Ch. 12: Money and Banking

Del Mar College

John Daly©2003 South-Western Publishing, A Division of Thomson Learning

Money and its Function

• Money is any good that is widely accepted for purposes of exchange and in the repayment of debts.

• Money reduces transaction costs because it is a medium of exchange.

• Money is a unit of account. We don’t have to keep prices in oranges, apples, or computers; money provides this role for us.

• Money is a store of value, it maintains its value over time. We accept payment for our efforts and keep money until we spend it.

Money Vs. Barter

• Making exchanges takes longer in a barter system: not only do you have to find something you want, but you have to have something the seller wants as well. This is called a double coincidence of wants.

• Some goods are more readily accepted than other goods.

• Historically, goods that have evolved into money are: gold, silver, copper, cattle, rocks, and shells.

Money in a Prisoner Of War Camp

During WW2, R.A. Radford was captured and imprisoned in a POW camp. During his captivity, he noticed an economy built up based on the ration packages sent by the red cross. Instead of having money, items were initially bartered until some started using cigarettes as currency.

Money, Leisure, and Output

• A money based economy frees up time spent looking for someone interested in your goods, who has something you want.

• A person’s standard of living is, to a degree, dependent on the number and quality of goods he consumes and the amount of leisure he consumes.

What Gives Money its Value?

• Our money has value because of its general acceptability.

• We accept paper dollars because we know that other people will accept dollars later when we try to spend them.

• Money has value to people because it is widely accepted in exchange for other goods that are valuable.

Gresham’s Law: Good Money and Bad Money

• Bad money drives good money out of circulation.

• In truth, bad money drives out good money if both moneys have the same face value, have different intrinsic values, and are fixed at an exchange rate of one to one.

Defining the Money Supply

• M1 is sometimes referred to as the narrow definition of the money supply or as transactions money.

• M1 consists of currency held outside banks, checkable deposits, and traveler’s checks.

Defining the Money Supply: M2

• M2 is sometimes referred to as the broad definition of the money supply.

• M2 is made up of M1 plus small-denomination time deposits, savings deposits, money market accounts, overnight repurchase agreements, and overnight eurodollar deposits held by US residents.

Where Do Credit Cards Fit In?

• A credit card is an instrument or document that makes it easier for the holder to obtain a loan.

• Credit card transactions shift around the existing quantity of money between various individuals and firms, but do not change to total money available.

Q & A

• Why (not how) did money evolve out of a barter economy?

• If individuals remove funds from their checkable deposits and transfer them to their money market accounts, will M1 fall and M2 rise? Explain your answer.

• How does money reduce the transaction costs of making exchanges?

How Banking Developed

• Early bankers used goldsmith’s warehouse receipts.

• Early bankers began to issue receipts for more gold than they had on hand.

• This was the beginning of fractional reserve banking.

The Federal Reserve System

• Commonly called “The Fed”, this is the central bank of the United States.

• The Fed is essentially a bank’s bank.

• The Fed’s chief function is to control the nation’s money supply.

The Money Creation Process

• The sum of bank deposits at the Fed and the bank’s cash vault is total bank reserves.

• The Fed mandates member commercial banks to hold a certain fraction of their checkable deposits in reserve form. This fraction is called the required reserve ratio.

• The difference between a bank’s total reserves and its required reserves is its excess reserves.

The Banking System and The Money Creation Process

• The process starts with the Fed.• The Fed prints the funds, and Jack deposits the

funds in his bank.• The Reserves of the bank increases, while the

reserves of no other bank decreased.• The banking system made loans and in the process

created checkable deposits for the people who received the loans.

• Remember, checkable deposits are part of the money supply. So, in effect, by extending loans, and in the process creating checkable deposits, the banking industry has increased the money supply.

The Banking System CreatesCheckable Deposits (Money)

The Banking System And The Money Expansion Process

• When the $9000 that bankers created in new checkable accounts is added to the $1000 the Fed initially printed, we see that $10,000 has been added to the money supply.

Maximum change in checkable deposits = (1/r) x R

• Where r = the required reserve ratio and R is the change in reserves resulting from the original injection of funds.

• In the formula, (1/r) is known as the simple deposit ratio.

Why Maximum? Answer: No Cash Leakages And Zero Excess Reserves

• All monies were deposited in bank checking accounts.

• Every bank lent all its excess reserves, leaving every bank with zero excess reserves.

• Because we assumed no cash leakages and zero excess reserves, the change in checkable deposits is the maximum possible change.

Who Created What?

• The money expansion process has two major players: the Fed, and the Banking System.

• The maximum change in bankable deposits is equal to: (1/r) x ER, where ER is the excess reserves.

The Money Contraction Process

• This process is the Money Creation process in reverse

Q & A

• If a bank’s deposits equal $579 million and the required-reserve ratio is 9.5%, what dollar amount must the bank hold in reserve form?

• If the Fed creates $600 million in new reserves, what is the maximum change in checkable deposits that can occur if the required-reserve ratio is 10%?

• Bank A has $1.2 million in reserves and $10 million in deposits. The required-reserve ratio is 10%. If Bank A loses $200,000 in reserves, by what dollar amount is it reserve deficient?