Money and Banking

Cowrie Shell or Money?

• Is this an image of a cowrie shell or money?
• The answer is: Both.
• For centuries, people used the extremely durable cowrie shell as a medium of exchange in various parts of the world.

      (Credit: modification of work by “prilfish”/Flickr Creative Commons)

14.1 Defining Money by Its Functions

• What the world would be like without money?
• Barter – trading one good or service for another, without using money.
• Double coincidence of wants – a situation in which two people each want some good or service that the other person can provide.

Functions for Money

• Money – whatever serves society in four functions:
  • Medium of exchange – whatever is widely accepted as a method of payment.
  • Store of value – something that serves as a way of preserving economic value that one can spend or consume in the future.
  • Unit of account – the common way in which we measure market values in an economy.
  • Standard of deferred payment – money must also be acceptable to make purchases today that will be paid in the future.

Commodity versus Fiat Money

• Commodity money – an item that is used as money, but which also has value from its use as something other than money.
• Commodity-backed currencies – dollar bills or other currencies with values backed up by gold or another commodity.
• During much of its history, gold and silver backed the money supply in the United States.
• Now, by government decree, if you owe a debt, then legally speaking, you can pay that debt with the U.S. currency, even though it is not backed by a commodity.
• Fiat money – has no intrinsic value, but is declared by a government to be the country’s legal tender.
• The only backing of our money is universal faith and trust that the currency has value, and nothing more.

A Silver Certificate and a Modern U.S. Bill

• Until 1958, silver certificates were commodity-backed money – backed by silver, as indicated by the words “Silver Certificate” printed on the bill, pictured at bottom.
• Today, The Federal Reserve backs U.S. bills, but as fiat money (inconvertible paper money made legal tender by a government decree). (Credit: “The.Comedian”/Flickr Creative Commons)

14.2 Measuring Money: Currency, M1, and M2

• The Federal Reserve Bank:
  • The central bank of the United States,
  • Bank regulator and responsible for monetary policy,
  • Defines money according to its liquidity.
• The Federal Reserve Bank has two definitions of money:
  • M1 money supply – a narrow definition of the money supply that includes currency and checking accounts in banks, and to a lesser degree, traveler’s checks.
  • M2 money supply – a definition of the money supply that includes everything in M1, but also adds savings deposits, money market funds, and certificates of deposit.

M1 Money

• M1 money supply includes:
  • Coins and currency in circulation – the coins and bills that circulate in an economy that are not held by the U.S Treasury, at the Federal Reserve Bank, or in bank vaults.
  • Checkable (demand) deposits – checkable deposit in banks that is available by making a cash withdrawal or writing a check.
  • Traveler’s checks

M2 Money

• M2 money supply includes:
  • All M1 types
  • Savings deposits – bank account where you cannot withdraw money by writing a check, but can withdraw the money at a bank – or can transfer it easily to a checking account.
  • Money market fund – the deposits of many investors are pooled together and invested in a safe way like short-term government bonds.
  • Certificates of Deposit (CD’s) and other time deposits – account that the depositor has committed to leaving in the bank for a certain period of time, in exchange for a higher rate of interest.

The Relationship between M1 and M2 Money

• M1 and M2 money have several definitions, ranging from narrow to broad.
• M1 = coins and currency in circulation + checkable (demand) deposits + traveler’s checks.
• M2 = M1 + savings deposits + money market funds + certificates of deposit + other time deposits.

Where Does “Plastic Money” Fit In?

• Debit card – like a check, is an instruction to the user’s bank to transfer money directly and immediately from your bank account to the seller.
• Credit card – immediately transfers money from the credit card company’s checking account to the seller, and at the end of the month the user owes the money to the credit card company.
  • A credit card is a short-term loan.
  • Not considered money.
• Smart card – stores a certain value of money on a card and then one can use the card to make purchases.
  • Examples: long-distance phone calls or making purchases at a campus bookstore and cafeteria
• Credit cards, debit cards, and smart cards are different ways to move money when you make a purchase.

14.3 The Role of Banks

• Most money is in the form of bank accounts, which exist only as electronic records on computers.
• Payment system – helps an economy exchange goods and services for money or other financial assets.
• Transaction costs – the costs associated with finding a lender or a borrower for this money.
• Banks bring savers and borrowers together.
• Banks lower transactions costs and act as financial intermediaries.

Banks as Financial Intermediaries

• Financial intermediary – an institution that operates between a saver with financial assets to invest and an entity who will borrow those assets and pay a rate of return.
• Discussion Question: What are institutions in the financial market, other than banks, that are financial intermediaries?
• Depository institution – institution that accepts money deposits and then uses these to make loans.

