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 Banking 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, etc. 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 of 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 deposited. 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 deregulations. 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 every $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.