Principles of Economics
Principles of Economics

Principles of Economics

Lead Author(s): Stephen Buckles

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Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

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Only available with supplementary resources at additional cost

Only available with supplementary resources at additional cost

Customizable

Ability to revise, adjust and adapt content to meet needs of course and instructor

All-in-one Platform

Access to additional questions, test banks, and slides available within one platform

Pricing

Average price of textbook across most common format

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Up to 40-60% more affordable

Lifetime access on any device

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

$130

Hardcover print text only

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

$175

Hardcover print text only

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

$140

Hardcover print text only

Always up-to-date content, constantly revised by community of professors

Constantly revised and updated by a community of professors with the latest content

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

In-book Interactivity

Includes embedded multi-media files and integrated software to enhance visual presentation of concepts directly in textbook

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

Customizable

Ability to revise, adjust and adapt content to meet needs of course and instructor

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

All-in-one Platform

Access to additional questions, test banks, and slides available within one platform

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

About this textbook

Lead Authors

Stephen Buckles, Ph.DVanderbilt University

Stephen Buckles is a Senior Lecturer at Vanderbilt University, where he also received his Ph.D. in Economics. Buckles has been the recipient of numerous awards, including Madison Sarratt Prize for Excellence in Undergraduate Teaching (Vanderbilt, 2008), Kenneth G. Elzinga Distinguished Teaching Award (Southern Economic Association, 2006), and the Dean’s Award for Excellence in Teaching (Vanderbilt, 2007). His course pack, which this text is based on, has been used by thousands of students and engages the concepts of active learning.

PJ Glandon, PhDKenyon College

PJ Glandon joined Kenyon College as an Associate Professor of Economics after completing his Ph.D. at Vanderbilt University.

Contributing Authors

Benjamin ComptonUniversity of Tennessee

Caleb StroupDavidson College

Chris CotterOberlin College

Cynthia BenelliUniversity of California

Daniel ZuchengoDenver University

Dave BrownPennsylvania State University

John SwintonGeorgia College

Michael MathesProvidence College

Li FengTexas State University

Mariane WanamakerUniversity of Tennessee

Rita MadarassySanta Clara University

Ralph SonenshineAmerican University

Zara LiaqatUniversity of Waterloo

Susan CarterUnited States Military Academy

Julie HeathUniversity of Cincinatti

Explore this textbook

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Chapter 24: Money

Figure 24.1: Currency is one example of something economist call money. [1]​
​“National discussions of crucial importance to ordinary citizens – such as funding for scientific and medical research, bailouts of financial institutions, a and the current Republican tax proposals – inevitably involve dollar figures in the millions, billions, and trillions. [...]  In a sound bite, a savings of $200 million might sound comparable to a $20 trillion cost.  Scaling reveals the truth:  One is $2 (200 cent) beverage, the other the $200,000 price of an American home. ” [1]              -Dr. Andrew D. Hwang

​24.1 Objectives

After reading this chapter, you will be able to:

  • Explain what money is and its economic function.
  • Explain the difficulties of deciding what should be included in definitions of the money supply.
  • Explain the money creation process and what determines the amount of money created.
  • Explain how interest rates are determined using the supply and demand for money.
  • Understand the relationship between bond prices and interest rates.
  • Understand the meaning of the time value of money and be able to use the concept in making decisions.

​Think back to the discussion in the first chapter of the text. What is money? Why do we have something called money? Why is it created, even in relatively undeveloped economies?

Question 24.01

Question 24.01

Go ahead – write it out. What is money?

Hover here to see the hint for Question 24.01.
Click here to see the answer to Question 24.01.

24.2​ Why Did Money Appear?

Figure 24.2: A gold coin of Diodotus from 245 BC. The Greek inscription reads “(of) King Diodotus.”​ [2]

Money is anything that is used to buy and sell goods and services. In Greece, gold and silver were made into coins during the seventh century BC. Rare jewels, stones, horses, cigarettes, and shells have all been used at various times and places as forms of money. Some perform the economic function of money better than others.

Whatever good is used as money should perform three important economic functions. First, is it a good medium of exchange? That is, can you use it as a method of payment for goods and services? Two, is it a store of value? That is, can you store it and use it later? Three, is it a unit of account? That is, does it work as an objective measure of cost or value?

In the United States, the dollar generally performs these functions better than any other good. Therefore, it is our form of money. The dollar is a fundamental part of our modern economy and plays an important role in our models of economic activity. When we talk about the supply of and demand for goods, we talk about them in terms of prices, measured in dollars. When we talk about income in the United States, we mean in dollars. When we describe production in the United States, we value production in dollars. Whenever someone buys something, sells something, earns something, or owes something, they almost always buy with, sell for, earn, or owe dollars.

​24.2.1 Alternatives to Money

Figure 24.3: Bartering occurs at the local market in Pátzcuaro, Michoacán, México.​ [3]

​There are two alternatives if societies do not use money. One alternative would be a society that does not exchange goods and services. The disadvantages of this should be obvious given the benefits of specialization and trade. If everyone had to make everything they wanted for themselves, mankind would be stuck in the Stone Age.

The second alternative is barter. Bartering is when goods and services are exchanged for each other rather than being exchanged for an intermediate good (i.e., money). For example, a strawberry farmer might exchange his strawberries for clothes from a tailor. The tailor might exchange clothes for shoes from the cobbler. However, there are possible problems with bartering. If the tailor isn’t interested in the strawberries, the strawberry farmer goes without clothes. Two people must want what the other has for trade to take place.

Additionally, the individuals must negotiate an exchange quantity that is agreeable for both. This means it can be difficult to price things. A pair of shoes from the cobbler may be worth two shirts from the tailor or a crate of strawberries from the farmer. The farmer’s crate of strawberries is worth a pair of shoes from the cobbler and two shirts from the tailor. But if the farmer also grows wheat and wheat is only half as valuable as his strawberries, then one bushel of wheat is worth one-half a crate of strawberries, half a pair of shoes, or one shirt. The shirt is worth one-half a crate of strawberries, one bushel of wheat, or one-half pair of shoes. That is confusing! Keeping track of all the different acceptable exchanges would be time-consuming. Additionally, prices or prior agreed exchanges would change depending on the demand and the scarcity of the good. If the demand for strawberries changed or if the supply of strawberries was decreased due to a drought, this has the potential to change the bartering of many goods in the society. Not only is there confusion, but the time spent bartering would also increase.

Without a standard way to price items, it is difficult to determine the relative values of things when there are many goods in the market. Using money to price items in one standard unit eliminates this confusion. Most importantly, being able to buy shirts, shoes, and strawberries with money allows us to avoid the problem of finding individuals who have what you want, want what you have, and will agree to a trade at the quantities you want. The video clip “Trading a cell phone for a Porsche” shows bartering and the length of time it takes to find someone to trade with. The video shows how he was eventually able to barter for a car. One subtle idea the clip demonstrates is how people value the objects traded. Each person he traded with was willing to make the trade because each preferred the item he had more than the item he wanted.


Question 24.02

Which of the following is an example of bartering?

A

An Uber rider gives the Uber driver a $5 tip for the car ride.

B

A cabinet maker gives the plumber a desk since the plumber fixed the cabinet maker’s plugged bathtub.

C

A neighbor gives a young teenager a check for $40 in exchange for grass cutting.

D

All of the above are examples of bartering.

24.3​ Other Monies

Figure 24.4: Chinese Cowry shell money, 16th 8th century BCE.​ [4]

The United States uses dollars as money. The dollar is referred to as the currency of the United States. Money is referred to as currency if it is the dominant circulating medium of exchange. Other nations or groups of nations use different currencies: Canadian Dollars, Euros, British Pounds, Mexican Pesos, and Japanese Yen. These are all examples of paper money, issued by national governments or collections of governments in the case of the Euro.

