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.

Anything that serves all of the following purposes can be thought of as money:

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

Store of value — can be held for future purchases.

Standard of value — measures price of goods and services

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.

Greenbacks were issued in 1861 by the U.S. Federal government.

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.

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).

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.

Cash is a small part of the money supply.

Currency and coins account for less than a third of the basic money supply.

Most money consists of balances in transactions accounts.

Composition of the Basic Money Supply

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.

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

Banks create transactions-account balances by making loans.

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.

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

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.

The loan is accomplished by a simple bookkeeping entry.

Total bank reserves have remained unchanged.

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.

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

Ability of a monopoly bank to hold fractional reserves is based on two facts:

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.

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

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 are equal to the required reserve ratio times transactions deposits.

The minimum reserve requirement directly limits deposit-creation possibilities.

Excess Reserves

Excess reserves are bank reserves in excess of required reserves.

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

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

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 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.

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

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

Bank three keeps 75% of the new deposit on reserve ($4.69) and loans out $1.56.

Limits of Deposit Creation

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

If the required reserve ratio = .75:

Excess Reserves as Lending Power

Each bank may lend an amount equal to excess reserves and no more.

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.

Increases in money supply tend to increase 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

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.