Money and Banks: Detailed Study Notes

Foundations of Money: Definition, Functions, and History

• Core Learning Objectives:

  • LO13-1: Understand what money is and its fundamental functions.

  • LO13-2: Identify what constitutes a bank's assets and liabilities.

  • LO13-3: Explain the precise mechanisms by which commercial banks create money.

  • LO13-4: Analyze how the money multiplier operates across the banking system.

• The Nature and Philosophy of Money:

  • Sophocles observed: "Of evils upon earth, the worst is money. It is money that sacks cities, and drives men forth from hearth and home; warps and seduces native intelligence, and breeds a habit of dishonesty."

  • While money influences human morals, ideals, and pursuits, an advanced economy cannot function without it.

  • Money is distinct from cash and income: the total volume of money in an economy vastly exceeds physical cash, and the total flow of income differs fundamentally from the stock of money.

• The Inefficiency of Barter:

  • Barter: The direct exchange of one good for another, without the use of money.

  • In an economy without money, obtaining breakfast would require raising chickens or trading directly with a farmer (e.g., Farmer Brown). The transaction can only occur if a double coincidence of wants exists—the farmer must desire the specific goods or services offered in exchange.

  • Money simplifies market exchange by serving as an universally acceptable intermediary. A grocer accepts money for eggs only because that money can subsequently pay workers and purchase desired goods and services.

• Case Study: Barter and Economic Collapse in Venezuela:

  • When the Venezuelan bolivar experienced hyperinflation and lost its purchasing power, paper currency ceased to be accepted.

  • In October 2021, the government of President Maduro introduced a new currency. Despite this, the bolivar lost half its value in 2022 alone. By early 2023, the exchange rate stood at:         $\$1\text{ U.S. dollar} = 2,000,000\text{ bolivars}$

  • Citizens turned to direct barter for survival at local outdoor markets:

    • Batteries and candles traded for plantains.

    • Milk traded for sugar.

    • Feminine hygiene products traded for coffee beans.

    • Toilet paper traded for a bag of sugar.

    • Fresh fish traded for plantains.

    • $1\text{ kilogram of pasta}$ traded for $1\text{ packet of diapers}$.

  • Shoppers unable to access open-air markets spend hours negotiating trades online via Facebook, WhatsApp, and Instagram.

• Historical Evolution of Money Forms:

  • Colonial America functioned without U.S. dollars, utilizing Spanish and Portuguese gold coins, Indigenous wampum, tobacco, grain, fish, furs, and gunpowder/bullets for small change.

  • Following American independence, the U.S. Constitution prohibited the federal government from issuing paper money. Currencies were issued by state-chartered banks.

  • Between 1789 and 1865, more than $30,000$ different paper banknotes were issued by $1,600$ separate banks across $34$ states, prompting people to favor gold, silver, or physical commodities due to rampant insolvency and fraud.

  • In 1861, the federal government issued its first paper currency—$\$10\text{ million}$ in "greenbacks"—to finance the Civil War.

  • The National Banking Act of 1863 granted the federal government permanent authority to issue the national currency.

• The Three Essential Characteristics of Money:

  • Money: Anything generally accepted as a medium of exchange.

  • To be classified as money, an asset must satisfy three functions:

    1. Medium of Exchange: Accepted universally as payment for goods, services, and debts.

    2. Store of Value: Can be held and saved to make purchases in future periods.

    3. Standard of Value: Acts as a common yardstick or unit of account for pricing goods, services, and obligations.

Components and Measures of the Money Supply

• Mechanisms for Accessing Bank Balances:

  • Paper Checks: A check is not money itself; it is a written instruction directing a bank to transfer funds from a checking balance to a third party. Checkable balances are money because they fulfill the three monetary functions. Checks provide safety and convenience, eliminating trips to the bank and mitigating theft risks.

  • Debit Cards and Electronic Transfers: Debit cards, Automated Teller Machines (ATMs), and electronic fund transfers draw funds directly from transactions accounts, functioning as immediate digital substitutes for cash.

  • Credit Cards: Credit cards are not money. They are a payment service and a mechanism for obtaining a short-term loan from a financial institution. The cardholder incurs a debt that must be settled later using actual money (by check or electronic transfer). Credit cards do not possess a store of value or a standard of value.

  • Digital Wallets and Apps: Services such as Apple Pay, PayPal, and Venmo are payment routing services rather than independent components of the money supply. They merely link to an underlying bank account, debit card, or credit card to execute transactions.

• Cashless Consumer Trends:

  • According to Pew Research Center data from October 2022, American consumer payment habits reflect a shift away from physical cash:

    • Paid with cash all or nearly all of the time: $14\%$

    • Paid with cash some of the time: $44\%$

    • Paid with cash none of the time: $41$

• The Spectrum of Bank Accounts:

  • Financial institutions offer diverse deposit vehicles, ranging from standard zero-interest checking to interest-bearing checking, accounts with automatic transfer services (ATS), Negotiable Order of Withdrawal (NOW) accounts, credit union share drafts, mutual savings bank demand deposits, savings accounts, and certificates of deposit (CDs).

