycle, I cannot understand why people are not investing in homes whose
prices are dropping steadily when it now costs them less than ever to borrow the money to do so.
Also, what do you all think will happen within the presidential election if Buckle up, it could be
a bumpy 2008 is right about the economy taking a huge step up in the latter half of the year?
This could really shine some light on the Republican Party, or maybe people will continue to
bash President Bush and give him not even half the credit for the good as he gets for the bad.
Interesting to see how economics affects so many other parts of our nation.