Econ module 7 chapter 14: Macroeconomics: Defining and Measuring Money, Banking, and Money Creation
Defining Money by Its Functions
Conceptual Overview of Money: Money is not an end in itself; people cannot physically consume dollar bills or their bank accounts. Its primary usefulness lies in its exchange for goods and services. As humorist Ambrose Bierce (1842–1914) wrote in 1911, money is a “blessing that is of no advantage to us excepting when we part with it.”
Flexibility of Money: Money must be widely accepted by both buyers and sellers. It has historically taken various forms across cultures, including gold, silver, cowrie shells, cigarettes, and cocoa beans.
Barter and the Double Coincidence of Wants
The Barter System: This refers to an economy without money where people exchange one good or service directly for another. Barter is considered highly inefficient for modern, advanced economies.
Double Coincidence of Wants: A situation where two individuals each possess a good or service that the other wants.
Example: An accountant needing shoes must find a shoemaker who specifically needs accounting services and has the right shoe size.
Inefficiencies of Barter:
Complexity: Modern economies involve thousands of different jobs and goods, making direct trades nearly impossible to coordinate.
Perishability and Future Contracts: Barter makes future purchasing difficult. A farmer cannot easily buy a tractor in six months using a crop of strawberries that will rot long before the trade.
Opportunity Cost: The time spent bartering is time taken away from producing goods or enjoying leisure, which limits economic growth.
The Four Functions of Money
Medium of Exchange: Money acts as an intermediary between buyers and sellers. Instead of a direct trade (accounting for shoes), an individual exchanges a service for money and then uses that money to buy the desired good. It must be widely accepted in markets for labor, goods, and financial capital.
Store of Value: Money must maintain its value over time. While shoes might go out of style or wear out (thus and being a poor store of value), money can be held and spent later. Note: Money does not need to be a “perfect” store of value; in an economy with inflation, it loses some buying power but remains money.
Unit of Account: Money serves as the “rule” or common denominator by which we measure value. It simplifies thinking about trade-offs (e.g., knowing a tax return fee equals two pairs of shoes).
Standard of Deferred Payment: Money must be acceptable for making purchases today that will be paid for in the future. Loans and future agreements are stated in monetary terms, facilitating long-term economic activity.
Commodity versus Fiat Money
Commodity Money: Items used as money that also have intrinsic value from other uses.
Gold: Used as a conductor in electronics/aerospace, in reflective glass for skyscrapers, in medicine, and in jewelry. Historically served as a medium of exchange, store of value, and unit of account.
Commodity-Backed Currencies: Dollar bills or currencies with values backed by a physical commodity held at a bank.
Silver Certificates: Used in the U.S. until as late as . Holders could exchange the bill (e.g., a bill featuring George Washington) for a dollar’s worth of silver.
Fiat Money: Paper money that has no intrinsic value but is declared legal tender by government decree.
The U.S. dollar is fiat money, carrying the statement: “This note is legal tender for all debts, public and private.”
The value of fiat money is backed only by universal faith and trust in its worth.
Cryptocurrency (Bitcoin): Digital currency not backed by any commodity or government decree. It is unregulated by central banks and created through complex mathematics. It serves as a medium of exchange and an online store of value.
Measuring Money: Liquidity, M1, and M2
Definition of Liquidity: Refers to how quickly a financial asset can be used to purchase a good or service. Cash is highly liquid; a savings account is less liquid as it requires a withdrawal process.
The Federal Reserve Bank: The central bank of the United States, responsible for bank regulation, monetary policy, and defining the money supply based on liquidity.
M1 Money Supply (Narrowest Definition):
Currency in Circulation: Coins and bills not held by the U.S. Treasury, the Federal Reserve, or in bank vaults.
Checkable (Demand) Deposits: Funds in checking accounts that banks must provide —on demand— when a customer writes a check or uses a debit card.
Savings Deposits: As of May , the Federal Reserve moved savings accounts into the M1 category because technology (ATMs, internet banking) made them nearly as accessible as checking accounts.
Total M1 (May 2021): Approximately (or ).
M2 Money Supply (Broader Definition):
Includes everything in M1.
Money Market Funds: Pooled deposits from individual investors invested in safe ways, such as short-term government bonds.
Time Deposits (Certificates of Deposit or CDs): Accounts where the depositor commits to leaving the money for a set period (months to years) in exchange for a higher interest rate. Usually includes deposits less than approximately .