  • Because accounts have varying degrees of liquidity and legal restrictions, economists classify the money supply into distinct statistical aggregates.

• The M1 Measure of Money:

  • Money Supply (M1): Currency held by the public, plus balances in transactions accounts.

  • Transactions Account: A bank account that permits direct payment to a third party—for example, with a check or debit card.

  • Transactions accounts include demand deposits, NOW accounts, ATS accounts, credit union share drafts, and traditional savings accounts that allow immediate third-party transfers without requiring an over-the-counter withdrawal.

  • Transactions deposits represent the readiest substitute for currency and account for the vast majority of day-to-day purchases.

• The M2 Measure of Money ("Near Money"):

  • Money Supply (M2): M1 plus balances in time accounts and money market funds.

  • Time Deposits: Accounts such as certificates of deposit (CDs) require funds to remain untouched for a specified maturity period in exchange for higher interest rates. Premature withdrawals incur financial penalties.

  • Money Market Mutual Funds: Pooled investment accounts that purchase short-term, interest-bearing securities such as U.S. Treasury bills. While funds can often be withdrawn quickly, they primarily serve an investment/savings function rather than a transactions medium.

  • CD Yield Realities (Front Page Economics, February 2023):

    • In early 2023, the highest interest rate offered by major banks on a five-year CD was $3.90\%$, compared to an average checking account yield of $0.23\%$.

    • A $\$1,000$ principal deposited for five years at $3.90\%$ compound interest yields $\$1,210.81$, representing a modest return of $\$210.81$ that can be largely erased by early withdrawal penalties.

• Composition of M1 and M2 (Federal Reserve, January 2023):

  • M1 Total: $\$20\text{ trillion}$

    • Currency in circulation held by the public: $\$2\text{ trillion}$ ($10\%$ of M1).

    • Transactions account balances: $\$18\text{ trillion}$ ($90\%$ of M1).

  • M2 Total: $\$21\text{ trillion}$

    • Includes all $\$20\text{ trillion}$ of M1.

    • Money market mutual funds and other savings/time deposits: $\$1\text{ trillion}$.

  • Because M2 is only $\$1\text{ trillion}$ ($\approx 5\%$) larger than M1, macroeconomic policy discussions concentrate primarily on M1.

• Purchasing Power and Aggregate Demand:

  • Aggregate Demand (AD): The total quantity of output (real GDP) demanded at alternative price levels in a given time period, ceteris paribus.

  • Monitoring M1 provides policymakers with a direct gauge of available liquid purchasing power. The total volume of transactions deposits governs consumer and business spending capacity.

Bank Mechanics, Balance Sheets, and Deposit Creation

• Physical Currency vs. Electronic Deposit Creation:

  • U.S. paper currency is printed exclusively by the Bureau of Engraving and Printing in Washington, D.C., and Fort Worth, Texas.

  • U.S. coins are struck at official mint facilities in Philadelphia, Pennsylvania, and Denver, Colorado.

  • Because physical cash comprises only $10\%$ of the basic money supply ($\$2\text{ trillion}$ out of $\$20\text{ trillion}$), the remaining $90\%$ ($\$18\text{ trillion}$) exists as digital entries created by commercial banks.

  • Deposit Creation: The creation of transactions deposits by bank lending.

• Principles of Money Creation:

  • Transactions account balances constitute the overwhelming majority of the money supply.

  • Commercial banks create transactions account balances by extending loans and crediting the borrower's deposit account with electronic funds.

• T-Accounts and Balance Sheet Dynamics:

  • T-Accounts: The accounting ledgers used by banks to track assets and liabilities.

  • Assets: Items of commercial value owned by the bank or obligations owed to the bank (e.g., cash reserves, physical vaults, loans/promissory notes, securities).

  • Liabilities: Legal obligations owed by the bank to outside parties, predominantly customer deposits payable on demand.

  • Balance Sheet Identity: A bank's assets must always equal its liabilities plus net worth:         $\text{Assets} = \text{Liabilities} + \text{Bank Equity}$

• The Monopoly Bank Model (University Bank):

  • Assume an isolated economic setting where University Bank is the only financial institution in existence.

  • Initial Cash Deposit:

    • An individual breaks a personal piggy bank containing $\$100$ in accumulated coins and deposits them into a newly opened checking account at University Bank.

    • Balance Sheet Entry:             \begin{array}{l|l}\n            \textbf{Assets} & \textbf{Liabilities} \\\n            \hline\n            +\100\text{ in coins} & +\100\text{ in customer deposits}\n            \end{array}

    • Impact on the Money Supply:             \begin{array}{lr}\n            \text{Cash held by the public:} & -\100 \\\n            \text{Transactions deposits at bank:} & +\100 \\\n            \hline\n            \Delta M_1: & \$0\n            \end{array}

    • An initial cash deposit creates zero new money. It alters the composition of M1 (reducing currency in circulation by $\$100$ while increasing transactions deposits by $\$100$) without changing the total size of M1.

• The Initial Loan and Direct Money Creation:

  • Banks do not earn profit by warehousing physical cash; they earn income by charging interest on loans.

  • Campus Radio requests a $\$100$ loan from University Bank to purchase a broadcasting headset.

