Global Economics

ECON 2100
Fall 2024
Arathi Bala

Chapter 27: Money and Banking

Learning Objectives
• Defining Money by Its Functions
• Measuring Money: Currency, M1, and M2
• Discuss the role of Banks
• Understand how Banks Create Money
Cowrie Shell or Money?
● Is this an image of a cowrie shell
or money?
● The answer is: Both.
● For centuries, people used the
extremely durable cowrie shell
as a medium of exchange in
various parts of the world.
Credit: Ancient-origins.net
Defining Money by Its Functions
● What the world would be like without money?

● Barter - trading one good or service for another, without using money.

● Double coincidence of wants - a situation in which two people each

want some good or service that the other person can provide.
Functions for Money
● Money - whatever serves society in four functions:

▫ Medium of exchange - whatever is widely accepted as a method of payment.

▫ Store of value - something that serves as a way of preserving economic value

that one can spend or consume in the future.

▫ Unit of account - the common way in which we measure market values in an

economy.

▫ Standard of deferred payment - money must also be acceptable to make

purchases today that will be paid in the future.
Commodity versus Fiat Money
● Commodity money - an item that is used as money, but which also has
value from its use as something other than money.

● Commodity-backed currencies - dollar bills or other currencies with

values backed up by gold or another commodity.

● During much of its history, gold and silver backed the money supply in
the United States.
Commodity versus Fiat Money
● Now, by government decree, if you owe a debt, then legally speaking,
you can pay that debt with the U.S. currency, even though it is not
backed by a commodity.

● Fiat money - has no intrinsic value, but is declared by a government to

be the country's legal tender.

● The only backing of our money is universal faith and trust that the
currency has value, and nothing more.
A Silver Certificate and a Modern U.S. Bill

● Until 1958, silver certificates were commodity-backed money - backed

by silver, as indicated by the words “Silver Certificate” printed on the
bill, pictured at bottom.
● Today, The Federal Reserve backs U.S. bills, but as fiat money
(inconvertible paper money made legal tender by a government
decree).
Measuring Money: Currency, M1, and M2
● The Federal Reserve Bank:
▫ The Central Bank of the United States,
▫ Bank regulator and responsible for monetary policy,
▫ Defines money according to its liquidity.

● The Federal Reserve Bank has two definitions of money:

▫ M1 money supply - a narrow definition of the money supply that includes
currency and checking accounts in banks, savings deposits and to a lesser
degree, traveler’s checks.

▫ M2 money supply - a definition of the money supply that includes everything in

M1, but also adds savings money market funds and certificates of deposit.
M1 Money
● M1 money supply includes:
▫ Coins and currency in circulation - the coins and bills that circulate in an
economy that are not held by the U.S Treasury, at the Federal Reserve Bank, or
in bank vaults.

▫ Checkable(demand) deposits - checkable deposit in banks that is available by

making a cash withdrawal or writing a check.

▫ Traveler’s checks
▫ Savings deposits - bank account where you cannot withdraw money by writing
a check but can withdraw the money at a bank - or can transfer it easily to a
checking account (Prior to May 2020, savings deposits were a part of M2)
M2 Money
● M2 money supply includes:
▫ All M1 types

▫ Money market fund - the deposits of many investors are pooled together
and invested in a safe way like short-term government bonds.

▫ Certificates of Deposit (CD’s) and other time deposits - account that the
depositor has committed to leaving in the bank for a certain period of
time, in exchange for a higher rate of interest.
The Relationship between M1 and M2 Money

M2
M1
Money market funds,
Coins, checkable
certificate of deposits,
deposits, travelers
other time deposits
check, savings
deposits

• M1 = coins and currency in circulation + checkable (demand) deposits

+ traveler’s checks + savings deposits
• M2 = M1 + money market funds + certificates of deposit + other time
deposits.
Where Does “Plastic Money” Fit In?
● Debit card - like a check, is an instruction to the user’s bank to transfer
money directly and immediately from your bank account to the seller.
● Credit card - immediately transfers money from the credit card company’s
checking account to the seller, and at the end of the month the user owes
the money to the credit card company.
▫ A credit card is a short-term loan.
▫ Not considered money.
● Smart card - stores a certain value of money on a card and then one can use
the card to make purchases.
▫ Examples: long-distance phone calls or making purchases at a campus
bookstore and cafeteria
● Credit cards, debit cards, and smart cards are different ways to move money
when you make a purchase.
The Role of Banks
● Most money is in the form of bank accounts, which exist only as electronic
records on computers.
● Payment system - helps an economy exchange goods and services for money
or other financial assets.
● Transaction costs - the costs associated with finding a lender or a borrower
for this money.
● Banks bring savers and borrowers together.
● Banks lower transactions costs and act as financial intermediaries.
Banks as Financial Intermediaries
● Financial intermediary - an institution that operates between a saver
with financial assets to invest and an entity who will borrow those
assets and pay a rate of return.

