Money and Banks

The Uses of Money Imagine that there was no money. Barter is the direct exchange of one good for another, without the use of money.

The Uses of Money Anything that serves all of the following purposes can be thought of as money: Medium of exchange Store of value Standard of value

The Uses of Money Medium of exchange — accepted as payment for goods and services (and debts).

The Uses of Money Store of value — can be held for future purchases. Standard of value — measures price of goods and services

The Uses of Money Money facilitates market exchanges and specialization in production.

Many Types of “Money” In history of the U.S. many things have been used as money. There were no U.S. dollars in the early days of Colonial America.

Many Types of “Money” Greenbacks were issued in 1861 by the U.S. Federal government. Confederate states also issued paper money to finance their side of the U.S. Civil War.

Cash vs. “Money” The concept of money includes more than dollar bills and coins. Checking accounts can and do perform the same market function as cash.

Cash vs. “Money” Money is anything generally accepted as a medium of exchange.

Transactions Accounts A bank account that permits direct payments to a third party (e.g., with a check).

Transactions Accounts The balance in your transactions account substitutes for cash, and is, therefore, a form of money.

Basic Money Supply The basic money supply is referred to by the abbreviation M1. M1 is currency held by the public, plus balances in transactions accounts.

Basic Money Supply Cash is a small part of the money supply. Currency and coins account for less than a third of the basic money supply.

Basic Money Supply Most money consists of balances in transactions accounts.

Composition of the Basic Money Supply Total money supply ($1,090 billion) BILLIONS OF DOLLARS Currency in circulation $537 Transactions-account balances $545 Travelers checks $8

Composition of M1 Transaction-account balances Traveler’s checks Currency in circulation Credit cards are NOT money

Near Money Savings accounts Certificates of deposit Money market mutual fund

Aggregate Demand How much money people have may be one of the determinants of aggregate demand. Aggregate demand is the total quantity of output demanded at alternative price levels in a given time period, ceteris paribus.

Creation of Money The Bureau of Printing and Engraving and the U.S. Mint play only a minor role in creating money. Most of what we call money is not cash but bank balances.

Deposit Creation A bank effectively creates money when it makes a loan. Transactions-account balances are counted as part of the money supply.

Deposit Creation Transactions-account balances are the largest part of the money supply.

Deposit Creation Banks create transactions-account balances by making loans.

Deposit Creation Deposit creation — creation of transaction deposits by bank lending.

A Monopoly Bank To keep things simple, assume one bank in a town, and nobody regulates bank behavior.

A Monopoly Bank You deposit $100 from your piggy bank into the monopoly bank and receive a new checking account.

A Monopoly Bank When cash or coins are deposited in a bank, the composition of the money supply changes, not its size.

An Initial Loan The monopoly bank loans $100 to Campus Radio. It deposits $100 into Campus Radio’s checking account.

An Initial Loan The loan is accomplished by a simple bookkeeping entry. Money has been created because the checking account is considered to be money.

An Initial Loan Total bank reserves have remained unchanged. Bank reserves are assets held by a bank to fulfill its deposit obligations.

Using the Loan The money supply does not contract when Campus Radio spends the $100. The ownership of the deposit changes.

Fractional Reserves Bank reserves are only a fraction of total transactions deposits.

Fractional Reserves The reserve ratio is the ratio of a bank’s reserves to its total deposits.

Fractional Reserves Ability of a monopoly bank to hold fractional reserves is based on two facts: People use checks for most transactions. There are no other banks.

Reserve Requirements If a bank could create money at will, it would have a lot of control over aggregate demand. In reality, no private bank has that much power.

Reserve Requirements The power to create money resides in the banking system, not in any single bank.

Reserve Requirements The Federal Reserve System requires banks to maintain some minimum reserve ratio.

Required Reserves Required reserves are the minimum amount of reserves a bank is required to hold by government regulation

Required Reserves Required reserves are equal to the required reserve ratio times transactions deposits.

