Ch. 01: Money and Banking
Money
Money, also referred to as the money
supply, is defined as anything that is
generally accepted in payment for goods or
services or in the repayment of debts. Money
is linked to changes in economic variables
that affect all of us and are important to the
health of the economy.
Money Vs. Barter
• Making exchanges takes longer in a barter system: not
only do you have to find something you want, but you
have to have something the seller wants as well. This is
called a double coincidence of wants.
• Some goods are more readily accepted than other
goods. Historically, goods that have evolved into money
are: gold, silver, copper, cattle, rocks, and shells.
What Gives Money its Value?
• Our money has value because of its general acceptability.
• We accept paper dollars because we know that other
people will accept dollars later when we try to spend
them.
• Money has value to people because it is widely accepted
in exchange for other goods that are valuable.
Defining the Money Supply
• M1 is sometimes
referred to as the
narrow definition of
the money supply or
as transactions
money.
• M1 consists of
currency held
outside banks,
checkable deposits,
and traveler’s
checks.
Defining the Money Supply: M2
• M2 is sometimes referred to as the broad definition of
the money supply.
• M2 is made up of M1 plus small-denomination time
deposits, savings deposits, money market accounts,
overnight repurchase agreements, and overnight
eurodollar deposits held by US residents.
How Banking Developed
• Early bankers used
goldsmith’s warehouse
receipts.
• Early bankers began to
issue receipts for more
gold than they had on
hand.
• This was the beginning
of fractional reserve
banking.
The Federal Reserve System
• The central bank of the United States. The Fed, as it is commonly
called, regulates the U.S. monetary and financial system. The
Federal Reserve System is composed of a central governmental
agency in Washington, D.C.
The federal Reserve System has following duties
1.Conducting monetary policy.
2. Regulating banking institutions and protecting the credit rights of
consumers
3.Maintaining the stability of the financial system
4. Providing financial services to the U.S. government
The Money Creation Process
• The sum of bank deposits at the Fed and the
bank’s cash vault is total bank reserves.
• The Fed mandates member commercial banks
to hold a certain fraction of their checkable
deposits in reserve form. This fraction is called
the required reserve ratio.
• The difference between a bank’s total reserves
and its required reserves is its excess reserves.
Functions of Money
• Medium of Exchange:
– Eliminates the trouble of finding a double
coincidence of needs (reduces
transaction costs)
– Promotes specialization
• A medium of exchange must
–
–
–
–
–
be easily standardized
be widely accepted
be divisible
be easy to carry
not deteriorate quickly
Functions of Money (cont’d)
• Unit of Account:
– used to measure value in the economy
– reduces transaction costs
• Store of Value:
– used to save purchasing power over time.
– other assets also serve this function
– Money is the most liquid of all assets but
loses value during inflation
Evolution of the Payments System
 Commodity Money: valuable, easily
standardized and divisible commodities (e.g.
precious metals, cigarettes).
 Fiat Money: paper money decreed by
governments as legal tender.
 Checks: an instruction to your bank to transfer
money from your account
 Electronic Payment (e.g. online bill pay).
 E-Money (electronic money):
– Debit card
– Stored-value card (smart card)
– E-cash
Why Study Money
• Monetary policy is the control of the money
supply. It is conducted by the Central bank. CB
uses interest rates and other instruments to
control the money supply. The Purpose of Mon.
Pol. Is to control inflation which is the rate of
change of the price level.
Why Study Money (cont’d)
• Fiscal policy is the management of the govt.
budget: government spending
and taxation.
– Budget deficit is the excess of expenditures
over revenues for a particular year
– Budget surplus is the excess of revenues over
expenditures for a particular year
– Any deficit must be financed by borrowing.
5 Core Principles of Money & Banking
Time has value
Risk requires compensation
Information is the basis for decisions
Markets set prices and allocate resources
Stability improves welfare
1. Time has value
• If you work you will get paid by time. You
pay interest on loans based on the time of
the loan.
• As a result of interest, time affects the value
of financial transactions, e.g., bonds .
•
2. Risk requires compensation
The world is filled with uncertainty; some
possibilities are welcome (doubling the value
of your house) and some are not (you lose
your job).
3. Information is the basis for decisions.
• Most of us collect information before
making decisions, and the more important
the decision the more information we
collect. Banks spend time to collect
information about the borrowers to give
loans to high quality borrowers only.
•
The collecting and processing of
information is the foundation of the
financial system.
4. Markets set prices and allocate resources.
•
Markets are the core of the economic system;
they are the place, physical or virtual, where
firms go to issue stocks and bonds, and where
individuals go to purchase assets.
•
Financial markets are essential to the
economy, channeling its resources and
minimizing the cost of gathering information
and making transactions. Well-developed
financial markets are a necessary
precondition for healthy economic growth
5. Stability improves welfare.
•
Reducing volatility reduces risk. Only
government policymakers can reduce some
risks. By stabilizing the economy as a whole
monetary policymakers eliminate risks that
individuals can’t and so improve everyone’s
welfare in the process.
•
Stabilizing the economy is the primary function
of central banks. A stable economy grows
faster than an unstable one