Chapter 27
Money and Banking
1
Do you know anyone with a lot of money?
What does that mean?
Some people make a great income each year. So they
probably have a lot of money.
Some people are born into families with a lot of wealth – Bill
Gates’ kids are an example. They, too, probably have a lot
of money.
Here we want to focus on those things that we call money.
But we do not focus on the income or wealth aspects. We
want to see how policy dealing with money can affect the
operation of the economy.
2
Overview
Here we want to study the monetary system in the US.
Monetary policy is a tool designed to get the interest rate to
a level so that investment can be at a desired level. Policy
makers ultimately want to have economic growth, price
stability and full employment.
Reaching these goals can be influenced by Federal Reserve
policy. Let’s begin our study of this material by asking
what is money?
3
What is money?
You might say money is the dollars we have, and that is right ,
but more basically anything that performs the functions of
money is money. The four functions of money are
1) medium of exchange, 2) Unit of account, and
3) Store of value, and 4) standard of deferred payment.
A medium of exchange means money is the thing that is
readily accepted as payment for goods and services. When
money is used we don’t have to barter. Barter can be a drag
because of the double coincidence of wants. Without money I
have to find someone who wants an econ lecture if I want to
play golf. With money we force kids to take econ even though
they don’t want to ;), I get money, and then I can buy golf! I
spend way less time acquiring the golf when there is money!
4
What is money?
As a unit of account, the monetary unit(what we call the
dollar) is how we state relative value. Goods and services
have prices stated in terms of the monetary unit. We know the
relative worth of stuff by looking at the dollar amount of the
stuff.
Money is a store of value, meaning that you can use it now, or
you can use it later. Other assets also act as a store of value,
but money has the advantage of immediate use by a firm or a
household in meeting all financial obligations.
Money is a standard of deferred payment in that when we take
goods and services today, but make payment in the future, the
future payment is stated in terms of the money used (in the US
we take about the dollar).
5
Commodity money and fiat money section
Commodity money is when money takes the form of
something with intrinsic value. Money would have value
for uses other than just money. Cigarettes in a prison
would be commodity money.
I think fiat money is the money tucked into the glove
compartment on that little car. 
Really, fiat money (or token money) has no intrinsic
value. Government says something is money and it is.
Our dollars are fiat money.
6
M1 definition of money
In the US, the most basic definition of money is
M1 = coins + paper + checkable deposits + other checkable
deposits + travelers’ checks, or more basically for our
purpose
= currency + checkable deposits.
Checks are dollar denominated accounts at banks and
other financial institutions. They are money because they
are generally accepted as a medium of exchange.
Caution:
1) Credit cards are NOT money, they are loans for our
purposes.
7
M2
I am not making this up, but the M2 definition of money
is M1 plus savings and time deposits, certificates of
deposits (CD’s) and money market funds.
Liquidity is a concept that refers to how fast an asset can
be used to buy goods and services. Items in the M1
definition are the most liquid because these items can be
used right away to buy goods and services. Items in M2
are a little less liquid because usually a check can not be
written on these accounts and thus one has to spend time
converting M2 items into M1 before making purchases.
In 2012 M1 added up to $2.4 trillion and M2 added up to
$10.4 trillion.
8
What ‘backs’ our money?
A gold standard or other metal standard - meaning there
can be only as much money as there is gold, or some
formula amount of money per ounce of gold - may not be
consistent with our desires to make trades. This is why
modern economies have moved away from metal
standards.
So, what backs our money?
Our money is backed by our faith that it can be readily
used. We accept money because we know others will
accept it from us!!
9
The Role of Banks
10
Bank as Financial
Intermediary
Banks act as a “broker” between saver/lenders and
spender/borrowers.
Hey, if you want, when you have income left over at the end
of the month you can try to find people who might like to use
your leftovers to buy something. That is a drag, so you
probably put the money in the bank. (Or really you have your
pay deposited and take out what you need and leave the rest
in the bank.) If this is you, you are saver!
Banks have these funds from many people and after a while
the banks noted that on any day most people did not want
access to there funds, so the banks lends out some of the
funds! Borrowers know banks make loans.
Banks are in between lenders and borrowers!!
11
Money Creation
12
Overview
In order to see how monetary policy can be used to
influence economic performance (we saw fiscal policy
before) we first have to look at the banking system.
We will look at some basic operations of banks. Plus we
will see how the actions of people (the public), Federal
Reserve (the Central Bank of the US economy) action,
combined with bank operations, leads to changes in the
money supply.
Remember we say that money is basically
1 - currency, and
2 - checkable deposits.
13
Bank Balance sheet
To understand the banking system we will look at banks from a
balance sheet perspective. On a balance sheet you will find bank
1) assets
2) liabilities and net worth.