  • Rather than dispensing cash, University Bank credits Campus Radio's checking account with an electronic balance of $\$100$, accepting an IOU (promissory note) in return.

  • Balance Sheet Entry Post-Loan:         \begin{array}{l|l}\n        \textbf{Assets} & \textbf{Liabilities} \\\n        \hline\n        \100\text{ in coins (reserves)} & \100\text{ (initial depositor's balance)} \\\n        \100\text{ in loans (IOU)} & \100\text{ (Campus Radio balance)} \\\n        \hline\n        \textbf{Total Assets: } \200 & \textbf{Total Liabilities: } \200\n        \end{array}

  • Net Monetary Impact:

    • Public cash holdings: No change ($\$0$).

    • Transactions account deposits: Increases by $\$100$ ($\$100$ original deposit + $\$100$ created loan deposit = $\$200$).

    • $\Delta M_1 = +\$100$. Money has been created through credit expansion.

• Secondary Spending and Fractional Reserves:

  • Campus Radio writes a $\$100$ check to Atlas Audio to pay for the headset.

  • Atlas Audio deposits the $\$100$ check back into its own account at University Bank.

  • University Bank debits Campus Radio's account by $\$100$ and credits Atlas Audio's account by $\$100$.

  • Total reserves held by the bank remain intact at $\$100$ in coins, yet total deposit liabilities stand at $\$200$ ($\$100$ owned by the original depositor, $\$100$ owned by Atlas Audio).

  • Bank Reserves: Assets held by a bank to fulfill its deposit obligations.

  • Reserve Ratio: The ratio of a bank's reserves to its total transactions deposits.         $\text{Reserve Ratio} = \frac{\text{Bank Reserves}}{\text{Total Deposits}}$

  • In the monopoly bank example:         $\text{Reserve Ratio} = \frac{\$100}{\$200} = 0.50\text{ (or } 50\%\text{)}$

  • Because account holders transact using checks and debit cards without simultaneously demanding cash liquidation, the bank supports $\$200$ of liabilities using only $\$100$ of underlying reserves.

Reserve Requirements and the Multibank Multiplier

• Regulatory Limits on Lending (Required Reserves):

  • Unchecked lending is constrained by the Federal Reserve System, which establishes mandatory minimum reserve levels.

  • Required Reserves: The minimum amount of reserves a bank is required to hold; equal to required reserve ratio times transactions deposits.         $\text{Required Reserves} = \text{Required Reserve Ratio} \times \text{Total Deposits}$

  • Monopoly Bank Constraint Example: If the Federal Reserve mandates a required reserve ratio of $75\%$ ($0.75$), University Bank would need:         $\text{Required Reserves} = 0.75 \times \$200 = \$150$

  • Since University Bank holds only $\$100$ in cash reserves, extending a $\$100$ loan violates legal thresholds. The bank's lending ceiling is strictly determined by its excess reserves.

• Excess Reserves as the Basis of Lending Power:

  • Excess Reserves: Bank reserves in excess of required reserves.         $\text{Excess Reserves} = \text{Total Reserves} - \text{Required Reserves}$

  • Fundamental Lending Rule: An individual bank can make additional loans in an amount equal to its excess reserves and no more.

• Multibank Step-by-Step Deposit Expansion (Table 13.1):

  • Assume a multibank economy with a legal required reserve ratio of $20\%$ ($c = 0.20$).

  • Step 1: Cash Deposit at University Bank

    • Customer deposits $\$100$ cash into University Bank.

    • Total reserves acquired: $\$100$.

    • $\text{Required reserves} = 0.20 \times \$100 = \$20$.

    • $\text{Excess reserves} = \$100 - \$20 = \$80$.

    • Banking System Impact: $\Delta\text{ Deposits} = +\$100$, $\Delta M_1 = \$0$.

  • Step 2: University Bank Extends Maximum Loan

    • University Bank lends its excess reserves of $\$80$ to Campus Radio by crediting its checking balance.

    • Total deposits at University Bank rise to $\$180$ ($\$100$ original + $\$80$ new loan).

    • $\text{New required reserves} = 0.20 \times \$180 = \$36$.

    • $\text{Remaining excess reserves} = \$100 - \$36 = \$64$.

    • Banking System Impact: $\Delta\text{ Deposits} = +\$80$, $\Delta M_1 = +\$80$.

  • Step 3: Campus Radio Spends the Loan at Another Bank

    • Campus Radio writes an $\$80$ check to Atlas Headset, which deposits it into Eternal Savings.

    • Eternal Savings presents the check through the clearinghouse, transferring $\$80$ of physical reserves away from University Bank.

    • University Bank Balance Sheet: Liabilities fall to $\$100$ (original depositor); total reserves fall to $\$20$ (all of which are required: $0.20 \times \$100 = \$20$); excess reserves equal $\$0$; loans outstanding equal $\$80$.

    • Eternal Savings Balance Sheet: Acquires $\$80$ in deposits (Atlas Headset) and $\$80$ in new reserves.

    • $\text{Eternal Savings required reserves} = 0.20 \times \$80 = \$16$.