Total M2 (May 2021): Approximately (or ).
Plastic Money and Payment Methods
Debit Cards: These are instructions to the bank to transfer money immediately from a user's account to a seller. The money is the checkable deposit, not the card itself.
Credit Cards: Not considered money; they are short-term loans. The credit card company pays the seller, and the user receives a bill at the end of the month. Having more cards does not increase the quantity of money in the economy.
Smart Cards: Cards that store a certain value of money for specific purposes (e.g., long-distance calls, campus cafeteria). Use is often restricted to specific locations or purchases.
The Role of Banks as Financial Intermediaries
Financial Intermediaries: Institutions that stand between two parties (savers and borrowers). Banks accept deposits (mingled into a big pool) and use them to make loans.
Payment System: Banks facilitate the exchange of goods/services for money or financial assets, removing the need for people to carry large stockpiles of physical cash.
Transaction Costs: The costs associated with finding a lender or borrower. Banks lower these costs by serving as a central hub.
Types of Depository Institutions:
Commercial Banks: Standard banks providing checking and savings.
Savings and Loans (Thrifts): Historically limited by federal law (1930s-1980s) regarding interest rates and required to focus on housing-related loans.
Credit Unions: Non-profit financial institutions owned and run by members (e.g., community groups or employees). As of December , there were credit unions with assets totaling .
Banking Market Concentration: As of , the largest banks (% of all banks) controlled % of all banking assets.
Bank Balance Sheets (T-Accounts)
Assets: Items of value owned by the bank.
Reserves: Money held at the bank (vault cash) or at the Federal Reserve. The Federal Reserve sets a reserve requirement, forcing banks to hold a specific percentage of deposits.
Loans: Primary assets that generate interest income. These are issued in the primary loan market.
Bonds: Specifically U.S. Government Securities (e.g., Treasury bonds). These are low-risk assets that provide a stream of future payments.
Liabilities: Debts or amounts the bank owes to others.
Deposits: These are liabilities because the bank must return this money to customers when they wish to withdraw it.
Net Worth (Bank Capital): Calculated as . In a healthy bank, this is positive. If negative, the bank is bankrupt.
The Secondary Loan Market: The market where financial institutions buy and sell existing loans.
Buying institutions pay less for a loan if it is high-risk or if its interest rate is lower than the current market rate.
They pay more if the loan interest rate is higher than current market rates.
Bankruptcy and the 2008-2009 Financial Crisis
Loan Defaults: Banks factor in a small percentage of defaults into their planning. However, unexpected waves of defaults (as seen in a recession) can cause net worth to become negative.
Securitization: Bundling individual loans (like mortgages) into a financial security sold to investors. Investors receive a rate of return based on mortgage payments.
Subprime Loans: Loans made with little scrutiny of the borrower (low down-payment, no income verification).
NINJA Loans: A nickname for subprime loans given to people with “No Income, No Job, or Assets.”
Asset-Liability Time Mismatch: Customers can withdraw liabilities (deposits) in the short term, but banks receive payments on assets (loans/bonds) in the long term. This causes risk if interest rates rise or many people withdraw at once.
The Crisis Outcome: Falling housing prices after made mortgage-backed securities worth far less than expected, leading to the failure of banks between and .
Diversification: Strategy to reduce risk by lending to a variety of customers in different industries and locations. While helpful for localized issues, it cannot prevent losses during a widespread national recession.
How Banks Create Money
The Process of Lending: The banking system creates money through the cycle of receiving deposits and making loans.
Example: Singleton Bank:
Singleton Bank receives a deposit of .
The Reserve Requirement is %, so the bank keeps on reserve and has in excess reserves.
Singleton Bank lends the to Hank’s Auto Supply via a cashier's check.
Hank deposits the check into First National. The money supply (M1) has now increased by (the original at Singleton plus the new at First National).
First National keeps % () and loans out the remaining to Jack’s Chevy Dealership. This is deposited into Second National.
The Money Multiplier Formula: This formula determines the total money the system can create through multiple rounds of lending.
Calculation for Singleton Bank: .
Cautions Regarding the Multiplier:
Reserve Variations: Banks may hold extra reserves during a recession due to fear of defaults.
Consumer Behavior: If people do not re-deposit money (e.g., “mattress savings”), the multiplier effect is diminished.