Using a mechanism called a t-account, we have assets on the left
and liabilities and net worth on the right. In general assets =
liabilities +NW, but we will focus on changes, not totals.
assets
liabilities + NW
14
examples of assets and
liabilities
Some assets we will talk about are
1) reserves of the bank(BR)
2) loans the bank has made(L)
For now we will mention the liability called
1) checkable deposits or demand deposits(D)
Note: remember we said money or M1=currency (CU) +
checkable deposits (D). By currency, we mean the funds in the
hands of the nonbank public.
Let’s look at some examples of bank operations.
15
currency deposits
A
L+NW
Say you have $100 in currency
and you put it into your checking
BR +100 D+100
account. The bank now has a
liability -> it owes you $100. But
it also has what are called
reserves, in this case the currency
you brought in is put in the bank
vault.
Note the currency in the vault is not in the hands of the
nonbank public, so is not money, but now reserves of the
bank. In this example the money supply was not changed,
but transformed from currency to checkable deposits.
16
Let’s ponder some more what we just had on the last
screen.
When people hold these bills
the bills are called money.
When people put the bills into
their checking account the
people still have money, but
now in the form of checking
account balances.
The bank then has the bills
and the bills are then called
reserves!
17
currency withdrawal
A
BR -100
L+NW
D -100
Say you want $100 in currency
from your checking account. The
bank no longer has a liability and
it loses an equal amount of
reserves, in this case from the
bank vault.
In this example the money supply was not changed, but
transformed from checkable deposits to currency.
18
Imagine the economy is just starting its use of money. Say
the Federal Reserve (FED), the central bank in the US, has
some guys fly around in a helicopter and they drop 100 single
dollar bills over the land where people live. At this point the
money supply would be $100 and made up of only currency.
If people just used these bills and never put money in a bank,
then the money supply would stay at $100 unless the FED
put more money in or took money out of the system.
A few potential problems of holding money only in the form
of currency is that it may be lost, or it could be stolen.
Because of this (and a few other things we do not need to
worry about here ) folks put their money into a bank.
For now let’s assume people do not want to hold any
currency. So, they put all $100 into a checking account.
19
A
BR 100
All currency is deposited into
banks
L+NW
D 100
At this point the money supply is
still only $100 but is now made up
of checking account balances.
Banks customers as a group usually do not want all of their
deposits back on a certain day. As an example, maybe on
every dollar customers have in a bank they only want to
write checks worth 5 cents on a given day.
What I am trying to express here is that banks have noticed
that customers as a group only take out a fraction of their
deposits on a given day.
20
Let’s note a few ideas.
Bank reserves are held because the bank has to be able to give
you these bills if you so desire (and you have balances in your
account – otherwise they try to put you in jail;).
Bank reserves do not earn the bank any interest (well, very
little when the rules where changed after the late 2000’s), but
there is the gain of keeping customers happy by being able to
give out bills when desired.
Banks have noticed that at any point in time depositors do not
want all their money to be transformed back from checking
account balances to currency.
With these three things in mind banks have discovered that
they can lend out some of the bank reserves and then interest
can be charged on the loan.
21
By remembering what I have here you can score some
points on the next few assignments and the final exam.
If banks always kept all the reserves in the bank, we would
have a 100% reserve banking systems.
When banks lend some of the reserves and thus only keep a
fraction of its reserves the banking system becomes a
fractional reserve banking system.
Let’s assume banks desire to keep in reserve 20% of the
deposits obtained. This means the banks will lend out the
rest. Also remember we said the public does not want to
hold currency at this time.
Let’s next see what happens in the banking system when
bank loans are made.
22
I have plus signs and minus signs to denote changes in these
amounts.
A
L+NW
At the top you see what the banking
BR +100 D +100
system looks like when the public
deposits the $100.
A
Next you see how the loan is made.
L+NW
Since the bank wants to hold 20% of
L + 80
D +80
deposits as reserves it loans 80 by
A
L + NW creating an asset called loans and adds
to checkable deposits for the person
BR -80
D -80
who gets the loan.
The third point is the person with the
loan spends the money and the bank
A
L+NW
loses an equal amount of reserves.
BR +20
D +100 At the bottom here you see the final
L +80
position for the bank. The 100 in new
deposits will support 80 in loans.
23
Bank loan
Bank loan is money creation
At any point in time the bank can only lend out what
it has in excess reserve. The bank notes what is excess
over a period of time. The bank we saw before had
excess reserves of 80 and lent out 80.
Once a bank loan is made, a process is started in the
economy and the process culminates in a multiple
expansion of the money supply. Multiple here means
more than the amount that occurred at first.
Let’s now turn to the process of multiple deposit
expansion.
24
A
BR +80
L+NW
D +80
A
L+NW
L + 64
D +64
A
BR -64
A
BR +16
L +64
L + NW
D -64
L+NW
D +80
Round 2
The person who obtained the first loan
bought something. The seller of that
stuff gets the check and deposits it in
their bank. We see that first here.
