Money and Banking
CHAPTER FIFTEEN
MONEY AND BANKING
CHAPTER OVERVIEW
This chapter introduces students to the U.S. financial system. The chapter first covers the nature and
functions of money and then discusses the Federal Reserve System’s definition of the money supply.
Next, the chapter addresses the question of what “backs” money by looking at the value of money, money
and prices, and the management of the money supply. The focus then turns to the institutional structure
with is a rather comprehensive description of the U.S. financial system, which focuses on the features
and functions of the Federal Reserve System.
The second half of the chapter explains the fractional reserve system and the creation of checkable
(demand) deposit money by commercial banks. A number of routine but significant introductory
transactions are covered, followed by a description of the lending ability of a single commercial bank.
Next, the lending ability and the money multiplier of the commercial banking system are traced through
the balance statements of an individual bank. The chapter concludes with a discussion of the bank
panics of 1930-1933, illustrating the vulnerability of a fractional reserve system and the important role
of deposit insurance and confidence in the system.
INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to:
1. List and explain the three functions of money.
2. Define the money supply, M1 and near-monies, M2.
3. State three reasons why currency and checkable deposits are money and why they have value.
4. Describe the structure of the U.S. banking system.
5. Explain why Federal Reserve Banks are central, quasi-public, and bankers’ banks.
6. Describe seven functions of the Federal Reserve System and point out which role is the most
important.
7. Recount the story of how fractional reserves began with goldsmiths.
8. Explain the effects of a currency deposit in a checking account on the composition and size of the
money supply.
9. Compute a bank’s required and excess reserves when given its balance-sheet figures.
10. Explain why a commercial bank is required to maintain a reserve and why it isn’t sufficient to
cover deposits.
11. Describe what happens to the money supply when a commercial bank makes a loan.
12. Describe what happens to the money supply when a loan is repaid.
13. Explain what happens to a commercial bank’s reserves and checkable deposits after it has made a
loan.
14. Describe how a check drawn on one commercial bank and deposited in another will affect the
reserves and excess reserves in each bank after the check clears.
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15. Describe what would happen to a single bank’s reserves if it made loans that exceeded its excess
reserves.
16. Explain how it is possible for the banking system to create an amount of money that is a multiple
of its excess reserves when no single bank ever creates money greater than its excess reserves.
17. Compute the size of the monetary multiplier and the money-creating potential of the banking
system when provided with appropriate data.
18. Define and identify terms and concepts listed at the end of the chapter.
LECTURE NOTES
I.
Functions of Money
A. Medium of exchange: Money can be used for buying and selling goods and services.
B. Unit of account: Prices are quoted in dollars and cents.
C. Store of value: Money allows us to transfer purchasing power from present to future. It is
the most liquid (spendable) of all assets, a convenient way to store wealth.
II.
Components of the Money Supply
A. Narrow definition of money: M1 includes currency and checkable deposits
(see Figure 15.1).
1. Currency (coins + paper money) held by public.
a. Coins are “token” money, which means its intrinsic value is less than actual value.
The metal in a dime is worth less than 10¢.
b. All paper currency consists of Federal Reserve Notes issued by the Federal Reserve.
2. Checkable deposits are included in M1, since they can be spent almost as readily as
currency and can easily be changed into currency.
a. Commercial banks are a main source of checkable deposits for households and
businesses.
b. Thrift institutions (savings & loans, credit unions, mutual savings banks) also have
checkable deposits.
3. Qualification: Currency and checkable deposits held by the federal government, Federal
Reserve, or other financial institutions are not included in M1.
B. Money Definition: M2 = M1 + some near-monies which include: (See Figure 15.1)
1. Savings deposits and money market deposit accounts.
2. Certificates of deposit (time accounts) less than $100,000.
3. Money market mutual fund balances, which can be redeemed by phone calls, checks, or
through the Internet.
C. Which definitions are used? M1 will be used in this text, but M2 is watched closely by the
Federal Reserve in determining monetary policy.
III.
What “backs” the money supply?
A. The government’s ability to keep its value stable provides the backing.
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B. The value of money arises not from its intrinsic value, but its value in exchange for goods
and services.
1. It is acceptable as a medium of exchange.
2. Currency is legal tender (or fiat money). In general, it must be accepted in repayment of
debt, but that doesn’t mean that private firms and government are mandated to accept
cash; alternative means of payment may be required. (Note that checks are not legal
tender but, in fact, are generally acceptable in exchange for goods, services, and
resources. Legal cases have essentially determined that pennies are not legal tender.)
