MONEY AND BANKS
WHAT IS THIS CHAPTER ABOUT?
This chapter begins by defining money and then establishes the roles of money and how money interacts with banks. Schiller provides numerous examples of definitions of money, including “e-cash.” In addition, the complicated process of money creation is developed in a step by step process which students will be able to understand. Questions to keep in mind while reviewing this chapter are:
1. What is money?
2. How is money created?
3. What role do banks play in the circular flow of income and spending?
KEY TERMS
BarterAggregate DemandRequired Reserves
MoneyDeposit CreationExcess Reserves
Transactions AccountBank ReservesMoney Multiplier
Money Supply (M1,M2)Reserve Ratio
OUTLINE
II. What Is Money?
A. Without money, you would have to use barter to get items you want.
B. The use of money in market transactions depends on sellers’ willingness to accept money as a
medium of exchange.
C. Without money, the process of acquiring goods and services would be more difficult and time-
consuming.
III. The Money Supply
A. Many types of “money”
1. Anything that serves all of the following purposes can be thought of as money:
- Medium of exchange: Is accepted as payment for goods and services (and debts).
- Store of value:Can be held for future purchases.
- Standard of value:Serves as a measurement for the prices of goods and services.
2. Between 1789 and 1863, paper bills were issued by state banks.
- People preferred to get paid in gold, silver, or other commodities rather than the uncertain paper currency.
3. The first paper money issued by the federal government was printed in 1861 to finance
the Civil War.
4. The National Banking Act of 1863 gave the federal government permanent authority to
issue money.
B. Modern concepts
1. The essence of money is not its physical form (taste, color, feel), but its ability to
purchase goods and services.
2. Checking accounts can and do perform the same market functions as cash. Therefore,
they must be included into our concept of money.
3. Credit cards are not money. They are only a payment service with no store of value in
and of themselves.
4. Diversity of bank accounts.
- Spawned by the Monetary Control Act of 1980.
- While there are many forms of “bank” accounts (checking, savings, investment accounts, etc.), some bank accounts are better substitutes for cash than others (i.e. consumers can’t write checks on most savings accounts).
C. Cash and transactions accounts.
1.M1, the money supply, includes:
- Currency in circulation
- Transaction-account balances
- Traveler’s checks
2. Transaction-account balances are the largest component of the money supply. (See
Figure 13.1.)
- The distinguishing feature of transaction accounts is that they permit direct payment to a third party (by check).
- Transaction accounts are usually checking accounts but others include NOW accounts, ATS accounts, credit union share drafts, and demand deposits at mutual savings banks.
D. M2.
1. M2 is the money measure that includes all of M1 plus balances in savings accounts
and money-market mutual funds. (See Figure 13.1.)
2. Savings-account balances are almost as good a substitute as transaction-account
balances.
3. How much money is available affects consumers’ ability to purchase goods and, hence,
aggregate demand.
IV. Creation of Money
A. The deposit of funds into a bank does not change the size of the money supply, but it does
change the composition of the money supply (transfer from cash to transaction deposits).
B. Deposit creation is the creation of transaction deposits by bank lending.
1. The creation of transaction-accounts balances by giving loans increases the money supply
because the new balance is created rather than transferred from another source.
C. The reserves that a bank possesses are only a fraction of its total deposits. The ratio of its
reserves to its total deposits is called the reserve ratio.
D.The Federal Reserve puts limits on the amount of bank lending, thereby controlling the basic money supply. The Fed does this by setting a minimum reserve ratio for all banks.
1.Required reserves is the minimum amount of reserves that the Fed’s imposed reserve ratio forces a bank to maintain:
- Required reserves = minimum reserve ratio x total deposits.
2.Excess reserves is the amount of reserves a bank has above and beyond the required reserves the Fed forces it to maintain. It represents a bank’s ability to make additional loans.
- Excess reserves = total reserves - required reserves.
3.The minimum reserve ratio directly limits deposit-creation possibilities.
E.Multibank system.
1. To keep track of the changes in reserves, deposit balances, and loans that occur in the multibank world, we use balance sheets, or T-accounts.
- On the left side of the T-account are the bank's assets, which consist of what the bank owns or others owe the bank.
- On the right side of the balance sheet are the bank's liabilities, which consist of what the bank owes to others (e.g., transactions account balances).
- A bank's books must always balance, because all the bank's assets must belong to someone (its depositors or its owners).
2.Each bank in the system loans only its excess reserves, and the amounts get smaller and smaller because each successive bank in the system has less and less excess reserves after holding required reserves against the initial deposit received.
V. The Money Multiplier
A. In a multibank system, deposits created by one bank invariably end up as reserves in another bank.
This process can theoretically continue until all banks have zero excess reserves (no more loans
can be made).
B. The money multiplier is the number of deposit dollars that the banking system can create from
$1 of excess reserves. It is equal to $1 / (required reserve ratio).
C. The entire banking system can increase the volume of loans by the amount of excess reserves
multiplied by the money multiplier. This is the limit to which the money supply can be increased
through the process of deposit creation.
VI. Banks and the Circular Flow
A. Banks perform two essential functions for the macro economy:
1. Banks transfer money from savers to spenders by lending funds (reserves) held on
deposit.
2. The banking system creates additional money by making loans in excess of total reserves.
B. Market participants respond to changes in the money supply by altering their spending
behavior (shifting the aggregate demand curve).
C. Constraints on deposit creation.
1. Deposits:Consumers must be willing to use and accept checks rather than cash.
2. Borrowers:Consumers must be willing to borrow the money that banks provide.
3. Regulation:The Federal Reserve sets the ceiling on deposit creation.
VII. The Economy Tomorrow: When Banks Fail
A. A consequence of the fractional reserve system is that no bank can pay off its customers if they all sought to withdraw their deposits at one time.
1. Occasional “runs” of depositors rushing to withdraw their funds have created panics in the past. As word spread, it became a self-fulfilling prophecy as the bank would be forced to shut down when faced with more withdrawals than its reserves.
2. In the early part of the Great Depression (1930-1933), 9000 banks failed.
B. Deposit insurance
1. In 1933-34, the FDIC and FSLIC were created by Congress to ensure depositors that their money would be safe -- thus eliminating the motivation for deposit runs.
C. The savings and loan crisis.
1. The economic conditions in the 1970s saw many S&Ls stuck earning money on low-
interest, long-term loans (mortgages etc.) while having to pay out short-term high-interest
fees to their customers.
2. Competition from new financial institutions (e.g. money-market mutual funds) enticed
deposits away from S&Ls.
3. As a result, many S&Ls failed. In 1988, more banks failed (200) in any year
since the Great Depression.
D. Bank bailouts
1. The S&L failures cost the federal government billions (over $60 billion in 1992 alone) as
the FSLIC and FDIC paid off depositors.
2. The cost was so great the FSLIC itself ran out of funds.
3. The Resolution Trust Corporation was created in 1989 to manage the outstanding loans of banks the federal government had to bail out. Part of the bailout funds were recouped
from this effort.
Chapter 13 - Page 1