Next you see that since the bank wants
to only hold 20% of deposits as reserves
it loans .8(80) = 64 by creating an asset
called loans and adds to checkable
deposits for the person who gets the
loan.
The third point is the person with the
loan spends the money and the bank
loses an equal amount of reserves.
At the bottom here you see the final
position for the bank. The 80 in new
deposits will support 64 in loans.
25
Before I move on to more of the story, note what
happened on the previous screen.
1) In the banking system an aditional 80 dollars in
checking account balances occurred because someone was
able to get a loan.
2) The bank added to the first round by making another
$64 in loans.
3) At the end of the day the bank has looked at its new
deposits, evaluated what it wants to hold on to as reserves
and lends out the rest.
Another round of lending can still occur – let’s see that
next.
26
A
BR +64
L+NW
D +64
Round 3
The person who obtained the second
loan bought something. The seller of
that stuff gets the check and deposits it
in the bank. We see that first here.
A
Next you see that since the bank wants
L+NW
L + 51.20
D +51.20 to only hold 20% of deposits as reserves
it loans .8(64) = 51.20 by creating an
A
L + NW asset called loans and adds to checkable
BR -51.20
D -51.20 deposits for the person who gets the
loan.
The third point is the person with the
A
L+NW
loan spends the money and the bank
loses an equal amount of reserves.
BR +12.80
D +64
At the bottom here you see the final
L +51.20
position for the bank. The 64 in new
deposits will support 51.20 in loans. 27
Multiple deposit expansion
Let’s review again. The first bank received 100 in new deposits
and since it only needs to keep 20% (because most folks don’t
want all their funds on any one day) it lent out 80. This ended
up in another bank because the person who got the loan didn’t
want to take the money home, throw it on the floor, and roll in the
cash (would you do that?). The person wanted to spend it! That
spending meant someone else sold some goods and got a check
to put in their bank. That bank evaluated its position and
made a loan……
DO you see a pattern here? Note each successive loan is for a
smaller amount than the previous loan.
28
Begin
Round 1
Round
Round 3
D +80 BR+12.80 D +64
2
BR +100 D +100 BR +20 D +100 BR +16
L
+80
L +64
L +51.20
Bit of a review again – bring the last few slides together. On
this slide you see the beginning when 100 in cash was put in
the bank. Then I show three rounds in the final position of
each round, but more will occur.
Recall that money is made up of currency and checkable
deposits. The beginning and round 1 is the first bank
involved. While there is 100 more in checking there is 100 less
in cash in the hands of the non-bank public. This means no
change in the money supply. But rounds 2, 3 and on have
new deposits that are new additions to the money supply. On
the next slide I show some math, but you only need to have
the end result of that math.
29
New money from the lending process here
80 + 64 + 52.10 + …
= 80(1 + .8 + .82 + …) (math folks help us get to the next
line)
= 80[1/(1 - .8)] (wow, look at that!)
= 80(1/0.2)
= 80(5) = 400
Let’s look at this a little more closely. The 80 was the initial
amount of excess reserves in the system when cash was put
in the bank. The 5 is the money multiplier (It is similar to
the multiplier we saw back with aggregate demand). Note
the 5 is from 1/0.2, where the 0.2 is the 20% banks like to
hold in reserve to meet the needs of its depositors. These
two items make up the money multiplier.
30
Required reserves
Hey, you want to know something? Well, listen up! The
20% I mentioned that banks want to hold to meet the needs
of the depositors is too high a number. Many banks would
really only need to keep way less than 20%. Moreover, some
banks would like to earn more money and they might hold
less than they really need.
The Federal Reserve system has a rule banks must follow so
that they don’t have too few reserves. The rule is called
reserve requirements. The Fed sets, and does change from
time to time, the minimum reserve required amount banks
must hold to meet the amount of checking account balances
that are in the bank.
31
Required reserves
If the reserve requirement is 20% banks have to have in reserves
(BR) 20% of the checking account balances. So if D = 100, BR
must be no lower than 20. If D = 500, BR must be no lower than
100.
For the most part, we will assume in class that whatever the
Fed sets as the reserve requirement will be the target banks
shoot for.
So, if the reserve requirement is 20% the money multiplier is 5.
If the reserve requirement is 10% the money multiplier is 10.
32
Summary
1) FED dropped 100 single dollar bills on public for a money
supply of $100,
2) Public put all money in the bank in checking accounts, for a
money supply still of $100,
3) Banks only desired to hold reserves equaling 20% (because
we now see that is what the FED set) of deposits and they lent
out the rest.
4) After many rounds of lending bank deposits end up at $400
of additional checking account balances in addition to the $100
start.
5) The 100 of new bank reserves ends up supporting a money
supply of 500, the 400 of new deposits from the lending process
and the initial 100 Fed dropped, but transferred to checking by
public.
33