Money and Banks
Money: Definition and Measurement
A barter system is one in which goods and services are exchanged directly for goods and services. It requires a double coincidence of wants. For example, if I decide that I want a new, red Saturn, I must find someone who has one and she must be willing to trade the Saturn for something that I have. For example, I might have a brand new Chevy Blazer that the Saturn owner wants. We can then exchange the Saturn for the Blazer. Such transactions are difficult and clumsy. We can ease the transition process by using a monetary system.A monetary system uses some universally recognized currency to facilitate transactions. Now if I wish to acquire a Saturn, I simply go to the owner of the Saturn and pay money for the car. I do not need to have something of equal value that the Saturn owner wishes to have. The double coincidence of wants is unncecessary.
We need to carefully define "money." In common usage, the terms money, income, and wealth are often used interchangeably. But to an economist, money and income are very different things. Income is the flow of revenue over a particular time period. For an income measurement to make sense, one must define it in terms of a particular time period. For example, I earn $10 per hour, or my salary is $2,000 per month, or my income is $25,000 per year. Without a time qualification, income could refer to almost anything. Few of you think of yourselves as millionaires, but in your lifetimes you will indeed earn income over $1,000,000.
Wealth is the value of your stock of assets at a particular point in time. Your assets are things of value that you own. For example, your house, stocks, car, and funds in your savings account are all part of your wealth. Wealth is a stock, it can be added up at any moment in time.
Money is something that serves these three purposes, First, it is a medium of exchange, or a means for making transactions. Second, it is a unit of account, or a standard unit for quoting prices. Third, it is a store of value, a means to store wealth from one time period to the next. You can put your money under your mattress and it will be there next month. Lots of things can be used as money. In much of our history, we used gold and silver. Some places use rocks to trade goods. During wars, cigarettes and chocolates are often used. As long as the commodity serves the three purposes described above, it can be money. In today's world, we use fiat money, or paper money. The money is inherently worthless except for the purchasing power that we trust it will bring. Without trust, the paper money becomes useless pieces of paper.
Measuring the Quantity of Money
Money is measured in terms of its liquidity, how easily it can be converted to cash. Currency, by definition, is highly liquid because it is already cash. Checking accounts are liquid becasue one can write checks as a way to carry out transactions. Houses and cars, however, are not nearly as liquid.The narrowest measure of money which includes only the most liquid assets is called M1. M1 includes:
- Currency,
- Demand Deposits (no-interest checking accts),
- Other Checkable Deposits, and
- Traveler's Checks.
- M1,
- Savings Deposits,
- Small Time Deposits, and
- Money Market Deposit Accounts.
Click the appropriate text to view a historical data series of M1 and M2.
Banking
The Fractional Reserve System
Our banking system is called a Fractional Reserve System which means that banks must only keep a fraction of the deposits they hold on hand. The rest can be loaned out. For example, suppose banks are required to keep 10% of deposits on hand. This is called the Required Reserve Ratio (r). For every $100 of deposits, only $10 must be held by the bank. Thus, r=0.10 or 10%.Banks are in business like any other private company--to make a profit. They earn profits primarily on the spread between the rate they must pay for funds and the rate they charge for lending funds.
Dangers of a Fractional Reserve System
There are at least two problems with a fractional reserve system. First, the financial system is susceptible to bank runs. If depositors lose faith in their banks, they run to the banks to withdraw the funds. This happened on a large scale during the Great Depression. Since banks have only a fraction of the deposits actually on hand at the bank, only the first customers to get in line will receive their money.The second problem with a fractional reserve system is the possibility of bank failures. Since banks are in business to make a profit, they can make poor management decisions by making risky loans. Depositor funds are at risk.
We have developed partial solutions to these problems over the years, particularly in the years following the Great Depression. To prevent bank runs, we have implemented a system of deposit insurance. Most banks are members of FDIC, the Federal Deposit Insurance Corp. This is an insurance system that banks pay funds into in order to cover depositors funds if the bank fails. This helps to avoid widespread bank runs because depositors are assured of the security of their deposits. However, this also leads to an incentive system in which depositors do not care how a bank is managed. There is no consumer regulation on quality of banks' operations. Even when Savings and Loans were going bust in the late 1980s, depositors kept putting their money in them.
