Chapter 29 – Money, Banking, and the Federal
Reserve System
The Meaning of Money
What Is Money?
Money is any asset that can easily be used to purchase goods and services.
Currency is circulation- actual cash in the hands of the public – is considered money. As
are checkable bank deposits – bank accounts which can be accessed using checks, debit
cards, and digital payments.
There are two widely used definitions of the money supply, the total value of financial
assets in the economy that are considered money.
1. Currency in circulation, checkable bank deposits, and traveler’s checks.
2. Three categories as in first definition, plus other assets that are “almost” checkable,
such as savings account deposits.
Money plays a crucial role in generating gains from trade because it makes indirect
exchange possible. There is no longer the need for a double coincidence of wants.
Roles of money
1. Medium of Exchange
A medium of exchange is an asset that individuals acquire for the purpose of trading goods
and services rather than for their own consumption. In normal times, the official money
of a country is also the medium of exchange in virtually all transactions in that country.
During troubled economic times, however, other goods and services often play that role
instead. Example of cigarettes in World War II prisoner-of-war camps.
2. Store of Value
In order to act as a medium of exchange, money must also be a store of value – a means of
holding purchasing power over time. Necessary but not distinctive feature of money.
3. Unit of Account
Money normally serves as the unit of account – the commonly accepted measure individuals
use to set prices and make economic calculations.
Types of Money
For a long time people used commodity money – a good used as a medium of exchange that
has intrinsic value in other uses- example gold and silver. The paper currency that initially
replaced commodity money was commodity-backed money, a medium of exchange with no
intrinsic value whose ultimate value is guaranteed by a promise that it can be converted into
valuable goods. -> Big advantage was that it tied up fewer valuable resources.
Today’s monetary system has eliminated any role for gold and silver. Fiat money is a
medium of exchange whose value derives entirely from its official status as a means of
payment. -> Two advantage of fiat money: It does not use up any real resources beyond the
paper it’s printed on. And second, the supply of money can be adjusted based on the needs
of the economy, instead of being determined by the amount of gold and silver discovered.
Risks of fiat money include that of counterfeiting, and that governments printing too
much money can lead to inflation.
Measuring the Money Supply
The Federal Reserve calculates the size of two monetary aggregates, overall measure of the
money supply, which differ in how strictly money is defined. M1, the narrowest
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,definition, contains only currency in circulation (cash), checkable bank deposits, and
traveler’s checks. M2 adds several other kinds of assets, referred to as near-moneys –
financial assets that can’t be directly used as a medium of exchange but can readily be
converted into cash or checkable bank deposits. (much bigger; M1 + near-moneys)
The Monetary Role of Banks
What Banks Do
Currency in bank vaults and bank deposits held at the Federal Reserve are called bank
reserves. A T-account summarizes the financial position of a bank or business in a single
table that shows assets on the left and liabilities on the right. The fraction of bank
deposits that a bank holds as reserves is its reserve ratio.
The Problem of Bank Runs
A bank can lend out most of the funds deposited in its care because in normal times only a
small fraction of its depositors want to withdraw their funds on any given day.
A bank run is a phenomenon in which many of a bank’s depositors try to withdraw their
funds due to fears of a bank failure. Bank runs aren’t bad only for the bank in question
and its depositors. Historically, they have often proved contagious.
Bank Regulation
1. Deposit Insurance
Deposit insurance guarantees that a bank’s depositors will be paid even if the bank can’t
come up with the funds, up to a maximum amount per account. The insurance eliminates
the main reason for bank runs, because depositors know their funds are save.
2. Capital Requirements
Insurance creates incentive problem. Because depositors are protected from loss, they have
no/little incentive to monitor their bank’s financial health, allowing risky behavior by the
bank to go undetected. To reduce the incentive for excessive risk taking by the bank,
regulators require that bank owners hold substantially more assets than the value of bank
deposits. -> In practice, banks’ capital is required to equal at least 7% of the value of their
assets.
3. Reserve Requirements
Reserve requirements are rules set by the Federal Reserve that determine the minimum
reserve ratio for banks. Example US, min. reserve ratio for checkable bank deposits is 10%.
4. The Discount Window
The discount window is an arrangement in which the Federal Reserve stands ready to lend
money to banks in trouble. The ability to borrow money means a bank can avoid being
forced to sell its assets at extreme low prices in order to satisfy demands of a sudden rush of
depositors demanding cash.
Limits to Regulation’s Reach: Shadow Banking
The modern US banking system is well-protected against old-fashioned bank runs. However,
new-fashioned bank runs can still happen. firms in the shadow banking sector aren’t fully
covered by the protections or regulations that have been made conventional.
Determining the Money Supply
Banks through their creation of checkable bank deposits affect the money supply in 2 ways:
1. Banks remove some currency from circulation: dollar bills that are sitting in the bank
vaults aren’t part of the money supply.
2. Banks create money by accepting deposits and making loans – that is, they make the
money supply larger than just the value of the money in circulation.
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, How Banks Create Money
When Silas deposits $1,000 into a checkable bank account, there is initially no effect on the
money supply: currency in circulation falls by $1,000, but checkable bank deposits rise by
$1000. The corresponding entries on the bank’s T-account, depicted in panel (a), show
deposits initially rising by $1000 and the bank reserves initially rising by $1000.
In the second stage, depicted in panel (b), the bank holds 10% of Silas’s deposit ($100) as
reserves and lends out the rest ($900) to Maya. As a result, its reserves fall by $900 and its
loans increase by $900. Its liabilities, including Silas $1000
remain unchanged. The money supply, the sum of checkable
bank deposits and currency in circulation, has now increased
by $900, the $900 now held by Maya. Suppose Maya uses
her cash to buy a television, and the shop owner (Anne
Acme) deposits the $900 into a checkable bank deposit. Part
of this will again be lend out. And this process can go on and
on. -> The money multiplier. Table 29-1 on the side, shows
the process of money creation.
Reserves, Bank Deposits, and the Money
Multiplier
Excess reserves are a bank’s reserves over and above its required reserves.
Increase in checkable bank deposits from $1000 in excess reserves = $1000/rr (where rr =
reserve ratio) In a checkable-deposits-only monetary system, the total value of checkable
bank deposits will be equal to the value of bank reserves divided by the reserve ratio.
The Money Multiplier in Reality
In reality, the determination of the money supply is more complicated, because it depends
not only on the ratio of reserves to bank deposits but also on the fraction of the money
supply that individuals choose to hold in the form of currency. To define the money
multiplier in practice, it’s important to recognize that the Federal Reserve control the sum of
bank reserves and currency in circulation, called the monetary base, but it does not control
the allocation of that sum between bank reserves and currency in circulation.
The monetary base is the sum of currency in circulation and bank
reserves. It is different from the money supply in two ways:
1. Bank reserves, which are part of the monetary base, aren’t
considered part of the money supply.
2. Checkable bank deposits, which are part of the money supply
because they are available for spending, aren’t part of the
monetary base.
The money multiplier is the ratio of the money supply to the
monetary base.
It is smaller than $1/rr because people hold some funds as cash.
(-> Before the crisis currency in circulation accounted for more than 90% of the monetary
base).
The Federal Reserve System
A central bank is an institution that oversees and regulates the banking system and controls
the monetary base. In the US this is the Federal Reserve. ECB for EU-countries, etc.
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