Lesson Plan - Money


I. Why do we have money?
- in a self-sufficient world is money useful?
- in a world of specialization and exchange is money useful?
- why not simply barter?
- uses of money
- medium of exchange
- store of value
- measure of value (unit of account)
- standard of deferred payment
- what is money?
- commodity monies
- definition = money which has some intrinsic value (i.e., value in use)
- goods used as money include precious metal, wheat, tobacco, etc.
- what characteristics must a good have for it to serve well as money in the long-run?
- durability
- divisibility
- homogeneity
- portability
- stability of supply
- scarcity
- fiat money
- definition = money which has no intrinsic value (i.e., no value in use)
- why use fiat money?
- cheaper
- controllable supply
- does fiat money possess the characteristics which make a money long-lasting?
II. The supply of money in a fractional reserve banking system
- the supply of money
- what is currency?
- measures of the supply of money
- M1 = currency + Demand Deposits (what are those?)
- M2 = M1 + small time deposits (what are those?)
- M3 = M2 + large time deposits + institutional money market funds
- L = M3 + other liquid assets
- what is the difference between these different measures?
III. The creation of money in a fractional reserve banking system
- the reserve ratio (rr) = the percent of deposits which are not loaned out.
- use the following assumptions to see how money is created
- all banks have the same reserve ratio (rr)
- no banks hold excess reserves (reserves in excess of that implied by rr)
- there are no cash drains from the system
- What happens when $1,000 in extra money is deposited into a demand deposit account?
- what is a t-account? (Make sure you can follow the accounting t-accounts)
- assuming the rr=20 percent, the bank will
- keep $200 on hand to meet cash requirements
- loan out $800 to another customer
- what does that customer do with the $800? Deposit it in a bank => demand deposits increase by a further $800
- Hence, the bank will loan out a further $640, which will be deposited in a bank
- Hence, the bank will loan out a further $512, which will be deposited in a bank
- Hence, the bank will loan out a further $410, which will be deposited in a bank
- Hence, the bank will loan out a further $328, which will be deposited in a bank
- etc.
- Every time demand deposits increase => the money supply increases
- how much in total has the money supply increased?
- $1,000 increase in the money supply from the initial $1,000 deposit
- plus $4,000 additional increase in the money supply through fractional reserve banking
- the potential money multiplier = mp = for every dollar in additional deposits, how much could the money supply increase?
- mp = 1/rr (why? remember that rr = reserve ratio)
- if RR = total (planned) reserves, then rr*Demand Deposits (DD) = RR
- the actual money multiplier = ma = for every dollar in additional deposits, how much does the money supply increase?
- why do banks hold Excess Reserves?
- xr = the excess reserve ratio = the proportion of demand deposits that banks do not loan out in excess of the reserve ratio
- ma = 1/(rr + xr) (why?)
- assumes that no one, either firms nor individuals, hold money as cash
- what is the monetary base (MB)?
- currency plus reserves
- Hence, ma = MS/MB
- MS = money supply = M1
- or MS = ma*MB
- Multibank expansion of the money supply
- How is money destroyed?
- What happens if people do hold cash?