Equation of Exchange: MV = PQ
M = supply of money
V = velocity of money (number of times a year that a dollar is spent on final G & S.)
P = price level (average price of each unit of output)
Q = physical volume of G & S produced.
MV is the amount spent by consumers This is the same as the total C + I + G + Xn
PQ is the amount received by sellers. This is the same as nominal GDP (current output at
What happens if M changes? When M increases you have to look to see if the economy is in
full capacity. If it is not then Q increase. If it is then P increases.
One argument about V is that it is determined by peoples willingness to hold money in a non
interest bearing form. If the interest rates go way up people are willing to hold less money. This
means that the money they are holding must turn over quicker so V increases.
Historically we have found that V is actually pretty stable.
Balance Sheet: a statement of assets and claims summarizing the financial position of
a firm or bank at some point in time.
A balance sheet must always balance. Every asset is claimed by someone.
net worth: the claims of the owners against the firms assets
liabilities: claims of the nonowners.
Assets = net worth + liabilities
In the beginning people would not want to carry around large sums of gold. They
would therefore bring the gold to goldsmiths who would issue them receipts.
Eventually people found it easier to trade receipts rather than gold. They knew that
they could get the gold if they wanted to. The receipt was backed by gold.
Soon the goldsmiths saw that more gold was deposited than taken out. They decided
to issue receipts that was not backed by gold. They did this in the form of loans.
The fractional reserve system of banking was started. Only a fraction of the receipts were covered with gold.
The goldsmiths created money. Today the same thing occurs. Banks make loans
based on an amount that the Federal Reserve requires them to keep in reserve.
Bank panics occur when the people want to redeem more gold (money) than the
goldsmiths (banks) have on hand to redeem. In order to try to stop panics from
happening the banks are required to hold a certain reserve.
Lets start a bank:
We start by selling stock so that we can get cash. We will sell $250,000.
The cash we get is an asset. Yet we owe people for that cash. This makes stock a
Assets Liabilities + Net Worth Cash 250,000 Capital Stock 250,000
We will now build a 220,000 dollar building and buy 20,000 in equipment. These are
assets. Remember we must balance.
Assets Liabilities + Net Worth Cash 10,000 Capital Stock 250,000 Property 240,000
In order to make things easier, we will now ignore the previous transaction. As a bank we will make loans and accept deposits. Lets start by taking in $100,000 in
Assets Liabilities and Net Worth Cash 350,000 Capital Stock 250,000
Demand Deposits 100,000
In doing this the makeup of M1 has changed. Currency is down by 100,000 and
Demand Deposits are up by $100,000. By definition of M1 the money in banks is not included in demand. This avoids double counting of money.
We now have money in the form of deposits.
legal reserve (reserve): an amount of funds equal to a specified percentage of its own
deposit liabilities which a member bank must keep on deposit with the Federal
Reserve Bank in its district or as vault cash.
reserve ratio: this is the specified percentage of its demand liabilities which the
commercial bank must keep as reserves.
Reserve ratio = banks required reserves / banks demand-deposit liabilities.
EX: 10% = 10,000/100,000
From here on we will for simplicity reasons assume a rate of 20%. Lets assume that the bank foresees more deposits. They do not want to keep sending
money so they are going to send not 20,000 but 350,000 up front. (Usually they will
hold 1 to 2% in their vaults. This vault cash would be considered part of the reserves.)
Assets Liabilities and Net Worth Cash