Money and Banking

Cowrie Shells and the Evolution of Money

Cowrie shells were used as money across a broad geographic area and for a long time.
They were used as money as early as 700 B.C. in China and widely used across India and Africa by the 1500s.
They were used to pay taxes in certain African nations in the early twentieth century.
Cowries worked well as money because:
- They are extremely durable.
- They can be counted or measured by weight/volume.
- They are impossible to counterfeit.
- Governments tightly controlled their collection.

Introduction to Money and Banking

Key topics covered:
- Defining money by its functions
- Measuring money: currency, M1, and M2
- The role of banks
- How banks create money
Money and banking are central to macroeconomics.
Macroeconomic goals include economic growth, low unemployment, and low inflation.
Keynesian and neoclassical frameworks are used for macroeconomic analysis.
Monetary policy focuses on money, banking, and interest rates.
Fiscal policy focuses on government spending, taxes, and borrowing.

Defining Money by Its Functions

Money is used for goods and services exchange.
Money is widely accepted by both buyers and sellers.

Barter and the Double Coincidence of Wants

Barter involves trading one good/service for another.
It is inefficient for modern economies.
Barter requires a double coincidence of wants: two people each want what the other can provide.
Barter does not allow easy entry into future contracts.
Barter hinders economic growth because time is spent bartering instead of producing.

Functions of Money

Money solves problems created by the barter system.
Money serves as a medium of exchange, acting as an intermediary between buyer and seller.
Money must be widely accepted as payment.
Money serves as a store of value, allowing value to be stored easily.
Money serves as a unit of account, providing a common measure of value.
Money acts as a common denominator that simplifies trade-offs.
Money must serve as a standard of deferred payment, allowing future purchases to be paid in monetary terms.

Commodity versus Fiat Money

Commodity money has value from use as something other than money (e.g., gold, silver, cowrie shells).
Gold is used in electronics, aerospace, and medicine, and for jewelry.
Commodity-backed currencies are backed by commodities held at a bank.
Fiat money has no intrinsic value but is declared legal tender by a government.
U.S. paper money states: “THIS NOTE IS LEGAL TENDER FOR ALL DEBTS, PUBLIC AND PRIVATE.”
Fiat money is based on universal faith and trust in its value.

Measuring Money: Currency, M1, and M2

Economists define money based on liquidity (how quickly an asset can be used to buy a good or service).
Cash is very liquid.
Savings accounts are less liquid.
The Federal Reserve Bank defines money according to its liquidity.
M1 money supply includes very liquid monies like cash, checkable deposits, and traveler’s checks.
M2 money supply is less liquid and includes M1 plus savings and time deposits, certificates of deposits, and money market funds.
M1 includes coins and currency in circulation, and checkable deposits (demand deposits).
M2 includes everything in M1, plus savings deposits, money market funds, and small certificates of deposit (CDs).
The Federal Reserve System tracks M1 and M2 and releases weekly information about the money supply.
In February 2015, M1 in the United States was 3 trillion, while M2 was 11.8 trillion.
Table 14.1 provides a breakdown of M1 and M2 components in February 2015.

Components of M1 in the U.S. (February 2015, Seasonally Adjusted)

Currency: 1,271.8 billion
Traveler’s checks: 2.9 billion
Demand deposits and other checking accounts: 1,713.5 billion
Total M1: 2,988.2 billion (or 3 trillion)

Components of M2 in the U.S. (February 2015, Seasonally Adjusted)

M1 money supply: 2,988.2 billion
Savings accounts: 7,712.1 billion
Time deposits: 509.2 billion
Individual money market mutual fund balances: 610.8 billion
Total M2: 11,820.3 billion (or 11.8 trillion)
The lines separating M1 and M2 can be blurry.
Changes in banking practices and technology have made M2 savings accounts more like M1checking accounts.
Debit cards, credit cards, and smart cards are ways to move money, but do not change the quantity of money in the economy.
Money in a modern economy is closely linked to bank accounts.
The banking system largely conducts macroeconomic policies concerning money.

The Role of Banks

Banks facilitate transactions, payments, savings, and borrowing.
Banks are intermediaries in the payment system.
Banks lower transaction costs and act as financial intermediaries, bringing savers and borrowers together.
Banks also play a key role in creating money.

Banks as Financial Intermediaries

Banks are financial intermediaries between savers and borrowers.
Financial intermediaries include insurance companies and pension funds, but these are not depository institutions.
Deposited funds mingle in one pool, which the financial institution then lends.
Banks funnel financial capital to healthy businesses with good prospects for repaying loans.
Figure 14.4 illustrates banks as financial intermediaries.

