Chapter 14: Money and Banking

Money and Banking

Defining Money by Its Functions

  • Money is anything of value accepted in exchange for goods/services or debt payment.
  • Functions of money include:
    • Medium of Exchange: Widely accepted for goods/services.
    • Unit of Account: Provides a common measurement of value.
    • Store of Value: Retains value over time, allowing future use.
    • Standard of Deferred Payment: Accepted for future payments.
  • Credit Cards: Not considered money as they do not meet the store-of-value criterion.

Barter System

  • Direct exchange of goods without money.
  • Problems:
    • Requires a coincidence of wants.
    • Inefficient, wasting time in transactions.
  • Money simplifies and increases market transactions.

Functions of Money

  • Money serves to facilitate transactions, measure value, retain purchasing power over time, and provide a mechanism for future payments.

Commodity and Fiat Money

  • Commodity Money: Has intrinsic value (e.g., gold, silver).
  • Fiat Money: Value derived from government regulation (e.g., paper currency).

Money Supply

  • M1: Narrowest definition, includes:
    • Currency in circulation
    • Checkable deposits
    • Travelers checks
  • M2: Broader definition, includes:
    • All of M1
    • Savings deposits
    • Small time deposits (< $100,000)
  • M1 is more liquid than M2.

The Role of Banks

  • Banks lower transaction costs as financial intermediaries:
    • They connect savers and borrowers.
  • Payment systems are crucial for exchanging goods/services.
  • Components:
    • Savers deposit and earn interest.
    • Borrowers take loans and pay interest.

How Banks Create Money

  • More money exists in checking accounts than physical currency.
  • Bank Balance Sheet:
    • Lists assets (value owned) and liabilities (debts owed).
    • Net worth = Total assets - Total liabilities.

Fractional Reserve Banking

  • Banks must keep a fraction (reserve requirement) of deposits as reserves.
  • The remainder can be loaned out, creating money.

Required and Excess Reserves

  • Total Reserves (TR): Cash held by the bank.
  • Required Reserves (RR): Legally mandated amount to hold based on deposits.
  • Excess Reserves (ER): Amount over RR that can be lent out:
    • $ER = TR - RR

Money Creation Process

  1. Accepting a New Deposit:
    • Deposit increases both assets and liabilities by the same amount.
    • Example: $1000 deposit.
  2. Making a Loan:
    • Lend out a portion of excess reserves, increasing money supply.
    • Example: Loan $900, keeping $100 as reserves.
  3. Clearing the Loan Check:
    • When a loan check is deposited elsewhere, banks adjust reserves.
  4. Subsequent Loans: Other banks lend further, continuing the cycle.

Money Multiplier

  • Describes maximum potential change in money supply from new reserves:
    • ext{Money Multiplier (mm)} = rac{1}{ ext{Required Reserve Ratio (RRR)}}
  • Total money supply increase is an exponential function of initial deposits.

Impact of Money Multiplier on Money Supply

  • Total increase in deposits is limited by the reserve fraction.
  • The multiplication process continues until an eventual total increase is established.

Real-World Considerations

  • Cash Leakages: Some money may not enter the banking system if not redeposited.
  • Economic stress can also limit banks from utilizing excess reserves for lending.

Practice Examples

  • Example 1: Transaction leads to excess reserves of 3600; max bank expansion = 3600.
  • Example 2: Kristy's $10,000 deposit at a 20% reserve ratio could potentially increase total checking deposits to $50,000 (based on a multiplier of 5).