Chapter 14: Money and Banking Study Guide
Defining Money and Its Functions
The Concept of Barter and Its Limitations
Barter: The act of trading one good or service for another without the use of money.
Double Coincidence of Wants: A specific situation required for barter to occur where two individuals each possess a good or service that the other person desires.
The absence of money makes trade difficult because it relies on this rare alignment of needs.
The Four Functions of Money
Money: Defined as whatever serves society in the following four capacities:
Medium of Exchange: A method of payment that is widely accepted for goods and services.
Store of Value: A mechanism for preserving economic value that can be spent or consumed at a future date.
Unit of Account: The common metric used to measure and record market values within an economy.
Standard of Deferred Payment: The requirement that money must be acceptable for making purchases today that are scheduled to be paid in the future.
Types of Money: Commodity vs. Fiat
Commodity Money: An item used as money that also possesses intrinsic value from its use as something other than money (e.g., gold or silver used in industrial or decorative capacities).
Commodity-Backed Currencies: Currency such as dollar bills whose value is directly backed by a specific commodity like gold or silver.
Historical Context: Gold and silver backed the U.S. money supply for much of its history.
Silver Certificate: Until 1958, these were commodity-backed bills, indicated by the text "Silver Certificate" printed on them, meaning they were redeemable for silver.
Fiat Money: Money that has no intrinsic value but is declared by the government to be a country's legal tender.
Modern U.S. currency is fiat money backed by the Federal Reserve and governed by decree.
The value of fiat money relies entirely on universal faith and trust that the currency holds value.
Measuring Money: Currency, M1, and M2
The Federal Reserve Bank
Serves as the central bank of the United States.
Acts as a bank regulator and is responsible for conducting monetary policy.
Classifies and defines money based on its liquidity.
The M1 Money Supply (Narrow Definition)
Coins and Currency in Circulation: The physical bills and coins circulating in the economy that are not held by the U.S. Treasury, the Federal Reserve, or in bank vaults.
Checkable (Demand) Deposits: Money held in bank accounts that is available for immediate withdrawal as cash or by writing a check.
Traveler’s Checks: Included in M1 to a lesser degree.
The M2 Money Supply (Broad Definition)
Includes all components of M1 plus the following:
Savings Deposits: Bank accounts where funds cannot be withdrawn directly by writing a check, but can be withdrawn at the bank or easily transferred to a checking account.
Money Market Funds: Investment vehicles where the deposits of many investors are pooled and invested in safe, short-term assets like government bonds.
Certificates of Deposit (CDs) and Time Deposits: Accounts where the depositor commits to leaving the money in the bank for a fixed period in exchange for a higher interest rate.
Mathematical Relationships of Money Supply
Role of "Plastic Money"
Debit Card: An instruction to the bank to transfer money immediately from the user's account to a seller.
Credit Card: A tool that transfers money from the credit card company's account to the seller immediately. The user then owes that money to the company.
Note: A credit card is considered a short-term loan and is NOT classified as money.
Smart Card: Stores a specific value of money on the card for use in specific contexts (e.g., long-distance phone cards or campus bookstore/cafeteria cards).
Cards are methods for moving money, not the money itself.
The Role and Mechanics of Banks
Banks as Financial Intermediaries
Most modern money exists as electronic records in bank accounts rather than physical cash.
Payment System: Helps the economy exchange goods and services for financial assets.
Transaction Costs: The costs associated with finding a lender or borrower.
Banks lower these costs by acting as intermediaries between savers (who deposit money for interest) and borrowers (who take loans and pay interest).
Bank Balance Sheets
Balance Sheet: An accounting tool listing assets, liabilities, and net worth.
Asset: Items of value owned by the firm/individual (e.g., loans made by the bank, reserves, government bonds).
Liability: Debts or amounts owed by the firm/individual (e.g., deposits made by customers).
Net Worth (Bank Capital): The excess of asset value over liabilities.
T-Account: A two-column balance sheet format. The left side lists Assets; the right side lists Liabilities.
Reserves and Health of a Bank
Reserves: Funds a bank keeps on hand that are not loaned out or invested.
The Federal Reserve mandates that banks hold a specific percentage of deposits as reserves.
A financially healthy bank maintains a positive net worth. If net worth becomes negative, a bank faces bankruptcy and cannot fulfill all withdrawal requests.
Risks and Mitigation Strategies
Loan Defaults: High rates of borrowers failing to repay loans.
Asset-Liability Time Mismatch: When customers can withdraw liabilities (deposits) in the short term, but the bank's assets (loans) are only repaid over the long term.
Risk Reduction Strategies:
Diversify: Spreading loans across various firms to avoid being impacted by a single failure.
Secondary Loan Market: Selling loans to other financial institutions.
Liquidity: Holding a greater share of assets in government bonds or reserves.
How Banks Create Money
The Process of Money Creation
Money is created when banks make loans which are then re-deposited into the banking system.
Example Phase 1 (Singleton Bank):
Initial state: Bank purely stores $10 million in deposits.
Loan process: Singleton Bank keeps a 10% reserve ($1 million) and loans out $9 million to "Hank’s Auto Supply."
Example Phase 2 (First National Bank):
Hank deposits the $9 million into First National.
Money supply expands by $9 million because Singleton created a loan and First National now has a new deposit.
First National keeps 10% ($900,000) and loans out $8.1 million to "Jack’s Chevy Dealership."
Example Phase 3 (Second National Bank):
Jack deposits $8.1 million into Second National.
The money supply increases by an additional $8.1 million.
The Money Multiplier
In a multi-bank system, the total amount of money the system can create is determined by the reserve requirement.
Formula:
Total Money Creation:
Limitations and Cautions
The quantity of money is linked to the quantity of lending/credit.
Banks can choose to hold extra reserves (excess reserves beyond the legal requirement) based on:
Macroeconomic Conditions: In a recession, banks hold more reserves due to fear of loan defaults.
Government Rules: The Federal Reserve can change reserve requirements to affect the money supply.
Consumer behavior: If people do not deposit cash, banks cannot create loans and recirculate money.
Questions & Discussion
Money Multiplier Math Problem
Prompt: If the reserve requirement is 10%, and a bank’s excess reserves are $9 million, what is the change in the M1 money supply?
Calculation:
Reserve Requirement =
Money Multiplier =
Change in M1 =
Answer: The M1 money supply would increase by $90 million.