Money,
Banking, and
Finance
Learning Goals

After today‘s lecture, yall will be able to:
– Describe the consequences of inflation and deflation.
– Describe the functions and types of money.
– Describe the measures of the money supply
– Explain how banks create money.
– Describe the categories and functions of nonbank financial institutions.
– Explain the concept of “speculative bubble” and illustrate it with concrete examples.
2
Chapter Outline
Why Money?
2. What is Money?
3. The Banking System
4. Money and Finance
1.
3
Why Money: Making Transactions Easier

Imagine there was no money:
– You would need to barter
– If you want to get a certain good which you don‘t have and want to exchange
something else, you need to find someone who wants just the opposite exchange
– Sometimes, goods are not easily divisible (imagine you want to get some eggs, but
only have a cow)
4
Money and Aggregate Demand


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Imagine you want to buy a house or make an investment, but do not have
the means to do so
You go to a bank and ask for a loan
If the bank gives you a loan, you will buy the house
If the bank does not give you a loan or conditions are too harsh, you will
walk away not buying the house
Hence, if the government can influence credit conditions, it can influence
aggregate demand!
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Some More Basic Thoughts About Money:
This, however, is only true if inflation is low to moderate
 In some cases, inflation becomes so high that money is not generally
accepted anymore
 In these cases, people might resort to barter as money would lose value
to quickly
 barter: exchange of goods, services, or assets directly for other goods,
services, or assets, without the use of money.

6
Where Do Hyperinflations Come From?



Hyperinflation usually happens if the government starts using the printing
press to pay for its expenditure (because it does not manage to collect
sufficient revenue)
If the economy is large and growing and there are not too many newly printed
bills, the money usually is just absorbed
However, if the governments prints too much money, there will be
hyperinflation
– Germany 1920s
– Hungary in 1946
– Zimbabwe in 2007
– Kebabistan in 2021-2022
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What is the Danger of a Hyperinflation in Europe Today?
No real danger
 Governments are not allowed to use the printing press to pay for their
deficit (EU treaty)
 Even (recently agreed) purchases of government bonds by the ECB are
limited
 Money in modern, developed economies comes into existence by other
means (via the banking system)

8
Why is Inflation Disliked Even if it is Lower?

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It redistributes from creditors to debtors
It might wipe out savings
It makes planning difficult
It hurts those with nominally fixed incomes (people on unemployment
assistant, pensioners etc.)
It creates “menu” costs
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What About Falling Prices – Do They Bring Problems as Well?

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Deflation: when the aggregate price level falls
Wealth is redistributed from debtors to creditors
Debtors tend to be those who spend more – firms are usually debtors
This might lead to bankruptcies and problems in the banking sector
People might postpone spending
There might thus be problems for aggregate demand
10
What is Money?

We usually define money by its functions:
– Medium of Exchange—promotes economic efficiency by minimizing time spent in exchanging goods
and services
•
•
•
•
Must be widely accepted
Must be divisible
Must be easy to carry
Must not deteriorate quickly
– Store of Value — used to save purchasing power; most liquid of all assets but loses value during inflation
– Unit of Account — used to measure value in
the economy
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What is NOT Money?

A lot of things you might in everyday life call “money” is NOT money in
the eyes of economists
– Income: If someone has a high income (“he earns a lot of money”), you would call
this income, not money
– Wealth: If someone has a lot of stocks or bonds, he does not have money in the
economic meaning of the term
12
Types of Money

Commodity money: something that contains intrinsic value and is used in
exchange
– Coins made of gold or silver; sometimes cigarettes developed into a medium of
exchange in hard times
– To be used as money, a commodity must be generally acceptable, standardized,
durable, portable, scarce, and, preferably, easily divisible
13
The System of Gold-Backed Currencies
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Gold and silver coins inconvenient to carry around in large quantities
Paper monies were issued representing claims on actual commodities
Starting in the late 1830s, most European countries had their national
currencies by law backed by gold
Exchange rate between different currencies was computed from their
respective value relative to gold, and international transactions were
finally settled in gold reserves
System of gold-backed currencies broke down with the start of World
War I
14
What is the Basis of Value of the Coins and Euro Banknotes we use
Today?
The basis of value is—precisely and no more than—the expectation that
the euro bill will be acceptable in exchange.
 Fiat money

– A euro bill is money because the government declares it to be money
– Fiat money possesses exchange value
– The value of the goods or services that such money can pay for in the market
15
Nowadays, You Are Likely to Make Many of Your Transactions by Other
Means

Type of money which is purely based on a promise to pay by someone
other than the central bank, is called credit money
– Your deposit in a checking account
16
Figure 11.1 The Liquidity Continuum
 Items more to the left are more liquid or, in other words, more easily used to
purchase something of value. The farther to the right on this continuum, the less
liquid the item is. Currency is as liquid as it gets, and real estate is usually about the
most difficult asset to convert to money (seldom taking less than a few months).
More
Liquid
Currency
Checking Account
Liquidity Continuum
Less
Liquid
Share of Stock
Real Estate
Precious Metal
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Do You Use Money if You Use a Credit Card to Make a Purchase?
No!
one is taking out a temporary loan from the credit card company
 only one day a month, when you send a check or electronic transfer to
your credit card company from your checking account, you make a
“money” transaction

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Bank Deposits and Money

Dank deposits fulfill the criteria for money
– Store of value
– Widely accepted in payment
– Unit of account
But: deposits have a different degree of liquidity; not all can be used for
payment
 What do we count as money?

