An Introduction to Money and the Banking SystemDoes money really make the world

go ‘round?

When people think about economics, they usually think of money. So far, we have not said much about money but yet nearly all economic transactions involve money.

First, a Few Basic Definitions

• Money is anything generally accepted in payment for goods and services– Individuals decide how to allocate income

between spending and savings.• Income is a flow variable of earnings per unit

of time (e.g., salaries are earned per year)• Wealth is the accumulation savings and assets

over time. Wealth is a stock variable – a dollar amount at a point in time.

WHAT ARE THE FUNCTIONS OF MONEY?

Money

Money Function #1: a Medium of Exchange

• Medium of exchange – an object used to pay for goods and services

• Eliminates the need for a double coincidence of wants (the basis of the barter system)

• To function effectively, money must be– easily standardized– widely accepted– divisible– easy to transport– relatively non-perishable

Money Function #2: a Unit of Account

• Unit of account – used to measure the value of a good or service

• Facilitates understanding how much goods and services are worth

• Price tags in a clothing store or supermarket let us know exactly how much we need to cough up in order to make a purchase

Money Function #3: a Store of Value

• Store of value – an object used to store purchasing power

• Money is a liquid asset, making it an attractive way to hold one’s wealth. That is, it’s much easier to convert money from your checking account into cash than it is to convert a 20-year bond into cash.

• Liquidity – the ease in which an asset can be converted to cash– Cash has 100% liquidity, a Van Gogh painting does not

Money Functions: Summary

• Medium of exchange• Unit of account• Store of value

WHAT KINDS OF MONEY ARE THERE?

Money

Two Basic Forms of Money

Commodity money or specie Fiat Money

Other Forms of Money• Checks (promises to pay money on demand)

+ difficult for fraudulent behavior compared to currency and precious metal+ can be written for any amount+ lowers transactions costs (shipping money)– less liquid– need to be cleared (takes 3 business days) through the clearing system– checks can bounce—need some trust

• Electronic Payments (wages & salaries)• Electronic Funds/Cash

– debit cards are used like checks but immediately debits the account of the buyer and credits the account of the seller (eliminates the need for trust)

• E-money – money stored electronically on cards or computer accounts, ex. a Starbucks

gift card

Another Form of Money: Near Money

• Near money may “look” and “act” like money but ultimately falls into a different category

• Two examples of near money– Credit cards provide a useful medium of exchange

and a store of value, but are ultimately a form of credit, because they represent money being loaned out

– Stocks and bonds are a good store of value and unit of value (although their worth fluctuates), but are not accepted as a medium of exchange

Money Forms: Summary

• Commodity money or specie• Fiat money• Checks• Electronic payments• E-money• Near money

WHY DO BANKS EXIST?

The Banking System

Why do Banks Exist?

• Banks exist as the ultimate financial intermediary• This means that they provide a conduit (or they

intermediate) between lenders (savers: households) and borrowers (debtors: firms and other households).

• Banks channel savings into investments. Ex. suppose you are a saver, would you lend your money to a stranger? No! You know nothing about that person. How do you know they will pay you back with interest? Instead, you will keep your money in your pocket or deposit your money… in a bank. The bank then lends your deposits out (it “invests” in households & firms)

Main Banking Functions

• Traditionally, banks specialize in collecting deposits (for safe keeping) and lending funds

• Banks collect information on borrowers and monitor borrowers on the lender’s behalf

• Banks are the backup source of liquidity to all other institutions, financial and non-financial

• Banks are the transmission path for monetary policy (government regulation and supervision of the money supply)

Main Banking Functions: a Diagram

Depositors “invest” in a diversified portfolio of loans and securities

Depositors are offered liquid claims and banks hold more illiquid portfolios

Costs arising from borrower's private info are reduced as banks gather vital borrower information

Banking Functions: Underlying Functions

• In a world without banks, loaning money would be problematic for 3 general reasons:

• Asymmetric Information: one party has more information about a transaction than the other party

• Adverse Selection: some individuals or firms taking a loan are more likely to be a riskier group than another group of borrowers (they may be bad credit risks). Adverse selection occurs before the transaction.

• Moral Hazard: an individual or firm changes its behavior after the transaction

Banking Functions: Underlying Functions

Banks help to minimize these three basic problems by:

• Screening: banks establish good credit risks from bad credit risks by gathering information on assets, liabilities, income etc.

• Monitoring: banks ask for collateral to minimize moral hazard and write restrictive actions into the loan contract to limit a borrower’s activities

• Building long-term relationships: a borrower may have a savings account with thebank, or have business history with a bank. These relationships are important especially for firms– lowers their borrowing costs and makes it easier to obtain a loan– makes it easier for lender to monitor borrower activities especially if monitoring procedures

have already been established. – also, lenders can collect information easily–lowers their lending costs.

• Requiring collateral: helps to overcome the moral hazard because the borrower knows he/she will be penalized a default on the loan occurs. Collateral is a promise to a lender as compensation if the borrower defaults. The borrower must post something of value in order to secure the loan

Banking Functions: Summary

• Primary financial intermediaries• Deposit collections• Primary lending institutions• Risk sharing (collateral & long-term

relationships)• Liquidity creation• Information providers (screening &

monitoring)

WHY DO BANKS NEED TO BE REGULATED?

Bank Regulations

Bank Regulations• Banks are regulated closely because of the importance of

banking on the whole economy.• The government regulates banks to protect consumers and

to prevent undue systemic risk• Nearly all banking systems use the fractional reserve

banking system. This means a bank keep a fraction of its deposits at the bank and loans out the rest to other banks or customers

• Since banks earn interest of their loans, banks have an incentive to loan money. So, there is trade-off between increasing profits and bank soundness and safety. History has shown that governments need to regulate in order to better help banks to manage these trade-offs (risks)

Bank Regulations: Specific Safeguards

• Deposit Insurance: the Federal Deposit Insurance Corporation (FDIC) insures up to $100,000 (Congress recently & temporarily upped this amount to $250,000) in deposits for each individual holding account at the bank, regardless of what happens to the bank. Began in1933 after lots of bank failures.– Designed to create banking stability and prevent bank runs of 1930-32– Due to a few bank failures, people tried to convert deposits into cash. As banks

attempted to meet cash demands, loans fell as banks attempted to convert assets into cash, causing liquidity to fall further. As more banks could not meet cash demands, rumors increased causing confidence in the banking system to erode.

• Bank Supervision: government (FDIC, the U.S. Federal Reserve, Office of the Comptroller of the Currency) conducts bank examinations and can intervene if a bank is failing

• Reserve Requirements: banks must hold a certain fraction of their funds in reserve (10%)

• Regulation D: sets uniform requirements for all depository institutions to maintain reserve balances either with their Federal Reserve Bank or as cash in their vaults. Why? This regulation prevents banks from lending out all of their deposits.

Bank Regulations: Summary

• Regulation exists because of banks’ importance in the micro and macro economies

• Regulation exists to protect consumers and to minimize risk

• Specific regulations that you need to know– Deposit insurance– Supervision through examination (audit)– Reserve requirements

Summary

• Can you answer the following questions?– What are the functions of money?– In what forms does money exist?– How does money differ from near-money?– Why do banks exist?– Why do banks need to be regulated?– What can happen if banks are not regulated or if

bank regulation is lax?