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Chapter 14Econ104 Parks
Money and Banking
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What is Money?
• A barter system is one in which goods and services are exchanged directly for goods and services.– It requires a double coincidence of wants.
• A monetary system uses some universally recognized currency to facilitate transactions.
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Money, income, and wealth
• Income is the flow of revenue over a particular time period.
• Wealth is the value of your stock of assets at a particular point in time.
• Money is something that serves as a– medium of exchange– unit of account– store of value
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• http://www.richmondfed.org/about_us/visit_us/tours/money_museum/index.cfm
• http://www2.moneymuseum.com/frontend/library/pictures/overview.jsp
• http://www.journalofantiques.com/June04/coinsjune04.htm
• http://www.banknotes.com/intro.htm#history
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Measuring the Quantity of Money
• Money is measured in terms of its liquidity, or how easily it can be converted to cash.
• The narrowest measure of money which includes only the most liquid assets is called M1. M1 includes:– currency, – demand deposits (no-interest checking accounts), – other checkable deposits, and – traveler's checks.
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0
100
200
300
400
500
600
700
800
900
1000
1/1/1959 6/23/1964 12/14/1969 6/6/1975 11/26/1980 5/19/1986 11/9/1991 5/1/1997 10/22/2002 4/13/2008
CurCirc CurM1
Currency in Circulation is US Treasury accounting while Currency component of M1 is an estimate of the currency used.
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Currency per capita
0
500
1000
1500
2000
2500
3000
3500
1/1/1959 6/23/1964 12/14/1969 6/6/1975 11/26/1980 5/19/1986 11/9/1991 5/1/1997 10/22/2002 4/13/2008
CurCirc CurM1
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$2947 or $2771 per person – every person in the US – how much do you have?
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REAL per capita Currency
500
600
700
800
900
1000
1100
1200
1300
1400
1/1/1959 6/23/1964 12/14/1969 6/6/1975 11/26/1980 5/19/1986 11/9/1991 5/1/1997 10/22/2002 4/13/2008
CurCirc CurM1
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REAL per capita Currency
500
600
700
800
900
1000
1100
1200
1300
1400
1/1/1959 6/23/1964 12/14/1969 6/6/1975 11/26/1980 5/19/1986 11/9/1991 5/1/1997 10/22/2002 4/13/2008
CurM1 Linear (CurM1)
9/1/2008
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M1
0
200
400
600
800
1000
1200
1400
1600
1800
1/1/1959 6/23/1964 12/14/1969 6/6/1975 11/26/1980 5/19/1986 11/9/1991 5/1/1997 10/22/2002 4/13/2008
M1
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M1 per capita
0
500
1000
1500
2000
2500
3000
3500
4000
4500
5000
Jan-1959 Jun-1964 Dec-1969 Jun-1975 Nov-1980 May-1986 Nov-1991 May-1997 Oct-2002
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REAL M1 per capita
0
500
1000
1500
2000
2500
3000
3500
1/1/1959 6/23/1964 12/14/1969 6/6/1975 11/26/1980 5/19/1986 11/9/1991 5/1/1997 10/22/2002 4/13/2008
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Measuring the Quantity of Money
• M2 is a slightly broader definition of money that includes some less liquid assets. M2 includes: – M1, – savings deposits, – small time deposits (e.g. certificates of deposits),– money market deposit accounts.
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0
1000
2000
3000
4000
5000
6000
7000
8000
9000
1/1/1959 6/23/1964 12/14/1969 6/6/1975 11/26/1980 5/19/1986 11/9/1991 5/1/1997 10/22/2002 4/13/2008
CurM1 M1 M2
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0
2000
4000
6000
8000
10000
12000
14000
1/1/1959 6/23/1964 12/14/1969 6/6/1975 11/26/1980 5/19/1986 11/9/1991 5/1/1997 10/22/2002 4/13/2008
Cur M1 M2
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REAL Cur, M1, M2
525
625
725
825
925
1025
1125
1225
1/1/1959 6/23/1964 12/14/1969 6/6/1975 11/26/1980 5/19/1986 11/9/1991 5/1/1997 10/22/2002 4/13/2008
2000
4000
6000
8000
10000
12000
Cur M1 M2
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Banking: The Fractional Reserve System
• A fractional reserve system is one in which banks must keep only a fraction of the deposits they hold on hand. The rest can be loaned out.