The issuance of currency by government is a relatively recent phenomenon. Historically, a wide variety of objects have performed the economic function of money. Gold, silver, and other precious metals have a long history of being used as money over a wide geographical range. Another popular money has been the cowry, shown above in Figure 24.4, which is a small oval shell used throughout Africa and the Middle and Far East until as recently as the early twentieth century. Residents of the Fijian Islands in the middle Pacific used whales’ teeth, called “tambua,” into the nineteenth century. The Yap Islands, another Pacific Islands group, are recorded as using large, polished stones as money as recently as 1945. These stones, or “Fei,” ranged from saucer sized for small denominations to wagon wheel sized for large values. Native Americans used beads made from clam shells, which they called wampum. In 1637, the colony of Massachusetts declared wampum legal tender for amounts up to one shilling. Another colony, North Carolina, declared seventeen different commodities, including maize and wheat, to be legal tender. Legal tender is anything that can and must be legally accepted as payment of debts and to buy goods.

Figure 24.5: Yapese stone money or Rai or Fei. This money could be as large as 12 feet in diameter or as little as 1.4 inches in diameter.​ [5]

Agricultural products have been used by many cultures as money. The Mayans used cacao beans, from which chocolate is made, as money. Ancient Mesopotamia and Egypt used grain as money and created primitive banking systems including checkable deposits and transfers of grain from one account to another. Cows, buffalo, goats, and sheep have been used as money all over the world. The popularity of cattle as a form of money can be seen in the derivation of our words “pecuniary” and “capital.” Both come from the Latin word for cattle, “pecus.” Cows are still used as money in parts of Africa. Horses were used as money by peoples in the Russian steppes until the early 1900s.

24.4​ Then What Really Is Money?

If all these diverse things have been used as money at one time or another, then what is money? As said earlier, money is anything that can be used to buy goods and services. However, not all goods make sense to use as money. Money must serve as a medium of exchange, meaning that market transactions are conducted using money. Money should also be able to be used as a unit of account, meaning that it can be used to price goods and services. Money should also be a store of value, meaning that wealth can be stored in the form of money until it is ready to be spent. Dollars conveniently fulfill these functions, but some money may do only one or two of these things well.

​ 24.4.1 A Medium of Exchange

​Money functions as a medium of exchange when market transactions are accomplished using that money. Goods are sold for money and goods are bought with money. People are willing to exchange something with obvious value, like a car, for slips of green paper because they know that those slips of green paper can be exchanged elsewhere for other things of value, like food or electricity or computers or furniture. The slips of green paper are themselves useless for anything else. Dollars aren’t very good at anything other than buying or selling other things. They have too much ink already printed on them to write notes on, they’re too small to wrap things with, and they don’t burn properly to be a good fuel. However, suppliers of goods and services in the United States will generally accept a one-hundred-dollar bill in exchange for one hundred dollars’ worth of a commodity. Not all money is worthless outside its use as money. Some monies are commodities as well, therefore called commodity money. Most monies through history have been commodity money. Cattle and grain can be eaten, cacao beans can be made into chocolate, and precious metals can be made into jewelry or used in electronics. Cigarettes, used as money in prisons and in Europe towards the end of the Second World War, can be smoked.

Figure 24.6: Dried Ramen Noodles [6]​

This NPR article discusses dried ramen noodles being used as currency in American prisons.

​In 2016, Michael Gibson-Light, then a doctoral student in Sociology, reported that ramen noodles were being used in prison as currency. The study was inspired by the book Prison Ramen: Recipes and Stories From Behind the Bars by Gustavo “Goose” Alvarez. In 2015, Alvarez told NPR that Ramen is "everybody's staple in prison: No matter who you are, you're cooking with ramen. You can use it to barter. Some people don't like them, some people will never eat them, but they use them — that's their funny money." Ramen noodles would be considered a commodity money since it has a use aside from being money: it can be eaten.

24.4.2​ A Unit of Account

​We use dollars as a unit of account. We determine the relative prices of things by comparing their values in dollars. The dollar works as a yardstick. We use it to measure value. If a book is worth seventeen dollars and a pair of shoes is worth ninety dollars, it is easy to compare how expensive they are without needing to keep track of the price of shoes in terms of books and the price of books in terms of shoes. The Mayans used cacao beans almost entirely as a unit of account. Goods in the marketplace were priced in terms of cacao beans, but goods were exchanged through barter. If someone wanted to exchange a rope of chilies, worth six cacao beans, for a bundle of firewood, worth seven cacao beans, they would trade the chilies plus one cacao bean for the wood.

24.4.3​ A Store of Value

​Money is used to preserve wealth over time, thus becoming a store of value. Many other things make good stores of value as well; anything that doesn’t degrade much over time can suffice. The people of Yap mainly used their Fei as a way to store value. Large stones are not a good way to make purchases because of the difficulty of transporting them, but they are useful in storing wealth because of their durability. Land is a good store of value, as are gold, silver, diamonds, and art. They can all be exchanged later for goods worth about as much as the goods you exchanged to purchase them. Herds of cattle can be used to store value, although they require care and feeding. Crops make a poor store of value because they are perishable. If you deposited three cartons of cigarettes in a bank and then withdraw them a year from now, they will have lost much of their value. If you purchase a bottle of wine, on the other hand, it may become more valuable in ten or fifteen years. A wine cellar is more useful as a store of value than a basement full of Marlboros. Dollar bills store value well. A dollar printed in 2005 is worth exactly as much as a dollar printed in 2015. Note that the dollar still functions as a store of value even though it may not be able to be traded for the same amount of goods and services every year.

Question 24.03

What are the desirable characteristics of the good used as money?

A

Money is a store of value.

B

Money is a medium of exchange.

C

Money holds the same value through time.

D

Money is a unit of account.

Question 24.04

You are keeping $50 in your pocket in case you find your favorite candy for sale. Sadly you’ve been told that the candy is discontinued, but you still carry the money in case you find the candy. Which function of money does this satisfy?

A

Money is a store of value.

B

Money is a medium of exchange.

C

Money is a unit of account.

D

None of the above.

Question 24.05

Which of the following is a store of value?

A

U.S. dollars and coins

B

Credit cards

C

Gold bars

D

A Picasso painting


Figure 24.7: Bitcoin is a digital currency that was introduced in 2009. [7]​​

Bitcoin is designed to be a digital “currency” that does not exist in any physical form. You cannot carry Bitcoins in your pocket like you can carry a U.S. dollar. Technically, Bitcoin is not considered a currency by economists because it is not commonly accepted as a medium of exchange, one of the definitions of a currency. However, they can be used for the purchase of goods and services at some online retailers.

Bitcoins may not perform the functions of money. Do Bitcoins serve as a medium of exchange? Yes, Bitcoins are a medium of exchange for those merchants who accept Bitcoins as a method of payment for goods and services. Is Bitcoin a unit of account? Yes, goods and services can be priced in terms of Bitcoins. Is Bitcoin a store of value? Perhaps, but the value of a Bitcoin in terms of the U.S. dollar has been quite volatile since its inception. The value of bitcoin fluctuates by the minute and has changed by as much as 50 percent in a single day, so it is not a stable store of value. Bitcoin is also an unstable unit of account. When the value of a Bitcoin increases or decreases so rapidly, it becomes difficult to assess the value of the goods and services for which you could exchange your Bitcoin. Because of the volatility of the Bitcoins’ value, bitcoins may not serve all of the desirable functions of money.

Question 24.06

Bitcoins are used to purchase goods and services from certain vendors. This is evidence that Bitcoin fulfills which of the following functions of money?

A

Bitcoins are a store of value.

B

Bitcoins are a medium of exchange (for those stores that accept it).

