Money and Banking

Definition of Money

• Barter System: In the absence of money, people exchange goods and services directly, which is called barter.
  • Double Coincidence of Wants: For barter to work, each party must have what the other wants, making it rare and costly.
• Money: Any commodity or token generally accepted as a means of payment.
  • Means of Payment: A method for settling debt.

Types of Money

• Commodity Money: Items used as money that have intrinsic value.
  • Example: Metallic coins.
• Fiat or Token Money: Items with no intrinsic value but are accepted as money.
  • Example: Banknotes.

Functions of Money

• Medium of Exchange: Generally accepted item for exchanging goods and services.
• Unit of Account: A standard numerical unit of measurement that provides a consistent measure of pricing.
• Store of Value: Retains purchasing power over time.

Unit of Account Example

Official Measures of Money in the US

• M1 (Narrow Money):
  • Includes currency, traveler’s checks, and checking deposits by individuals and businesses.
• M2 (Broad Money):
  • Includes M1 plus time deposits, saving deposits, money market mutual funds, and other deposits.

Composition of M1 and M2

• M1 consists completely of means of payment.
• M2 includes liquid assets that cannot be readily used as means of payment.

Depository Institutions

• Definition: Firms that accept deposits from households and businesses and provide loans.
• Types:
  • Commercial banks.
  • Thrift institutions.
  • Money market mutual funds.

Economic Benefits Provided by Depository Institutions

1. Create Liquidity: Convert holdings into cash quickly.
2. Pool Risk: Diversification to reduce individual risk.
3. Lower the Cost of Borrowing: Economies of scale in lending.
4. Lower the Cost of Monitoring Borrowers: More efficient loan evaluation processes.

Regulation of Depository Institutions

• Required to maintain reserves, use collateral, and some deposits are insured.

Fractional Reserve Banking

• Definition: A system where banks maintain only a fraction of deposits as reserves, lending the rest.
• Example: If Mr. A deposits $100, the bank may keep $20 as reserves and lend out $80.

The Federal Reserve System

• The central bank of the U.S., responsible for regulating depository institutions and controlling the money supply.
• Goals include:
  • Output growth.
  • Full employment.
  • Price stability.
  • Balance of payments stability.

Fed's Balance Sheet

• Assets: Federal Reserve's holdings.
• Liabilities: Total money supply created by the Fed, denoted as M0 (currency + reserves).

Money Creation Process

Basic Elements

• Banks create deposits when making loans; this creates new money.
• Limited by:
  • The monetary base.
  • Desired reserves.
  • Desired currency holdings.

Example of Money Creation

• If the reserve ratio (RR) is 20% and initial deposit is $100:
  1. Bank holds $20 (RR)
  2. Lends out $80; lending leads to further deposits.
  3. Each deposit loops through the banking system, increasing total deposits.

Money Multiplier

• The money multiplier is the ratio of the change in the quantity of money to the change in the monetary base.
• Formula: ext{Money Multiplier} = \frac{1 + \text{CD}}{\text{DR} + \text{CD}}
  • Where CD = currency drain ratio, DR = desired reserve ratio.

Quantity Theory of Money

• This theory posits that in the long run, an increase in the quantity of money results in a proportional increase in the price level.
• Equation: MV = PY
  • Where, M = Money supply, V = Velocity of money, P = Price level, Y = Output (Real GDP).
• Indicates that changes in P are proportional to changes in M.