Banks as Financial Intermediaries, Illustrated

• Banks act as financial intermediaries because they stand between savers and borrowers.
• Savers place deposits with banks, and then receive interest payments and withdraw money.
• Borrowers receive loans from banks and repay the loans with interest.
• In turn, banks return money to savers in the form of withdrawals, which also include interest payments from banks to savers.

A Bank’s Balance Sheet

• Balance sheet – an accounting tool that lists assets and liabilities.
• Asset – item of value that a firm or an individual owns.
• Liability – any amount or debt that a firm or an individual owes.
• Net worth – the excess of the asset value over and above the amount of the liability; total assets minus total liabilities.
• Bank capital – a bank’s net worth.

A Bank’s Balance Sheet

• This figure shows a hypothetical and simplified balance sheet for the Safe and Secure Bank.
• T-account – a balance sheet with a two-column format, with the T-shape formed by the vertical line down the middle and the horizontal line under the column headings for “Assets” and “Liabilities”.
• The “T” in a T-account has:
  • the assets of a firm, on the left
  • its liabilities, on the right.

Reserves and Bankruptcy

• Reserves – funds that a bank keeps on hand and that it does not loan out or invest in bonds.
• The Federal Reserve requires that banks keep a certain percentage of depositors’ money on “reserve”.
• We define net worth of a bank as its total assets minus its total liabilities.
  • For a financially healthy bank, the net worth will be positive.
  • If a bank has negative net worth and depositors tried to withdraw their money, the bank would not be able to give all depositors their money.

How Banks Go Bankrupt

• Potential problems for a bank:
  • High rate of loan defaults
  • Asset-liability time mismatch – the ability for customers to withdraw bank’s liabilities in the short term while customers repay its assets in the long term.
• Strategies to reduce risk:
  • Diversify – making loans or investments with a variety of firms, to reduce the risk of being adversely affected by events at one or a few firms.
  • Sell some of the loans they make in the secondary loan market.

Hold a greater share of assets (government bonds or reserves).

14.4 How Banks Create Money, Part 1

• The banking system can create money through the process of making loans.

Singelton Bank Balance Sheet

• In the T-account balance sheet above, Singelton Bank is simply storing money for depositors, and not making loans.
  • It cannot earn any interest income and cannot pay its depositors an interest rate.

Singelton Bank Balance Sheet

• Now, by loaning out $9 million and charging interest, it will be able to make interest payments to depositors.
• This alters Singelton Bank’s balance sheet:
  • It now has $1 million in (required 10%) reserves and a loan to Hank’s Auto Supply of $9 million.

How Banks Create Money, Part 2

First National Balance Sheet

• Singelton Bank issues Hank’s Auto Supply a cashier’s check for the $9 million.
• Hank deposits the loan in his regular checking account with First National Bank.
• The deposits at First National Bank rise by $9 million and its reserves also rise by $9 million.
• Bank lending has expanded the money supply by $9 million.

First National Balance Sheet

• Now, First National Bank must hold some required reserves ($900,000) but can lend out the other amount ($8.1 million) in a loan to Jack’s Chevy Dealership.

How Banks Create Money, Part 3

Second National Balance Sheet

• If Jack’s Chevy Dealership deposits the loan in its checking account at Second National, the money supply just increased by an additional $8.1 million.
• Making loans that are then deposited into a demand deposit account increases the M1 money supply.
• This money creation is possible because there are multiple banks in the financial system.
  • They are required to hold only a fraction of their deposits,
  • loans end up deposited in other banks,
  • which increases deposits and the money supply.

The Money Multiplier and a Multi-Bank System

• If all banks loan out their excess reserves, the money supply will expand.
• In a multi-bank system, institutions determine the amount of money that the system can create by using the money multiplier.
• The money multiplier formula = 1 / Reserve Requirement
• By multiplying the money multiplier by the excess reserves, we can determine the total amount of M1 money supply created in the banking system.
• Discussion Question: If the reserve requirement is 10%, and a bank’s excess reserves are $9 million, what is the change in the M1 money supply?

Cautions about the Money Multiplier

• The quantity of money in an economy is closely linked to the quantity of lending or credit in the economy.
• All the money in the economy, except for the original reserves, is a result of bank loans that institutions repeatedly re-deposit and loan.
• A bank can also choose to hold extra reserves, above the required amount.
• Banks may decide to vary how much they hold in reserves for two reasons:
  • macroeconomic conditions
  • government rules
• In a recession, banks are likely to hold a higher proportion of reserves due to fear that customers are less likely to repay loans.
• The Federal Reserve may also raise or lower the required reserves held by banks as a policy move to affect the quantity of money in an economy.
• Additionally, if people do not deposit cash, banks cannot recirculate the money in the form of loans.