The Economy, Banking, and Money Creation Notes

The Fundamentals and Functions of Money

• Core Question: Money value and its necessity in an economy are explored through questions about whether checkable deposits, paper currency, Bitcoin, or video game currencies are "instantly spendable" and truly possess intrinsic value.
• Three Primary Functions of Money:
  • A Medium of Exchange: Used to facilitate the trade of goods and services.
  • A Store of Value: An asset that maintains its purchasing power over time.
  • A Unit of Account: A standard numerical unit of measurement for the market value of goods, services, and other transactions.
• Liability-Based Money: Most modern money exists as an "IOU" or liability. Holding liability money means a commercial bank or the central bank owes that amount to the holder. Transfers are conducted via electronic movement of this debt or physical currency as payment.

Historical Perspectives: Barter and Shay’s Rebellion

• Barter Economies: The existence of pure barter economies is historically debated. The transcript poses whether people could effectively trade if they had assets to sell but no currency.
• Shay’s Rebellion (Massachusetts, 1786):
  • The Scenario: Productive farmers created their own money by writing IOUs to meet local needs.
  • The Conflict: The state government demanded tax payments in official currency, which farmers did not have. Farmer Benedict, for example, held only IOUs from other farmers and could not pay his tax bill.
  • Consequences: Failure to pay debt lead to prison and foreclosure. Unlike the past, the state did not stay tax payments.
  • The Rebellion: Farmers took up arms to shut down courts and prevent foreclosure judgments.
  • Significance: The rebellion alarmed elites across the U.S., leading to the Constitutional Convention to create a national state capable of imposing order and collecting taxes and debts.

The Mechanics of the Modern Banking System

• The Checking System: Most money exists as "Checkable Deposits" in bank accounts, originally as physical ledgers and now as electronic entries.
• Payment Process:
  • A check or electronic transfer is a promise to pay from a controlled account.
  • The recipient’s bank verifies with the source bank if sufficient funds exist.
  • Reconciliation: At the end of the day, banks "reconcile" by adding up all payments owed between them and transferring the net balance.
• The Balance Sheet:
  • Assets: Anything of value that is owned.
  • Liabilities: Anything of value that is owed.
  • Net Worth (Equity): Calculated as $\text{Net worth} = \text{Assets} - \text{Liabilities}$.
  • Accounting Equation: $\text{Assets} = \text{Liabilities} + \text{Net worth}$.
• Wealth and Loans: Net worth does not change when borrowing or lending. A loan adds a cash asset to the borrower’s balance sheet but creates an equal liability in debt.

The Money Creation Process

• Loaning and Creation: Banks create money when they issue loans. Deposits are effectively created at the moment of the loan, rather than being limited by existing deposits.
• Profit Motive: Banks approve loans if they expect the interest charged to outweigh the cost of money, operating expenses, and risk of default.
• Maturity Transformation: Banks provide a service where deposits are liquid (withdrawable at any time) while loans are illiquid (repaid over a specified time). This creates two specific risks:
  • Default Risk: The risk that loans will not be repaid.
  • Liquidity Risk: The risk that assets cannot be converted to cash quickly enough to meet withdrawal demands, potentially causing "bank runs."

Measuring and Regulating Money: M0 and M1

• Base Money ($M0$): Currency in circulation plus central bank reserves. It is tradeable immediately. In the U.S., it comprises approximately $10\%$ of the money supply; in England, it is $3\%$ to $4\%$.
• Broad Money ($M1$): Defines spendable money. It includes $M0$ plus liquid assets:
  1. Currency outside depository institutions.
  2. Demand deposits at commercial banks.
  3. Other liquid deposits (checkable deposits, savings deposits, and money market accounts).
  4. Treasury bills under $1$ year.
• Reserve Requirements: U.S. banks were historically required to keep $10\%$ of their assets in liquid reserves at the Federal Reserve (earning interest).
  • When making a loan, banks must meet this requirement by transferring cash to the Fed.
  • To obtain this cash, they may borrow from other banks at the nominal/short-term interbank rate or sell assets.

