Principles of Economics/Money

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Definitions of Money[edit]

Economists use multiple definitions of money. By far the most important are:

  • Monetary base (MB)
    • "high-powered money"
    • stricter definition of money
    • consists of all currency (C) and reserves (R)
    • note that this is the actual extant money
  • Money type 1 (M1)
    • "money in the economy"
    • consists of all currency (C) and deposits (D)
    • standard definition of money
    • note that this is the amount of money that influences the well-being of the economy

These definitions of money are very confusing.

When customers deposit money in banks, the banks keep a certain small portion as reserves (R) and hold onto it for when customers withdraw. The remaining deposited money is then lent out to others, who, upon having that money, deposit into banks, who lend a fraction of that, and so on. Eventually, this cycle involves infinitesimally small amounts of money, so the cycle actually does come to an end, based on the basic geometric series rule:

 (r)^1 + (r)^2 + (r)^3 + ... = \frac{ 1 }{ 1 - r }

where

  • r is the portion of money that banks lend out

The result is that the economy is working with more money than really exists, because firms and individuals can still work with abstract money such as loaned money. This is the principal way in which banks "make money".

Equations[edit]

Monetary Base = Non Borrowed Monetary Base + Discount Loans

Monetary Base (MB) * Money base money multiplier (m) = M1

Monetary Base = "High-powered money" = Currency (C) + Reserves (R) = Currency (C) + (Deposits (D) * Required Reserve Ratio (r))

(Contrast with M1, which is Currency + Deposits)