CHAPTER 13: MONEY AND BANKING

Note: this chapter is almost complete.

Chapter Outline:

             Money: Definition and Measurement
             Measuring the Quantity of Money
              Financial Intermediaries and their roles
              Financial Regulation, Deregulation and Innovation
                The Fractional Reserve System
                Dangers of a Fractional Reserve System
             Bank Bookkeeping
             Money Creation by Banks
             The Money Multiplier

          Money: Definition and Measure ment
What is money?
Money is anything that is acceptable in exchange for goods and services.

In the past there are many kinds of money that have been used. The main kinds of money
that we countries used and are using include:

1.     Fiat Money - money that is declared as money by the government. This is
includes coins and currency. Fiat money is the circulating debt of the Federal Reserve.
Fiat money has its own advantages and disadvantages:
Advantages: 1) It is cheap to produce and hence is used as a source of revenue for the
government called seignorage. 2) it is easy to carry.
Disadvantages:          1) Because it is cheap to produce, there is a strong temptation to
print more.2) It is susceptible for counterfeiting.

2.      Commodity Money - includes gold, silver and other precious metals.
Advantages: can be used be used for other purposes than money (earrings, necklaces,
Disadvantages: 1) it could be a victim of Gresham's law_ bad money drives out good
money. That is, people may try to give up only debased, mutilated money and hence the
ones circulating could be these "bad" monies. 2) it is heavy to carry. 30 it is susceptible
for counterfeiting as well.

                     3.      Bank Money - are deposits in checking accounts.
Advantages: less susceptible for counterfeiting; 2) easier to use for transactions.
            A barter system is one in which goods and services are exchanged directly
            for goods and services. It requires a double coincidence of wants. For
            example, if I decide that I want a cow, I must find someone who
            has one and she must be willing to trade the cow for something that I have.
            For example, I might have a that the cow owner wants. We can then exchange
the cow for the horse. Such transactions are difficult and clumsy. We can ease the
transition process by using a monetary system.

          A monetary system uses some universally recognized currency to facilitate
          transactions. Now if I wish to acquire a cow, I simply go to the owner of
          the cow and pay money for the cow. I do not need to have something of
          equal value that the cow owner wishes to have. The double coincidence of
          wants is unnecessary.

          We need to carefully define "money." In common usage, the terms money,
          income, and wealth are often used interchangeably. But to an economist,
          money and income are very different things.

          Income is the flow of revenue over a particular time period. For an income
          measurement to make sense, one must define it in terms of a particular time
          period. For example, I earn $8 per hour, or my salary is $1800 per month,
          or my income is $23,000 per year. Without a time qualification, income could
          refer to almost anything. Few of you think of yourselves as millionaires, but in
          your lifetimes you will indeed earn income over $1,000,000.

          Wealth is the value of your stock of assets at a particular point in time. Your
          assets are things of value that you own. For example, your house, stocks, car,
          and funds in your savings account are all part of your wealth. Wealth is a
          stock, it can be added up at any moment in time.

Functions of Money

          Money is something that serves these three purposes. First, it is a me dium
          exchange, or a means for making transactions. Second, it is a unit of account,
          or a standard unit for quoting prices. Third, it is a store of value, a means to
          store wealth from one time period to the next. You can put your money under
          your mattress and it will be there next month. Lots of things can be used as
          money. In much of our history, we used gold and silver. Some places use
          rocks to trade goods. During wars, cigarettes and chocolates are often used.
          As long as the commodity serves the three purposes described above, it can
          be money. In today's world, we use fiat money, or paper money. The money
          is inherently worthless except for the purchasing power that we trust it will
          bring. Without trust, the paper money becomes useless pieces of paper.
          Supply and Measure ment of Money

          Money is measured in terms of its liquidity, how easily it can be converted to
          cash. Currency, by definition, is highly liquid because it is already cash.
          Checking accounts are liquid because one can write checks as a way to carry
          out transactions. Houses and cars, however, are not nearly as liquid.

          The narrowest measure of money which includes only the most liquid assets is
          called M1. M1 includes:

            1.        Currency,
            2.        Demand Deposits (no-interest checking accounts),
            3.        Other Checkable Deposits, and
            4.        Traveler's Checks.

          M2 is a slightly broader definition of money that includes less liquid assets.
          M2 includes:

1.     M1, plus,
1.     Savings Deposits, plus,
2.     Small-Time Deposits (less than $100,000), plus
3.     Money market Mutual Funds (MMMF) and
4.     Money Market Deposit Accounts, MMDA.

          The distinction between M1 and M2 has been narrowing due to advances in
          banking. M2 is much more liquid than it used to be. Currently, we have nearly
          $1.3 trillion in M1 in the economy and over $3.7 trillion in M2.

The role of Financial Interme diaries

Defn. Financial intermediaries are: (1) commercial banks, (2) thrift institutions such as
saving and loan associations, mutual savings banks, credit unions, and (3) money market
mutual funds such as retirement funds, and insurance companies.