Economic Models and the Business Cycle

• The Babysitter Economy: A model illustrating recession. Parents hoarded "scrip" (coupons for hours of babysitting), leading to a lack of economic activity because no one wanted to spend their limited scrip.
• The Business Cycle: Fluctuating levels of economic activity measured from the start of one recession to the start of the next.
• The Long Depression (Late 19th Century): Characterized by high factory production but "starvation wages" that prevented consumption. Early economists wrongly suggested contracting the money supply.
• Great Depression Data (1929-1941):
  • Unemployment reached $33\%$.
  • Corporate profits dropped from $\$9.5 \text{ billion}$ in $1929$ to a low of $- \$1.7 \text{ billion}$ in $1932$ (recovery started reaching $\$5.7 \text{ billion}$ by $1936$).
  • Gross National Product (GNP) dropped significantly between $1929$ and $1933$, only recovering fully during WWII production.

Keynesian Economics and the New Deal

• Classical Failure: Classical economics failed to revive the economy under President Hoover.
• The First New Deal: Roosevelt’s National Recovery Act (NRA) attempted to set high prices and wages to prevent undercutting, but failed to end the Depression.
• John Maynard Keynes’ "General Theory":
  • Proposed that economies are not self-correcting.
  • Argued the engine of the economy is demand, not business profitability.
  • Deficit Spending: Only the government can spend enough to revive demand by borrowing more than it earns in revenue (known as "priming the pump").
• Historical Application: Keynes advised FDR in $1934$ to increase spending by $\$12$ to $\$15 \text{ billion}$. FDR, a fiscal conservative, only tried a few billion. When spending was cut in $1937$ to balance the budget, the "Roosevelt Recession" occurred, causing employment to fall sharply.

The Federal Reserve and Policy Levers

• Federal Reserve Board: Governors serve $14$-year terms to remain independent of political currents. They control U.S. monetary policy.
• Monetary Policy Levers:
  • Pro-Growth: Lowering interest rates. This makes more loans profitable, increasing lending and money creation.
  • Anti-Growth: Raising interest rates to reduce lending and inflation.
  • Inflation Target: The Fed typically targets $2\%$ inflation as a margin of safety against deflation.
• Fiscal Policy Levers:
  • Pro-Growth (Inflationary): Increased government spending (public works, social programs) and tax cuts.
  • Anti-Growth (Disinflationary): Reduced spending and increased taxes.

Monetarism and the Quantity Theory of Money (QTM)

• The Theory: Also known as the Quantity Theory of Money. It posits that the total amount of money is determined by the amount of base money and that inflation is directly correlated to the amount of base money.
• The Identity Equation: $\text{[amount of money]} \times \text{[velocity of circulation]} = \text{[prices]} \times \text{[\# of economic transactions]}$. This can be summarized as $\text{MV} = \text{PQ}$.
• Criticisms: Monetarism is often considered a "failed theory" because its assumptions—that velocity and output are stable—are empirically falsified. Velocity is not constant, as shown by its downward trend from the late $1990s$ through $2020$.

Historical Data and Investment Indicators

• Inflation by Decade:
  • $1913-1919$: $92.86\%$
  • $1920-1929$: $-8.99\%$
  • $1930-1939$: $-18.60\%$
  • $1970-1979$: $103.45\%$
  • $2010-2019$: $19.00\%$
  • $2020-2025 \text{ (partial)}$: $25.52\%$
  • Long-Term Average (1913-2025): $3.16\%$
• Berkshire Hathaway vs. S&P 500: Since May $1965$, Berkshire Hathaway has seen a cumulative annualized return difference of $+10.0\%$ over the S&P 500. A Class A share reached $\$546,725$.
• Commodities: Gold and oil are used as hedges against inflation, but the CFTC warns they are not inherently "safe" as prices fluctuate with demand. The Dow Jones to Gold ratio and Gold to Oil ratio identify different market regimes across decades.

Questions & Discussion

• Is Bitcoin money? Discussed in light of liquidity and universal acceptance.
• Supply Review: Determinants of supply the Chinese government is encouraging and whether the US can catch up without intervention.
• Shay’s Rebellion Significance: How tax bills and lack of currency led to the restructuring of the US government.
• Checking System: How do we make payments today compared to physical checks?
• Mortgage Considerations: If running a bank, what factors determine a mortgage loan and its interest rate (Incomes, Costs, Risk of Default)?
• Federal Reserve Independence: What are the pros and cons of an independent central bank, specifically in light of Donald Trump’s threats to fire the Chairman for not lowering rates?
• FDIC Limits: Should the government cover losses in the banking system beyond the official maximums?