CHAPTER Money, the

Price Level and

13 Inflation
After studying this chapter you will be able to:

 Define money and describe its functions

 Explain what banks are and do
 Describe the functions of a central bank
 Explain how the banking system creates money
 Explain how the demand for and supply of money
determines the nominal interest rate
 Explain how the quantity of money influences the price
level and the inflation rate

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When you want to buy something, you use coins, notes,
write a cheque or present a debt card or credit card.
Are all these things money?
When you deposit some coins or notes in a bank, is it still
money?
What happens when the bank lends your money to
someone else? How can you get it back?
Why does the amount of money in the economy matter?
How does it affect the interest rate?

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What Is Money?

Money is any commodity or token that is generally

acceptable as a means of payment.
A means of payment is a method of settling a debt.
Money has three other functions:
 Medium of exchange
 Unit of account
 Store of value

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What Is Money?
Medium of Exchange
A medium of exchange is an object that is generally
accepted in exchange for goods and services.
In the absence of money, people would need to exchange
goods and services directly, which is called barter.
Barter requires a double coincidence of wants, which is
rare, so barter is costly.
Unit of Account
A unit of account is an agreed measure for stating the
prices of goods and services.

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What Is Money?

Store of Value
As a store of value, money can be held for a time and later
exchanged for goods and services.
Money in the UK Today
In the UK, money consists of:
Currency
Deposits at banks and building societies

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What Is Money?

Currency is notes and coins held by individuals and

businesses.

The official UK measure of money is M4.

M4 consists of currency held by the public plus bank

deposits and building society deposits.

M4 does not include notes and coins held by banks and

building societies and it does not include bank deposits of
the UK government.

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What Is Money?

Figure 13.1
illustrates the
composition of M4
and shows the
relative magnitudes
of the components
of money.

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What Is Money?
Are All the Components of M4 Really Money?

Currency is the means of payment, so it is money.

Sight deposits can be transferred from one person to

another by writing a cheque or using a debit card, so sight
deposits are money.

Time deposits can easily be switched into sight deposits,

so time deposits are money.

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What Is Money?

Cheques, Debit Cards and Credit Cards Are Not Money

Cheques are not money. A cheque is an instruction to your
bank to move some funds from your account to someone
else’s account.
Debit cards are not money. Using a debit card is like
writing a cheque except the transaction takes place in an
instant. A debit card is not a means of payment.
Credit cards are not money. Credit cards enable the holder
to obtain a loan quickly, but the loan must be repaid with
money. A credit card is not a means of payment.

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Monetary Financial Institutions

A monetary financial institution is a financial firm that

takes deposits from households and firms and makes
loans to other households and firms.
Types of Monetary Financial Institutions
The main monetary financial institutions whose deposits
are money are:
 Commercial banks
 Building societies

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Monetary Financial Institutions

Commercial Banks
A commercial bank is a private firm, licensed under the
Banking Act of 1987, to take deposits and make loans.

A commercial bank’s balance sheet lists the bank’s assets,

liabilities and net worth.

Liabilities + Net worth = Assets

Among the bank’s liabilities are the deposits that are the
main component of money.

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Monetary Financial Institutions

Building Societies
A building society is a private firm, licensed under the
Building Societies Act 1986, to accept deposits and make
loans.
Differences between building societies and banks are:
 A building society is usually owned by its depositors.
 Deposits are usually saving accounts.
 Loans are usually for house purchases.
 Reserves are kept at commercial banks.

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Monetary Financial Institutions

What Depository Institutions Do

To goal of any bank is to maximize the wealth of its
owners.
To achieve this objective, the interest rate at which it lends
exceeds the interest rate it pays on deposits.
But the banks must balance profit and prudence:
 Loans generate profit.
 Depositors must be able to obtain their funds when they
want them.

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Monetary Financial Institutions

A commercial bank puts the depositors’ funds into four

types of assets:
1 Reserves: notes and coins in its vault or its deposit at
the Bank of England
2 Liquid assets: UK government Treasury bills and
commercial bills
3 Securities: longer-term UK government bonds and
other bonds such as mortgage-backed securities
4 Loans: commitments of fixed amounts of money for
agreed-upon periods of time

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Monetary Financial Institutions

Table 13.2 shows the

sources and uses of
funds in all UK
commercial banks in
November 2010.

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Monetary Financial Institutions
Economic Benefits Provided by
Monetary Financial Institutions
All monetary financial institutions make a profit from the
spread between the interest rate they pay on deposits and
the interest rate at which they lend.
Monetary financial institutions provide four services:
 Creating liquidity
 Pooling risk
 Lower the cost of borrowing
 Lower the cost of monitoring borrowers

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Monetary Financial Institutions

How Monetary Financial Institutions Are Regulated

Monetary financial institutions engage in risky business.

To make the risk of failure small, commercial banks are

required to hold levels of reserves and owners’ capital
equal to or surpass ratios laid down by regulation.

The required reserve ratio is the minimum percentage of

deposits that a bank is required to hold in reserves.

The required capital ratio is the minimum percentage of

assets that must be financed by the bank’s owners.

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How Banks Create Money

Creating Deposits by Making Loans

When a bank receives a deposit, its reserves increase by
the amount deposited.
But the bank doesn’t hold all of the deposit as reserves, it
loans some of the amount deposited.
These loans end up as deposits.
The banking system as a whole can increase loans and
deposits with no change in reserves.
The increase in deposits is an increase in money.

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How Banks Create Money

What limits the amount of money that the banking system

can create?
The quantity of loans and deposits that the banking
system can create are limited by three factors:
 The monetary base
 Desired reserves
 Desired currency holding

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How Banks Create Money

The Monetary Base

The monetary base is the sum of Bank of England notes
and banks’ deposits at the Bank of England plus coins
issued by the Royal Mint.
The monetary base limits the total amount of money that
the banking system can create because banks have a
desired level of reserves.

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How Banks Create Money

Desired Reserves
The fraction of a bank’s total deposits held as reserves is
the reserve ratio.
The required reserve ratio is the ratio of reserves to
deposits that banks are required, by regulation, to hold.
Desired reserve ratio is the ratio of reserves to deposits
that banks consider prudent to hold.
Excess reserves equal actual reserves minus desired
reserves.

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How Banks Create Money

Desired Currency Holding

People hold money in the form of currency and deposits.
People have a definite view about the proportion of money
they want to hold as currency based on expenditure plans.
When the total quantity of money increases, people will
want to hold more currency.
So currency drains from the banking system.
The currency drain ratio is the ratio of currency to
deposits.
The greater the currency drain ratio, the smaller is the
quantity of money that the banking system can create.
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How Banks Create Money
The Money Creating Process
The money creating process begins when the monetary
base increases and the banking system has excess
reserves.
The process is:
1 Banks have excess reserves.
2 Banks lend excess reserves.
3 The quantity of money increases.
4 New money is used to make payments.
5 Some new money remains on deposit.

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How Banks Create Money

6 Some of the new money is a currency drain.

7 Desired reserves increase because deposits have
increased.
8 Excess reserves decrease, but remain positive.
Figure 13.3 on the next slide shows one round in the money
creation process.

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