Fundamental Questions

1. What is money?

2. How is the U.S. money supply defined?

3. How do countries pay for international transactions?

4. Why are banks considered intermediaries?

5. How does international banking differ from domestic banking?

6. How do banks create money?

Teaching Objectives

The primary purpose of this chapter is to introduce the principles of money and banking in the domestic and the global economies.

The unique features of the chapter include discussion of the functions of money and the definition of the money supply. An examination of international banking includes a look at the emergence of the Eurocurrency market. In this vein the international payments system is discussed. The chapter concludes with a presentation of the deposit multiplier and the process through which banks create money.

An area that requires special attention is how the banking system creates money. This material will be important in the future discussion of monetary policy. Also, the international payments system will be recalled when world trade equilibrium and global macroeconomic linkages are discussed (Chapter 17).

Key Term Review

money
liquid asset
currency substitution
credit
M1 money supply
transactions account
international reserve asset
international reserve currency
European currency unit (ECU)
composite currency
special drawing right (SDR)
Federal Deposit Insurance Corporation (FDIC)
Eurocurrency market (off-shore banking)
international banking facility (IBF)
fractional reserve banking system
required reserves
excess reserves
deposit expansion multiplier

Lecture Outline and Teaching Strategies

1. What Is Money?

Money is anything that is generally accepted in exchange for goods and services.

1.a. Functions of money

1.a.1. Medium of exchange: Money increases the efficiency of the economy by minimizing transaction costs.

Teaching Strategy: Ask your class why money needs to be portable to be an effective medium of exchange.

1.a.2. Unit of account: Money use reduces information costs.

Teaching Strategy: To show how money use reduces information costs, ask your students to list the prices that would be needed in a barter economy that produces only three goods. Then show that in an economy with money only three prices are required, the price in terms of the monetary unit.

1.a.3. Store of value: Durability and inflation can affect this function.

Teaching Strategy: If you have students in your class from the former Soviet Union or other countries in which there has been high inflation, ask them what strategies are common for dealing with money that is no longer a good store of value.

1.a.4. Standard of deferred payment: Debt obligations are written in terms of money values.

1.b. The U.S. money supply: The money supply includes assets that serve the functions of money. Economists have found it difficult to determine whether an asset is a monetary asset.

Teaching Strategy: Point out that because many assets can serve as monetary and nonmonetary assets, it is difficult to measure the true supply of money.

1.b.1. M1 money supply: Currency accounts for 39 percent of the M1 money supply. Travelers' checks account for 1 percent of the M1 money supply.

Teaching Strategy: You can use the office coffee kitty as a case study in Gresham's Law. Over time the kitty becomes filled with foreign coins, video game tokens, pennies, and almost anything that will make a jingling sound, and most of the good coins disappear.

1.b.2. M2 money supply

1.b.3. M3 money supply

1.c. Global money: The money supplies of different nations are linked through the foreign exchange market.

1.c.1. International reserve currencies: The emergence of the European currency unit (ECU) has diminished the role of the dollar as a reserve currency.

1.c.2. Composite currencies: The ECU is an accounting entity that is a composite of European currencies.

2. Banking

In the 1980s the lines that differentiated various financial institutions were blurred by the Depository Institutions Deregulation and Monetary Control Act.

2.a. Financial intermediaries: These are the links between savers and borrowers in the economy.

2.b. U.S. banking

2.b.1. Current structure: Banking went through many changes in the 1980s.

2.b.2. Bank failures: Bank deposits are insured by the Federal Deposit Insurance Corporation (FDIC).

Teaching Strategy: It should be noted that, from the perspective of depositors, the FDIC has been a very effective institution. Depositors have been protected, and the banking system has not suffered a banking panic since the Great Depression.

2.c. International banking: Because of less restrictive regulations, international banks are highly competitive with domestic banks.

2.c.1. Eurocurrency market: Eurocurrencies are deposits that are denominated in the currencies of countries other than the countries in which the deposits are made.

2.c.2. International banking facilities: IBFs allow international banking to take place within the United States.

3. Banks and the Money Supply

Banks create money by simply carrying out their normal business.

3.a. Deposits and loans: An example of how banks create money by lending money.

Teaching Strategy: Be sure to work through the balance-sheet analysis of how banks create deposits and the money supply. This is a most effective way to get what is often a difficult idea across.

3.b. Deposit expansion multiplier

Teaching Strategy: Draw parallels between the deposit expansion multiplier and the spending multiplier to build on ideas with which your students are already familiar.