These financial intermediaries have four economic functions:

                      a.      They provide liquidity by borrowing short and lending
                              long. They stand to repay loans on short notice. On the
                              other hand, they make loans available for a long time (15,
                              20 years of a mortgage is an example).
                      b.      They minimize the cost of borrowing by bringing lenders
                              and borrowers together. If you want to run a business and
                              you are short of funds (in millions of dollars), you just need
                                to go the financial intermediary to get the necessary funds
                                that hundreds and possibly thousands of people have
                      c.        They reduce cost of monitoring borrowe rs by
                                investigating the creditworthiness of individuals and
                                companies. By depositing your money with your financial
                                intermediary, you avoid the cost of losing your assets if you
                                were to lend it to firm who could have defaulted on its
                                loans. Banks monitor each borrower before and after the
                                loans are provided to the individual or form.
                      d.        Risk pooling- They do this by being able to lend to a large
                                number of borrowers, in which some may be risky
                                borrowers. If the majority of borrowers are less risky and
                                only a few may default, the bank may still come out ahead.
                                The default is spread across all depositors and individual
                                depositors avoid the risk of losing all of their assets. Banks
                                bring together diversified group of borrowers.
                      e.        They create money via the fractional reserve system and
                                multiple creation of deposits (see, Figures 14.2 and 14.3
                                in this chapters) and therefore are responsible in the
                                creation of part of the money supply. About 65% of the
                                money circulation is bank money (called M1, which is
                                basically deposit on checking accounts).

The Value of Money
It depends on:
        1.     Acceptability;
        2.     legal Tender;
        3.     Relative Scarcity.

The Demand for Money
                  1.            Transaction Demand;
                  2.            Asset Demand;
                  3.            Total Demand

Combining the Demand and Supply of Money

(show graphically about here)
The Federal Reserve System (Brief History)

Financial Regulation, Deregulation and Innovation
Banks make money by providing loans. And this is their major source of income. There
is a built- in temptation to loan out every penny they have. But there is also a danger for
banks to run out cash and face a bank run. As a result, financial intermediaries are hea vily
regulated. They are regulated especially in four balance sheet regulations which are:

a.     Capital require ments - the minimum amount of an owner's own financial
resources that must be kept into an intermediary. This is done to discourage financial
intermediaries from making loans that are too risky.
b.     Reserve Requirements - rules setting out the minimum percentages of deposits
that must be held in currency or other safe, liquid assets.
       b.      Deposit Rules - restrictions on the different type of deposits that an
               intermediary can accept. For example, commercial banks in the past
               provided to checking accounts while others were only allowed to provide
               saving accounts. These have changed after the 1980s and 1990s financial
       c.      Lending rules - in the past, S&Ls were allowed only to provide mortgage
               loans while commercial banks were allowed to provide commercial loans.
               These have changed after the 1980s and 1990s financial deregulations.

        How Banks Create Money: The Fractional Reserve System

           Our banking system is called a Fractional Reserve System which means that
           banks must only keep a fraction of the deposits they hold on hand. The rest
           can be loaned out. For example, suppose banks are required to keep 10% of
           deposits on hand. This is called the Required Reserve Ratio (RRR). For
           $100 of deposits, only $10 must be held by the bank. Defining the required
           reserve ratio in percentage terms,

              RRR = required reserves/ total deposits x 100, or

              required reserves = RRR x total deposits / 100.

           Banks are in business like any other private company: to make a profit. They
          earn profits primarily on the spread between the rate they must pay for funds
          and the rate they charge for lending funds.

          Dangers of a Fractional Reserve System

           There are at least two problems with a fractional reserve system. First, the
           financial system is susceptible to bank runs. If depositors lose faith in their
           banks, they run to the banks to withdraw the funds. This happened on a large
           scale during the Great Depression. Since banks have only a fraction of the
          deposits actually on hand at the bank, only the first customers to get in line will
       receive their money.

          The second problem with a fractional reserve system is the possibility of bank
          failures. Since banks are in business to make a profit, they can make poor
          management decisions by making risky loans. Depositor funds are at risk.

          We have developed partial solutions to these problems over the years,
          particularly in the years following the Great Depression. To prevent bank runs,
          we have implemented a system of deposit insurance. Most banks are
          members of FDIC, the Federal Deposit Insurance Corp. This is an insurance
          system that banks pay funds into in order to cover depositors funds if the bank
          fails. This helps to avoid widespread bank runs because depositors are
          assured of the security of their deposits. However, this also leads to an
          incentive system in which depositors do not care how a bank is managed.
          There is no consumer regulation on quality of banks' operations. Even when
          Savings and Loans were going bust in the late 1980s, depositors kept putting
          their money in them.

          To reduce the likelihood of bank failure and bad or corrupt management
          practices, we have developed an extensive system of bank regulation.
          Banks are probably the most regulated companies in the U.S. They are
          subject to frequent audits to make sure loan portfolios are sound and that all
          activities are legal. The system is far from perfect, however, given the recent
          wave of bank failures and corruption.

          Commercial Banks and Bank Bookkeeping

             Capital = Assets - Liabilities.

          The table below lists the most common bank assets and liabilities.
Assets                                      Liabilities
Reserves                                    Checking Deposits
Govt. Securities                            Savings Deposits
Loans Outstanding                           Time Deposits
Reserves are funds that the bank keeps on hand to meet depositor demands
for funds and to satisfy the minimum reserve requirements set by the Federal
Reserve. Reserves can consist of either vault cash or funds held by the Fed for
the bank. Many banks, especially those in large cities, prefer the Fed to hold
onto the cash for them. The funds can be withdrawn at any time.

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