chapter 24 money and banking

Money & Banking Study Notes

The Meaning of Money

• Definition of Money: Any asset that can easily be used to purchase goods and services.

• Barter: Exchange that does not involve money.

  • Requires a double coincidence of wants: A two-person situation where each wants some good or service that the other can provide.

The Problem with Double Coincidence of Wants

• Issue: Having a double coincidence of wants between two particular people is unlikely.

  • Example: An accountant trying to find someone with the right size shoes willing to exchange for accounting services would likely struggle.

• Solution: The problem is avoided with money, which everybody is willing to accept in exchange.

The Main Functions of Money

1. Medium of Exchange:

   • Something people universally accept as payment for goods and services.

2. Store of Value:

   • A means of holding purchasing power over time.

3. Unit of Account:

   • Used as the units in prices and other communications of value or cost.

Unit of Account Example

• Historical Example: Prices at a Hudson Bay Company trading post in 1795 were expressed in terms of beaver pelts (e.g., one pair of boots costs six beaver pelts).

Types of Money

• Commodity Money:

  • A good used as a medium of exchange that has intrinsic value in other uses.

  • Example: Cowrie shells used in various parts of the world for centuries as a medium of exchange.

  • (Credit: modification of work by “prilfish”/Flickr Creative Commons)

• Commodity-Backed Money:

  • A medium of exchange with no intrinsic value whose ultimate value is guaranteed by a promise it can be converted into valuable goods.

  • Historical Note: Until 1958, silver certificates were commodity-backed money, indicated by the words “Silver Certificate” printed on the bill.

• Fiat Money:

  • Money with no intrinsic value, but whose value derives from its official status as a means of payment.

Practice Question

• Question: It’s well known that prisoners have used cigarettes for money. What type of money would cigarettes be?

  • Answer Options:

    • Commodity money

    • Commodity-backed money

    • Fiat Money

Forms of Money

1. Currency (in circulation):

   • Cash held by the public (e.g., dollar bills and coins).

2. Checkable Bank Deposits:

   • Bank accounts on which people can write checks, also known as “demand deposits.”

Measuring the Money Supply

• Money Supply Definition: The total value of financial assets in the economy that are considered money.

• Monetary Aggregate Definition: An overall measure of the money supply.

The Two Main Monetary Aggregates

• M1 Includes:

  • Currency in circulation (not held as reserves by banks).

  • Savings deposits.

  • Checkable bank deposits.

• M2 Includes:

  • M1 plus money market accounts, certificates of deposit (CDs), and other time deposits.

What Determines an Asset’s Liquidity?

• Liquidity Definition: How quickly and easily an asset can be exchanged for its full value.

  • Example of High Liquidity: Currency - it can be exchanged for its full value nearly any time.

  • Example of Low Liquidity: A house - takes months to find a buyer willing to pay the right price.

Financial Institutions

• Role: Financial institutions lend money to earn a profit by charging interest and fees.

• Interest Rate Strategy: Attempt to charge a higher interest rate on borrowers than they pay to depositors and other funding sources.

• Risk: Lenders must assess the risk of borrower default (not being able to repay loans).

Types of Financial Institutions

1. Banks: Offer deposits, check-writing services, debit and credit cards, and loans.

2. Credit Unions: Similar to banks but exclusive to members (who are part owners). Typically offer higher interest rates for depositors and lower for borrowers compared to banks.

3. Payday Lenders and Title Pawn Lenders: Offer high-interest loans to individuals with fewer options. They typically do not offer deposit accounts, hence do not create money when they lend.

Banks as Financial Intermediaries

• Definition: Banks are financial intermediaries that utilize liquid assets (from bank deposits) to finance the illiquid investment projects of borrowers.

The Role of Banks in Society

• Purpose: Act as a bridge between lenders and borrowers.

• Impact: Without banks, there would be significantly less financial activity as individuals are often unwilling to invest in illiquid investments.

Fractional Reserve Banking

• Definition: Financial institutions operate under a fractional reserve banking system, holding only a fraction of depositor funds in reserve.

• Bank Reserves: The currency that banks hold in their vaults plus deposits at the Federal Reserve.

• Reserve Ratio Definition: The fraction of bank deposits that a bank holds as reserves, calculated as:
  $ext{Reserve Ratio} = rac{ ext{Reserves}}{ ext{Deposits}} imes 100\%$

T-Accounts for Banks

• Purpose: Shows assets and liabilities of banks.