– Pragmatic solution: different monetary aggregates which include bank deposits
with different kinds of maturities
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Monetary Aggregates: The Example of the euro area,
in Billion €
Mid 2009
Cash in Circulation
March 2013
733.6
866.7
+ Overnight Deposits
3606.7
4336.0
= M1
4340.3
5202.7
+ Deposits with agreed maturity up to 2 years
2134.9
1784.9
+ Deposits redeemable at a period of notice up to
3 month
1722.9
2102.2
= M2
8198.2
9089.7
+ Repurchase agreements
331.0
122.3
+ Money market fund (MMF) shares/units
745.0
457.8
+ Debt securities up to 2 years
171.8
140.0
9445.9
9809.9
= M3
20
The Banking System
Table 11.1 A Simplified Balance Sheet of a Commercial Bank
Assets
Liabilities
Reserves
€10 million
Government bonds
€20 million
Loans
€70 million
Deposits
€100 million
bank reserves: funds not loaned out by a private bank, but kept
as vault cash or as deposit at the central bank
In most countries, banks are required to keep some share of
their deposits as reserves – this is called required reserves
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How Commercial Banks Earn Profits

Government bonds
– Earn interest by lending money to national governments
– Relatively safe and liquid

Portfolio of loans
– Funds that are owed to the bank by businesses, households, nonprofits, or
nonfederal levels of government
– Less liquid than government bonds
– Major asset and major way to make earnings
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Table 11.2 Bank Types
Chief Functions
Retail banks
Safekeeping of money, checking accounts, loans
Savings banks
Similar to retail bank but specializing in loans, particularly
mortgages and loans to small and medium sized businesses
Cooperative banks
Same as a retail bank, but cooperatively owned by customers
Private banks
Caters almost exclusively to high net worth individuals; functions
extend beyond traditional banking into variety of financial
services
Investment banks
No traditional banking functions; involved in underwriting and
issuing securities, assistance with company mergers and
acquisitions, market making, and general advice to corporations
Universal banks
Covering both investment and retail banking services
Central banks
Overseeing the monetary stability of the national economy by
setting interest rates and providing liquidity to commercial banks
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How Commercial Banks Create Money

When a commercial bank decides to make a loan, it credits the amount
to the checking account
– With the stroke of a key, deposit money is created!
– This increases M1

Hence, commercial banks can create money!
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The Central Bank and Commercial Banks‘ Money Creation
In the euro area (and other jurisdictions), commercial banks are required
to hold a certain share of their deposits as reserves
 Banks need to borrow these reserves

– From other banks
– From the ECB
These reserves do not need to be available at the time when a deposit or
a loan is made, but have to be put in the account within a certain time
 If commercial banks need cash, they have to borrow it from the ECB

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Central Bank
Borrower
Commercial
Bank A
Commercial
Bank B
Bank makes loan
Increase Money Supply M1
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reserves do
not need to
be available
at the time
when a
deposit or a
loan is made!
Central Bank
Commercial
Bank hold
certain share
of deposits at
Central Bank
or Bank A/B borrows from
Central Bank against collateral
and interest rate
Borrower
Reserve Requirement
Commercial
Bank A
Commercial
Bank B
Bank makes loan
Bank A/B borrows reserves from Bank B/A
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Central Bank
CB provides
cash
Commercial
Bank
provides
collateral and
pays interest
Commercial
Bank A
Borrower
Commercial
Bank B
ATM
Commercial Bank provides Cash
NO increase in M1
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Money and Finance
Functions of Finance
Provision of money to support investment in real capital
 Portfolio investment, i.e. investing funds in securities such as stocks or
bonds

 another form of saving, a means of postponing consumption
31
Speculation as Investment
Exploit changes in prices to achieve short-term profit
 Economic impact of risking their own funds is limited
 Speculators may borrow money in order to exploit what they see as
market opportunities based on short-term price movements
 Leverage—investments based on borrowed funds
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Nonbank Financial Institutions
a financial institution that performs a number of
services similar to those offered by banks but that is
not a licensed bank and is not subject to banking
regulations
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An industry that has been growing in size and importance
relative to banking
Activities do not directly affect the money supply
Loans from these entities, unlike transactions using bank
accounts, are not liquid  “nonmoney assets”
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Nonbank Financial Institutions

Collective investment vehicle or pooled fund
– an investment vehicle that pools investments from many different sources, making
investment decisions for them all as a group