3. The relative scarcity of money compared to goods and services will allow money to
retain its purchasing power.
C. Illustrating the Idea: Are Credit Cards Money?
Credit cards are not money, but their use involves short-term loans; their convenience allows
you to keep M1 balances low because you need less for daily purchases. A debit card, or
more accurately the checkable deposit behind it, is part of the money supply.
D. Money’s purchasing power determines its value. Higher prices mean less purchasing power.
E. Excessive inflation may make money worthless and unacceptable. An extreme example of
this was German hyperinflation after World War I, which made the mark worth less than 1
billionth of its former value within a four-year period.
1. Worthless money leads to use of other currencies that are more stable.
2. Worthless money may lead to barter exchange system.
IV.
The Federal Reserve and the Banking System
A. The Federal Reserve System (the “Fed”) holds power over the money and banking system.
1. Figure 15.2 gives the framework of the Fed and its relationship to the public.
2. The central controlling authority for the system is the Board of Governors, which has
seven members appointed by the President for staggered 14-year terms. The chairperson
is appointed for 4-year terms.
3. The Fed is the “central bank” of the U.S., just like the central bank of most nations, but
comprised of 12 Federal Reserve banks instead of one.
4. The system has twelve districts, each with its own district bank. They help implement
Fed policy and are advisory. (See Figure 15.3)
a. Each is quasi-public: It is owned by member banks but controlled by the
government’s Federal Reserve Board, and any profits go to the U.S. Treasury.
b. They act as bankers’ banks by accepting reserve deposits and making loans to banks
and other financial institutions. In making loans, the Federal Reserve is the “lender
of last resort,” meaning that the Fed is available to lend money should other avenues
(e.g. other commercial banks) not be available.
5. The Federal Open Market Committee (FOMC) includes the seven governors plus five
regional Federal Reserve Bank presidents whose terms alternate (except for the president
of the NY Fed). They set policy on buying and selling of government bonds, the most
used monetary policy, and meet several times each year.
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6. About 7,800 commercial banks existed in 2005. They are privately owned and consist of
state banks (three-fourths of total) and large national banks (chartered by the Federal
government).
7. Thrift institutions such as credit unions (the most common), are regulated by different
agencies than commercial banks, but are still subject to monetary control by the Fed.
There are approximately 11,400 thrift institutions in the U.S.
8. Global Snapshot 15.1 gives the world’s twelve largest financial institutions as of 2003.
B. Functions of the Fed and money supply:
1. The Fed issues “Federal Reserve Notes,” the paper currency used in the U.S. monetary
system.
2. The Fed sets reserve requirements and holds the reserves of banks and thrifts not held as
vault cash.
3. The Fed may lend money to banks and thrifts, charging them an interest rate called the
discount rate.
4. The Fed provides a check collection service for banks (checks are also cleared locally or
by private clearing firms).
5. Federal Reserve System acts as the fiscal agent for the Federal government.
6. The Federal Reserve System supervises member banks.
7. Monetary policy and control of the money supply is the “major function” of the Fed.
C. Federal Reserve independence is important but is also controversial from time to time.
Advocates of independence fear that more political ties would cause the Fed to follow
expansionary policies and create too much inflation, leading to an unstable currency such as
that in other countries.
V.
The Fractional Reserve System
A. In a fractional reserve system banks can loan out a portion of the money deposited, allowing
them to increase the amount of money in circulation.
B. Illustrating the Idea: The Goldsmiths
1. In the 16th century goldsmiths had safes for gold and precious metals, which they often
kept for consumers and merchants. They issued receipts for these deposits.
2. Receipts came to be used as money in place of gold because of their convenience, and
goldsmiths became aware that much of the stored gold was never redeemed.
3. Goldsmiths realized they could “loan” gold by issuing receipts to borrowers, who agreed
to pay back gold plus interest.
4. Such loans began “fractional reserve banking,” because the actual gold in the vaults
became only a fraction of the receipts held by borrowers and owners of gold.
C. Significance of fractional reserve banking:
1. Banks can create money by lending more than the original reserves on hand. (Note that :
today gold is not used as reserves).
2. Lending policies must be prudent to prevent bank “panics” or “runs” by depositors
worried about their funds. Also, the U.S. deposit insurance system discourages panics.
VI.
Money Creation Potential by a Single Bank in the Banking System
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A. Formation of a commercial bank: Following is an example of the process.
1. Somewhere Bank is formed with $250,000 worth of owners’ shares of stock (see Balance
Sheet 1).