• Example T-account:

  • Assets:

    • Loans: $1,000,000

    • Reserves: $100,000

  • Liabilities:

    • Deposits: $1,200,000

Why Banks Hold Reserves

• Reason for Reserves: To allow depositors to withdraw currency from their accounts.

  • Banks do not hold 100% of deposits because they can earn interest by lending those funds.

  • This poses a risk – it is impossible for all depositors to withdraw their deposits simultaneously.

Bank's Net Worth Calculation

• Definition of Net Worth: The value of a bank's assets minus its liabilities.

• Example Calculation:

  • Net Worth = Assets - Liabilities = $1,300,000 - $1,000,000 = $300,000

Monetary Base vs. Money Supply

• Monetary Base (B) Definition:

  • Sum of currency in circulation (C) and aggregate bank reserves (R).

  • $B = C + R$

• Money Supply (M) Definition:

  • Currency plus aggregate liquid deposits (D).

  • $M = C + D$

  • Professor Zinn's Perspective: Considers money supply as a measure of “spending power” within an economy.

Relationships between Monetary Base and Money Supply

• Diagram Representation: Relationships shown as $B = C + R$ and $M = C + D$.

• Fractional Reserves Implication: Implies R < D, hence B < M.

A Missing Variable

• Question: What determines the difference between M and B?

• To find the missing value, considerations of additional factors are needed.

Simplified Balance Sheet

• Definition: Represents the entire banking sector without accounting for owner’s equity.

• Balance Sheet Identity: Guarantees that: $ext{Assets} = ext{Liabilities} + ext{Equity}$

  • Simplified to $ext{Assets} = ext{Liabilities}$ resulting in:
    $R + L = D$

The Missing Variable in Simplified Balance Sheet

• Interpretation:

  • Implies $L = D - R$.

  • The value of loans owed to banks fills the gap.

Simplified Heart of Monetary Economics

• Final Relationships Derived:

  • $M = B + L$

  • $D = R + L$

  • Conclusion: This shows that the money supply increases as banks lend and decreases when loans are repaid.

1994, Scarce Reserves Data

• In Trillions of Dollars:

  • R = 0.06, C = 0.35, B = 0.41, F = 3.07, D = 3.13

  • M = 3.48

2022, Abundant Reserves Data

• Context: This represents the financial landscape where reserves are more plentiful.

How Banks “Create” Money

• Process: Banks increase the money supply when they lend money; borrowers decrease the money supply as they repay loans.

• Effect: As banks lend, borrowers gain more money to spend, while the total deposit accounts remain the same. Hence, total spending power increases.

How Banks Create Money: An Example

• Scenario: Silas keeps cash under his mattress.

  • When Deposited: If Silas deposits at a bank, and banks lend 90% of deposits (reserve ratio of 10%), the first bank lends $900 to Maya.

    • Maya pays the money to Anne, who then deposits it at her own bank - thus starting the cycle again.

Practice Problem

• Goal: Calculate reserves in each stage using a 10% total reserve ratio.

Practice Problem on Monetary Base

• Objective:

  • Add currency to bank reserves for each stage to get the monetary base.

  • Does the monetary base change? The monetary base remains consistently at $1000 across the banking activities in the problems previously discussed.

The Monetary Base and Banking Activity Relation

• Conclusion: The monetary base (currency + reserves) does not change due to banking activity. While lending affects the money supply, it does not change the monetary base determined by monetary authorities.

The Money Multiplier

• Definition: The money multiplier measures the ratio of the money supply to the monetary base: $ext{Money Multiplier} = rac{M}{B}$

  • Indicates the degree to which banking activities contribute to the money supply.

Recent US Data on the Money Multiplier

• Observation: The US money multiplier for M2 drastically decreased during the 2008 financial crisis as reserves were injected into the system without a proportional increase in bank lending.

Practice Problem on Money Multiplier

• Situation: Given bank reserves of $500, currency in circulation of $1,000, and checkable deposits of $2,000.

  • Calculation of:

    • Monetary Base:

      • $500 + 1000 = 1500$

    • Money Supply:

      • $1000 + 2000 = 3000$

    • Money Multiplier:

      • $rac{3000}{1500} = 2$