● Discussion Question: What are institutions in the financial market,

other than banks, that are financial intermediaries?

● Depository institution - institution that accepts money deposits and

then uses these to make loans.
Banks as Financial Intermediaries, Illustrated
Banks as Financial Intermediaries
• Banks act as financial intermediaries because they stand between
savers and borrowers.
• Savers place deposits with banks, and then receive interest payments
and withdraw money.
• Borrowers receive loans from banks and repay the loans with interest.
• In turn, banks return money to savers in the form of withdrawals,
which also include interest payments from banks to savers.
A Banks’ Balance Sheet
● Balance sheet - an accounting tool that lists assets and liabilities.

● Asset - item of value that a firm or an individual owns.

● Liability - any amount or debt that a firm or an individual owes.

● Net worth - the excess of the asset value over and above the amount
of the liability; total assets minus total liabilities.

● Bank capital - a bank’s net worth.

A Bank’s Balance Sheet
• This figure shows a hypothetical and simplified balance sheet for the
Safe and Secure Bank.
A Bank’s Balance Sheet

● T-account - a balance sheet with a two-column format, with the T-

shape formed by the vertical line down the middle and the horizontal
line under the column headings for “Assets” and “Liabilities”.

● The “T” in a T-account has:

○ the assets of a firm, on the left
○ its liabilities, on the right.
Reserves and Bankruptcy
● Reserves - funds that a bank keeps on hand and that it does not loan
out or invest in bonds.

● The Federal Reserve requires that banks keep a certain percentage of

depositors’ money on “reserve”.

● We define net worth of a bank as its total assets minus its total
liabilities.
▫ For a financially healthy bank, the net worth will be positive.
▫ If a bank has negative net worth and depositors tried to withdraw their
money, the bank would not be able to give all depositors their money.
How Banks Go Bankrupt
• Potential problems for a bank:
▫ High rate of loan defaults
▫ Asset-liability time mismatch - the ability for customers to withdraw
bank’s liabilities in the short term while customers repay its assets in the
long term.

• Strategies to reduce risk:

▫ Diversify - making loans or investments with a variety of firms, to reduce
the risk of being adversely affected by events at one or a few firms.
▫ Sell some of the loans they make in the secondary loan market.
▫ Hold a greater share of assets (government bonds or reserves).
How Banks Create Money
• The banking system can create money through the process of making
loans. Given below is the balance sheet of Singleton Bank.

• In the T-account balance sheet above, Singelton Bank is simply storing

money for depositors, and not making loans.
How Banks Create Money
• If Singelton Bank decides to loan out, after maintaining the required
reserves,

• Now, by loaning out $9 million and charging interest, it will be able to

make interest payment to depositors.
• This alters Singelton Bank’s balance sheet:
• It now has $1 million in(required reserves 10%) and a loan to Hank’s
Auto Supply of $9 million.
How Banks Create Money
● Singelton Bank issues Hank’s Auto Supply a cashier’s check for the $9
million.
● Hank deposits the loan in his regular checking account with First
National Bank.
● The deposits at First National Bank rise by $9 million and its reserves
also rise by $9 million.
● Bank lending has expanded the money supply by $9 million.
How Banks Create Money
• Now, First National Bank must hold some required reserves ($900,000)
but can lend out the other amount ($8.1 million) in a loan to Jack’s
Chevy Dealership.
How Banks Create Money
• If Jack’s Chevy Dealership deposits the loan in its checking account at
Second National, the money supply just increased by an additional $8.1
million.
How Banks Create Money
• This money creation is possible because there are multiple banks in the
financial system
• They are required to hold only a fraction of their deposits.
• The loans end up deposited in other banks.
• This increases the deposits and the money supply.
The Money Multiplier and a Multi-Bank System
● If all banks loan out their excess reserves, the money supply will expand.
● In a multi-bank system, institutions determine the amount of money that the
system can create by using the money multiplier.
● The money multiplier formula = 1 / Reserve Requirement
● By multiplying the money multiplier by the excess reserves, we can
determine the total amount of M1 money supply created in the banking
system.
● Discussion Question: If the reserve requirement is 10%, and a bank’s excess
reserves are $9 million, what is the change in the M1 money supply?
Cautions about the Money Multiplier
● The quantity of money in an economy is closely linked to the quantity of
lending or credit in the economy.

● All the money in the economy, except for the original reserves, is a result of
bank loans that institutions repeatedly re-deposit and loan.

● A bank can also choose to hold extra reserves, above the required amount.

● Banks may decide to vary how much they hold in reserves for two reasons:
▫ macroeconomic conditions
▫ government rules
Cautions about the Money Multiplier
● In a recession, banks are likely to hold a higher proportion of reserves
due to fear that customers are less likely to repay loans.

● The Federal Reserve may also raise or lower the required reserves held
by banks as a policy move to affect the quantity of money in an
economy.

● Additionally, if people do not deposit cash, banks cannot recirculate the

money in the form of loans.