Lecture Notes: Money and Deposit Creation

Presenter: Clark Ross, Davidson College

Course: AP Macroeconomics

Key Concepts

Money Supply

• M1: Basic money supply, approx. $5.3 trillion in summer 2020.
  • Components:
    • Circulating currency: $1.8 trillion
    • Demand deposits (checking accounts): $3.5 trillion
• M2: Broader measure, approx. $18.3 trillion in summer 2020.
  • Includes M1, savings deposits, small denomination time deposits, money market mutual funds.
  • Less liquid than M1.

Velocity of Money

• Velocity (V) links money supply (M) to nominal GDP (P x Q).
• Equation: M x V = P x Q (Nominal GDP)
• Example (Summer 2020):
  • M = $5.3 trillion
  • Nominal GDP = $19 trillion
  • Velocity = 3.64 (historically low)

Money Market and Interest Rates

Money Market Graph

• Axes:
  • Vertical: Nominal interest rate
  • Horizontal: Quantity of money
• Supply: Set by the central bank (Federal Reserve)
• Demand: Downward sloping
• Equilibrium: Intersection gives nominal interest rate, influences federal funds rate.

Central Bank Policies

• Expansionary Policy: Buy bonds, increase reserves, lower interest rates.
• Contractionary Policy: Sell bonds, decrease reserves, increase interest rates.
• Goals of Expansionary Policy:
  • Increase GDP and employment, decrease unemployment.

Deposit Creation and Banking System

Bank Balance Sheets

• Assets include: Loans, government bonds, cash reserves.
• Liabilities: Deposits (require cash reserves)
• Owner's Equity: Residual value

Required Reserve Ratio

• Example ratio: 10%
• Determines the amount of cash reserves a bank must hold.

Deposit Creation Process

1. Initial Deposit:
   • Person A deposits $1,000 at Bank 1.
   • Bank 1 holds $100 (10%) as reserves, can loan $900.
2. Subsequent Transactions:
   • Person B borrows $900, pays Contractor C.
   • Contractor C deposits $900 in Bank 2, which loans $810 to Person D.
   • Process continues across multiple banks, creating a multiplied increase in deposits.

Multiplier Effect

• Multiplier Formula: 1/Required Reserve Ratio
• Example: 10% reserve ratio results in a multiplier of 10.
• Total increase in demand deposits: $10,000
• Net money supply increase: $9,000 (account for cash decrease)

Limitations in Multiplier Effect

• Banks may hold excess reserves.
• Leakage to currency (cash not deposited).
• Process requires time and multiple iterations.

Conclusion

• Expansionary Monetary Policy: Increases money supply and lowers interest rates, boosts investment, and aggregate demand.
• Contractionary Policy: Reduces money supply to combat inflation.
• AP Macro Exam Preparation: Understanding monetary policy, deposit creation is critical for exams.

Thank you to the College Board for sponsoring this program.