To reduce the likelihood of bank failure and bad or corrupt management practices, we have developed an extensive system of bank regulation. Banks are probably the most regulated companies in the U.S. They are subject to frequent audits to make sure loan portfolios are sound and that all activities are legal. The system is far from perfect, however, given the recent wave of bank failures and corruption.
Bank Bookkeeping
Banks keep books like any other private company. An asset is an item of value that a bank owns. A 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.Capital = Assets - Liabilities.
The table below lists the most common bank assets and liabilites.
| Assets | Liabilities |
|---|---|
| Reserves | Checking Deposits |
| Govt. Securities | Savings Deposits |
| Loans Outstanding |
|
Money Creation by Banks
Banks (in combination 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 M1. Let's see how this works.Suppose the required reserve ratio is 10 percent, or .10. First Federal Bank initially has $1,000,000 in deposits so it must have 10% × $1,000,000 = $100,000 on hand as reserves. First Federal also has $1,200,000 in loans outstanding. The bottom of the chart analyzes the reserve position of First Federal. It does not represent new assets. Excess reserves are the amount of reserves that the bank has over its required level. Since First Federal has $100,000 in reserves and is required to have $100,000 in reserves, it has no excess reserves.
Emily has $100,000 in cash. She is obviously concerned about carrying around such a large sum of money for fear of being robbed or losing it. So she goes to First Federal and deposits the $100,000 into her checking account. The bank takes the $100,000 and puts it in the vault, increasing its reserves from $100,000 to $200,000. However, First Federal now has more reserves on hand than it needs. The banks needs to keep only 10 percent of the $100,000, or $10,000 on hand. This generates $90,000 in excess reserves, reserves above and beyond the required amount.
First Federal earns no interest on reserves that simply sit in a vault. So the bank lends out the $90,000 to Bob. First Federal's outstanding loans rise by $90,000 to $1,290,000. Reserves fall, however, to $110,000. First Federal is back to a position of no excess reserves.
It seems like not a lot has changed. But let's count the money supply so we can keep track of its quantity. Recall that M1 is the addition of currency outstanding plus checking account balances. First Federal started with $1,000,000 in deposits and Emily was carrying around $100,000 in cash for a total value of $1,100,000. After Emily deposited her $100,000 in the bank, M1 was still $1,100,000, but now all of it was in the bank and none of it was currency. But what happens after First Federal lends the $90,000 to Bob? Now we have $1,100,000 in checking deposits plus $90,000 in cash that is in Bob's pockets. The money supply has expanded! M1 is now $1,100,000 + $90,000 = $1,190,000.
The process won't stop here. The $90,000 is taken by Bob and put into Second Federal Bank. Second Federal has increased reserves of $90,000 but only needs to keep $9,000 on hand, generating excess reserves of $81,000.
Suppose Second Federal takes the excess reserves and lends them to Amy.
M1 is now $1,100,000 + $90,000 + $81,000 = $1,271,000. Amy puts the funds
into Third Federal Bank which generates excess reserves of $72,900. The
process continues in this fashion.
The Money Multiplier
How much new M1 will ultimately be created? First we have to ask what is the maximum change in demand deposits:Maximum Change in Demand Deposits = (1/r) x Initial Change in Reserves
(1/r) is called the Money Multiplier because a given amount of reserves is multiplied into a greater amount of deposits.
In our example, r =.10 so (1/r)= 1/10% = 1/.10 = 10. The initial change in reserves was $100,000, so the maximum change in demand deposits is 10 x $100,000 = $1,000,000.
We also have to determine the change to the money supply, M1. Since M1 is equal to currency + demand deposits, then
change in M1 = change in currency + change in demand deposits
In our example, the change in currency is -$100,000, since currency was taken out of public circulation (remember, vault cash is not part of M1). Thus, the change in M1 is (-$100,000+$1,000,000)= $900,000. In this example, the change in the money supply is less than the change in demand deposits.
This money multiplier formula calcuates the maximum possible expansion of M1 because it assumes:
- everyone deposits their new loans into a checking account at a bank.
- banks hold no excess reserves.
The money creation process works exactly the same in reverse. For example, if someone withdraws money from a bank, a bank will be short of its required reserves and must reduce loans. M1 will decrease by $900,000 in the example above.
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