    • $\text{Eternal Savings excess reserves} = \$80 - \$16 = \$64$.

    • Banking System Impact: $\Delta\text{ Deposits} = \$0$, $\Delta M_1 = \$0$.

  • Step 4: Eternal Savings Lends Excess Reserves

    • Eternal Savings lends its $\$64$ in excess reserves to Herman's Hardware, crediting its account.

    • Total deposits at Eternal Savings become $\$144$ ($\$80$ Atlas + $\$64$ Herman's Hardware).

    • $\text{Required reserves} = 0.20 \times \$144 = \$28.80$.

    • $\text{Excess reserves} = \$80 - \$28.80 = \$51.20$.

    • Banking System Impact: $\Delta\text{ Deposits} = +\$64$, $\Delta M_1 = +\$64$.

• The Money Multiplier Formula and Mechanism:

  • Money Multiplier: The number of deposit (loan) dollars that the banking system can create from $1 of excess reserves; equal to 1 ÷ required reserve ratio.         $\text{Money Multiplier} = \frac{1}{\text{Required Reserve Ratio}}$

  • For a reserve ratio of $0.20$:         $\text{Money Multiplier} = \frac{1}{0.20} = 5$

  • Potential Deposit Creation Formula:         $\text{Potential Deposit Creation} = \text{Excess Reserves of Banking System} \times \text{Money Multiplier}$

  • With initial excess reserves of $\$80$:         \text{Potential Deposit Creation} = \80 \times 5 = \$400$

  • Total expansion across the entire banking system:

    • Cumulative increase in bank loans: $\$400$.

    • Cumulative increase in the money supply ($M_1$): $\$400$.

    • Cumulative total transactions deposits: \100\text{ (initial)} + \$400\text{ (created)} = \$500$.

    • Final required reserves: $0.20 \times \$500 = \$100$ (absorbing the entire initial cash injection; excess reserves drop to $\$0$).

• Comprehensive Money Multiplier Progression (Table 13.2):

  • Assuming an initial cash deposit of $\$100$ into Bank A with a required reserve ratio of $20\%$ ($0.20$), and all banks fully lend out their available excess reserves:

Macroeconomic Functions and Constraints on Deposit Creation

• Two Core Macroeconomic Functions of Banks:

  • Financial Intermediation: Banks transfer purchasing power from savers to spenders by lending out deposited funds to consumers, businesses, and government entities.

  • Money Supply Expansion: The banking system creates additional money in excess of total reserves by issuing loans, directly altering aggregate purchasing power and shifting the aggregate demand (AD) curve.

• Financing Injections and Stabilizing the Circular Flow:

  • Income originates in product markets, flows to business firms, is distributed to factor markets as wages and dividends, and returns to households as disposable income.

  • Consumer saving represents a leakage from the circular flow of spending. If saving is not offset by an equivalent injection of investment, government spending, or net exports, aggregate demand falls below full-employment output, generating a recessionary GDP gap and unemployment.

  • By collecting household savings and channeling them into productive business loans (for plants, technology, and equipment), consumer credit (for mortgages and automobiles), and municipal projects (for infrastructure), commercial banks convert saving leakages into spending injections.

• Four Constraints on the Deposit Creation Process:

  1. Public Deposit Preferences: Deposit creation requires that businesses and consumers deposit their funds in transactions accounts and accept electronic or check payments. If the public hoards physical currency, reserves leak out of the banking system, reducing lending capacity.

  2. Willingness of Banks to Lend: Holding excess reserves does not guarantee lending. During economic crises (such as the 2009–2010 Great Recession), banks suffered severe mortgage defaults and restricted lending to preserve liquidity, which curtailed aggregate demand.

  3. Willingness of Borrowers to Take Loans: Deposit creation requires creditworthy consumers, businesses, and governments willing to borrow available funds. If economic expectations deteriorate and borrowing drops, excess reserves remain idle, halting the multiplier process.

  4. Government and Central Bank Regulation: The Federal Reserve regulates bank lending capacity by establishing legal reserve requirements and deploying monetary policy instruments.

Cryptocurrencies: Mechanics, Evaluation, and Policy

• Mechanics of Bitcoin and Decentralized Currencies:

  • Cryptocurrency: A digital currency in which transactions are verified and records maintained by a decentralized system rather than by a centralized authority.

  • Bitcoin was created in 2009, with its initial real-world commercial transaction taking place that year.

  • It is governed by an open-source algorithmic protocol that caps total lifetime issuance at a finite limit of $21\text{ million}$ bitcoins.

  • Blockchain and Mining:

    • Transactions are bundled into digital data blocks verified by network participants called miners.

    • Miners allocate extensive computational processing power to resolve complex cryptographic puzzles, securing the public ledger (blockchain).

    • Miners receive compensation for their accounting verification through newly minted bitcoins and network transaction fees.

• Evaluation of Cryptocurrencies as Money:

  • Medium of Exchange: Cryptocurrencies function partially as a medium of exchange. They provide cross-border functionality, pseudonymity, low transaction friction, and bypass intermediary bank fees. Some nations (such as Ecuador) explored or designated digital currencies as legal tender. However, cryptocurrencies lack universal retail acceptance compared to fiat currencies like the U.S. dollar or euro.

