How Is Money Measured in the United States Today?

M1: The Narrowest Definition of the Money Supply: Means of Payment

Measuring the Money
Supply, May 2007 M2: A Broader Definition of Money

What about Credit Cards and Debit Cards?

How Banks Create Money
Balance Sheet for Wachovia
Bank, December 31, 2006
Reserves Deposits that a bank keeps as cash in its vault or on deposit with
the Federal Reserve = R
Required reserves Reserves that a bank is legally required to hold, based on
its checking account deposits = RR.
Required reserve ratio The minimum fraction of deposits banks are required
by law to keep as reserves RR = r D.
How Banks Create Money in a Fractional Reserve Banking
System: Using T-Accounts
How Banks Create Money

Now PNC has excess

reserves and can make
a loan
How Banks Create Money:
The multiple creation of money and credit
BANK INCREASE IN CHECKING ACCOUNT DEPOSITS

Wachovia $1,000
PNC + 900 (= 0.9 x $1,000)
Third Bank + 810 (= 0.9 x $900)
Fourth Bank + 729 (= 0.9 x $810)
. +
. +
. +
Total Change in Checking Account
Deposits =$10,000
Deposit multiplier The ratio of the
amount of deposits created by banks Simple deposit multiplier = 1/r
to the amount of new reserves.
The Simple Deposit Multiplier versus the Real-World Deposit Multiplier:
People hold currency and banks hold excess reserves, slowing multiple
creation of deposits and credit
Reserves Deposits that a bank keeps as cash in its vault or on deposit with
the Federal Reserve = R = RR + ER = rD + eD
Required reserves Reserves that a bank is legally required to hold, based on
its checking account deposits = RR.
Required reserve ratio The minimum fraction of deposits banks are required
by law to keep as reserves RR = r D.
Excess reserves Reserves that banks hold over and above the legal
requirement. ER = e D
The Money Supply Model
Money = Currency plus checkable deposits: M1

M=C+D
The monetary base (MB)the assets of the central bank backs the money
supply
The CBs assets = MB =The CBs liabilities = C + R
The Fed controls the monetary base (MB) better than it controls reserves but it
doesnt perfectly control MB
MB = MBn + BR
The money supply (M) is a multiple m of the monetary base

M = m x MB = m x (MBn + BR)
 c = {C / D} C = c D and
e = {ER / D} ER = e D
Substituting in the previous equation
MB (r D) (e D) (c D) (r e c) D
Divide both sides by the term in parentheses
1
D MB
r ec
M D C and C c D
M D (c D) (1 c) D
Substituting again
1 c
M MB
r ec
The money multiplier is then
1 c
m
r ec
 Factors that Affect
The Money Multiplier
Changes in the required reserve ratio r
The money multiplier and the money supply are negatively
related to r
Changes in the currency ratio c
The money multiplier and the money supply are negatively
related to c
Changes in the excess reserves ratio e
The money multiplier and the money supply are negatively
related to the excess reserves ratio e
The excess reserves ratio e is negatively related to the
market interest rate
The excess reserves ratio e is positively related to
expected deposit outflows
 Money and the Great Depression

The Great Contraction in monetarist analysis

Banking Crises
Currency holdings
Excess reserve holdings
Monetary contraction