Jim’s Notes

Money and Banking

What Is Money?

History of Money – 2 Versions

Classical version – not historically well-supported

Historical search for a socially-acceptable, universal barter commodity
Livestock
Precious metals/ Jewels
Coins
Token money
Commodity- or metal-backed paper money
Currency-backed by Other Currency and Exchange
Fiat money

‘Chartal’ version – supported by archeaological and anthropological evidence

Governments /rulers require that taxes be paid using the govt-issued tokens only
tokens are declared ‘legal tender’
this creates a value and a demand for the tokens among the public
Governments or rulers issue tokens as payment when purchasing goods and services
government spending becomes a mechanism for suppying ‘money’ to the economy
Private paper money (‘notes’) which is evidence of debt (promise to repay) may, if legal, also circulate and be used as money
but definition of the units of the private money (currency units) depends on the government-issued money definition and promise of convertibility

Credit – evidence of a debt

Way of matching transactions over time

‘Social Contrivance’

Anything generally accepted as legal tender or in payment of taxes

Medium of Exchange

Facilitates trade

Purchasing Power

substitute for real assets

Money solves problems

Reduces Transaction Costs

‘medium of exchange’
eliminates ‘coincidence of wants and time’ that barter has

Store of value

eliminates need to complete both sides of a real economic trade at the same moment in time
Example:
seller delivers real economic good/service to buyer now
buyer delivers ‘money’ , a token of real economic value, to seller now
seller completes the real economic trade sometime in the future when they convert the ‘money’ (token) into a real economic good/service by buying something

Term of Account

standardized unit to measure economic value and debts

Definitions and measures of money

Monetary Base:

Money issued by Central Bank/Government:

Currency and coins
Bank reserves held at Central Bank

Spending Money (liquid): M1

Public’s Liquid spending power in circulation among public

currency and coins in circulation among public
checking accounts (demand deposits at commercial banks)
traveler’s checks

Less Liquid Money: M2

Slightly less liquid than M1

All of M1
Time deposits at commercial banks
Certificates of Deposit at banks

What about credit cards? Debit cards?

Debit cards represent ‘money’ since they use checkable deposit balances

Credit cards are not considered ‘money’ per se

Credit cards are actually ability to create loans.
Since credit cards create new loans (credit card balances), they create new money.

The ‘Money Supply’ usually refers to quantity of M1 in circulation unless otherwise stated

Structure of a modern ‘fractional reserve’ bank

Modern Bank Not Like Your Piggy Bank

A ‘piggy-bank’ is a 100% reserve bank: a safe storage for all the money.

Modern banks are ‘fractional reserve’ banks

Depositors’ money has been loaned out.

At any one time, only part of deposited money is in bank as reserves (cash)

If all depositors ask to withdraw all deposits at the same time, there will not be enough reserves to pay all depositors. The bank ‘fails’.

The following must be always be true: (accounting identities and definitions)

Total Assets = Total Liabilities+Equity

Bank’s point of view.

Loans are considered assets
Deposits are liabilities

’Reserves’ are cash the bank can use to pay depositor’s withdrawals

Balance Sheet:

Assets

Reserves
In vault – cash on hand
Deposits at The Fed (central bank)
Securities Owned (Bonds) – often securities issued by (loaned to) other banks/investors
Loans

Liabilities

Deposits
checkable deposits
savings and longer-term deposits
Short-term Bonds and Securities Issued – often money borrowed from other banks/investors
Capital (equity) of the bank shareholders
Paid-in capital to buy bank’s stock
Retained Profits

Creation of Money by Private Banks – Analyzing Reserves

Banks create new ‘money’ (purchasing power) by making new loans

Analyzing reserves: key relationships

Total reserves = Cash on hand in vault + deposits at central bank

Total reserves can also be split into ‘required’ and ‘excess’

Total Reserves = Required Reserves + Excess Reserves

Required Reserves = Banks’ total demand deposits * RequiredReserveRatio

RequiredReserveRatio = RequiredReserves / Total Demand Deposits

How much money a bank can lend depends on reserves

Determine ‘required reserves’: Banks estimate likely withdrawals and the banks’ desired ‘safety cushion’

–> ‘Desired’ reserves or ‘Required reserves’
In some cases, such as US demand deposits at commercial banks, the Central Bank sets a minimum reserve ratio (rr)
many nations’ central banks do not require a fixed minimum reserve ratio
Required Reserve Ratio (rr): reserves as % of deposits
Set by The Federal Reserve since 1913 for demand deposits
Required Reserve ratio presently 10% (typically 10% to 20%).

ONLY Excess reserves can be used to create new loans

thus, if a bank has only the required reserves and has no excess reserves, it cannot make a new loan

New loans create new M1.

Make Loans from ‘excess reserves’

New Loans create new ‘purchasing power’

–> new ‘money’ (M1

Let’s Look at An Example – story of Acme Bank

Notice that:

M1 only increases if a loan is being made
New loans (borrowing) creates new money (increases M1)
Paying off loans destroys (reduces) money
the bank can only loan if it has excess reserves
new bank deposits help increase the bank’s reserves
withdrawals from the bank deplete the bank’s reserves

Deposits and the banking cycle

New deposits increase total reserves

part of deposit increases required reserves (deposit times rr)
rest of deposit increases excess reserves and is available to make new loans

A lending bank prefers making loan available as a deposit to a checking account since the deposit transaction creates more reserves

this should be considered as two transactions: a loan and a deposit

Money Multiplier cycle

New Loans (new M1) generally create new deposits at some bank

Banking system-wide loan and deposit cycle: new loans –> new deposits –> new reserves –> new excess reserves –> new loans

an intial increase in bank reserves (either from a new deposit or from central bank) will multiply after many cycles into a much larger increase in money supply (M1)

Required Reserve Ratio limits how fast new money is created (how big and fast the cycles are)

higher required reserve ratio –> higher required reserves –> lower excess reserves –> smaller/fewer loans

lower required reserve ratio –> lower required reserves –> higher excess reserves –> more and larger loans

Money Multiplier:

theoretical limit on how much new M1 can be created system-wide AFTER all cycles of loan-deposit-loan are exhausted

‘ultimate’ or ‘maximum’ or ‘eventual’ increase in M1 after an initial deposit or reserve increase

money multiplier = 1/ rr

Example: if rr = 20%, then money multiplier = 1/ .20 = 5
an initial increase of $2000 in M1 from the central bank when rr= 20% could become as much as 2000 x 5 = 10,000 increase in M1 after all cycles of lending are exhausted