  • Store of Value (Failure): Bitcoin fails as a dependable store of value due to its extreme price volatility:

    • Historical range: from $\$0.0009$ (one nine-hundredth of a cent) to an all-time high of $\$67,567$ in November 2021.

    • During 2022 alone, bitcoin fluctuated between a peak of $\$31,792$ and a trough of $\$16,336$.

    • This price instability prevents bitcoin from preserving predictable future purchasing power.

  • Standard of Value (Failure): Because its purchasing power fluctuates widely from day to day, bitcoin cannot serve as an objective unit of account or pricing benchmark for market contracts and consumer goods.

• The FTX Exchange Collapse (November 2022):

  • FTX was a major international cryptocurrency exchange platform facilitating the purchase, sale, and custody of digital assets, including its proprietary token, FTT.

  • On November 8, 2022, FTX held an estimated market enterprise valuation of $\$32\text{ billion}$.

  • Investigative audits revealed that customer deposits placed with the exchange were illicitly diverted into personal accounts and leveraged trading bets managed by the firm's founder and affiliated entities.

  • When customers initiated mass withdrawal requests, FTX was insolvent, precipitating a bankruptcy filing on November 11, 2022.

  • The market price of an FTT token collapsed from $\$24.00$ on November 8, 2022, to $\$1.27$ on November 23, 2022, wiping out billions in investor capital.

  • High-profile endorsers and athletes (including Tom Brady, Steph Curry, and Naomi Osaka) incurred financial and reputational losses, while organizations such as the Miami Heat and the University of California football program cancelled stadium and arena naming rights.

• Regulatory Policy Debate:

  • Pro-Regulation Stance: Critics, led by legislators such as Senator Elizabeth Warren, advocate bringing cryptocurrency exchanges under comprehensive oversight by the Securities and Exchange Commission (SEC) and the U.S. Department of the Treasury. Proponents argue that rigorous capital adequacy rules, reserve audits, and anti-fraud enforcement are required to protect retail investors from manipulation, fraud, and exchange insolvencies.

  • Anti-Regulation Stance: Proponents of decentralized finance argue that strict government intervention would undermine the foundational benefits of digital currencies, including transaction privacy, algorithmic transparency, financial inclusion, and independence from central bank monetary expansion.

Questions for Discussion

• Question 1: Why are checking account balances, but not credit cards, regarded as "money"? (LO13-1)

  • Analysis: A checking account balance represents an asset owned by the account holder that serves as a medium of exchange, a store of value, and a standard of value, permitting immediate third-party payment via check or debit card. A credit card is a financial instrument that accesses a pre-approved line of revolving credit from an issuing bank. Paying with a credit card incurs a debt rather than extinguishing an obligation. Because a credit card is a payment service rather than an asset, store of value, or unit of account, it is excluded from definitions of money.

• Question 2: In what respects are modern forms of money superior to the colonial use of wampum as money? (LO13-1)

  • Analysis: Modern money exhibits distinct physical and economic advantages over colonial commodity moneys like wampum (bead shells):

    • Portability and Durability: Modern currency and electronic bank entries can be transported and transferred instantly without physical degradation or bulky weight.

    • Divisibility: Dollars and cents can be divided into fine denominations, whereas wampum shells could not be divided without damaging the asset.

    • Standardization: Fiat currency offers identical units with counterfeit protections, avoiding quality variations common in shells.

    • Predictable Scarcity: Modern monetary systems regulate the money supply through institutional policy rather than environmental harvest variations.

• Question 3: How are an economy's production possibilities affected when barter replaces cash exchanges? (LO13-1)

  • Analysis: When hyperinflation or systemic collapse forces an economy to abandon money in favor of barter (as seen in Venezuela), transaction costs increase. Market participants must expend labor and time locating trading partners with reciprocal wants (search friction). This diversion of resources away from productive enterprise shrinks the economy's output, shifting its production possibilities curve inward and causing real GDP to contract.

• Question 4: Are digital wallets like Apple Pay and Google Wallet new forms of money? (LO13-1)

  • Analysis: No. Digital wallets are secure electronic interfaces that store and transmit existing financial credentials (debit cards, credit cards, and bank account numbers). They facilitate transactions using previously existing M1 bank balances or credit lines without creating new monetary units or altering the money supply.

• Question 5: What percentage of monthly bills are typically paid with (a) cash, (b) check, (c) credit card, and (d) debit card? How do consumers settle credit card balances, and how does cash usage compare with the composition of the money supply? (LO13-1)

  • Analysis: Most recurring bills (rent, utilities, tuition) are settled using electronic fund transfers, checks, or debit cards, with credit cards used for retail purchases and cash utilized minimally. Credit card balances are settled at month's end via transactions account transfers. This corresponds directly to Federal Reserve data in Figure 13.1, where physical currency accounts for only $10\%$ ($\$2\text{ trillion}$) of the M1 money supply, while checkable transactions accounts account for $90\%$ ($\$18\text{ trillion}$).