C

Bitcoins are a unit of account.

D

None of the above.

24.5​ Why We Use Dollars

Figure 24.8: The first bill is a 1905 Gold Certificate. The second bill is a $20 bill from 1995. Notice how the Gold Certificate looks similar to the $20 bill from 1995.​ [8]

​Now it should be clearer that money, a concept that might appear pretty simple, actually has several sides to it. U.S. citizens are fortunate that the dollar functions easily not only as a medium of exchange but also as a unit of account and as a store of value as well. This is not an accident; years of trial and error have continually changed how we use money. In fact, the experiment continues even today. Until the 1930s, the U.S. dollar was a type of commodity money. Dollar bills could be traded for gold. Now the dollar is simply paper money, issued by the federal government. Money like this is called fiat money. It is money because the federal government says that it is money. The U.S. government no longer exchanges paper currency for gold or silver.

The dollar derives its value only from the fact that nearly everyone is willing to accept the dollar as a means of payment. Furthermore, the U.S. government has defined it as legal tender – that is, courts will enforce the settlement of any debt repaid with dollars. You could say that the dollar is valuable only because people believe it is valuable. If people ever stop accepting the dollar in exchange for goods and services, then the dollar will no longer have any worth, as money or as anything else. Don’t lose sleep over this thought, though. The dollar is just as sound as money as it was before you knew this. If you want to go out and buy a stereo or a hamburger or a gallon of gas, the dollar is still your best bet.

24.6​ The Money Supply

Question 24.07

Question 24.07

So what do we use as our money? What is it that we use on a daily basis to buy and sell things? Make a list right now in the box on the right of the things you consider to be money in our economy.

Hover here to see the hint for Question 24.07.
Click here to see the answer to Question 24.07.​

​The answer (or answers) to what is money is not as simple as it might seem. In fact, the answer is continually changing as we use new forms and kinds of money. Some of what we use is currency, such as dollar bills and all of the coins in circulation. But most of the time, we use checks to transfer deposits from our checking accounts to someone else’s checking account. Sometimes we use debit cards to give someone our deposits; sometimes we use credit cards and then later write checks to transfer deposits to the credit card companies, which in turn send deposits to the companies that originally sold us goods and services. People also sometimes use deposits in savings accounts and money market mutual funds to complete economic transactions. The variety of forms of money and changes over time make it particularly challenging to count how much money exists. The Federal Reserve System is responsible for oversight of the financial system of the United States and has formal definitions for money.

24.6.1​ Definitions of the Money Supply

MB: The monetary base, or MB, is currency in circulation plus any deposits at the Federal Reserve. We will discuss the Federal Reserve in much more detail in Chapter 25. For now, think of the Federal Reserve, or “the Fed,” as a bank for banks. Most banks in the U.S. have deposits with the Federal Reserve that can be exchanged for currency or used to pay other banks. Only banks that are members of the Federal Reserve System and a few other institutions can have deposits with the Fed. The important thing to know about the monetary base is that the Federal Reserve has complete control over this quantity. We will discuss how that works in Chapter 25.

M(1): The sum of currency in circulation and checking account deposits was $3.7 trillion in December 2018.

       Currency          44%
        Checkable deposits     56%
        Travelers checks less than    1%

M(2): The sum of M(1) and savings accounts, money market mutual funds, and small denomination (less than $100,000) time deposits (these include certificates of deposit which are other deposits with a specified date of maturity) was $14.5 trillion in March 2019, which is an all-time high.

           Currency             11%
        Checkable deposits       
14%
        Travelers checks less than       
1%
        Savings deposits        
64%
        Small time deposits       
4%
        Money market mutual funds      
6%

​24.6.2 Currency in Circulation

In 2016, it was estimated that the average currency held by Americans over the age of 19 was $5,742 per person. This estimate is the currency that average Americans have in their wallets or pockets or wherever a person keeps $5,742 when it is not in the bank. These numbers assume that the volume of currency in circulation that is not in a bank or otherwise accounted for in a business is held by American citizens.

ECN24_Table24.1_updated.jpg
Table 24.1: Amount of each type of currency circulation. The numbers on the vertical-axis denote billions of notes. Note: Includes Federal Reserve notes, U.S. notes, and currency no longer issued. Excludes the volume of denominations larger than the $100 note.

​The amount of bills for each type of currency in circulation is shown in Table 24.1 above. The numbers on the vertical-axis denote billions of notes. Notice that in year 2018, the table shows there are 12.4 billion $1 bills in circulation and 13.4 billion $100 bills in circulation. This means that 31% of all bills in circulation are $100 bills. If we convert this into percentages of the total money supply, it means that 82.38% of money in circulation is in $100 bills.1 From the earlier estimate of currency held by Americans, this would imply that each person holds approximately fifty-four $100 bills.

However, the Federal Reserve estimates that as much as 60 percent of U.S. currency is circulating outside of the United States. Additionally, U.S. currency is also likely found in illegal markets in the United States. This would include drug markets and other illegal activities that rely on currency for transactions. This means the earlier statistic of $5,742 held by average Americans is overstated.

​Certificates of Deposit

A Certificate of Deposit (CD) is a savings certificate that states the value of the certificate and when it can be traded in for money. An investor purchases a CD with an interest rate for a fixed amount of time. At the end of that time, the investor can withdraw the initial deposit and interest earned on the CD. If the CD is less than $100,000, it is called a small CD or a small-time deposit. If it is greater than $100,000, it is called a large or jumbo CD. If the CD is withdrawn early, meaning before the end of the agreement, then the owner will have to pay a penalty. The Federal Reserve includes small-time deposits in M2 money supply.

IRAs

An Individual Retirement Account (IRA) is a savings account that accrues interest and generally cannot be withdrawn until the owner of the account is of retirement age. If the owner withdraws the money early, he or she is heavily taxed and must pay a penalty. For this reason, money market accounts held in IRA’s are not included in the M2 money supply.​

Table 24.2: Bank of America Accounts 2017


Question 24.08

Question 24.08

Use Table 24.2 found above and explain which items are found in M(2).

Hover here to see the hint for Question 24.08.
Click here to see the answer to Question 24.08.

Question 24.09

Question 24.09

Use Table 24.2 found above and explain which items are found in M(1).

Hover here to see the hint for Question 24.09.
Click here to see the answer to Question 24.09.

Question 24.10

Question 24.10

Write a brief paragraph describing why deposits in many students’ checking accounts are part of M(1).

Hover here to see the hint for Question 24.10.
Click here to see the answer to Question 24.10.

Question 24.11

Question 24.11

Briefly explain why small-time deposits or CDs are or are not money.

Hover here to see the hint for Question 24.11.
Click here to see the answer to Question 24.11.

24.7​ Banking and the Creation of Money

​If we look again at M(1) and M(2), we’ll see that circulating currency – actual bills and coins in individuals’ and businesses’ hands – make up a small part of what is commonly defined as the money supply. Various deposits make up approximately seven times more of the money supply than does currency. How can our supply of money be so much larger than the amount of available currency?

​Our system of banking creates money. Banks don’t create money by printing dollar bills and pressing coins, but rather by making loans. Let’s see how by looking at an example. We will make some simplifying assumptions for the purpose of making the example easier to understand, but it is still a realistic example.

​24.7.1 The First Step

Suppose that the amount of currency in circulation is one thousand dollars and there are no deposits in the banking system and no traveler’s checks. The total money supply, M(1), is $1,000. Assume that one person, Fabian, has all the money. (See step 1 in Figure 24.9.) Fabian goes to bank A and opens a checking account. He gives bank A $1,000 in currency, and bank A gives him a promise that if he withdraws any amount up to and including $1,000 that the bank will give him currency and any withdrawal less than $1,000 will remain in the form of checking deposits. The money supply is still $1,000, but it is now in the form of checkable deposits instead of circulating currency (step 2 in Figure 24.9). The original currency is no longer in circulation; it is in bank A’s vault. It is not being actively used to make payments and therefore it is not counted as part of the money supply. Only the deposit is counted as part of the money supply.

