Money, Banking, and the Financial System — Study Notes

Money: What is Money and How Did It Come to Be?

  • Money is defined as any good that is widely accepted for purposes of exchange and the repayment of debt.
  • Three functions of money:
    • Medium of Exchange: Anything generally acceptable in exchange for goods and services.
    • Unit of Account: A common measure in which relative values are expressed.
    • Store of Value: The ability of an item to hold value over time.

Origins of Money and the Move from Barter to Money Economy

  • Barter economy: trading goods and services directly for other goods and services.
  • Double coincidence of wants: A trade requires each participant to want what the other has at the same time.
  • Costs of barter: Transaction costs are higher, making exchanges slower and more cumbersome.
  • Transition to money economy: Money evolves naturally in a market economy to reduce transaction costs.
  • Early banking origins: Gold coins were common, but carrying them was difficult and unsafe.
  • Goldsmiths as the first bankers:
    • Stored gold and issued warehouse receipts to customers.
    • Receipts became widely accepted as money.
  • Fractional reserve banking begins when goldsmiths lend a portion of stored gold beyond the gold on deposit, earning interest while still redeeming receipts.
  • Key term: Fractional Reserve Banking – a banking system in which banks hold reserves equal to only a fraction of their deposit liabilities.

What is Money: Key Definitions and Examples

  • Money definition reminder: A good widely accepted for exchange and debt repayment.
  • Common misconception: People may refer to income, credit, and wealth as money, but economists distinguish them.

Knowledge Check 1a (Question and Answer)

  • Question: Economists define money as A) anything that can be used as a medium of exchange. B) any good that is widely accepted for purposes of exchange and the repayment of debt. C) the income one receives for services rendered. D) an individual's wealth in terms of assets owned.
  • Answer: B
  • Rationale: The most general, precise definition is that money is any good widely accepted for purposes of exchange and debt repayment.

Knowledge Check 1b: Unit of Account

  • Question: The function of money termed unit of account refers to A) the function money serves as a common measure in which relative values are expressed. B) a characteristic that money is intrinsically valuable. C) tax revenues will fall. D) the ability of money to be used as a means by which goods and services are exchanged.
  • Answer: A
  • Example: If one hamburger costs $10 and a milkshake costs $5, one hamburger is worth two milkshakes.

Knowledge Check 1c: Barter and Output/Leisure

  • Question: A money economy is likely to have ____ and ____ than a barter economy, because a double coincidence of wants is ____ in a barter economy. A) less output, less leisure, unnecessary B) less output, less leisure, necessary C) more output, more leisure, unnecessary D) more output, more leisure, necessary
  • Answer: D
  • Explanation: Barter requires double coincidence of wants, which adds time; money economy frees up time for more production and leisure.

Money Supply: M1 and M2

  • M1 is a narrow measure of the money supply and was changed in May 2020 by the Fed.
  • M1 components:
    • Currency held outside banks (coins and paper money).
    • Demand deposits: Non-interest earning deposits that are on demand with no restrictions.
    • Other liquid deposits: Other checkable deposits, savings deposits (interest-earning), money market deposit accounts (MMDAs).
  • Formula for M1:
    M1 = ext{Currency outside banks} + ext{Demand deposits} + ext{Other liquid deposits}
  • M2 is a broader measure: M1 plus additional components.
  • M2 components:
    • All of M1.
    • Small-denomination time deposits.
    • Money market mutual funds (retail).
  • Time deposits: An interest-earning deposit with a specified maturity date.
    • Small-denomination time deposits: Deposits of less than $100,000.
  • Money Market Mutual Funds (Retail): An interest-earning account at a mutual fund company, usually with a minimum balance and limited check-writing privileges.
  • May 2020 Fed update note: Definitions of M1 and M2 were changed by the Fed (brief historical note in the slide).

Credit Cards and Where They Fit

  • Credit cards are not money.
  • They are instruments that make it easier for the holder to obtain a loan.
  • When using a credit card, you repay with money; credit card balances do not count as money.
  • Do not double-count money: credit card spending borrows from the payer’s funds, not creating new money.

Knowledge Check 2a: Credit Cards and Money

  • Question: Which statement is false?
    • A) M1 includes currency outside banks, demand deposits, and other liquid deposits.
    • B) A money market mutual fund is an interest-earning account at a mutual fund company.
    • C) Credit cards are money since they serve as a medium of exchange.
    • D) Currency is money, but to an economist money is more than just currency.
  • Answer: C
  • Explanation: Credit cards are not money; they facilitate borrowing and spending from funds that exist elsewhere.

Knowledge Check 2b: Time Deposits and M1 vs M2

  • Question: A time deposit is an interest-earning deposit A) with a specified maturity date. B) similar to a non-interest-earning checking account. C) that is included in M1 but not M2. D) that is included in M1 and M2.
  • Answer: A
  • Explanation: Time deposits have a specified maturity date and are not part of M1; they are included in M2.

