Chapter 9
Money and Banking
Chapter Summary
(1) Money serves three major functions: as a medium of exchange, which allows individuals to work for a money wage rather than for receipt of a commodity; as a measure of value, which provides a common denominator for measuring prices, costs, revenues, and income; and as a store of value, which allows individuals to postpone the spending of current money income and thereby save.
(2) Financial instruments other than money may serve as a store of value. The decision to hold one of these alternative financial instruments depends upon the saver's time horizon, the return on alternative financial instruments, and the willingness of savers to assume risk.
(3) Depository institutions provide savers with liquid, safe financial instruments which are good stores of value for money. As a result of these substitutes, the Federal Reserve publishes three definitions of money: MI, which is a medium-of-exchange definition, and M2 and M3, which include M I as well as liquid financial instruments issued by deposit intermediaries.
(4) The Federal Reserve (the "Fed") controls the quantity of check-writing deposits in the United States by placing a reserve requirement on checking deposits and by controlling the amount of reserves held by banks.
(5) The relationship between the maximum amount of check-writing deposits issued by banks (D„,„) and the amount of reserves held by banks (R) is given by the equation D„,, = d R, where d equals Ur, and r is the reserve requirement on check-writing deposits. Reserves consist of currency held by banks plus deposits at Federal Reserve Banks.
(6) The MI money supply depends upon the amount of reserves held by banks, the reserve requirement on check-writing deposits, and the amount of currency held outside the banking system. In equation form, Ml = nil B; B (the monetary base) is the sum of currency outside banks and reserves held by banks; ml = ( I + c)/(r + c) where c (the currency ratio) is CID (C represents currency outside banks; D represents check-writing deposits).
Important Terms
Asset. Something which is owned by an individual, business. or government.
Check-writing deposit. A bank liability which is payable to the owner upon demand or is transferred to another party by the writing of a check.
Currency ratio. The ratio of currency outside banks (C) to check-writing deposits (D); c = CID.
Deposit multiplier. The multiple effect that bank reserves (R) have upon check-writing deposits; the deposit multiplier is expressed as d = DIR. The maximum value of the deposit multiplier is 1/r.
Depository Institutions. An institution which borrows (accepts as deposit) money and promises to repay the sum borrowed plus interest upon demand or at a specified future date. Examples include commercial banks, savings banks, savings and loan associations, and credit unions.
149
150 MONEY AND BANKING {CHAP. 9
Excess reserves The amount of reserves held by banks in excess of those that are required.
Financial instrument. The document issued by one party who secures funds from another party who has saved.
Financial market. A market in which newly issued financial instruments transfer current saving to those who wish to borrow or in which previously issued financial instruments are exchanged.
Liability. An amount owed by an individual, a business, or a government.
Liquid financial instrument. An instrument which can be converted into money quickly and with little or no loss of nominal capital value.
Mt The medium-of-exchange definition of money: consists of currency outside banks plus check-writing deposits
issued by deposit intermediaries.
M2. An expanded definition of money: consists of MI, savings deposits, small time deposits (up to $100,000), non-
institution money-market mutual funds, and overnight Eurodollars and RPs.
MS. A more inclusive definition of money: consists of M2, large time deposits, institution money-market mutual funds, and term RPs and Eurodollars.
Monetary base (B). The sum of currency outside banks (C) plus reserves held by banks (R); B = C + R. Money multiplier (m1). The multiple effect that reserves have upon the M1 money supply; M UR = m 1. Net worth. The total assets of an individual or business less its total liabilities.
Required reserves. The reserves a bank must hold relative to the amount of check-writing deposits the bank has issued.
Reserves. The amount of currency held by banks and bank deposits at Federal Reserve Banks.
