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

2. © OnlineTexts.com p. 2 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. 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.

3. © OnlineTexts.com p. 3 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 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

4. © OnlineTexts.com p. 4 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. 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.

5. © OnlineTexts.com p. 5 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. 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.

6. © OnlineTexts.com p. 6 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 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

7. © OnlineTexts.com p. 7 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. 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.

8. © OnlineTexts.com p. 8 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. 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.

9. © OnlineTexts.com p. 9 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 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.

10. © OnlineTexts.com p. 10 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. 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.

11. © OnlineTexts.com p. 11 Money Creation example Initial balance sheet of First Federal Bank. RRR=10%.

12. © OnlineTexts.com p. 12 Money Creation example Emily deposits $100,000 in cash into First Federal. M1=$1,100,000

13. © OnlineTexts.com p. 13 Money Creation example First Federal lends $90,000 to Bob. M1=$1,100,000 + $90,000 = $1,190,000

14. © OnlineTexts.com p. 14 Money Creation example Bob deposits $90,000 into Second Federal. M1=$1,100,000 + $90,000 = $1,190,000

15. © OnlineTexts.com p. 15 Money Creation example Second Federal lends $81,000 to Amy. M1=$1,100,000 + $90,000 + $81,000 = $1,271,000

16. © OnlineTexts.com p. 16 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 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.

17. © OnlineTexts.com p. 17 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. 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.