• Question 6: Why must a bank's assets always equal its liabilities? (LO13-2)

  • Analysis: Under standard double-entry accounting rules, every asset possessed by an enterprise is claimed by either creditors or equity owners. For a commercial bank, its assets (reserves, loans, securities, physical facilities) must equal its liabilities (customer deposits, borrowed funds) plus owners' equity (bank capital). Any change in asset valuation is offset by a corresponding adjustment on the liabilities and equity ledger.

• Question 7: Does the fact that banks keep only a fraction of customer balances in reserve present risks? Why do depositors avoid bank runs, and what occurs during panics? (LO13-3)

  • Analysis: Fractional reserve banking creates structural liquidity risk because banks cannot liquidate all customer deposits on demand simultaneously. However, depositors maintain confidence due to government-backed safeguards, including Federal Deposit Insurance Corporation (FDIC) coverage, emergency lending facilities at the Federal Reserve discount window, and regulatory oversight. If a collective panic occurs and depositors attempt simultaneous withdrawals (a bank run), the bank exhausts its liquid reserves, faces immediate insolvency, and must shut down unless assisted by central bank emergency liquidity.

• Question 8: What would happen to the lending capacity of banks if the reserve requirement were eliminated? (LO13-4)

  • Analysis: If the required reserve ratio were set to zero ($c = 0$), required reserves would equal zero, converting all vault cash and central bank deposits into excess reserves. The theoretical money multiplier ($\frac{1}{c}$) would become infinite ($\frac{1}{0} \rightarrow \infty$). In practice, banks would remain constrained by internal capital adequacy standards, prudential liquidity needs, customer creditworthiness, and borrower demand.

• Question 9: If all banks heeded Shakespeare's admonition "Neither a borrower nor a lender be," what would happen to the circular flow? (LO13-3)

  • Analysis: If banks ceased lending, financial intermediation would end. Household savings would be hoarded as idle cash reserves rather than channeled to businesses and consumers for investment and consumption. This unmitigated saving leakage would lower aggregate spending, generating a recessionary GDP gap, widespread bankruptcies, and rising unemployment.

• Question 10: Would consumers and workers accept bitcoin in payment for goods, services, or paychecks? (LO13-1)

  • Analysis: While bitcoin's cryptographic security and decentralized settlement appeal to some market participants, its short-term price volatility prevents widespread use for wages or retail sales. Receiving wages in bitcoin exposes workers to substantial fluctuations in purchasing power, making it difficult to pay fixed dollar-denominated expenses like rent, debt obligations, and taxes.

Chapter Problems and Applied Calculations

• Problem 1: Barter Terms of Trade in Venezuela

  • Prompt: According to the World View "Plantains for Fish," how many packs of diapers could a Venezuelan obtain in barter for three kilos of pasta? (LO13-1)

  • Solution: The report specifies that $1\text{ kilo of pasta}$ trades for $1\text{ packet of diapers}$. Therefore, $3\text{ kilos of pasta}$ purchase:         $3 \times 1\text{ packet of diapers} = 3\text{ packets of diapers}$

• Problem 2: Percentage Share of Cash in Monetary Aggregates

  • Prompt: Refer to Figure 13.1. What percentage does cash account for in (a) M1 and (b) M2? (LO13-1)

  • Solution:

    • $\text{Total M1} = \$20\text{ trillion}$; $\text{Currency in circulation} = \$2\text{ trillion}$.             \text{Percentage of M1} = \frac{\2\text{ trillion}}{\20\text{ trillion}} \times 100 = 10\%

    • $\text{Total M2} = \$21\text{ trillion}$; $\text{Currency in circulation} = \$2\text{ trillion}$.             \text{Percentage of M2} = \frac{\2\text{ trillion}}{\21\text{ trillion}} \times 100 = 9.52\%

• Problem 3: Single-Bank T-Account and Deposit Creation Potential

  • Prompt: A bank has $\$1,000$ in deposits, and the required reserve ratio is $10\%$. (a) Enter the appropriate values in the T-account. (b) Calculate the potential total deposit creation of the bank. (LO13-2)

  • Solution:

    • (a) Bank Balance Sheet (T-Account):             $\text{Required Reserves} = 0.10 \times \$1,000 = \$100$             $\text{Excess Reserves} = \$1,000 - \$100 = \$900$             \begin{array}{lr|lr}\n            \textbf{Assets} & & \textbf{Liabilities} & \\\n            \hline\n            \text{Required Reserves} & \100 & \text{Deposits} & \1,000 \\\n            \text{Excess Reserves} & \900 & & \\\n            \hline\n            \textbf{Total Assets} & \1,000 & \textbf{Total Liabilities} & \$1,000\n            \end{array}

    • (b) The individual bank can create loans up to its available excess reserves:             $\text{Single Bank Deposit Creation} = \text{Excess Reserves} = \$900$             (Note: If calculated for the entire banking system, potential expansion would equal \900 \times \frac{1}{0.10} = \$9,000$.)

