© OnlineTexts.com p. 1 Chapter 14 Econ104 Parks Money and Banking

Chapter 14Econ104 Parks

Money and Banking

What is Money?

• A barter system is one in which goods and services are exchanged directly for goods and services.– It requires a double coincidence of wants.

• A monetary system uses some universally recognized currency to facilitate transactions.

Money, income, and wealth

• Income is the flow of revenue over a particular time period.

• Wealth is the value of your stock of assets at a particular point in time.

• Money is something that serves as a– medium of exchange– unit of account– store of value

• http://www.richmondfed.org/about_us/visit_us/tours/money_museum/index.cfm

• http://www2.moneymuseum.com/frontend/library/pictures/overview.jsp

• http://www.journalofantiques.com/June04/coinsjune04.htm

• http://www.banknotes.com/intro.htm#history

Measuring the Quantity of Money

• Money is measured in terms of its liquidity, or how easily it can be converted to cash.

• The narrowest measure of money which includes only the most liquid assets is called M1. M1 includes:– currency, – demand deposits (no-interest checking accounts), – other checkable deposits, and – traveler's checks.

1/1/1959 6/23/1964 12/14/1969 6/6/1975 11/26/1980 5/19/1986 11/9/1991 5/1/1997 10/22/2002 4/13/2008

CurCirc CurM1

Currency in Circulation is US Treasury accounting while Currency component of M1 is an estimate of the currency used.

Currency per capita

1/1/1959 6/23/1964 12/14/1969 6/6/1975 11/26/1980 5/19/1986 11/9/1991 5/1/1997 10/22/2002 4/13/2008

CurCirc CurM1

$2947 or $2771 per person – every person in the US – how much do you have?

REAL per capita Currency

1/1/1959 6/23/1964 12/14/1969 6/6/1975 11/26/1980 5/19/1986 11/9/1991 5/1/1997 10/22/2002 4/13/2008

CurCirc CurM1

REAL per capita Currency

1/1/1959 6/23/1964 12/14/1969 6/6/1975 11/26/1980 5/19/1986 11/9/1991 5/1/1997 10/22/2002 4/13/2008

CurM1 Linear (CurM1)

9/1/2008

1/1/1959 6/23/1964 12/14/1969 6/6/1975 11/26/1980 5/19/1986 11/9/1991 5/1/1997 10/22/2002 4/13/2008

M1 per capita

Jan-1959 Jun-1964 Dec-1969 Jun-1975 Nov-1980 May-1986 Nov-1991 May-1997 Oct-2002

REAL M1 per capita

1/1/1959 6/23/1964 12/14/1969 6/6/1975 11/26/1980 5/19/1986 11/9/1991 5/1/1997 10/22/2002 4/13/2008

Measuring the Quantity of Money

• M2 is a slightly broader definition of money that includes some less liquid assets. M2 includes: – M1, – savings deposits, – small time deposits (e.g. certificates of deposits),– money market deposit accounts.

1/1/1959 6/23/1964 12/14/1969 6/6/1975 11/26/1980 5/19/1986 11/9/1991 5/1/1997 10/22/2002 4/13/2008

CurM1 M1 M2

1/1/1959 6/23/1964 12/14/1969 6/6/1975 11/26/1980 5/19/1986 11/9/1991 5/1/1997 10/22/2002 4/13/2008

Cur M1 M2

REAL Cur, M1, M2

1/1/1959 6/23/1964 12/14/1969 6/6/1975 11/26/1980 5/19/1986 11/9/1991 5/1/1997 10/22/2002 4/13/2008

Cur M1 M2

Banking: The Fractional Reserve System

• A fractional reserve system is one in which banks must keep only a fraction of the deposits they hold on hand. The rest can be loaned out.

• The required reserve ratio (RRR) is the fraction of deposits that must be held.– If RRR = 10%, banks must hold $10 in reserves for

every $100 they lend out.– RRR = required reserves/ total deposits x 100

TotRes ExRes

1/1/1959 6/23/1964 12/14/1969 6/6/1975 11/26/1980 5/19/1986 11/9/1991 5/1/1997 10/22/2002 4/13/2008

ExRes TotRes

2/1/2008 3/22/2008 5/11/2008 6/30/2008 8/19/2008 10/8/2008 11/27/2008 1/16/2009 3/7/2009

TotRes ExRes

ReqResPct

67.00%

72.00%

77.00%

82.00%

87.00%

92.00%

97.00%

ReqResPct

Required Reservers as a Percent of Total Reserves

1/1/1959 6/23/1964 12/14/1969 6/6/1975 11/26/1980 5/19/1986 11/9/1991 5/1/1997 10/22/2002 4/13/2008

ReqResPct

Dangers of a Fractional Reserve System

• Depositor funds are at risk from bank failures.

• The financial system is vulnerable to bank runs.– The limited deposits on hand are distributed in a

first-come, first-serve basis.

Solutions to protect depositors and limit bank runs

• Deposit insurance– In the U.S. the Federal Deposit Insurance

Corporation (FDIC) protects depositors from losses with up to $100,000 in coverage.

– This insurance, however, provides incentives for banks to take risks because depositors have no incentive to monitor a bank’s condition.

• Bank regulation– Bank examiners periodically examine and assess

the risks of every commercial bank.

Dangers

• The Central Bank PRINTS money!

Bank Bookkeeping

• A bank asset is an item of value that a bank owns.

• A bank liability is an item of value that a bank owes.

• A bank's capital or net worth is the difference between its assets and liabilities

•Typical bank assets are reserves, securities, and loans.

•Deposits are typical liabilities.

•Typical bank assets are reserves, securities, and loans.

•Deposits are typical liabilities.

Money Creation by Banks

• Banks in conjunction with the Federal Reserve are unique in their ability to create money.

• They do not create the physical money that we touch, but they do create deposits.

Money Creation example

Initial balance sheet of First Federal Bank. RRR=10%.

Emily deposits $100,000 in cash into First Federal.

M1=$1,100,000

First Federal lends $90,000 to Bob.

M1=$1,100,000 + $90,000 = $1,190,000

Bob deposits $90,000 into Second Federal.

M1=$1,100,000 + $90,000 = $1,190,000

Second Federal lends $81,000 to Amy.

M1=$1,100,000 + $90,000 + $81,000 = $1,271,000

The Money Multiplier

• The money multiplier formula:

determines the maximum amount of money that can be created from Emily's initial deposit of $100,000.

• In this example, the money multiplier is equal to 1/10% = 1/.10 = 10, so the maximum change in the money supply = 10 x $90,000 = $900,000.

The Money Multiplier

• This money multiplier formula calculates the maximum possible expansion of M1 because it assumes that:– everyone deposits their new loans into a checking

account at a bank, and – banks hold no excess reserves.

• Note that the money creation process works exactly the same in reverse.

M1 Multiplier - M1 / TotRes

Multiplier

M1Multi

1/1/1959 6/23/1964 12/14/1969 6/6/1975 11/26/1980 5/19/1986 11/9/1991 5/1/1997 10/22/2002 4/13/2008

M1Multi

M2 Multi

M2Multi

1/1/1959 6/23/1964 12/14/1969 6/6/1975 11/26/1980 5/19/1986 11/9/1991 5/1/1997 10/22/2002 4/13/2008

M2Multi

© OnlineTexts.com p. 1 Chapter 14 Econ104 Parks Money and Banking

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