2. This bank obtains property and equipment with $240,000 of its funds (see Balance Sheet
2).
3. The bank begins operations by accepting deposits worth $100,000 (see Balance Sheet 3).
4. Bank must keep a percentage of deposits as required reserves.
a. Banks can keep reserves at a Federal Reserve Bank or as cash in vaults.
b. The required reserve is determined by the reserve ratio – the percentage of deposit
liabilities that must be held as cash or as reserves with the Fed.
c. Congress sets the limits on the reserve ratio, the Fed sets that actual ratio.
d. Banks tend to keep some of their reserves as vault cash to satisfy customers’ daily
demands for withdrawals.
e. For convenience, the cash and reserve deposits with the Fed will be combined into
“reserves” for the remainder of the chapter (Balance Sheet 4 and beyond).
5. Actual reserves are the total funds the bank has on deposit with the Fed or in the vault as
cash, regardless of whether or not they are required to hold it in reserve.
6. Excess reserves are reserves beyond what the bank must hold to satisfy the reserve
requirement.
a. Excess reserves are found by subtracting required reserves from actual reserves.
b. Excess reserves are the key to money creation.
7. The Fed requires banks to hold reserves so that it can control the amount of money
created through lending, not because holding reserves would be sufficient to stop a bank
panic. Deposit insurance helps discourage bank panics.
B. Continuation of Somewhere Bank’s transactions:
1. Transaction 5: A $50,000 check is drawn against Somewhere Bank by Mr. Bradshaw,
who buys farm equipment from the Ajax Farm Implement Company of Elsewhere.
2. Ajax deposits the check in Elsewhere Bank, which gains reserves at the Fed, and
Somewhere Bank loses $50,000 reserves at Fed; Mr. Bradshaw’s account goes down,
and Ajax’s account increases in Elsewhere Bank.
3. The effects of this transaction on Somewhere Bank are shown in Balance Sheet 5.
C. Money-creating transactions of a commercial bank are shown in the next transaction.
1. Transaction 6: Somewhere Bank grants a loan of $50,000 to Gristly in Somewhere (see
Balance Sheet 6a).
a. Money ($50,000) has been created in the form of new demand deposit worth
$50,000.
b. Somewhere Bank has reached its lending limit: It has no more excess reserves as
soon as Gristly Meat Packing writes a check for $50,000 to Quickbuck Construction
(See Balance Sheet 6b).
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D. Legally, a single bank in a multibank banking system can lend only to the extent of its initial
preloan excess reserves.
VII.
The Entire Banking System and Multiple-Deposit Expansion (all banks combined)
A. The entire banking system can create an amount of money which is a multiple of the
system’s excess reserves, even though each bank in the system can only lend dollar for dollar
with its excess reserves.
B. Three simplifying assumptions:
1. Required reserve ratio assumed to be 20 percent. (The actual reserve ratio averages 10
percent of checkable deposits.)
2. Initially banks have no excess reserves; they are “loaned up.”
3. When banks have excess reserves, they loan it all to one borrower, who writes check for
entire amount to give to someone else, who deposits it at another bank. The check clears
against original lender.
C. System’s lending potential: Suppose a junkyard owner finds a $100 bill and deposits it in
Bank A. The system’s lending begins with Bank A having $80 in excess reserves, lending
this amount, and having the borrower write an $80 check which is deposited in Bank B. See
further lending effects on Banks C and D. The possible further transactions are summarized
in Table 15.1.
D. Monetary multiplier is illustrated in Table 15.1.
1. Formula for monetary or checkable deposit multiplier is:
Monetary multiplier = 1/required reserve ratio or m = 1/R or 1/.20 in our example.
2. Maximum deposit expansion possible is equal to: excess reserves times the monetary
multiplier, or D = E x m.
3. The money creation process is reversible. Loan repayment destroys money and destroys
money creation potential through the money multiplier process.
E. Applying the Analysis: The Bank Panics of 1930 to 1933
1. Bank panics in 1930-33 led to a multiple contraction of the money supply (dropped about
23 percent), which contributed to the Great Depression.
2. Many of failed banks were healthy, but they suffered when worried depositors panicked
and withdrew funds all at once. More than 9000 banks failed in three years.
3. As people withdrew funds, this reduced banks’ reserves and, in turn, their lending power
fell significantly.
4. Banks sold securities to the public in a “scramble for liquidity,” but this further reduced
the money supply.
5. President Franklin Roosevelt closed the banks for one week in 1933 to end the panics.
When banks reopened, deposits were federally insured and depositors felt more secure.
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