Knowledge Check 2c: Moving Money from Checkable Deposits to MMMFs

  • Question: If people move money from their checkable deposits into their money market mutual fund accounts, it follows that A) M1 will decline and M2 will rise. B) M2 will decline and M1 will rise. C) both M1 and M2 will decline. D) M1 will decline and M2 will remain unchanged.
  • Answer: D
  • Explanation: M1 declines because it includes checkable deposits; M2 includes M1, so remains unchanged as all funds still exist in M2.

The Banking System: The Early Bankers and the Rise of Fractional Reserve Banking

  • The Early Bankers:
    • Gold coins were the principal money in early economies.
    • Carrying gold coins was inconvenient and risky.
    • People turned to goldsmiths for safe storage.
  • Goldsmiths as the first bankers:
    • They issued warehouse receipts for gold stored with them.
    • Receipts became widely accepted as money.
  • Goldsmiths began lending some stored gold:
    • They earned interest on loans while pledges to redeem receipts were maintained.
    • The amount of gold backing receipts exceeded actual gold on deposit.
  • Fractional reserve banking:
    • Banks hold reserves only a fraction of their deposit liabilities.

The Bank’s Reserves and Related Concepts

  • Reserves: Sum of bank deposits at the Federal Reserve and vault cash.
    • Example: If a bank has $40 million in deposits at the Fed and $10 million in vault cash, total reserves = $50 million.
  • Required Reserve Ratio (r): Percentage of each dollar deposited that must be held as reserves (at the Fed or as vault cash).
  • Required Reserves: Minimum dollar amount of reserves a bank must hold against its checkable deposits (as mandated by the Fed).
  • Reserve Requirement: The Fed rule specifying the amount of reserves a bank must hold to back up deposits.
  • Excess Reserves: Reserves held beyond the required amount; excess reserves = total reserves − required reserves.
  • Practical note: A well-functioning financial system matches savers and borrowers by pooling surplus funds with those in need of funds.

The Financial System: Direct and Indirect Finance; Financial Intermediaries

  • Direct Finance: Borrowers and lenders meet directly in a market setting (e.g., bond market).
  • Indirect Finance: Funds flow through a financial intermediary (e.g., banks) between savers and borrowers.
  • Financial Intermediary: An institution that transfers funds from savers to borrowers.
  • Lending and borrowing problems stem from asymmetric information:
    • Asymmetric Information: One party has information the other does not have.

Lending and Borrowing Problems: Pre- and Post-Loan Issues

  • Adverse Selection (before the loan):
    • The party with information unknown to the other side self-selects in a way that harms the other party.
  • Moral Hazard (after the loan):
    • One party changes behavior in a way that is hidden from and costly to the other party.
  • Example of moral hazard: A grant from parents for college books used instead for a ski trip, which could affect future borrowing willingness.

The Bank’s Balance Sheet and Insolvency

  • Balance Sheet: A record of a bank’s assets and liabilities.
  • Asset: Anything of value owned or claimable.
  • Liability: Anything owed to someone else.
  • Business objective: Turn liabilities into assets; effectively, what a bank owns vs. what it owes.
  • Insolvency: When liabilities exceed assets.

Knowledge Check 3a: Fractional Reserve Question

  • Question: Under a fractional reserve banking system, banks must hold only a fraction of their deposit liabilities in the form of A) government securities B) debt C) gold D) reserves
  • Answer: D
  • Explanation: Fractional reserve banking requires holding reserves as a fraction of deposits, not necessarily holding the full deposit in cash or equivalents.

Knowledge Check 3b: Bank Assets

  • Question: Which of the following is an asset for a bank? A) Reserves B) Checkable deposits C) Borrowings D) Nontransaction deposits
  • Answer: A
  • Explanation: Assets include reserves, loans, and securities; liabilities include checkable deposits, borrowings, and nontransaction deposits.

Knowledge Check 3c: Economic Concepts

  • Question: _ is a condition that exists when one party to a transaction changes his or her behavior in a way that is hidden from, and costly to, the other party. A) Adverse selection B) Asymmetric information C) Moral hazard D) Symmetric information
  • Answer: C
  • Explanation: Moral hazard arises when one party alters behavior after a transaction.

The Chapter Summary

  • By the end of the chapter, you should be able to:
    • Define the three functions of money.
    • Differentiate between various money aggregates (M1, M2, etc.).
    • Explain how financial intermediaries connect borrowers and savers.
  • Additional connections:
    • The evolution from barter to money reduced transaction costs via the elimination of the double coincidence of wants.
    • The money supply concepts (M1, M2) reflect different liquidities and accessibility to spending.
    • Credit cards are not money; they facilitate borrowing and spending linked to existing money.
    • The banking system uses reserves and required reserves to back deposits, with the concept of excess reserves providing flexibility for lending.
    • Direct vs. indirect finance shows two pathways to channel funds from savers to borrowers; information asymmetry creates challenges like adverse selection and moral hazard.
    • A bank’s balance sheet balances assets (what the bank owns) against liabilities (what the bank owes); insolvency occurs when liabilities exceed assets.