24.7.2​ How Banks “Create” Money

This is far from the end of the story. There is $1,000 in the form of a checking account deposit, and the bank is holding $1,000 of currency in its vault.​

Question 24.12

Question 24.12

If you were managing a bank, what would you want to do with that currency in the vault? Briefly explain.

Hover here to see the hint for Question 24.12.
Click here to see the answer to Question 24.12.

Table 24.3: For complete rules of the Federal Reserve Requirements, see: https://www.federalreserve.gov/monetarypolicy/reservereq.htm​​ Effective date: 1/17/19

​Banks use funds they accumulate from depositors to make loans. But they cannot use all of those funds. They need to keep some available for depositors who wish to withdraw their funds. Federal Reserve regulations, summarized in Table 24.3 above, require that banks keep a fraction of their deposits in reserve. Reserves are defined as currency in the vaults, or deposits banks have with the Federal Reserve System. (Banks do keep deposits at the Federal Reserve. The Federal Reserve’s primary purpose is to facilitate check clearing and electronic transfers. We will discuss The Federal Reserve in more detail later.) This ensures that when account holders wish to withdraw money or transfer funds to another bank, banks have currency and deposits to give them. This fraction of reserves is called the required reserve ratio.

​Continuing our story from earlier, let’s assume that the required reserve ratio is 10 percent, so the bank must hold at least 10 percent of its deposits as reserves. Deposits are $1,000, so the bank is required to have at least $100 in its vault (or deposited with the Federal Reserve as mentioned earlier). However, they have $1,000 in the vault, which means they now have $900 more than they are required to have. The extra currency in the bank’s vault is called excess reserves. Excess reserves are any amount of currency (or deposits with the Federal Reserve) in the vaults above and beyond the amount required by the required reserve ratio. The excess reserves of $900 mean that the bank can lend up to $900 without violating the required reserve ratio.

Bank A would like to lend up to $900 to an individual or business that they think is likely to pay them back. Suppose Jasmine is eligible to borrow the excess reserves from bank A. Let us suppose Bank A lends her the money and that she immediately deposits the funds into her bank account at bank B. Now there are checking deposits worth $1000 at bank A and $900 at bank B, so the money supply is now $1900 in the form of checkable deposits, and there is no currency in circulation (See step 3 in Figure 24.9).

Figure 24.9: The Creation of Money Tracing Out the Actions of Consumers, Banks, and Firms​​

​It may seem like this is some kind of trick, like accountants are pretending that there is now $900 that doesn’t really exist anywhere except on paper. However, this new $900 is most certainly real money. This money can buy goods and pay for services. If you write a check for $100 and give it to a store, that store will accept your check as valid payment. Where before there was only $1,000 that could be spent in our economy, there is now $1,900 that can be spent, even though none of this money is in the form of currency in circulation.

Bank A is holding $100 in reserves, and bank B is holding $900 in reserves. Ten percent of $900 is $90, so bank B now has $810 of excess reserves. Notice that the bank reserves between bank A and B are $1,000.

Now customer Todd goes to bank B and asks for $810 in loans. Bank B does a credit check and approves the loans. Todd borrows and deposits $810 into his account at bank C. Now banks A, B, and C have reserves of $1,000. Bank A has $100 in its vault, bank B has $90 in its vault, and now bank C has $810 in its vault. This is $1,000 in reserves. Additionally, Fabian has $1,000 in his account; Jasmine has $900 in her account; and now Todd has $810 in his account. The money supply is $2,710 (See step 4 in Figure 24.9).

Suppose Todd goes to Bob’s Burgers and purchases $810 in burgers. Also assume that Todd writes a check, which is deposited into Bob’s Burgers’ bank account at Bank C. Bank C must hold onto 10 percent of the deposit but does not have to hold onto any of Todd’s deposit since Todd spent his loan money and it is no longer in his bank account. Notice how the $810 was simply transferred from Todd’s account to Bob’s Burgers’s account, and that bank C must hold onto 10 percent of $810.

This illustrates how borrowers can spend the loan money and the creation of money is unchanged. Bank C must hold 10 percent regardless of whether the $810 exists in Todd’s account or in Bob’s Burgers’s account. (See step 5 in Figure 24.9.)

Question 24.13

What determines how much the money supply can expand?

A

How much money people deposit into their bank accounts

B

How much excess reserves the bank holds

C

The required reserve ratio

24.7.3​ An Upper Limit

​The pattern of summing the deposits of Fabian, Jasmine, Todd, Bob’s Burgers and all other people who borrow money from the banks, deposit it, and make purchases will continue if no one holds any currency. Banks will continue to loan out their excess reserves, which will then be deposited, and some or all of the consumer loans spent at businesses. Businesses will deposit the currency paid to them, and banks will hold onto the required reserves while lending out the excess reserves. Eventually, the process will stop when banks’ reserves are only required reserves, and they have no excess reserves with which to make loans. The reserves in our story were $1,000. The banks will have no excess reserves when the money supply (made up entirely bank deposits) is $10,000. Ten percent of $10,000 is $1,000, which is the total amount of reserves in the banking system. We can see that the upper limit on the amount of money the banking system can create depends on how much currency is initially deposited in the banking system and what the required reserve ratio is when banks are fully loaned out and holding no excess reserves.

Instead of summing and tracing out the path of loans, borrowing, and spending, we can use a formula to find the upper limit:

            ​ The Simple Money Multiplier

where total deposits between consumers and businesses are the upper limit or maximum money supply that can be created by the actions of banks, consumers, and businesses. In this example, the required reserve ratio is 0.10, and total reserves between all the banks are $1,000. Using the equation, total deposits = $10,000, which is what we found above.

Mathematically the formula is:

How to interpret the mathematics: For every $1 increase in total reserves, the total deposits increase by $10. Another way to say this is for each $1 increase in total reserves, the total deposits will increase by $10 assuming that banks make as many loans as they can, and no currency is withdrawn.

Question 24.14

Suppose that banks keep no excess reserves and individuals and firms hold on to no currency. If someone finds $7.5 million in currency and deposits all of it into a checking account, what is the upper limit or maximum amount of the money supply when the required reserve ratio is 10 percent?

A

$8.25 million

B

$75 million

C

$750,000

D

None of the above

Question 24.15

Question 24.15

Suppose that banks keep no excess reserves, but individuals or firms do hold on to any currency. If someone finds $7.5 million in currency and deposits less than $7.5 million into a checking account, could the money supply reach the upper limit that could be reached if none held onto any currency?

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Question 24.16

Question 24.16

Suppose that all banks keep some excess reserves, but no individuals or firms hold on to currency. If someone finds $7.5 million in currency and deposits all of it into a checking account, could the money supply reach the same upper limit that could be reached if banks held no excess reserves?

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24.7.4​ A Currency Withdrawal

​What happens to the money supply when someone withdraws currency from the banking system? The story is like the one described above about a deposit but in reverse. When people withdraw money from banks and hold it as currency, this decreases the number of reserves (either vault currency or deposits at the Fed) banks have. Since the banks have fewer reserves, they can make fewer loans.

Let’s illustrate this with an example. Let the reserve requirement be 10 percent. Assume Fabian has $1,000 and deposited $1,000. Assume that the next day before the bank can make any loans, he withdraws $100 and buries it in his backyard and forgets that he did it and no one is going to find it. This means that the total deposits will be less than the value calculated earlier.

