Money and the Banking System [Money] is a machine for doing quickly and commodiously what would be done, though less quickly and commodiously, without it. JOHN STUART MILL

Contents The Nature of Money How the Quantity of Money is Measured The Banking System The Origins of the Money Supply Banks and Money Creation Why the Deposit Creation Formula Is Oversimplified The Need for Monetary Policy Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

The Nature of Money Barter versus Monetary Exchange A barter system (with no money) would be awkward and extremely inefficient. Money greases the wheels of exchange and, thus, makes the whole economy more productive.

The Nature of Money The Conceptual Definition of Money The functions of money: Medium of exchange Unit of account Store of value Money = whatever serves as the medium of exchange

What is Money?

Types of Money Commodity Money Representative Money Fiat Money Has intrinsic value based on the material from which is made. Representative Money Is backed by something tangible. Fiat Money Is declared by the government and accepted by citizens to have worth.

The Nature of Money What Serves as Money? Societies have gradually moved from the use of commodity monies to the use of money that has no commodity backing at all.

Properties of Money Physical Properties Economic Properties Durability Portability Divisibility Uniformity Economic Properties Stability of value Scarcity Acceptability

How the Quantity of Money is Measured There is no single, obvious place to draw the line between “money” and “near money.” M1 = coins and paper money in circulation, plus checkable deposits M2 = M1 + money market deposit accounts, money market mutual funds, and savings accounts

FIGURE 28-2 Two Definitions of the Money Supply, February 2002 Currency outside banks $591 billion Money market mutual funds $972 billion Savings deposits $3345 billion M1 $1183 billion Checking deposits in commercial banks $324 billion Other checkable deposits $268 billion M1 = $1183 billion M2 = $5500 billion Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

The Banking System How Banking Began Fractional reserve banking began when goldsmiths realized they could profitably lend out a portion of the gold that had been deposited with them for safekeeping.

The Banking System How Banking Began Three important features of the fractional reserve banking system: Bank profitability Banks discretion over the money supply Exposure to bank runs

Federal Reserve System

The Banking System Principles of Bank Management: Profits versus Safety To make a profit, a banker must take risks. But because the business is risky, the same banker must also emphasize safety. The heart of banking is to be torn between the two principles.

FIGURE 28-1 Bank Failures in the United States, 1915-2000 2,200 FDIC established 2,000 1,800 200 1,600 160 1,400 Number of Bank Failures 120 Number of Bank Failures 1,200 80 1,000 40 800 1935 1945 1955 1965 1975 1985 '95 '00 600 Great Depression begins 400 200 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 '95 '00 Year Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

The Banking System Bank Regulation Deposit Insurance Bank Supervision The Federal Deposit Insurance Corporation insures people’s deposits at banks. Bank Supervision Ensures banks take only sensible, defensible risks Controls the money supply Reserve Requirements Helps control the money supply

The Origins of the Money Supply How Bankers Keep Books Banks keep balance sheets Assets = liabilities + net worth Assets include: Reserves Loans Liabilities include: Deposits owed to customers.

TABLE 28-1 Balance Sheet of Bank-a-mythica, Dec. 31, 2001 Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Banks and Money Creation The Limits to Money Creation by a Single Bank Banks can lend money in their vault that is above the minimum required reserve ratio. In doing so, they create new money.

TABLE 28-2 Bank-a-mythica’s Balance Sheet, Jan. 2, 2002 Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

TABLE 28-3 Bank-a-mythica’s Balance Sheet, Jan. 3-6, 2002 Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

TABLE 28-4 Bank-a-mythica’s Balance Sheet, Jan. 2-6, 2002 Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Banks and Money Creation Multiple Money Creation by a Series of Banks When all banks make loans with funds they have that are above the required reserve ratio, the society’s money supply expands.

Banks and Money Creation Multiple Money Creation by a Series of Banks  deposits = (1/m) x  reserves Assumes banks keep the minimum reserve ratio, m Assumes all new money held in the form of deposits Oversimplified deposit multiplier formula

TABLE 28-5 Changes in First National Bank’s Balance Sheet Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

TABLE 28-6 Changes in Second National Bank’s Balance Sheet Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

FIGURE 28-3 The Chain of Multiple Deposit Creation Running Sums (1) (2) (3) Reserves Deposits Loans $100,000 deposit $100,000 $20,000 on reserve $80,000 lent out $20,000 $80,000 $80,000 deposit $180,000 $16,000 on reserve $64,000 lent out $36,000 $144,000 $64,000 deposit $244,000 $12,800 on reserve $51,200 lent out $48,800 $195,200 $51,200 deposit $295,200 $10,240 on reserve $40,960 lent out $59,040 $236,160 $40,960 deposit $336,160 $8,192 on reserve $32,768 lent out $67,232 $268,928 And so on . . . • $100,000 • $500,000 • $400,000 Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Banks and Money Creation The Process in Reverse: Multiple Contractions of the Money Supply Deposits, and with them the money supply, contract when reserves are reduced. Banks reduce their loan commitments. Calculation of the contraction in the money supply utilizes the same formula as for money expansion.

TABLE 28-7 Changes in Balance Sheet of Bank-a-mythica Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

TABLE 28-8 Changes, Balance Sheet of First National Bank Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Why the Deposit Creation Formula Is Oversimplified Individuals hold some portion of additions to their money in the form of cash. Banks sometimes hold reserves above the required minimum.

The Need for Monetary Policy Left uncontrolled, banks would: Reduce the money supply in a recession Increase the money supply during boom periods Changes in the money supply would exacerbate the business cycle. One reason for monetary policy, therefore, is to prevent this behavior on the part of banks.