Index fund
– a type of pooled fund that tries to replicate a common stock or bond market index. As this
fund does not require active management by a manager, fees are usually lower than in
other types of pooled funds

Hedge fund
– a type of pooled fund that often engages in highly speculative investments and to which
access is generally restricted to wealthy clients
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Nonbank Financial Institutions

Pension fund
– a fund with the exclusive purpose of paying retirement benefits

Insurance company
– a company that pays to cover all or part of the cost of specific risks against which
individuals and companies chose to insure themselves

Reinsurer
– a company that sells insurance to insurance companies to share the risk in case of
large damages caused e.g. through natural disasters.
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Nonbank Financial Institutions

Securities broker
– an agent responsible for finding a buyer for sellers of different securities, thereby
offering enhanced liquidity to the seller

Building society
– a financial institution which collects savings from its customers and offers them at
preferential rates to other customers so that they can buy or build a residence

Shadow bank
– credit intermediation that involves entities and activities outside the regular
banking system
36
Modern Economies Are Much More Dependent Than Ever on Finance
In the euro area, total financial assets banking sector roughly doubled
from 2003 to 2013 to a total of €57 trillion (almost six times euro area
annual GDP)
 In the UK and US, financial assets have surpassed the equivalent of ten
times the respective national GDP
 Financial transactions is even larger. For the U.S., this value was 73 times
GDP already in 2009, primarily a result of rapid growth in high-frequency
trading
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Is Too Much Finance Bad for the Economy?
When economies grow on the basis of mass investment in assets with
questionable foundations, yet rise in price, the growth is unstable and
destined to be of short duration
 Such irrational speculative price rises are called bubbles
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38
The Dutch Tulip Frenzy (Tulip Mania)
1636-37
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Different tulip types had different values
Mass speculation
– first: only wealthy Dutch were buying them
– eventually, everyone was buying tulips

Rapid increase in prices
– peak: March 1637
– some select bulbs sold for several times the yearly
income of a skilled craftsman
– shortly thereafter, confidence in their value vanished

Almost overnight, the tulip market crashed, and many speculators were ruined.
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Stock Market Bubble 1929

“new reality”
– establishment of the Federal Reserve in 1913
– government policies to extend free trade, fight inflation, relaxation of antitrust
laws

1920s: everyone is buying shares
– consumer debt was taken on to buy stock shares (instead of consumer goods)
October 1929: the stock market crash
 The Great Depression
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Dow-Jones Industrial Stock Price Index for USA, 1914-1942
400
350
Dollars per Share
300
250
200
150
100
50
0
Source: National Bureau of Economic Analysis
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Since the 1970s, Many Other Bubbles Developed…
East Asia 1997
 “Dot-com” stock market bubble 1999/2000
 Housing bubbles in the US, UK, Ireland, Spain and other European
countries late 2000s
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
Bubbles are characterized by a rapid increase in prices that are not
generally accompanied by an equally rapid improvement in economic
conditions
 buying begets more buying
 appreciation in the asset values is fleeting
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Why Do We Fail to Learn From Past Mistakes?
Speculative bubbles form for psychological and economic reasons
 Psychological reasons
– faith or “blind optimism”
– herd behaviour

Economic reasons
– easy credit
– borrowing for purchases of stocks or real estate
– inflation of a financial bubble
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How Exactly Are All These Possibilities of Bank-Based and Non-BankBased Finance Linked to the Macroeconomy?
Finance is crucial to realize investment plans of firms
 no savings have to be collected prior to the
investment undertaking
 banks can create deposit money by extending loans
with “the stroke of a pen”
 investment plans depend on banks and non-banks
willingness and ability to provide funds to firms and
households
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Figure 11.2 Credit and Aggregate Demand
 A larger amount of credit disbursed tends to lead to more aggregate demand:
Money is usually borrowed by households and firms to finance spending on
consumer goods, residential properties or new equipment.
Credit Volume
More
financialized
economy
Less
financialized
economy
Aggregate Expenditure
 However, the more
finalized an economy,
the more of the credit
goes into nonproductive activities
without an impact on
aggregate demand. For
a financialized
economy, therefore,
the Credit-AE-curve is
further to the left.
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The International Aspect of Finance: Cross-Border Trading of Financial
Assets
Some invest in foreign assets because of good performance of – for
example – a Japanese car company
 Others invest abroad to speculate on changes in the exchange rate
 Trading financial assets across borders means that one country borrows
and another country acquires claims
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What to Take Home (I)
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Hyperinflation comes from running the printing press
Deflation is a fall in aggregate price levels
Money is a store of value, a medium of exchange, and a unit of account
Economists differentiate between commodity money and fiat money
Commercial banks make profits through collecting deposits and investing
in a portfolio of loans as well as miscellaneous securities
Deposit money is created when banks make loans
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What to Take Home (II)
Nonbank financial institutions are not subject to banking regulation
 Economies became financialized
 Irrational speculative real estate or asset price rises are called bubbles
 Finance is crucial to realize investment plans of firms
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