Recall the earlier calculation:

And now the new calculation:

We see when $100 is removed from the bank and cannot be lent out, this causes the total deposits to be smaller by $1,000. We could also calculate this mathematically,

​Notice the negative sign. This indicates that the total deposits will decrease by $1,000. For every $1 decrease in reserves, total deposits will decrease by $10, assuming banks maintain 10 percent of deposits as reserves. This interpretation is handy when all we know is how much bank reserves changed.

There are two ways to calculate the change in deposits that result from a change in bank reserves. One approach is to calculate total deposits before and after the change and then compute the difference. The other approach is to compute the difference in deposits directly by multiplying the change in reserves by the simple money multiplier (1 divided by the reserve ratio). You should be familiar with both methods.​

Question 24.17

Question 24.17

Assume that a depositor comes to the bank and withdraws part of her deposits in the form of currency. Explain how this will change the maximum amount of deposits that the banking system could create.

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Question 24.18

If bank reserves are equal to $2,000, the required reserve ratio is 10 percent, and banks make as many loans as they can, what will be the upper limit of the money supply assuming no borrower withdraws currency and leaves the loan balance in the bank after a loan is created?

A

$200

B

$20,000

C

$200,000

D

None of the above

Question 24.19

Assume that bank reserves are equal to $2,000, and the required reserve ratio is changed from 10 percent to 20 percent. Banks make as many loans as they can. What is the upper limit of the money supply when the required reserve ratio is increased? Also, assume no borrower withdraws currency and leaves the loan balance in the bank after a loan is created.

A

$200

B

$1,000

C

$10,000

D

None of the above

Question 24.20

Currently, bank reserves are equal to $2,000, the required reserve ratio is 10 percent, banks make as many loans as they can, and no borrower withdraws currency and leaves the loan balance in the bank after a loan is created. A news report has made people want to carry currency, and this causes the reserves to fall to $1,500. Assume the change is permanent. How much has the money supply decreased?

A

$500

B

$5,000

C

$50,000

D

None of the above

Question 24.21

Currently, bank reserves are equal to $2,000, the required reserve ratio is 10 percent, banks make as many loans as they can, and no borrower withdraws currency and leaves the loan balance in the bank after a loan is created. There is $500 in currency that is found and deposited into the bank. Assume that the currency was not previously in the banking system and is permanent. How much has the money supply increased?

A

$500

B

$5,000

C

$50,000

D

None of the above

Question 24.22

Currently, bank reserves are equal to $2,000, the required reserve ratio is 10 percent, banks make as many loans as they can, and no borrower withdraws currency and leaves the loan balance in the bank after a loan is created. But now banks decide to increase their reserves and start to hold 15 percent of their reserves. Assume this change is permanent. How much will the money supply change?

A

$6,667

B

$13,333

C

$20,000

D

None of the above

Question 24.23

Question 24.23

In your own words, describe the money creation process. Include a clear explanation of how it works and the determinants of the total amount of money that may be created.

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​24.8 Markets for Money

24.8.1 Demand for Money

The demand for any particular form of money does not refer to the fact that we would all like to have more of it. The demand for money instead describes the amount of our assets and wealth we are willing and able to hold in the form of currency at different costs, or “prices.” Most of the reasons for wanting to hold currency are obvious – they come from money’s role as a medium of exchange. Since we use money to purchase goods and services, it’s a good idea to have currency equal to or greater than the value of our purchases. When the prices of our purchases rise, we need to have more currency to pay for them. Also, if our volume of purchasing rises (that is, we buy more things at current prices), the demand for money will rise. The demand for money is linked closely to these two factors: real GDP and the price level. When real GDP rises, people are purchasing more and need more money to make those purchases. When the price level rises, purchases are more expensive, and people again need more money to make those purchases.

The demand for money is affected by the convenience of carrying currency. If it is very difficult or costly to change our assets and wealth into money, we are likely to hold more currency to avoid these costs. If, on the other hand, it is very easy, we might very well hold only as much as we need at a given time.

​This is similar to how we decide how much currency to carry on us at any given time. If banks only allow one withdrawal a week, customers are likely to make one large withdrawal so their currency will last until next week. If, on the other hand, banks allow unlimited withdrawals, provide ATMs at many conveniently located teller machines, and provide debit cards that allow us to make purchases without using currency, we are likely to carry very little currency at any given time. The state of our financial technology affects the demand for money by determining how convenient it is to change our wealth into money. Electronic transfer of funds from one type of account to another – say, from savings to checking – makes it easier to change our money to a more liquid form. Credit card technology allows us to make purchases without using currency except for monthly payments to the credit card company.

There is also a reason not to hold currency because there is a cost associated with holding currency. This cost is not an accounting cost (there is obviously no fee for holding currency); it is an opportunity cost.

Question 24.24

Question 24.24

What is the opportunity cost of holding currency?

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Figure 24.10: This graph shows the inverse relationship between the interest rate and the quantity of money.​

Think about your behavior. If the market interest rate were 75%, would you carry more or less currency? Likely less, because by holding onto one dollar in currency, you give up $0.75 of interest. This is your opportunity cost of holding currency; you give up the interest you could earn. Since high interest rates represent a higher opportunity cost, most people do not want to hold much currency. When the interest rate is low, the opportunity cost is lower, meaning that the interest you forego by holding currency is lower. This means more people are willing to hold onto currency.

These same ideas apply to businesses, not just individuals. When the interest rate is high, businesses wish to hold less currency, and when the interest rate is low they will hold more currency. Do not confuse this with businesses borrowing money from banks. This concept is covered in a later chapter. The money demand curve is simply how much currency individuals and businesses wish to hold at any given interest rate, holding all else equal.

We established that the “price” of money is its opportunity cost and that is the interest that could be earned on alternative investments such as bonds and money market mutual funds. Just like any demand curve, we plot the demand for money with price on the vertical axis and quantity demanded at each price on the horizontal axis. Movements along the demand curve are caused by changes in interest rates. Changes in demand or shifts of the entire demand curve are caused by changes in the technology related to getting and using money, the level of real GDP, and the price level.

Graphing Question 24.01

Graphing Question 24.02

24.8.2​ Supply of Money

We will assume that the quantity supplied of money does not respond to interest rates. This means that the supply of money is a vertical line located at the quantity of money in circulation.

If you recall, the amount of reserves and the money expansion process determine the money supply. The Federal Reserve System determines the monetary base (currency plus reserves), the non-bank public determines how much currency they wish to hold, and banks chose how much lending to do for a given amount of reserves. The money supply has an upper limit for a given amount of base money. This upper limit is achieved when banks do not have excess reserves (make the maximum amount of loans possible) and the nonbank public deposits all their money into banks, carrying no currency.

These conditions do not hold true in the real world. For example, between 2009 and 2017, the banking system had between 1 and 2.5 trillion in excess reserves. The reason that we model the supply of money as a vertical line is that it is ultimately determined by monetary policy makers at the Federal Reserve. Equilibrium in the money “market” is illustrated below in Figure 24.11.

Figure 24.11: Equilibrium in the Money Market. The graph shows the equilibrium interest rate is 10% when the money supply is fixed at $1,000 billion ($1 trillion).​

Graphing Question 24.03

Graphing Question 24.04

Graphing Question 24.05

Graphing Question 24.06

Graphing Question 24.07

Graphing Question 24.08

Question 24.25

Question 24.25

Describe the process of movement to equilibrium. Start with an interest rate of 15 percent. Think back to our discussions of supply and demand in chapters 3 and 4.

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Question 24.26

Question 24.26

Describe the process of movement to equilibrium. Start with an interest rate of 5 percent. Think back to our discussions of supply and demand in Chapters 3 and 4.

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Question 24.27

Question 24.27

Show the effects of a decrease in inflation on the money market. Explain why the market might change.