• The required reserve ratio (RRR) is the fraction of deposits that must be held.– If RRR = 10%, banks must hold $10 in reserves for
every $100 they lend out.– RRR = required reserves/ total deposits x 100
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0
10
20
30
40
50
60
70
Jan-1959 Jun-1964 Dec-1969 Jun-1975 Nov-1980 May-1986 Nov-1991 May-1997 Oct-2002
0
2
4
6
8
10
12
14
16
18
20
TotRes ExRes
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0
100
200
300
400
500
600
700
800
900
1/1/1959 6/23/1964 12/14/1969 6/6/1975 11/26/1980 5/19/1986 11/9/1991 5/1/1997 10/22/2002 4/13/2008
0
100
200
300
400
500
600
700
800
900
1000
ExRes TotRes
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0
100
200
300
400
500
600
700
800
900
1000
2/1/2008 3/22/2008 5/11/2008 6/30/2008 8/19/2008 10/8/2008 11/27/2008 1/16/2009 3/7/2009
TotRes ExRes
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ReqResPct
67.00%
72.00%
77.00%
82.00%
87.00%
92.00%
97.00%
Jan-1959 Jun-1964 Dec-1969 Jun-1975 Nov-1980 May-1986 Nov-1991 May-1997 Oct-2002
ReqResPct
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Required Reservers as a Percent of Total Reserves
0%
20%
40%
60%
80%
100%
120%
1/1/1959 6/23/1964 12/14/1969 6/6/1975 11/26/1980 5/19/1986 11/9/1991 5/1/1997 10/22/2002 4/13/2008
ReqResPct
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Dangers of a Fractional Reserve System
• Depositor funds are at risk from bank failures.
• The financial system is vulnerable to bank runs.– The limited deposits on hand are distributed in a
first-come, first-serve basis.
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Solutions to protect depositors and limit bank runs
• Deposit insurance– In the U.S. the Federal Deposit Insurance
Corporation (FDIC) protects depositors from losses with up to $100,000 in coverage.
– This insurance, however, provides incentives for banks to take risks because depositors have no incentive to monitor a bank’s condition.
• Bank regulation– Bank examiners periodically examine and assess
the risks of every commercial bank.
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Dangers
• The Central Bank PRINTS money!
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Bank Bookkeeping
• A bank asset is an item of value that a bank owns.
• A bank liability is an item of value that a bank owes.
• A bank's capital or net worth is the difference between its assets and liabilities
•Typical bank assets are reserves, securities, and loans.
•Deposits are typical liabilities.
•Typical bank assets are reserves, securities, and loans.
•Deposits are typical liabilities.
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Money Creation by Banks
• Banks in conjunction with the Federal Reserve are unique in their ability to create money.
• They do not create the physical money that we touch, but they do create deposits.
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Money Creation example
Initial balance sheet of First Federal Bank. RRR=10%.
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Money Creation example
Emily deposits $100,000 in cash into First Federal.
M1=$1,100,000
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Money Creation example
First Federal lends $90,000 to Bob.
M1=$1,100,000 + $90,000 = $1,190,000
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Money Creation example
Bob deposits $90,000 into Second Federal.
M1=$1,100,000 + $90,000 = $1,190,000
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Money Creation example
Second Federal lends $81,000 to Amy.
M1=$1,100,000 + $90,000 + $81,000 = $1,271,000
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The Money Multiplier
• The money multiplier formula:
determines the maximum amount of money that can be created from Emily's initial deposit of $100,000.
• In this example, the money multiplier is equal to 1/10% = 1/.10 = 10, so the maximum change in the money supply = 10 x $90,000 = $900,000.
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The Money Multiplier
• This money multiplier formula calculates the maximum possible expansion of M1 because it assumes that:– everyone deposits their new loans into a checking
account at a bank, and – banks hold no excess reserves.
• Note that the money creation process works exactly the same in reverse.
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M1 Multiplier - M1 / TotRes
12
17
22
27
32
Jan-1959 Jun-1964 Dec-1969 Jun-1975 Nov-1980 May-1986 Nov-1991 May-1997 Oct-2002
Multiplier
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M1Multi
0
5
10
15
20
25
30
35
40
1/1/1959 6/23/1964 12/14/1969 6/6/1975 11/26/1980 5/19/1986 11/9/1991 5/1/1997 10/22/2002 4/13/2008
M1Multi
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M2 Multi
25
45
65
85
105
125
145
165
185
Jan-1959 Jun-1964 Dec-1969 Jun-1975 Nov-1980 May-1986 Nov-1991 May-1997 Oct-2002
M2 Multi
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M2Multi
0
20
40
60
80
100
120
140
160
180
200
1/1/1959 6/23/1964 12/14/1969 6/6/1975 11/26/1980 5/19/1986 11/9/1991 5/1/1997 10/22/2002 4/13/2008
M2Multi
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