Outline of Chapter 9: Money and Banking
9.1 The Functions of Money
9.2 Financial Instruments and Markets
9.3 Depository Institutions
9.4 Banks, Check-Writing Deposits, and the Ml Money Supply
9.5 Creation and Control of the Check-Writing Deposit
Component of the MI Money Supply
9.6 Determinants of the M1 Money Supply
9.1 THE FUNCTIONS OF MONEY
Money serves as a medium of exchange, a measure of value, and a store of value. As a medium of exchange, money is the payment made to economic resources for their services, which the owners of these resources use to purchase goods and services. For example, labor is paid a money wage; individuals use this money to purchase food, clothing, and shelter. Paper currency and check-writing accounts comprise the medium of exchange in most countries. While paper currency issued by the federal government has no intrinsic value, it is accepted for transactions because it has value in exchange. Check-writing deposits are liabilities of banks. Money serves as a measure of value in that it is the common denominator for measuring prices, costs, revenues, and income. For example, a newspaper costs 500; Corporation A reports revenues of $100 million; workers at Corporation B earn $9.85 per hour. Money functions as a store of value in that the money received today can be saved and held for expenditures at some future date
EXAMPLE 9.1. Although coins have metal content, their value as a metal is less than the face value of the coin. Paper currency has no intrinsic value in the United States since it consists of Federal Reserve notes which are non-collateralized liabilities of the Federal Reserve, i.e., the Federal Reserve holds no specified commodity to back up the
CHAP. 91 MONEY AND BANKING 151
paper currency that it has issued. U.S. paper currency and coins are therefore fiat (faith) money since their value as a medium of exchange exceeds their nonmonetary value. In the United States, check-writing accounts are deposits at commercial banks, savings banks, savings and loan associations, and credit unions: ownership of funds in these deposit accounts is transferred from one owner to another by the writing of a check.
9.2 FINANCIAL INSTRUMENTS AND MARKETS
Savings can be held in financial assets other than money. Since currency and check-writing deposits offer savers little or no interest return, many savers are willing to transfer money balances they do not intend to spend for a period of time into a higher-yielding financial instrument. A credit or debt financial instrument is one which requires that a borrower make periodic interest payments and repay the amount loaned at the end of a contract period. An equity financial instrument gives the saver partial ownership of a firm and a share of its profits. Many financial instruments are marketable and can be sold to another party in a secondary financial market. A financial instrument is liquid when the current owner can quickly convert it into a money balance with a minimal loss of nominal capital value. A saver therefore has a choice of holding a liquid financial instrument or money as a store of value. The portfolio decision of holding money, liquid financial instruments, or illiquid financial instruments depends upon the time horizon of the saver. the return on these alternative financial assets, and the willingness of the saver to assume risk.
EXAMPLE 9.2. Savers can lend a money balance to others for a specified period of time. Suppose individuals consume $90 billion of their $100 billion income. The $10 billion saved is recorded in the following T account for Savers by ( 1 ) the $10 billion increase in money assets and the $10 billion increase in net worth. Suppose that, in an effort to earn a higher interest return, Savers lend the $10 billion money balance to Borrowers for a one-year period. This $10 billion loan is recorded as (2) a $10 billion decrease in the money assets of Savers and a $10 billion increase in the financial asset "I-year note of Borrowers." Borrowers' T account entries would be (3) a $10 billion increase in money assets and a $10 billion increase in their liabilities noted as "1-year note issued to Savers."
Savers
AAssets / &Liabilities & ANet Worth(a) / Money / +$10 billion / (I) / Net Worth / +$10 billion
(b) / Money / —$10 billion
(2) / I-year note of
Borrowers / +510 billion
Borrowers
SAssets ALiabilities
(3) Money +$10 billion
(3) 1-year note +$10 billion
issued to Savers
EXAMPLE 9.3. A financial instrument's liquidity depends upon the current holder's ability to convert it into money quickly with minimal loss of nominal capital value. Suppose Saver A lends $100.000 to Corporation Z for two years; the debt contract stipulates that Corporation Z must pay an annual 6% rate of interest on the $100,000 borrowed and repay the sum borrowed at the end of the second year. Suppose that one year later. Saver A needs cash and wishes to sell Corporation Z's note in the secondary market: assume market interest rates have risen from 6% to 7%. Corporation Z's debt instrument now has one year to maturity. Investors will not pay $100.000 for this debt instrument in the secondary market since the debt contract provides only a 6% interest payment. Saver A. however. may sell this note to Saver B for 599.065.42 since the note's rate of return increases to 7% when priced at 599.065.42. 'The 56000 interest payment plus the $934.58 capital gain (difference between the price paid for the note and the sum repaid at maturity) provides Saver B a 7% rate of return. since ($6000 + 5934.58)/$99.065.42 = 7%.I Saver A. however. earns a return less than 6% in holding the note for only one year. because the note was sold for less than its purchase price. Although the note sold quickly in the secondary market. Saver A experienced a $934.58 capital loss (a loss of nominal value) as a result of selling the debt instrument prior to maturity. The liquidity of a financial instrument depends upon how large a capital loss a saver might incur when a financial instrument is convened back into money prior to maturity.