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Figure 24.12: Equilibrium in the Money Market
Question 24.28

What would happen to the money market if there was an increase in economic growth?

A

Money demand will not change but money supply will.

B

Money demand will decrease.

C

Money demand will increase.

D

The effect on money demand cannot be determined.


Figure 24.13: Equilibrium in the Money Market
Question 24.29

How would the money market change if there was an increase in bank reserves?

A

The money supply will not change but money demand will.

B

The money supply will decrease.

C

The money supply will increase.

D

The effect on money supply cannot be determined.


Figure 24.14: Equilibrium in the Money Market

Summary

Typically, the interaction of supply and demand determines the quantity produced of a particular good. In our model of the money market, the supply of money is fixed, so shifts in demand do not affect the quantity of money. The demand for money has the usual inverse relationship between price (the interest rate on alternative low risk investments) and the quantity. For example, as the interest rate rises, the quantity of money demanded falls because people wish to hold more interest-bearing investments instead of currency. Equilibrium in the money market determines the interest rate. If the demand for money increases, the interest rate rises. If the demand for money decreases, the interest rate falls.

24.9​ Interest Rates

Table 24.4: Key interest rates. Values are from July 2017​

​Throughout our discussion of money, monetary policy, and economic policy, we will refer simply to “interest rates” as though they are all the same. By that, we mean a typical interest rate or an average interest rate. When interest rates change, they most often move in the same direction. However, there are exceptions. In any economy, there are hundreds of interest rates - ones for credit cards, home mortgages, college loans, personal loans, interest rates that corporations pay, and interest rates that governments pay.

The highest rates are normally those that are the riskiest for the lender, the longest term, or the least collateral. For example, credit cards have interest rates which are higher than rates on personal loans, personal loan rates are higher than mortgage rates, and mortgage rates are higher than rates charged to large successful corporations and corporate rates higher than the federal government interest rates. In addition to risk, the length of the loan and tax treatment of interest income influence the level of a specific interest rate.​

Question 24.30

Question 24.30

Thirty-year treasury bonds normally pay more than one-year treasury bills (bonds). Can you explain why?

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Most of the time, interest rates on different types of financial assets move together in the same direction. Observers and newspaper analysts will talk about changes in interest rates as though they are all the same and moving in the same direction.

24.10​ Bond Prices and Interest Rates

Question 24.31

Suppose that you have a bond that originally cost you to $1,000 to purchase. It pays you $50 in interest each year. That interest payment does not change, and the original purchase price will be returned to you far in the distant future. What would happen to the current market price of your bond (yes, there is a market, and you can resell the bond to someone else) if interest rates for all similar bonds in the economy rise to 6 percent?

A

The price of your bond will fall.

B

The price of your bond will increase.

C

The price of your bond will remain the same.

D

There is not enough information to answer this question.

​A bond is a piece of paper issued when a corporation or a local, state, or federal government borrows money. But they can also come from surprising sources. A few years ago, an investment bank raised $55 million in the sale of bonds that are backed by revenues from an established country music star’s first 25 albums. In essence, the new star is borrowing money based on her ability to generate future royalty payments from her existing recordings.

When a bond is first issued, it promises to repay the amount borrowed in a certain number of years, its maturity date. Say $1,000 in 30 years. It also promises to pay a specific amount of interest each year, normally whatever it takes to borrow the money – the market interest rate for that type of borrowing.

Bonds can be sold before they mature and are in fact bought and sold among individuals, financial institutions, and corporations in very active bond markets. Suppose your parents bought a newly-issued bond ten years ago for $10,000. The bond matures 20 years from now and, in the meantime, pays $400 a year in interest. Now they decide to sell the bond to help pay tuition. How much could they get? Is the bond still worth $10,000?

The answer depends upon the current level of interest rates. Suppose interest rates for this type of bond have increased since your parents purchased the bond. What will happen to the value? This bond will not be as attractive as it once was, because it pays less interest than the bonds that are issued now. If they try to sell the bond, they will not be able to sell if for the full $10,000. The price will fall.

Thus, we see headlines like the quote at the beginning of this section. There is an inverse relationship between bond prices and interest rates. As interest rates rise, the prices of existing bonds fall. As current interest rates fall, the prices of existing bonds rise.

Question 24.32

Question 24.32

Summarize why there is an inverse relationship between bond prices and interest rates.

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24.11​ The Time Value of Money​

Question 24.33

Question 24.33

Which would you prefer? $100 today or $100 one year from now? Explain why.

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There is another way to consider the opportunity cost. If you took the $100 today, you can also put it in a bank, earn interest for a year, and at the end of the year have $100 plus the interest earned. If the current interest rate you could earn is 5 percent, we can calculate the value of $100 one year from now. $100(1 + 0.05) = $105. The $100 today will be worth $105 a year from now. So, to compare the choices, the $100 today is worth more than a $100 payment one year from now. In fact, it is worth about $5 more. A rational individual chooses $100 now instead of $100 one year from now.

What is the present or current value of a payment that one might receive at some point in the future? Perhaps you have been promised a bonus at the end of your first year of employment. Or you expect to receive an inheritance from a distant aunt in the next several years. Or you are simply trying to evaluate an investment or a new business that will pay $100,000 five years from now.

​Are there sound financial reasons to go to college? You pay tuition and buy books and supplies and pay other fees over four years. You give up the income that you could have earned instead of being in college. But you do all of that now. Your income is in the future and, if you are typical, is higher than it would have been, as a result of your having attended college – for the next 40 years. Is it sufficiently high enough to justify the expense of college and give up earning an income now? To answer these questions, we need to be able to think about the concept called present value.

What is the value of those future payments? Simply comparing the dollar amounts of a payment today with one made in the future is not meaningful. A rational decision-maker should compare the present value of future payments with the costs of the decision that are paid now.

The way to calculate present value of future income or payments is, not surprisingly, to think about opportunity cost. The present value of a future payment is how much one would have to have now, that is in the present, to be equal to the future payment. The comparison assumes that you could earn interest on the present value between now and the time of the future payment.

​Suppose I expect to receive $100,000 profit one year from now and that I can earn an interest rate of 5 percent. What is that worth today? How much would I be willing to accept today in exchange for that $100,000 one year from now? In other words, what is the present value of $100,000? At an interest rate of 5 percent, I would be willing to trade approximately $95,000 now for $100,000 one year from now. Let’s begin by looking at the future value. The future value of a payment today is the present value plus the interest that could be earned.

​Future Value = Present Value + interest that can be earned

Future Value = Present Value + (Present Value x the interest rate)

or

Future Value = Present Value x (1 + the interest rate)

The present value plus the interest earned is equal to the future value. With 5 percent interest, the present value of $100 paid one year from now = $100 / (1 + 0.05) = $100 / 1.05 = $95.24 One way of interpreting this is, if we deposit $95.24 into the bank today at 5 percent interest, then in one year the deopsit will have earned interest of $4.76 (from 95.24*0.05). When this is added to the initial deposit, we will have $100.

The present value of a future payment is always going to be less than number of dollars to be paid in the future. The reason is that the present value is how much one would have to have now (assuming you put the amount in an interest-earning account) to be equal to that future number of dollars.

An interest rate of 10 percent will mean that $100 placed in a bank will be worth $110 in a year (or $100(1 + 0.10)). A second year, the original $100 will be worth $110 (1 + 0.10) or $121. The process continues with the third year.

      ​$100 (1 + 0.10) (1 + 0.10) (1 + 0.10) or $100 (1 + 0.10)3=$133.10

​To calculate the future value of money that earns interest for t years, we can use the following formula:

​ where i = the interest rate and t = the number of years.

The future value formula and ideas expressed above include compounding the interest. This simply means the interest earned is left in the bank and it grows with interest. The following example reinforces the formula given above and illustrates compounding interest.

