CHAPTER 13 – MONEY AND BANKS

I. Introduction
A. This chapter answers the following questions:

1. What is money?

2. How is money created?

3. What role do banks play in the circular flow of income and spending?

II. What Is Money?
A. Without money, you would have to use barter to get items you want.
B. Barter – The direct exchange of one good for another, without the use of money.
C. The use of money in market transactions depends on sellers’ willingness to accept money as a medium of exchange.
D. World View: “The Cashless Society. Bartering Chokes Russian Economy”
This Washington Post article discusses how bartering is keeping factories producing in Russia. When the Russian ruble lost its value, people would no longer accept it in payment. Market transactions had to be bartered, a clumsy and inefficient process.
E. 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:

   1. Medium of exchange: Is accepted as payment for goods and services (and debts).

   2. Store of value: Can be held for future purchases.

   3. Standard of value: Serves as a measurement for the prices of goods and services.

2. After the colonies became an independent nation, the U.S. Constitution prohibited the federal government from issuing paper money. Money was instead issued by state chartered banks.

3. Between 1789 and 1863, paper bills were issued by state banks.

4. Over 30,000 different paper bills were issued by 1600 banks in 34 states.

5. People preferred to be paid in gold, silver, or other commodities rather than the uncertain paper currency.

6. The first paper money issued by the federal government was called “greenbacks” and was printed in 1861 to finance the Civil War.

7. The National Banking Act of 1863 gave the federal government permanent authority to issue money.

B. Modern concepts

1. The “greenbacks” we carry around today are not the only form of “money” we use.

2. Checking accounts can and do perform the same market functions as cash. Therefore, they must be included into our concept of money.

3. Money – Anything generally accepted as a medium of exchange.

4. The essence of money is not its physical form (taste, color, and feel), but its ability to purchase goods and services.

5. Credit cards are another popular medium of exchange but are not money. They are only a payment service with no store of value in and of themselves.

6. World View: “The Check in Still in the Mail”
   Checks are the most common form of payment in the US, but non-check payments are more popular in Canada, Europe and Japan.

7. 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. M1: Cash and Transactions Accounts. (Figure 13.1, Page 265)

1. Money Supply (M1): - Currency held by the public, plus balances in transactions accounts.

2. M1 includes:

• Currency in circulation

• Transaction-account balances

• Traveler’s checks

3. Transaction-account balances are the largest component of the money supply.

4. Transactions Account – A bank account that permits direct payment to a third party (e.g., with a check)

5. Transaction accounts are usually checking accounts but others include NOW accounts, ATS accounts, credit union share drafts, and demand deposits at mutual savings banks.

6. The distinguishing feature of transaction accounts is that they permit direct payment to a third party (by check).

D. M2: M1 + Savings Accounts, etc. (Figure 13.1 and Table 13.1, Page 266)

1. M2 Money Supply – M1 plus balances in most savings accounts and money market mutual funds.

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.

4. Aggregate Demand – The total quantity of output demanded at alternative price levels in a given time period, ceteris paribus.

5. The official measures of the money supply (particularly M1 and M2) are fairly reliable benchmarks for gauging how much purchasing power market participants have.

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

1. Deposit Creation – The creation of transactions deposits by bank lending.

2. 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.

3. When a bank lends someone money, it simply credits that individual’s bank account.

4. In making a loan, a bank effectively creates money because transactions-account balances are counted as part of the money supply.

5. Two basic principles of the money supply are:

• Transactions-account balances are a large portion of our money supply

• Banks can create transactions-account balances by making loans.

6. Bank Regulation (Table 13.2, Page 268)

• The deposit-creation activities of banks are regulated by the government.

• The essential functions of a bank are to: accept deposits, offer check-writing privileges and to make loans.

7. A Monopoly Bank - Money creation in a one bank town.

• Assume a student deposits $100 from their piggy bank into the monopoly band and receives a new checking account.

• When someone deposits cash or coins in a bank, they are changing the composition of the money supply, not its size.

• The initial loan

1. The monopoly bank loans $100 to the Campus Radio station and issues a checking account. This loan is accomplished by a simple bookkeeping entry. The total bank reserves have remained unchanged.

2. Bank Reserves: Assets held by a bank to fulfill its deposit obligations.

3. Money has been created because the checking account is considered to be money.

4. Secondary Deposits - In a one bank system, when Campus Radio uses the loan, the money supply does not contract, rather ownership of deposits change.

5. Fractional Reserves

• Bank reserves are only a fraction of total transaction deposits.

• Reserve Ratio - The ratio of a bank's reserves to its total deposits.

• Formula:
   

  Reserve Ratio =	Bank Reserves
  	Total deposits

• The Federal Reserve System requires banks to maintain some minimum reserve ratio.

• The ability of a bank to hold fractional reserves is based on two facts.

1. Required Reserves

• Required Reserves - The minimum amount of reserves a bank is required to hold by government regulation; equal to required reserve ratio times transactions deposits.

• Formula:  

Required Reserves =

Minimum Reserve ratio  X

Total Deposits

8. The minimum reserve requirement directly limits deposit-creation possibilities.

C. A Multibank World (Table 13.3, Page 273)

1. In reality, there is more than one bank.

2. The ability of banks to make loans depends on access to excess reserves.
   Example: If a bank is required to hold $20 in reserves but has $100 currently, it can lend out the $80 excess.

