Chap 26

MONEY, BANKS, AND THE FEDERAL RESERVE 227
a) The formula for the money multiplier is [(1 + c) ÷ (r + c)] where c is ratio of currency
to deposits and r is the required reserve ratio.
2. The magnitude of the U.S. money multiplier depends on the definition of money that is
used. For M1, the money multiplier is 1.8. For M2, the money multiplier is 8.6.
Reading Between the Lines
The news article reports how electronic payments, such as debit cards, have grown in importance over the
past four years. Debit cards are now used for 32 percent of in-store purchases, the same proportion as cash
and more than checks or credit cards. The analysis stresses the role of transactions costs in determining
what means of payment is used.
New in the Seventh Edition
The topics in the 6th edition’s Chapters 12 and 13 (27 and 28 in Economics) have been reorganized into
this editions Chapters 10 and 11 (26 and 27 in Economics). In this edition, all the institutional
material—the definition of money, the description of the banking system, and the fundamentals of the
Fed—are in this chapter. comes into one chapter—Chapter 26. The material on how monetary policy
affects the economy and the demand for money has been moved to the next chapter.
The discussion of how banks create deposits by making loans has been simplified to consider only the
more realistic case of an economy with many banks. There is a new discussion of the size of the money
multiplier in the United States. The data and figures are updated to 2003. The new Reading Between the
Lines discusses electronic payments and the role transactions costs play in determining how a payment is
made.
Teaching Suggestions
1. What is Money?
The defining characteristic of money. Adam Smith wrote, “Money is a commodity or token that
everyone will accept in exchange for the things they have to sell.” Most people have interpreted this
statement as defining money as the medium of exchange. That interpretation is wrong. Smith is
defining money as the means of payment. Money is a commodity or token that everyone will accept
as payment for the things they have to sell.
When Michael Parkin was a young economist, he had the enormous good fortune to meet Anna
Schwartz, Milton Friedman, and a group of other leading monetary economists. It was during the
late 1960s when the monetarist debate was alive and well and people were still arguing about whether
the demand for money was interest inelastic (as the monetarists claimed) or almost perfectly elastic
(as the Keynesians claimed). Anna made a remark that for Michael was one of those defining
moments. She said money is the means of payment. Nothing else performs this function. It is unique
to money. Many things serve as a medium of exchange, unit of account, or store of value, but money
alone serves as the means of payment—the means of settling a debt so that there is no remaining
obligation between the parties to a transaction.
Get the class involved in figuring out what money is. To involve the students in the process of
determining what money is, after noting its definition and three functions, ask them what they think
should be counted as money. List the suggestions on the board before commenting on them. Coins
and currency will certainly be mentioned. Usually each class has a few members who have read the