Money & Banking - Chapter 27 Notes
The Meaning of Money
Money is any asset easily used to purchase goods and services.
Barter is exchange without money, requiring a double coincidence of wants.
Double coincidence of wants: Each party wants what the other can provide.
Example: An accountant needing shoes must find someone with the correct size who wants accounting services.
Money solves this by being universally acceptable.
The Main Functions of Money
Medium of exchange: Universally accepted payment for goods/services.
Store of value: Holds purchasing power over time.
Unit of account: Measures and compares the value of various goods/services.
Non-monetary goods can be units of account but are less clear.
Example: "I'd be willing to pay 20 bananas for a haircut." Problems: banana size, ripeness, kind.
It's clearer to say, "I'd be willing to pay $10 for a haircut."
Types of Money
Commodity money: A good used as a medium of exchange with intrinsic value in other uses.
Example: Cowrie shells were used as a medium of exchange in various parts of the world.
Commodity-backed money: Medium of exchange with no intrinsic value, but convertible into valuable goods.
Example: Silver certificates until 1958 were commodity-backed money, redeemable for silver.
Fiat money: Money with no intrinsic value; its value comes from its official status as payment.
Practice Question
Prisoners using cigarettes for money: What type of money is this?
Answer: Commodity money.
Forms of Money
Currency (in circulation): Cash held by the public (e.g., dollar bills and coins).
Checkable bank deposits: Bank accounts where people can write checks (also known as demand deposits).
Measuring the Money Supply
Money supply: Total value of financial assets in the economy considered money.
Monetary aggregate: Overall measure of the money supply.
The Two Main Monetary Aggregates
M1: Includes currency, checkable bank deposits, and traveler's checks.
M2: Includes all of M1, plus: money market accounts, savings deposits, and time deposits (CDs).
Monetary Aggregates, September 2011
M1 includes the most liquid forms of money.
M2 includes near-moneys: Financial assets not directly used as a medium of exchange but easily converted to cash or checkable deposits.
What Determines an Asset’s Liquidity?
Liquidity: How quickly and easily an asset can be exchanged for its full value.
Example: Currency is very liquid. It can be exchanged for its full value all the time.
In contrast: A house is illiquid (takes months to sell at the right price).
What Banks Do
Banks are financial intermediaries.
They use liquid assets (bank deposits) to finance illiquid investment projects of borrowers.
The Role of Banks in Society
Banks are bridges between lenders and borrowers.
Without banks, there would be less financial activity because individuals are unwilling to invest in illiquid assets.
Fractional Reserve Banking
Financial institutions use a fractional reserve banking system.
Banks hold a fraction of deposits as cash reserves as required (or in an account with the regional Federal Reserve Bank).
Fractional Reserve Banking
Bank reserves: Currency in vaults plus deposits at the Federal Reserve.
Total reserve ratio: Fraction of deposits held as reserves: .
Why Banks Keep Reserves
Banks hold reserves in case depositors want to withdraw currency.
They don't hold all deposits because they can earn interest by making loans with those funds.
It's impossible for all depositors to withdraw all their money at the same time.
T-accounts for Banks
Shows assets and liabilities.
Net worth (or capital) = assets - liabilities.
Example: Assets = Loans ( ) + Reserves ( ); Liabilities = Deposits ().
Net worth = .
What is the total reserve ratio R for this bank?
Assets: Loans ( ); Reserves ()
Liabilities: Deposits ( )
How Banks Create Money
Banks create money by accepting deposits and making loans.
Bank activity increases the money supply.
Deposits and loans are both considered money.
How Banks Create Money: An Example
Silas deposits cash from his shoebox at the bank. Suppose he deposits this cash at the bank.What’s the effect?
Assume banks loan out 90% of deposits (R = 0.1).
How Banks Create Money: An Example
The first bank lends to Maya, who pays the money to Anne, who deposits it at her bank—and the cycle starts all over.
First Stage: Silas keeps his cash under his bed. Second Stage: Silas deposits cash in first street bank, which lends out $900 to Maya, who then pays it to Anne Acme. Third Stage: Anne Acme deposits $900 in second street bank, which lends out $810 to another borrower.
The Money Multiplier
Assume all money is deposited in banks, and banks hold exactly × deposits as reserves (and lend out the rest).
Increase in bank deposits from in reserves = $1,000 + [$1,000 × (1 − R)] + [$1,000 × (1 − R)^2] + [$1,000 × (1 − R)^3] + . . .
This simplifies to .
Money multiplier is , the inverse of the total reserve ratio.
The Money Multiplier in Reality
The monetary base is the sum of currency in circulation and bank reserves.
A diagram illustrates:
Monetary base composed from bank reserves and currency in circulation.
Money supply composed from checkable bank deposits and currency in circulation.
Banking Activity Cannot Affect the Monetary Base
The monetary base (currency + reserves) is $1000 at each stage; it doesn't change due to banking activity.
Lending affects the money supply, but not the monetary base.
When $1 is deposited, a portion is lent out as currency, and the rest is held as reserves, so the monetary base remains constant.
The Money Multiplier in Reality
The money multiplier is the ratio of the money supply to the monetary base (ideally, when people deposit all currency).
In normal times(not in liquidity trap), the U.S. money multiplier for M1 is between 1.5 and 3.0.
Why isn't the money multiplier equal to when ?
Because people hold significant cash, reducing bank deposits.
Practice Problem
Bank reserves are $500, currency in circulation is $1,000, and checkable bank deposits are $2,000. What is the value of the monetary base? What is the value of the money supply? What is the money multiplier?
Practice Problem Solution
Monetary base = Bank reserves + Currency in circulation = $500 + $1,000 = $1,500.
Money supply = Currency in circulation + Checkable bank deposits = $1,000 + $2,000 = $3,000.
Money multiplier = Money supply / Monetary base = $3,000 / $1,500 = 2.