Chapter 27. Money and Banking. In this chapter you will learn to. 1. Describe the various functions of money, and how money has evolved over time. 2. Describe the roles of commercial banks and central banks in modern banking systems.
Money and Banking
1. Describe the various functions of money, and how money has evolved over time.
2. Describe the roles of commercial banks and central banks in modern banking systems.
3. Explain how commercial banks create money through the process of taking deposits and making loans.
4. Describe the M1 and M2 measures of the money supply.
What Is Money?
Money is a medium of exchange.
If there were no money, goods would have to be exchanged in a system of barter.
Barter is very inefficient due to the double coincidence of wants. Money makes it unnecessary.
Money is also used as a store of value.
- without high inflation, money retains its value
Finally, money is used as a unit of account.
- used to keep our financial accounts
LESSONS FROM HISTORY 27.1
Hyperinflation and the Value of Money
Money has evolved over time, taking various different forms:
Today, almost all currency is fiat money.
Money held as deposits with commercial banks and other financial institutions is called deposit money.
Bank deposits are an important part of the money supply.
As in the past, banks create money by issuing more promises to pay (deposits) than they have in cash reserves.
Most banking systems have:
- a central bank
- many financial intermediaries
A central bank acts as a bank to the banking system:
- usually a government-owned institution
- through it, the government conducts monetary policy
Created by an act of Congress in 1913.
The basic functions of the Fed are to:
Most of our discussion will focus on the Fed’s role in controlling the money supply monetary policy
A commercial bank is a privately owned, profit-seeking institution that provides a variety of financial services:
- accepts deposits
- makes loans
- provides credit-card services
- offers wealth-management services
APPLYING ECONOMIC CONCEPTS 27.1
The Structure of the Federal Reserve System
Banks’ cash reserves are normally quite small because only a small fraction of depositors want their money at any time.
A bank’s reserve ratio is the fraction of deposit liabilities that it actually holds as reserves
- either vault cash or deposits with the central bank
A bank’s target reserve ratio is the fraction of deposits it wishes to hold as reserves.
The U.S. banking system is a fractional-reserve system
Any reserves in excess of target reserves are called excess reserves
- these are central to the process of “money creation”
Some Simplifying Assumptions
- banks invest only in loans
- there are only demand deposits
- all banks have a fixed target reserve ratio
- there is no cash drain from the banking system
A single new deposit begins a long sequence of deposit creation.
With the target reserve ratio of 20%, the new deposit of $100 creates a total expansion of deposits of $500.
With no cash drain, a banking system with a target reserve ratio of v will change its deposits by 1/v times any change in reserves (the new deposit).
ΔDeposits = (1/v) ΔReserves
Deposit creation does not happen automatically; it depends on the decisions of bankers.
A cash drain:
- if households hold a fraction of their deposits in cash, the deposit-creation process is dampened
If c is the currency-deposit ratio, the final change in deposits will be given by:
The money supply is the total quantity of money that is in the economy at any time
- several definitions of “money”
Money supply = Currency + Deposits
The long-standing distinction between money and other highly liquid assets was:
- money was a medium of exchange that did not earn interest
- other assets earned interest but were not a medium of exchange
Today this distinction is very blurred.
- assets that are a store of value and are readily converted into a medium of exchange
- short-term bonds
- term deposits
- things that serve as a temporary medium of exchange but are not a store of value
- credit cards
Choosing a Measure
There is no single, timeless definition of money.
New financial assets are continually being developed that serve some of the functions of money.
The Role of the Federal Reserve
We have seen how commercial banks can expand reserves into deposit money.
The Federal Reserve has great influence over the amount of reserves in the banking system.