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Macroeconomics Foundations (ECON 102) · Module 4 of 7

Money & Banking

What money is, the money supply, fractional reserve banking and the money multiplier, and the money market.

In this module
  1. Functions & Measures of Money
  2. Fractional Reserve Banking & the Money Multiplier
  3. The Money Market
  4. Check yourself

Functions & Measures of Money

  • Money serves as a medium of exchange, a unit of account, and a store of value.
  • M1 includes currency, checkable deposits, and savings deposits (since 2020). M2 = M1 plus small time deposits and retail money market funds.
  • Bank balance sheets: assets (reserves, loans, securities) = liabilities (deposits) + owners' equity.
Worked example

Moving $500 from a checking account to a savings account changes M1 how? M2?

Solution. Since the Fed reclassified savings deposits as part of M1 in 2020, neither changes: both balances are counted in M1, and M1 is inside M2. (Under the older definition some textbooks still use, M1 falls by $500 and M2 is unchanged.)

Fractional Reserve Banking & the Money Multiplier

  • Banks keep a fraction of deposits as reserves and lend out excess reserves. Each loan is redeposited somewhere, so lending creates new money.
  • Money multiplier = 1 / reserve requirement. The maximum new money created by the banking system = excess reserves × money multiplier.
  • Real-world creation is smaller when people hold cash or banks hold extra reserves.
Worked example

Someone deposits $1,000 of new cash. The reserve requirement is 10%. What is the maximum amount of new money the banking system can create through loans?

Solution. Required reserves = $100, so excess reserves = $900. Money multiplier = 1/0.10 = 10. Maximum new money from loans = $900 × 10 = $9,000.

Common mistake: A cash deposit doesn't itself change the money supply (currency just became a deposit). The NEW money comes from the loans banks make.

The Money Market

  • The demand for money slopes down against the nominal interest rate (the opportunity cost of holding money). It shifts with the price level and real GDP.
  • In the simple money-market model the supply of money is vertical, set by the central bank. An increase in the money supply lowers the nominal interest rate.
Worked example

Real GDP rises and people need more money for transactions. What happens to the nominal interest rate if the money supply doesn't change?

Solution. Money demand shifts right, so the nominal interest rate rises.

Check yourself

2 of this module's 5 quiz questions. Pick your answers, then check them in the app, with an explanation for every question.

1. Prices listed in dollars show money acting as a:

2. If the reserve requirement is 20%, the money multiplier is:

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