• Problem 4: Withdrawals and Deposits Under Varying Reserve Requirements

  • Scenario 1: Withdraw $\$400$ cash from a checking account with a $5\%$ ($0.05$) reserve requirement (LO13-1, LO13-2):

    • (a) Change in total deposits:             $\Delta\text{ Total Deposits} = -\$400$

    • (b) Change in required reserves:             $\Delta\text{ Required Reserves} = 0.05 \times (-\$400) = -\$20$

    • (c) Change in excess reserves: The bank loses $\$400$ in total cash reserves. Because required reserves fall by $\$20$, the change in excess reserves is:             $\Delta\text{ Excess Reserves} = -\$400 - (-\$20) = -\$380$

  • Scenario 2: Deposit a $\$300$ check into a checking account with a $10\%$ ($0.10$) reserve requirement (LO13-1, LO13-2):

    • (d) Change in total deposits:             $\Delta\text{ Total Deposits} = +\$300$

    • (e) Change in required reserves:             $\Delta\text{ Required Reserves} = 0.10 \times \$300 = +\$30$

    • (f) Change in excess reserves: Total reserves increase by $\$300$ via check collection. The change in excess reserves is:             $\Delta\text{ Excess Reserves} = \$300 - \$30 = +\$270$

• Problem 5: Reserve and Loan Ratios

  • Prompt: A bank has total deposits of $\$9,000,000$ and reserves of $\$3,000,000$. (a) What is the current percentage of deposits held in reserve? (b) What percentage of deposits are currently loaned out? (LO13-2)

  • Solution:

    • (a) Percentage held in reserve:             $\text{Reserve Ratio} = \frac{\$3,000,000}{\$9,000,000} \times 100 = 33.33\%$

    • (b) Percentage loaned out:             $\text{Total Loans} = \$9,000,000 - \$3,000,000 = \$6,000,000$             $\text{Loan Ratio} = \frac{\$6,000,000}{\$9,000,000} \times 100 = 66.67\%$

• Problem 6: Excess Reserves and Lending Limit

  • Prompt: A bank's balance sheet has Reserves of $\$600$, Loans of $\$3,400$, and Deposits of $\$4,000$. Required reserves are $10\%$. (a) How much excess reserves does the bank hold? (b) How much more can this bank lend? (LO13-2, LO13-3)

  • Solution:

    • (a) Required reserves:             $\text{Required Reserves} = 0.10 \times \$4,000 = \$400$             $\text{Excess Reserves} = \text{Total Reserves} - \text{Required Reserves} = \$600 - \$400 = \$200$

    • (b) Maximum additional lending capacity for an individual bank:             $\text{Lending Capacity} = \text{Excess Reserves} = \$200$

• Problem 7: Calculating Required Reserve Ratio from Balance Sheet

  • Prompt: A bank's balance sheet lists Required Reserves = $\$40$, Excess Reserves = $\$140$, Loans = $\$620$, and Deposits = $\$800$. (a) What is the required reserve ratio? (b) How much money can this bank still lend? (LO13-2, LO13-3)

  • Solution:

    • (a) Required reserve ratio:             $\text{Required Reserve Ratio} = \frac{\text{Required Reserves}}{\text{Total Deposits}} = \frac{\$40}{\$800} = 0.05\text{ (or } 5\%\text{)}$

    • (b) Maximum additional lending capacity:             $\text{Additional Lending Capacity} = \text{Excess Reserves} = \$140$

• Problem 8: Money Multiplier Calculations

  • Prompt: What is the money multiplier when the required reserve ratio is (a) $2\%$ ($0.02$) and (b) $5\%$ ($0.05$)? (LO13-4)

  • Solution:

    • (a) For $r = 0.02$:             $\text{Money Multiplier} = \frac{1}{0.02} = 50$

    • (b) For $r = 0.05$:             $\text{Money Multiplier} = \frac{1}{0.05} = 20$

• Problem 9: The Virginia DMV Penny Deposit Case

  • Scenario: On January 10, 2017, an individual paid a DMV bill in Lebanon, Virginia, using $300,000\text{ pennies}$ ($\$3,000$) across five wheelbarrows. The DMV deposited the cash into its bank account. Assume a $5\%$ ($0.05$) reserve requirement. (LO13-3, LO13-4)

  • Calculations:

    • (a) Initial change in the money supply:             $\Delta M_1 = \$0$             (Currency held by public falls by $\$3,000$; checkable deposits rise by $\$3,000$.)

    • (b) Initial change in deposits:             $\Delta\text{ Deposits} = +\$3,000$

    • (c) Initial change in total reserves:             $\Delta\text{ Total Reserves} = +\$3,000$

    • (d) Initial change in excess reserves:             $\text{Required Reserves} = 0.05 \times \$3,000 = \$150$             $\text{Excess Reserves} = \$3,000 - \$150 = +\$2,850$

    • (e) Cumulative change in lending capacity across the banking system:             $\text{Money Multiplier} = \frac{1}{0.05} = 20$             \Delta\text{ System Lending Capacity} = \text{Excess Reserves} \times \text{Multiplier} = \2,850 \times 20 = +\$57,000$

• Problem 10: Effects of Changing the Reserve Requirement

  • Prompt: Identify which balance sheet items change when the Federal Reserve alters the reserve requirement. (LO13-3, LO13-4)

  • (a) For an individual bank:

    • Total deposits: No change (determined by depositor behavior).