​ If $100 is invested today at 8 percent interest, how much will the investment be worth in two years?

​                                                FV = $100(1 + 0.08)2
           FV = $116.64

To see the compounding of interest, we need to look at the growth from each year. The $100 investment earns $16.64 in interest over the two years as follows:

As shown above, we can see in the first year that the deposit grows by $8.00, and then in the second year, the deposit grows by $8.64 which means the interest earned in the first year is also paid interest during the second year. This is compounding meaning the interest earned each year will earn interest in each following year. This explains why an initial deposit can grow through time.​

Question 24.34

Question 24.34

A friend has won a lottery and comes to you and asks which choice he should take. Either $185 million paid one year from now, or $165 million paid now. If the interest rate is 6 percent, what would you tell him to do?

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Question 24.35

Question 24.35

Why, in your own words, is a payment now worth more than the same dollar amount ten years from now?

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​This idea can also be used to calculate current bond prices. Today, a bond maturing (paying back the original loan) in 5 years the bond would be worth:

If the interest rate goes up, bond prices fall. If the interest rate falls, bond prices increase. Verify this idea with an example of a $1,000 bond maturing one year from now and making one more interest payment of $100 at the end of the year. If current interest rates are 5 percent (that is the interest rates have fallen since the bond was issued), what is the present value or the price?

The original interest rate must have been 10 percent. That is, original principal was $1,000, and if the interest payment is $100, the interest rate would have been $100/ $1,000 or 10 percent. Notice the price has gone up to $1,047.62 as the interest rate has fallen.

What if interest rates rise to 20 percent?

Summary

  • ​Money is anything that is used to buy and sell goods and services.
  • Money in modern economies typically consists of currency and deposits in accounts in a variety of institutions.
  • Banks create money by accepting deposits and then making loans with a portion of those deposits.
  • The amount of money that can be created is determined by the amount of the initial deposit, the required reserve ratio, whether or not banks have made as many loans as they can, and how much currency is withdrawn in the process of money creation.
  • Interest rates are determined by the demand and supply of money. The demand for money depends primarily on the level of economic activity. The quantity demanded depends upon the level of interest rates. The supply is determined by how much money banks can create through the process of making loans.
  • Bond prices and interest rates are inversely related.
  • The present value of a payment in the future is determined by the amount of the payment and the interest that could be earned if one had access to a portion of that payment now.
  • The greater the interest rate, the less the present value of a specific future payment will be. The lower the interest rate, the greater the present value a specific future payment will be.

24.12​ Key Concepts

​History of money
Definitions
Purposes of money
Types
Creation
Simple money multiplier
The Federal Reserve System
Supply and demand for money
Interest rates and bond prices
Time value of money

24.13 Glossary

Bonds: Pieces of paper issued by a government or corporation promising to repay the amount borrowed plus make interest payments though out the term of the bond.

Commodity money: Something that is used as money that has value other than its use as money.

Demand for money: The quantity of money individuals and business want to hold at each interest rate.

Excess reserves: The total amount of bank reserves minus the amount of required reserves.

Federal funds rate: The market interest rate which banks pay each other when they borrow reserves from each other. The Federal Reserve Open Market Operations Committee set targets for the federal funds rate.

Federal Reserve System: An independent arm of government responsible for controlling the money supply and the availability of credit and regulating the banking system. It acts as the central bank.

Fiat money: A government declares something is money and the citizens of the country use it as money.

Fiscal policy: Policies that affect the level of federal government spending on goods and services, taxes, and transfers payments.

Future value: to be entered

Interest rate: Payments by a borrower to a lender for the right to borrow money. Interest rates are normally expressed as an annual percentage.

Liquid: Anything that can be converted into money quickly.

Monetary policy: Policies of the Federal Reserve System that affect the supply of money and credit.

Money creation: Money can be created through the process of banks making loans.

Money: Anything that is commonly used to buy and sell goods and services.

Open market operations: The purchases or sales of U.S. government securities by the Federal Reserve System for the purpose of increasing or decreasing the money supply and changing credit conditions.

Open market purchases: The purchases of U.S. government securities by the Federal Reserve System for the purpose of increasing the money supply and changing credit conditions.

Open market sales: The sales of U.S. government securities by the Federal Reserve System for the purpose of decreasing the money supply and changing credit conditions.

Present value: The value today of a future payment.

Required reserve ratio: The percentage of bank deposits that the Federal Reserve System requires banks to keep as reserves.

Required reserves: Banks are required to hold a percentage of their deposits on reserve as currency in their vaults or in deposits with a Federal Reserve Bank.

Reserves: The currency commercial banks keep in their vaults plus their deposits in accounts with Federal Reserve Banks.

Simple Money multiplier: The amount by which the money supply will eventually change as a result of each dollar of reserves that is added to or subtracted from the banking system.

Supply of money: Several different definitions are used by the Federal Reserve. M1 is currency in circulation plus checking account deposits. M2 includes M1 plus savings deposits, small time deposits, and deposits in money market mutual funds.


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​Footnote:

Calculation: all bills in the economy = $1.46 trillion dollars and $1.15 trillion dollars in the form of $100 bills.

Answer Key:

Answer to Question 24.01

Money is anything that is used to buy and sell goods and services.

Click here to return to Question 24.01.






Answer to Question 24.07

Possible answers to what we use as money will include currency, checking and saving account deposits, certificates of deposits (like saving accounts, except with penalties for withdrawals), and perhaps credit cards. All are very much money, except for credit cards. Credit cards are a lot like checks themselves – a means of transferring money. Credit cards simply mean that you will be billed later by the credit card company and then you will transfer money, that is, deposits, by writing a check to the credit card company. Some might mention stocks and bonds. Normally stocks and bonds are not included because they have to be changed into something (money) that can be used to buy goods and services.

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Answer to Question 24.08

On the Bank of America table, all accounts are included in the broader definition of money (M2) except for the IRA accounts. Those deposits are intended for use in retirement, and there are significant penalties for early withdrawal. Thus, they are not easily used as money.

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Answer to Question 24.09

On the Bank of America table, only the personal checking and regular savings account are found in M(1). They are both easily converted to currency. Many students might assume that the regular savings account is found in M(2), but this is incorrect. The items in M(1) can easily be converted to currency, and a regular savings account can easily be closed and the deposit converted to currency.

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Answer to Question 24.10

​Your gist statement should describe how you can write a check and use that check to buy goods and services at most stores, to pay rent, and to pay tuition. The deposits then are functioning as a medium of exchange. The “dollars” in your account serve as standards of value, just as currency does. And you can store value in your account and use the money at a later time. In short, all the conditions of money are satisfied by the deposits in your checking account.

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Answer to Question 24.11

Small-time deposits or CDs are included in M(2). Deposits in CDs serve as a standard of value, just as currency does. Plus, the CD can store value, and when the term of the CD is finished, the currency can be used to purchase goods and services. However, if the CD is withdrawn early, it is subjected to large tax penalties.

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Answer to Question 24.12

Banks would rather be making a profit on this $1,000 than just letting it sit in a safe, collecting dust. Borrowers will pay interest to lenders, so banks may decide to make loans.

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Answer to Question 24.15

Individuals holding currency means that at each stage of deposits and lending, a portion is not deposited in a bank. This means less money can be loaned out. The upper limit of the money supply when individuals and businesses do not hold onto currency would be greater than the money supply when individuals and businesses held onto some currency.

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Answer to Question 24.16

Banks holding excess reserves means fewer or smaller loans are made. The upper limit of the money supply when banks held no excess reserves would be greater than banks that held excess reserves. Thus, the money supply is lower when banks hold excess reserves.

Click here to return to Question 24.16.