Required Reserves The minimum reserve requirement directly limits deposit-creation possibilities.

Excess Reserves Excess reserves are bank reserves in excess of required reserves.

Excess Reserves The ability of banks to make loans depends on access to excess reserves.

Excess Reserves If a bank currently has $100 in reserves and is required to hold $75, it can lend out the $25 excess.

Excess Reserves

Excess Reserves So long as a bank has excess reserves it can make loans.

A Multi-Bank World In reality there is more than one bank in town. The key issue is not how much excess reserves any specific bank holds. It is how much excess reserves exist in the entire banking system.

The Money Multiplier Excess reserves are the source of bank lending authority. The cumulative amount of new loans is determined by the money multiplier.

The Money Multiplier The money multiplier is the number of deposit (loan) dollars that the banking system can create from $1 of excess reserves.

The Money Multiplier Process Initial deposit of $100 made at University Bank.

The Money Multiplier Process University Bank keeps $75 (75% of the $100 new deposit) on reserve and loans out $25 which is deposited in Bank Two.

The Money Multiplier Process Bank Two keeps 75% of the new deposit on reserve ($18.75) and loans out $6.25.

The Money Multiplier Process Bank three keeps 75% of the new deposit on reserve ($4.69) and loans out $1.56. Etc., etc., etc.

The Money Multiplier Process Loan $25 Loan $6.25 Loan $1.56 Bank #2 Bank #4 Bank #3 University Bank Initial deposit ($100) etc. Deposit Deposit Deposit

Limits of Deposit Creation The potential of the money multiplier to create loans is summarized by the equation:

Limits of Deposit Creation If the required reserve ratio = .75: The multiplier = 1.33 If the banking system has $25 in excess reserves: Potential deposit creation is $25 x 1.33 = $33.25

Excess Reserves as Lending Power Each bank may lend an amount equal to excess reserves and no more.

Excess Reserves as Lending Power The entire banking system can increase the volume of loans by the amount of the system’s excess reserves multiplied by the money multiplier.

The Macro Role of Banks Since virtually all market transactions involve the use of money, banks must have some influence on macro outcomes.

Financing Aggregate Demand Banks perform two functions: Banks transfer money from savers to spenders by lending funds held on deposit. The banking system creates additional money by making loans in excess of total reserves.

Financing Aggregate Demand Increases in money supply tend to increase aggregate demand. Aggregate demand declines when the money supply shrinks.

Financing Aggregate Demand The banking system can create any desired level of money supply if allowed to expand or reduce loan activity at will.

Banks in the Circular Flow Business firms Consumers BANKS Factor markets Product Income Domestic consumption Loans Saving Sales receipts Loans Wages, dividends, etc. Investment expenditures

Constraints on Lending Activity There are four major constraints on the ability of banks to make loans.

Bank Deposits Willingness of consumers and businesses to continue using and accepting checks rather than cash.

Willing Borrowers Willingness of consumers and businesses and governments to borrow money from banks.

Willing Lenders Banks may not be willing to satisfy credit demands choosing instead to hold excess reserves.

Government Regulation The Federal Reserve regulates bank lending practices.

Digital Money The most common forms of money cannot be used as a medium of exchange in electronic malls.

Credit Cards Almost all Internet purchases are completed with a credit card.

Credit Cards Dependence on credit cards limits the potential of e-commerce because of: Security issues such as credit card number theft. Use and sale of credit card databases by e-retailers for undisclosed purposes.

E-Payments Some companies offer a quasi-banking service by storing purchasing power that consumers and e-retailers can access.

E-Payments Consumers must "deposit" e-cash with credit card advances.

Speed of Spending Consumers still need cash and checking-account balances to pay for their e-purchases.

Speed of Spending Virtual malls allow consumers to spend money balances faster, thereby boosting aggregate demand.

Money and Banks End of Chapter 13