    • Total reserves: No change (determined by cash and central bank holdings).

    • Required reserves: Changes (calculated as reserve ratio times deposits).

    • Excess reserves: Changes (equals total reserves minus required reserves).

    • Unused lending capacity: Changes (directly tied to excess reserves).

  • (b) For the total banking system:

    • Total deposits: No initial change (expands or contracts later as new loans are made).

    • Total reserves: No change (fixed by central bank supply).

    • Required reserves: Changes (recalculated across all bank deposits).

    • Excess reserves: Changes (adjusts inversely to required reserves).

    • Unused lending capacity: Changes (amplified by the new money multiplier).

• Problem 11: Comprehensive Lottery Deposit Ledger Problem

  • Scenario: A lottery winner deposits $\$20\text{ million}$ in cash into a transactions account at Bank of America (B of A). Assume a required reserve ratio of $20\%$ ($0.20$) and zero initial excess reserves across the banking system. (LO13-3, LO13-4)

  • Solutions:

    • (a) Step 1: Initial Deposit at Bank of America (in Millions):             \begin{array}{lr|lr}\n            \textbf{Assets} & & \textbf{Liabilities} & \\\n            \hline\n            \text{Reserves:} & & \text{Deposits} & \20 \\\n            \quad\text{Required} & \4 & & \\\n            \quad\text{Excess} & \16 & & \\\n            \text{Loans} & \0 & & \\\n            \hline\n            \textbf{Total Assets} & \20 & \textbf{Total Liabilities} & \20\n            \end{array}

    • (b) Monetary impact of Step 1:             $\Delta M_1 = \$0$             (Currency drops by $\$20\text{ million}$, deposits increase by $\$20\text{ million}$.)

    • (c) Step 2: Loans Made at Bank of America (in Millions):

      • Bank of America lends its full excess reserves of $\$16\text{ million}$ by creating a new deposit account for the borrower:                 $\text{Total Deposits} = \$20 + \$16 = \$36$                 $\text{Required Reserves} = 0.20 \times \$36 = \$7.2$                 $\text{Excess Reserves} = \$20 - \$7.2 = \$12.8$             \begin{array}{lr|lr}\n            \textbf{Assets} & & \textbf{Liabilities} & \\\n            \hline\n            \text{Reserves:} & & \text{Deposits} & \36 \\\n            \quad\text{Required} & \7.2 & & \\\n            \quad\text{Excess} & \12.8 & & \\\n            \text{Loans} & \16.0 & & \\\n            \hline\n            \textbf{Total Assets} & \36.0 & \textbf{Total Liabilities} & \36.0\n            \end{array}

    • (d) Monetary impact of Step 2:             $\Delta M_1 = +\$16\text{ million}$             (New deposit created via credit extension.)

    • (e) Cumulative Banking System Changes After Full Multiplier Expansion:             $\text{Money Multiplier} = \frac{1}{0.20} = 5$

      • Total Reserves: $\Delta = \$0$ (remains fixed at the initial $\$20\text{ million}$ cash injection).

      • Total Deposits: $\Delta = +\$100\text{ million}$ (\20\text{ million initial} + [\$16\text{ million excess} \times 5] = \$100\text{ million}$).

      • Total Loans: $\Delta = +\$80\text{ million}$ (\16\text{ million initial excess} \times 5 = \$80\text{ million}$).

      • The Money Supply ($M_1$): $\Delta = +\$80\text{ million}$ (reflects total newly created loan deposits).

• Problem 12: Shifts Between M1, M2, and Cryptocurrencies

  • Prompt: Calculate the net changes in M1 and M2 for the following transactions (LO13-1):

    • (a) $\$100$ in coins is deposited into a checking account:

      • $\Delta M_1 = \$0$ (currency falls by $\$100$, transactions deposits increase by $\$100$).

      • $\Delta M_2 = \$0$ (since M1 is unchanged and time deposits are unaffected).

    • (b) $\$500$ is transferred from a money market mutual fund to a transactions account:

      • $\Delta M_1 = +\$500$ (transactions account component expands).

      • $\Delta M_2 = \$0$ (money market funds decrease by $\$500$, exactly offsetting the $\$500$ increase in M1).

    • (c) $\$300$ is transferred from a transactions account into cryptocurrency:

      • $\Delta M_1 = -\$300$ (funds exit the commercial banking system).

      • $\Delta M_2 = -\$300$ (cryptocurrencies are excluded from all official money supply aggregates).

• Problem 13: Quantitative Dimensions of the FTX Token Collapse

  • Prompt: Refer to Front Page Economics "The FTX Collapse." (a) By how much did the price of an FTT token decline between November 8 and November 23, 2022? (b) What was the percentage decline in value? (LO13-1)

  • Solution:

    • Token price on November 8, 2022: $\$24.00$

    • Token price on November 23, 2022: $\$1.27$

    • (a) Absolute price decline:             $\Delta P = \$24.00 - \$1.27 = \$22.73$

    • (b) Percentage decline:             $\text{Percentage Decline} = \frac{\$22.73}{\$24.00} \times 100 = 94.71\%$