3. Excess Reserves

• Excess Reserves - Bank reserves in excess of required reserves.

• So long as a bank has excess reserves, it can make loans.

• Excess reserves are reserves a bank is not required to hold.

• Formula:
  
  

  Excess Reserves =

  Total Reserves  -

  Required Reserves

• The T- account of the bank.

• Assets – Items on the left side of the T-account. These are things the bank owns or is owed by others such as cash in the vault, loans to bank customers, reserve credits at the Federal Reserve and securities the bank has purchased

• Liabilities – Items on the right side of the T-account. The bank owes these things to others. The largest of these are deposits of bank customers.

• The books of a bank must always balance, because all of the assets of the bank must belong to someone (its depositors or its owners).

4. Changes in the Money Supply – The creation of transaction deposits via new loans is the same thing as creating money.

5. More Deposit Creation – as the excess reserves are loaned out again, more deposits are created and thus more money is created.

V. The Money Multiplier (Figure 13.2 and Table 13.4, Page 274)
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). This is known as the money-multiplier process.
B. Money Multiplier – The number of deposit (loan) dollars that the banking system can create from $1 of excess reserves; equal to 1 /required reserve ratio
C. Formula:
 

Money Multiplier =	1
	Required Reserve Ratio

D. When a new deposit enters the banking system, it creates both excess and required reserves.

1. The required reserves represent leakage from the flow of money, since they cannot be used to create new loans.

2. Excess reserve can be used for new loans.

3. Once those loans are made, they typically become transactions deposits elsewhere in the banking system.

4. Some additional leakage into required reserves occurs, and further loans are made. The entire banking system can increase the volume of loans by the amount of excess reserves multiplied by the money multiplier. The money supply can be increased through the process of deposit creation to this limit.

Formula:
 

E. Excess Reserves as Lending Power

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

2. The entire banking system can increase the volume of loans by the amount of excess reserves multiplied by the money multiplier.

VI. Banks and the Circular Flow
A. Banks perform two essential functions for the macro economy: (Figure 13.3, Page 276)

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. Financing Injections

1. The consumer saving is a leakage. If additional spending by business firm, foreigners, or governments does not compensate for consumer saving at full employment, a recessionary gap will emerge, creating unemployment.

2. A substantial portion of consumer saving is deposited in banks. These and other bank deposits can be used to make loans, thereby returning purchasing power to the circular flow.

3. The banking system can create any desired level of money supply if allowed to expand or reduce loan activity at will.

D. 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.
B. Bank Panics

1. Occasional “runs” of depositors rushing to withdraw their funds have created panics in the past. As word spread, it became a self-fulfilling confirmation of a bank’s insolvency.

2. The resulting bank closing wiped out customer deposits, curtailed bank lending, and often pushed the economy into recession.

3. As their reserves dwindled, the ability of banks to create money evaporated and a chunk of money (bank deposits and loans) just disappeared.

4. In the early part of the Great Depression (1930-1933), 9000 banks failed.

C. Deposit insurance - 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.
D. The S & L 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. Consequently, many S&Ls failed. In 1988, more banks failed (200) in any year since the Great Depression.

4. The 1990-91 recession pushed still more banks into insolvency.

5. In The News: “Bank Reopens to Customer’s Questions”
   The article describes the failure of Superior Bank and its reopening under supervision of the FDIC.

E. 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. Parts of the bailout funds were recouped from this effort.

COMMON STUDENT ERRORS

Students often believe the following statements are true. The correct answer is explained after the incorrect statement is presented.

1. Banks cannot create money. It should be obvious by now that banks and other depository institutions are very important participants in the money-supply process. They create money by granting loans to borrowers and accomplish their role by adding to their customers’ transaction accounts. The accounts are money just as much as the printed money in your wallet is money. The banks create (supply) money, but only in response to borrowers’ demands for it. Without customers “demanding” loans, banks wouldn’t be able to create money at all.

2. Banks hold your deposits in their vaults. You can look at this two ways. First, when you deposit your paycheck, there’s nothing for the bank to “hold” in its vault, except the check, and that is returned to the person who wrote it. Second, if you deposited coin or cash, it’s all put together and you cannot distinguish any one person’s deposit from any other person’s deposit. Even then, when “cash in vault” becomes too large, much of it is shipped away by armored truck to the Federal Reserve Bank. Thus, banks do not hold your deposits in their vaults.

3. Gold and silver are intrinsically valuable and are necessary to secure the value of a currency. While precious metals such as gold and silver have frequently been used to back currencies, they do not back the dollar today. Like other commodities, heir value in terms of dollars continually fluctuates in response to supply and demand conditions. International monetary authorities have attempted to “demonetize” the precious metals and have been successful in holding the price of these metals down in terms of the major currencies. Nevertheless, during periods of calamity and fear, these precious metals are hoarded because people believe these items have intrinsic value; they then do take the role of a store of value.

4. Banks are irresponsible if they fail to store all of the money that is deposited with them so that it is available on demand. Banks must lend most of the money that is deposited with them so that they can earn interest and pay interest on those deposits.