Week 4: Money and European Banking
The Meaning of Money
Money: any asset that can easily be used to purchase goods and services
• Money plays a crucial role in generating gains from trade because it makes indirect exchanges possible
• Problem of finding a double coincidence of wants: in a barter system, two parties can trade only when each wants
what the other has to offer
An asset is liquid if it can be quickly converted into cash without much loss of value
Currency in circulation: when cash is held by the public
Checkable bank deposits: bank accounts on which people can write checks
The money supply is the total value of financial assets in the economy that are considered money
Roles of Money:
1. Medium for exchange
• Medium of exchange: an asset that individuals acquire for the purpose of trading goods and services rather than
for their own consumption
• People cant eat cash, instead they use this to trade for edible goods
2. Store of value
• Store of value: a means of holding purchasing power over time
3. Unit of Account
• Unit of account: the commonly accepted measure individuals use to set prices and make economic calculations
• Wages in $, in the Middle Ages this was determined by time
Types of Money:
Money has been in use for thousands of years. For most of that period, people used commodity money: the medium
of exchange was a good, normally gold or silver, that had intrinsic value in other uses.
• These uses gave commodity money value independent of its role as a medium of exchange.
The paper currency that initially replaced commodity money was commodity-backed money: a medium of exchange
with no intrinsic value whose ultimate value was guaranteed by a promise that it could always be converted into
valuable goods on demand.
• Advantage: tied up fewer resources, a note-issuing bank only had to keep enough gold or silver on demand to
satisfy demands for redemption of its notes, and it could rely on the fact that on a normal day only a fraction of it’d
paper notes would be redeemed. This meant the bank could lend out the rest, this allowed society to use the
remaining gold and silver for other purposes with no loss in their ability to achieve gains from trade.
Fiat money is money whose value derives entirely from its official status as a means of exchange.
• Advantages: creating it doesn’t use up any resources besides the paper it is printed on, and the supply of money
can be adjusted based on the needs of the economy instead of being determined by the amount of gold or silver
prospectors happen to discover.
• Disadvantage: Counterfeiters usurp a privilege of the government, which has the sole legal right to print bills. The
benefits that counterfeiters get by exchanging fake bills for real bills comes at the expense of the government.
Value of Money
1. Intrinsic value: Value ‘in itself’, for example gold or cigarettes, this is only a few cents for a $20 bill
2. Nominal value: Value ‘in name only’ (=value printed on bank note), $20 bank note is worth $20 because it says
so, but the value of the paper is much less than this
3. Seignorage: Central banks have a monopoly on the issuance of bank notes and they make profit by doing so,
because of the difference between the intrinsic and nominal values. If the ECB issues a $100 bank note, the
intrinsic value is a few cents while the nominal value is $100, so they made a $99 profit.
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,Short history of monetary systems
Measuring the Money Supply
• Monetary aggregates: overall measures of the money supply, which differ in how strictly money is defined
• M0: bank notes + coins
• M1: M0 + checking account (ATM)
• M2: M1 + near-money (easy access)
• M3: M2 + ‘near, near money’ (assets that can be sold quickly)
Since the breakdown of the Bretton Woods system a lot of money has come into circulation. Many people are
concerned that these bank notes will lose their value.
Monetary Base
• Monetary base = the sum of currency in circulation and reserves held by banks
The Monetary Role of Banks
• Roughly 40% of M1 consists of currency in circulation, the rest consisted of bank deposits, and deposits account for
the great bulk of M2
• By either measure, bank deposits are a major component of the money supply
What banks do:
• A bank uses liquid assets in the form of bank deposits to finance the illiquid investments of borrowers
• Banks can create liquidity because it isn’t necessary for a bank to keep all of the funds deposited with it in the form
of highly assets
• Banks can’t lend out all the funds placed in their hands by depositors because they have to satisfy any depositor who
wants to withdraw his or her funds
• In order to meet these demands, a bank must keep substantial quantities of liquid assets on hand
• Bank reserves: the currency banks hold in their vaults plus their deposits at the Federal Reserve
• A T-account is a tool for analysing a business’s financial position by showing, in a single table, the business’s assets
and liabilities
• Reserve ratio: the fraction of bank deposits that a bank holds as reserves
• If a significant share of its depositors demanded their money back at the same time, the bank wouldn’t be able to
raise enough cash to meet those demands.
• The reason is that banks convert most of their depositor’s funds into loans made to borrowers; thats how banks earn
revenue - by charging interest on loans
• Bank run: a phenomenon in which many of a banks depositors try to withdraw their funds due to fears of bank
failure
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, The balance sheet
• Double-sided book keeping (the T-account)
• Represents the assets and the liabilities of a company
• The balance sheet must always balance
• Payments must be written on both sides
Assets Liabilities
Assets: goods and resources Liabilities: debts of the company
owned by the company Private equity: contribution of owners
and past earnings
Investments: What do you do Sources of finance: Where does the
with the money? money come from?
Examples: buildings, machines, Examples: private equity, loans
equipment
The balance sheet of a bank
• Make a profit from the interest rate on their loans
• Source of money: deposits
• Deposits are taken out again, as loans to other customers
• Reserve: a rule by the government, this is to ensure the financial system is safe. Banks cannot loan out all the
money they receive in deposits, so they must keep a reserve account.
Assets Liabilities
Loans $1,200,000 Depostis $1,000,000
Reserves $100,000 Private equity $300,000
Commercial bank balance sheet:
• A typical business has a large amount of private equity
• Banks have little equity, they consists of mainly borrowed money. This poses a risk, since if a loan fails the company
goes bankrupt, and this becomes a liability which is taken out of their private equity
Are banks too big to fail?
• On average, the financial sector of a Euro country is 3.5X the size of its GDP
• When a bank is declared bankrupt, the national government has to step in
• Governments guarantee banks to keep voters happy
• However, if all banks go bankrupt there is no way the government can guarantee every account, since it does not
have this much money available
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