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Example 4B: The castaways on Gilligan’s Island are using Monopoly money as their medium of
exchange. One day a crate floats up to the island. When Gilligan opens the crate, he discovers
that it contains a dozen Monopoly games. Gilligan is ecstatic. “We’re rich!” he shouts. But the
castaways are no better off than before. Their level of production has not increased. With the
increase in the money supply, the price of goods and services will increase. But the money does
not make the goods and services valuable. The goods and services make the money valuable.
Measuring the Money Supply
Money is whatever is generally accepted as a medium of exchange. There are different measures
of the money supply:
1. Currency. Currency is the most basic measure of the money supply. Currency consists of the
coins and paper money issued by the federal government.
2. M1. M1 consists of currency in circulation (held outside banks) plus checkable deposits.
Checkable deposits are deposits in banks or other financial institutions on which checks can
be written. M1 is sometimes called “transactions money”.
3. M2. M2 consists of M1 plus small-denomination time deposits, savings deposits, and money
market accounts.
The measure of the money supply we will use is M1. As of November, 2014, the money supply
(M1) was approximately $2,850 billion. This was an increase of over 100% since August, 2008,
when the money supply was about $1,400 billion.
Checks and Credit Cards
A large percentage of transactions are made through the use of checks and credit cards. Are
checks and credit cards money? Checks are not money. Checks are a way to transfer the money
held in a checkable deposit. The checkable deposit is money, but the check is not.
Example 5: Professor D. Imwit writes a check for $1500 to purchase a new LED television. Has
Professor Imwit spent money? If the balance in Professor Imwit’s checking account is sufficient to
cover the amount of the check, Professor Imwit has spent money. The check allows Professor
Imwit to use some of his money (checkable deposit) to pay for the TV. If the balance of Professor
Imwit’s checking account is not sufficient to cover the check, Professor has not spent money. He
has committed fraud.
Are credit cards money? Credit cards are not money. When a purchase is made through the use
of a credit card, the purchaser is not spending money to make the purchase, he or she is taking
out a loan.
Example 6: Professor Imwit purchases a new LED television for $1500 using his credit card.
Professor Imwit has not spent money to buy the television. He has taken out a loan. When he
writes a check to make a payment on his credit card balance, he is spending money (assuming
that the balance in his checking account is sufficient to cover the amount of the check).
Money Creation
Our banking system is a fractional reserve system. In a fractional reserve system, banks are able
to create money.
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Money creation – increases in checkable deposits made possible by fractional reserve banking.
In a fractional reserve system, banks hold reserves equal to only a fraction of their deposits.
Fractional reserve banking makes it possible for banks to serve as financial intermediaries.
10 - 3 Money, Money Creation, and Inflation