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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.



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