Answer to Question 24.17

We should see that the bank has less currency held in reserves. Since the bank has fewer reserves, it cannot create as many loans as it could have made when the depositor withdrew no currency. The upper limit will be smaller when depositors withdraw currency and the currency is not deposited into any bank account.

Click here to return to Question 24.17.






Answer to Question 24.23

​Your gist statement should include the following analysis. Banks create money by making loans. If a bank has excess reserves, it can use those excess reserves to make loans. It will want to do so because that is how a bank earns profits. In making a loan, the bank adds to the borrower’s deposits. The money supply will then increase because deposits have increased.

How much money will be created depends upon the size of reserves, the reserve requirement, whether or not banks make all the loans that they are legally allowed to, and the portion of loans that is withdrawn in currency. For example, an increase in the size of the reserves will allow an expansion of the money supply. A decrease in the reserve requirement will allow banks to increase loans and thus increase the money supply. If banks only make a portion of all of the loans they legally can make, the money supply will be smaller than it otherwise would be. If consumers withdraw a large portion of loans in currency, the expansion in the money supply will be less than it otherwise would have been.

Click here to return to Question 24.23.






Answer to Question 24.24

There are alternatives to holding currency that pay interest, and the opportunity cost of holding currency is this foregone interest. Bonds, for example, pay interest, as do savings accounts, mutual funds accounts, or other financial assets. The interest rate paid on these alternatives is the cost of holding currency. As the rate of interest increases the income generated from interest bearing investments increases, it is more costly to hold currency. The quantity of money demanded falls. As the rate of interest falls, it is less costly to hold currency, and the quantity of money demanded increases.

Click here to return to Question 24.24.






Answer to Question 24.25

At an interest rate of 15%, the quantity of money demanded is $700 billion and the quantity supplied is $1000 billion. There is an excess supply (or surplus) of $300 billion. Banks want to supply a total of $1000 billion, but have to lower interest rates to attract customers. As the interest rate falls, the quantity demanded of money rises. The opportunity cost of holding currency is falling, and therefore some people will be willing to hold more. This process continues until the interest rate equals 10 percent and the quantity demanded and quantity supplied is equal at $1000 billion.

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Answer to Question 24.26

At an interest rate of 5 percent, the quantity of money demanded is $1,500 billion and the quantity supplied is $1,000 billion. There is a shortage of $500 billion. Banks realize that they can raise the interest rate and still make all the loans they would like to make. As the interest rate increases, the quantity demanded falls, this time due to rising opportunity costs. The process continues until the interest rate = 10 percent and the quantity demanded and supplied = $1,000 billion.

Click here to return to Question 24.26.






Answer to Question 24.27

With lower inflation, prices will be lower than they otherwise would be. With lower prices, the demand for money will be less. The demand curve will shift inwards. The surplus of money will cause interest rates to fall. A new equilibrium in the money market will be reached at a lower interest rate.

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Answer to Question 24.30

Longer time periods are more uncertain. To compensate for this and to entice you to invest for a longer time period, the return rate has to be higher to make tying up your money more appealing as an investment compared to the same rate of return for one-year and thirty-year investments.

Click here to return to Question 24.30.






Answer to Question 24.32

The inverse relationship is true for existing bonds because they become more attractive as interest rates fall and less attractive as interest rates rise. If rates fall, your bond is now paying a higher interest rate than most other bonds and is very attractive to potential buyers. The price will be bid up. If rates rise, your bond is no longer as attractive, and the price falls.

Click here to return to Question 24.32.






Answer to Question 24.33

​You probably answered the question by saying that you would rather have the dollars today because you can spend and enjoy it sooner. That is, there is a real opportunity cost to waiting.

Click here to return to Question 24.33.






Answer to Question 24.34

​The present value of $185 million one year from now would be equal to $185 million/1.06 or $174.5 million today. You should tell him to take $185 million one year from now as opposed to $165 million today since the present value of $185 million (which is $174.5) is more than $165 million.

If you answered this with the future value, you would still tell him to take $185 million in one year. If he took $165 million today and deposited it into a bank at 6 percent interest, then in one year it would be worth $165*(1.06) = $174.9 million. So in one year the $165 (valued at $174.5) is worth less than $185 million.

Click here to return to Question 24.34.






Answer to Question 24.35

There are a number of ways to approach the question. One answer is that if you received the money today and invested it, then in ten years, the deposit will have grown assuming the interest rate is greater than zero. So in ten years, would you rather have the initial payment only or the initial payment with interest through time? Most people would pick the current payment since the interest over those ten years since it adds up to a much larger amount. Thus, the current payment is worth considerably more than the same payment in the future.

Click here to return to Question 24.35​.



Data Sources:

Table 24.3


Image Credits:

[1] Image courtesy of unknown in the Public Domain.

[2] Image courtesy of  World Imaging under CC BY-SA 3.0.

[3] Image courtesy of  Tomascastelazo under CC BY-SA 3.0.

[4] Image courtesy of PHGCOM under CC BY-SA 3.0.

[5] Image courtesy of  Eric Guinther under CC BY-SA 3.0.

[6] Image courtesy of Takeaway under CC BY-SA 3.0.

[7] Image courtesy of typographyimages in the Public Domain.

[8] Image courtesy of unknown in the Public Domain.
  Image courtesy of unknown in the Public Domain.

This is an open-ended question asking you to explain what you think.
Anything that is commonly used to buy and sell goods and services.
The process of exchanging goods and services without using an intermediate good (money).
Something that can be used to buy and sell goods and services.
Something that is used as money that has value other than its use as money.
The function of money that determines the relative value of goods and services.
A government declares that something is money and the citizens of the country use it as money.
You might have this in your backpack or wallet, but there could be other answers.
Consider what is not included in the broad definition of M(2). Once you exclude what is not money, what’s left over is money.
Look at the definition of M(1). Now compare to the table and decide which items can easily be converted to currency. The items found in M(1) all share the characteristic that they are already exist as currency or can easily and quickly be converted to currency.
See if your checking account satisfies all the characteristics of money. Then check and see how liquid the account is.
Look at the definitions of M(1) and M(2).
If the bank doesn’t lend the currency, what are they giving up? Or in other words, are they making a profit when they hold onto the currency?
May consist of currency in bank vaults or deposits a bank keeps with the Federal Reserve.
The percentage of deposits that must be kept on reserve.
The reserves that banks have beyond the amounts that they are required to have.
If the banks receive smaller deposits, what should happen to the amounts they can loan out?
If the banks have excess reserves and keep more than the required reserve ratio, what should happen to loans they create? Will they be larger or smaller than when they held no excess reserves?
This is similar to the depositor depositing less currency into their bank account.
Begin your story with banks and how they create money.
Any asset that can be quickly and easily converted into money that can be used to buy goods and services.
What are you giving up when you hold onto currency? Think about what you could get (from the bank) if you deposited your currency.
The most that can be lent is what the market demands. Find that point and then look and see what needs to be adjusted to get the market to equilibrium.
The most that can be lent is what the market demands. Find that point and then look and see what needs to be adjusted to get the market to equilibrium.
Think about how much currency people would want to carry if prices were lower.
Would you rather have your money in one year or in thirty years? What would it take for you to invest for a longer period?
If interest rates increase or decrease, should bond prices increase or decrease?
Think about what you could do with the money if you received it today even if you planned to spend it next year.
Today’s value, in dollars, of a payment or multiple payments made in the future
Evaluating payments or multiple payments at a specific time in the future.
Convert the choices into the same time period, meaning you should consider the value of the two choices either in today’s terms or in one year from now. Converting the choices into the same time period is typically easier to understand.
The answer is not a mathematical answer since no numbers are given. One way to think about this is if you had the currency now and invested it, what does that imply about the future value?