An Introduction to Money
and the Banking System
Does 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.
Money
WHAT ARE THE FUNCTIONS OF
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
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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
Money
WHAT KINDS OF MONEY ARE
THERE?
Two Basic Forms of Money
Commodity money or specie
Fiat Money
Other Forms of Money
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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
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Commodity money or specie
Fiat money
Checks
Electronic payments
E-money
Near money
The Banking System
WHY DO BANKS EXIST?
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
Risk Sharing
Depositors “invest” in a
diversified portfolio of
loans and securities
Liquidity
Banking
Services
Information
Costs arising from borrower's private
info are reduced as banks gather vital
borrower information
Depositors are offered
liquid claims and banks hold
more illiquid portfolios
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:
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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 the
bank, 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.
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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
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Primary financial intermediaries
Deposit collections
Primary lending institutions
Risk sharing (collateral & long-term
relationships)
• Liquidity creation
• Information providers (screening &
monitoring)
Bank Regulations
WHY DO BANKS NEED TO BE
REGULATED?
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.
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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?