152 MONEY AND BANKING ICHAP. 9
93 DEPOSITORY INSTITUTIONS
Depository institutions (commercial banks, savings banks, savings and loan associations, and credit unions) borrow savers' money balances and lend them to individuals, businesses, or government. By pooling the funds of many small savers and investing in a diversified portfolio of financial instruments, depository institutions reduce the transaction costs and risks associated with lending to a borrowing unit. In the United States, the Federal Deposit Insurance Corporation (FDIC) insures the liabilities of deposit intermediaries. Savers therefore readily hold the liquid, non-check-writing liabilities of these depository institutions since they normally offer a higher interest return than money. Because the liabilities of depository institutions are liquid and therefore good stores of value, the Federal Reserve presents an MI, M2, and M3 definition of money. The M I definition is a transaction definition and consists of currency and check-writing deposits, while M2 and M3 add other liquid financial instruments to the MI definition (see Example 9.4). At the end of 1993, the M I money supply totaled $1128.4 billion, while the M2 money supply was $3564.5 billion and the M3 money supply was $4228.3 billion.
EXAMPLE 9.4.
Current measures of the money supply appear in Table 9-1. Savings deposits consist of passbook. statement, and money-market savings accounts at depository institutions. Small denomination time deposits are certificates of deposit (CDs) issued by these same financial intermediaries in amounts less than $100,000. CDs are classified as time deposits since the depositor agrees to keep these funds on deposit for a specified period of time, although the saver can convert a time deposit into an M I balance by incurring an interest penalty. Noninstitution (individual) money-market mutual fund balances are share liabilities issued by investment companies: these liabilities are valued at SI a share. Some savers keep funds in a money-market mutual fund rather than a savings deposit since this very liquid instrument normally offers a higher interest return. Overnight repurchase agreements (RPs) are large (usually $I million or more). overnight, collateralized loans between a borrower and a lender: overnight Eurodollars are dollar-denominated deposits outside the United States owned by U.S. residents. Large-denomination time deposits are CDs in excess of 5100.000. Tenn repurchase agreements and Eurodollars are longer than one day but still short term.
9.4 BANKS, CHECK-WRITING DEPOSITS, AND THE MI MONEY SUPPLY
When a bank lends. it gives the borrower a check drawn upon itself. An individual receives a check rather than currency when he or she borrows money from a bank since a check is a safer medium of exchange) The Federal Reserve controls the banking system's ability to issue check-writing deposits by imposing a reserve requirement on checking deposits. In the United States, bank reserves consist of currency held by banks and deposits that banks have at Federal Reserve Banks. The reserve requirement (r) on check-writing deposits is currently 10% (r = 0.10): it requires that a bank hold $1 in reserves for each $10 in checking account liability it has at the close of business. Since banks are privately owned in the United States and are managed to maximize profits, they usually expand loans and issue check-writing deposits when they have more reserves than they are required to hold (Example 9.7). Thus, the Federal Reserve can control the amount of check-writing deposits by controlling the reserves held by banks and by setting the reserve requirement on check-writing deposits.
EXAMPLE 9.5. When writing a check. the owner of a checking account instructs the bank to transfer a stipulated dollar amount to a designated payee. Suppose. for example. Individual E writes a check to Retailer G for $50 to pay for an item that he has purchased. When Retailer G deposits this check into her bank and the check clears, the checking deposit balance of Individual E decreases $50. while the checking deposit balance of Retailer G increases $50.