Introduction to
Money and Banking
This chapter -- covers some basic
fundamentals on Money and
Banking. In this way, it helps us to
become more familiar with how
Monetary Policy works.
Money -- Facilitator of Trade.
Specific Roles of Money
as a Facilitator of Trade
Medium of Exchange -- Money is
exchanged for goods and services
Standard of Value -- Value is
measured in dollars (the “price
tag”)
Standard of Deferred Payments -Loans and financial instruments
are denominated in terms of
money.
Store of Value -- People can use
money when they wish.
Definitions of Money
M1 = Currency held by the public
+ Travelers Checks
+ Checkable Deposits
M2 = M1 + Savings Deposits
+ Small Time Deposits
+ Money Market
Mutual Funds
Definitions of
Money Supply Components
Currency Held by the Public -- Paper
money and coin held by consumers
and firms.
Checkable Deposits -- bank
deposits which customers can write
checks upon.
Other Bank Deposits
Savings Deposits -- No checkable
privileges, but customers can
withdraw funds at any time without
penalty.
Time Deposits -- A contract
specifying payment of principal
and interest in an explicit way over
a given interval. Withdrawal
before maturity results in penalty.
Money Market Mutual Funds
offered by private institutions (not
banks)
pools investor funds
invests in short-term bonds
pays interest based upon overall
portfolio
restricted checkability (based upon
minimum size of check)
Quirks -- Defining Money
M1 emphasizes medium of
exchange function of money. M2
represents a broader measure.
Checkable deposits, not checks,
are included in the money supply
definitions.
Credit card purchases are not
included in money supply
definitions.
Liquidity of Financial Assets
Liquidity -- how easily an asset can
be converted into a medium of
exchange.
Ranking (most to least) based upon
liquidity: (1) Currency, (2)
Checkable Deposits, (3) Savings
Deposits, (4) Time Deposits.
The Role of Interest Rates
The Interest Rate -- compensates
financial investors for
inconvenience due to holding asset
(e.g. loss of liquidity).
Ranking (most to least) based upon
interest rate: (1) Time Deposits,
(2) Savings Deposits, (3) Checkable
Deposits, (4) Currency.
Types of Banks
Commercial Banks (full service)
Savings and Loans (consumer
mortgages)
Savings Banks (consumer
mortgages and consumer loans)
Credit Unions (consumer loans)
Banks as
Financial Intermediaries
Financial Intermediary -- An
institution that borrows from
lenders, then loans to
borrowers.
The Role of
Financial Intermediaries
Takes advantage of institutional
fact of life -- lenders want to “lend
small”, but borrowers want to
“borrow large”.
Pools small savers funds into
large amount, available for private
borrowers (e.g. mortgages,
businesses).
The Bank’s Balance Sheet
Assets
Liabilities + Equity
Assets -- Market value of items in
your possession.
Liabilities -- Amounts owed to
other parties.
Equity = Assets - Liabilities
Working With Assets,
Liabilities, and Equity
Note: Definition of equity implies:
Assets = Liabilities + Equity
(Balance sheets balance!).
A Balance Sheet Example
Consider a house that you buy
worth $120,000. You take out a
mortgage of $100,000.
Assets
Liabilities + Equity
House $120,000 Mortgage $100,000
Equity
$20,000
The Bank’s Major
Liabilities and Equity
(1) Deposits (D) -- Checking,
Savings, and Time Deposits of
bank customers.
(2) Borrowings (BORR) -- Funds
borrowed by banks, usually for
very short-term adjustments.
(3) Equity (E) = Total Assets
- Total Liabilities
The Bank’s Major Assets
(1) Reserves (R) -- vault cash of
banks plus deposits at the
Federal Reserve
-- Non-interest earning
-- Purpose: to back up customer
withdrawals from deposits
Fundamental
Balance Sheet Rule
Any customer withdrawal from
any of their deposits (checkable
deposits or savings and time
deposits) must be met with an
equal decrease in reserves.
An Example:
Customer Withdrawal
Customer withdraws $200 from
their savings deposit at Chase.
Chase
R - $200
D - $200
New Customer Deposits and
the Acquisition of Reserves
Example: Customer deposits $300
in their checkable deposit (D).
Chase
R + $300
D + $300
Other Assets
(2) Holdings of Bonds (B) -- source
of revenue from interest.
(3) Loans (L) -- revenue source
preferred to bonds.
-- less liquid
 higher interest rate
-- more personal aspect
Inherent
Instabilities in Banking
Loan Default -- borrower fails to
repay loan, bank loses assets and
equity.
Profits Versus Safety -- tradeoff
between having enough reserves
to meet depositors’ withdrawal
needs versus making sufficient
profits from loaning the funds.
Bank Regulation -- Dealing
With Banking Instabilities
Capital Requirements -- minimum
equity-asset ratio to absorb loan
defaults.
Discount Window -- Federal
Reserve serves as outlet for banks
to borrow reserves for emergency
withdrawal needs.
Deposit Insurance (provided by
the Federal Deposit Insurance
Corporation, or FDIC) -guarantees reimbursement up to
$100,000 per depositor if their
bank fails.
Reserve Requirements -mandating a “minimum safety
Level” of reserves.
Reserve Requirements: The
“Minimum Safety Level”
Federal Reserve: issues a reserve
ratio on customer deposits (rD)
with the provision that, at any time
R > (rD)(D)
Decomposition of Reserves
Required Reserves (RR),
RR = (rD)(D)
Excess Reserves (ER),
ER = R - RR
Equivalent Ways to Express
Reserve Requirement
R  RR, or ER  0
Bank Loaning -Balance Sheet Description
Consider the following example.
(rD = 0.10)
R
L
B
Chase
$4000 D $15000
$9000 E $1000
$3000
Computing Required and
Excess Reserves
R
L
B
Chase
rD = 0.10
$4000 D $15000
$9000 E $1000
$3000
RR = (rD)(D) = (0.10)($15000) = $1500
ER = R - RR = $4000 - $1500 = $2500
Chase Makes Loan of $2500
Step #1 -- Loan is Approved
Chase
R
$4000 D $17500
L
$11500 E $1000
Bonds $3000
Borrower signs loan contract,
receives check from bank.
Step #2 -- Loan is Spent
R
L
B
Chase
$1500 D $15000
$11500 E $1000
$3000
Seller deposits check in her bank.
Fleet
R
+ $2500 D + $2500
Bank Loaning and the
Money Supply
Consider from previous example,
Fleet gets new deposits ($2500)
while Chase has the same as
before.
Therefore M2 changes by $2500,
the amount of the loan.
Result – bank loaning changes the
money supply by the amount of
the loan.
Loaning and the
Banking System
Seller deposits check in her bank.
Fleet
R
+ $2500 D + $2500
Fleet now can make a loan.
As funds from Fleet’s loan get
deposited in another bank, the process
continues…