Relationship between Banks, Savings and Loans, and Credit Unions

Banks receive deposits from individuals and businesses and make loans.
Savings institutions (savings and loans or thrifts) also take loans and make deposits, but were historically limited in interest payments and required to focus on housing-related loans.
A credit union is a nonprofit financial institution owned and run by its members.
Credit unions accept deposits from members and make loans back to them.
In 2008, there were 7,085 banks. By 2014, this had fallen to 5,571 due to bank failures and mergers.
As of December 2014, there were 6,535 credit unions with 1.1 billion in assets.
A “Transfer Your Money” day in 2009 encouraged transfers to credit unions.
As of 2013, the 12 largest banks (0.2%) controlled 69% of all banking assets.

Bank’s Balance Sheet

A balance sheet lists assets and liabilities.
An asset is something of value that you own.
A liability is a debt or something you owe.
Net worth is the asset value minus liabilities.
A bank’s net worth is bank capital.
A bank’s assets include cash, reserves at the Federal Reserve, loans to customers, and bonds.
Figure 14.5 illustrates a hypothetical balance sheet for the Safe and Secure Bank.
It's sometimes called a T-account because of the T-shape format.
A bank's liabilities are its deposits.
Net worth is included on the liabilities side to have the T account balance to zero.
For a healthy business, net worth will be positive.
Assets always equal liabilities plus net worth.
Loans are assets from the bank's perspective because the borrower has a legal obligation to make payments.
Financial institutions make loans to borrowers in the primary loan market, and buy/sell these loans in the secondary loan market.
The perceived riskiness of the loan affects what financial institutions are willing to pay for it.
Government bonds are low-risk assets for banks.
Reserves are money that the bank keeps on hand.
The Federal Reserve requires banks to keep a percentage of depositors’ money on “reserve” (reserve requirement).
Net worth is total assets minus total liabilities.
For the Safe and Secure Bank, net worth is 1 million ( 11 million in assets minus 10 million in liabilities).
A financially healthy bank has positive net worth.

How Banks Go Bankrupt

A bankrupt bank has negative net worth (assets less than liabilities).
Banks factor in loan defaults into planning but can suffer if defaults are much greater than expected.
Balance sheets help explain bankruptcy.
The 2008–2009 financial crisis arose from unexpected defaults.
Many banks securitize mortgage loans by bundling them into financial securities sold to investors.
Securitization offers advantages like avoiding local financial risks.
Local homebuyers benefit because banks don't need extra funds to make a loan.
Securitization can lead to banks being less careful in making loans.
Banks may make “subprime loans” with low down-payments and little income verification.
NINJA loans (No Income, No Job, or Assets) were made in the mid-2000s.
Complex securities were designed so certain investors would take the first losses.
Housing prices fell after 2007, making it harder for people to make mortgage payments.
Banks faced bankruptcy as mortgage-backed financial assets declined in value.
In the 2008–2011 period, 318 banks failed in the United States.
Asset-liability time mismatch (short-term liabilities vs. long-term assets) can cause severe problems for a bank.
Diversifying loans can protect against high rates of loan defaults.
Banks can sell loans in the secondary market and hold government bonds or reserves.
Most banks see their net worth decline in a recession.

How Banks Create Money

The banking system can create money through loans.

Money Creation by a Single Bank

Singleton Bank has 10 million in deposits.
Figure 14.6 shows the T-account balance sheet for Singleton Bank.
Singleton Bank becomes a financial intermediary between savers and borrowers.
Figure 14.7 shows Singleton Bank’s balance sheet with 1 million in reserves and a 9 million loan to Hank’s Auto Supply.
Singleton Bank lends 9 million to Hank’s Auto Supply.
Hank deposits the loan in his checking account with First National, increasing deposits and reserves by 9 million (Figure 14.8).
First National must hold 10% as required reserves but can lend out the rest.
Lending expands the money supply since checkable deposits are part of M1.
If depositors draw down as Hank writes checks than there will be less to lend.
The bigger picture is that a bank must hold enough money in reserves to meet its liabilities.
If Jack deposits the loan in its checking account at Second National, the money supply just increased by an additional 8.1 million, as Figure 14.10 shows.
Money creation is possible because there are multiple banks, they hold only a fraction of deposits, and loans end up deposited in other banks.

The Money Multiplier and a Multi-Bank System

In a multi-bank system, banks determine the amount of money that the system can create by using the money multiplier.
The money multiplier tells us by how many times a loan will be “multiplied” as it is spent in the economy and then re-deposited in other banks
The money multiplier formula is: \frac{1}{Reserve:Requirement}
We then multiply the money multiplier by the change in excess reserves to determine the total amount of M1 money supply created in the banking system.

Using the Money Multiplier Formula

Step 1. With a reserve requirement of 10% (0.10), the money multiplier is: \frac{1}{0.10} = 10
Step 2. With excess reserves of 9 million, the total change in the M1 money supply is: {\text{Money Multiplier}}{\text{Excess Reserves}} = {10}{\$9 \text{ million}} = \$90 \text{ million}
Step 3. The total quantity of money generated in this economy after all rounds of lending are completed will be 90 million.

Cautions about the Money Multiplier

The money multiplier depends on the reserve requirement set by the Federal Reserve and banks' decisions to hold extra reserves.
Banks may vary reserves based on macroeconomic conditions and government rules.
In a recession, banks hold a higher proportion of reserves because they fear defaults.
The Lender of Last Resort is a tool to aid banks when banks have a high proportion of reserves.
The Federal Reserve may adjust reserve requirements to affect the money supply.
Money creation depends on people re-depositing money in the banking system.
If people store cash, banks cannot recirculate the money as loans.
Low-income countries have “mattress savings” because people do not trust banks.
Central banks assure that bank deposits are safe because people may start holding more money in cash, instead of depositing it in banks and the quantity of loans in an economy will decline.

Money and Banks—Benefits and Dangers

Money and banks are essential for a modern economy.
Money makes market exchanges easier than barter.
Banking makes money more effective in facilitating exchanges.
Banks making loans in financial capital markets is tied to money creation.
If banks do not work well, transactions become less convenient and safe.
Financial stress in banks can reduce loan availability, harming sectors that depend on borrowed money.
The 2008–2009 Great Recession illustrated this pattern.

The Many Disguises of Money: From Cowries to Bitcoins

The global economy has evolved from cowrie shells to fiat currency.
The need for paper currency is diminishing due to technology.
Debit and credit cards are increasingly used.
Bitcoins are a digital currency for online transactions.
Bitcoins are not backed by any commodity nor declared legal tender.
Bitcoins are unregulated by any central bank but are created online through solving math problems.
Bitcoins are relatively new and may be used in illegal activities.
Digital currencies may replace dollar bills in the future due to increased technology and reduced transaction costs.

Key Terms

Asset: item of value that a firm or an individual owns
Asset-liability time mismatch: customers can withdraw a bank’s liabilities in the short term while customers repay its assets in the long term
Balance sheet: an accounting tool that lists assets and liabilities
Bank capital: a bank’s net worth
Barter: literally, trading one good or service for another, without using money
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
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
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
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
Demand deposit: checkable deposit in banks that is available by making a cash withdrawal or writing a check
Depository institution: institution that accepts money deposits and then uses these to make loans
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
Double coincidence of wants: a situation in which two people each want some good or service that the other person can provide
Fiat money: has no intrinsic value, but is declared by a government to be the country's legal tender
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
Liability: any amount or debt that a firm or an individual owes
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
Medium of exchange: whatever is widely accepted as a method of payment
Money: whatever serves society in four functions: as a medium of exchange, a store of value, a unit of account, and a standard of deferred payment.
Money market fund: the deposits of many investors are pooled together and invested in a safe way like short-term government bonds
Money multiplier formula: total money in the economy divided by the original quantity of money, or change in the total money in the economy divided by a change in the original quantity of money
Net worth: the excess of the asset value over and above the amount of the liability; total assets minus total liabilities
Payment system: helps an economy exchange goods and services for money or other financial assets
Reserves: funds that a bank keeps on hand and that it does not loan out or invest in bonds
Savings deposit: 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
Smart card: stores a certain value of money on a card and then one can use the card to make purchases
Standard of deferred payment: money must also be acceptable to make purchases today that will be paid in the future
Store of value: something that serves as a way of preserving economic value that one can spend or consume in the future
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”
Time deposit: 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; also called certificate of deposit
Transaction costs: the costs associated with finding a lender or a borrower for money
Unit of account: the common way in which we measure market values in an economy

Key Concepts and Summary

Money is what people in a society regularly use when purchasing or selling goods and services.
Money serves as a medium of exchange, a unit of account, a store of value, and a standard of deferred payment.

Money can be:

Commodity money, which is an item used as money, but which also has value from its use as something other than money
Fiat money, which has no intrinsic value, but is declared by a government to be the country's legal tender.
M1 includes currency and money in checking accounts (demand deposits).
M2 includes all of M1, plus savings deposits, time deposits like certificates of deposit, and money market funds.
Banks facilitate using money for transactions in the economy because people and firms can use bank accounts when selling or buying goods and services, when paying a worker or receiving payment, and when saving money or receiving a loan.
In the financial capital market, banks are financial intermediaries; that is, they operate between savers who supply financial capital and borrowers who demand loans.
Banks run a risk of negative net worth if the value of their assets declines.
Banks can protect themselves against these risks by choosing to diversify their loans or to hold a greater proportion of their assets in bonds and reserves.
We define the money multiplier as the quantity of money that the banking system can generate from each 1 of bank reserves.
The quantity of money in an economy and the quantity of credit for loans are inextricably intertwined.