Banks, Money, and the Federal Reserve System – Chapter 14 Study Notes

Chapter 14: Banks, Money, and the Federal Reserve System

Chapter Overview

• 14.1 What Is Money, and Why Do We Need It?

• 14.2 How Is Money Measured in the United States Today?

• 14.3 How Do Banks Create Money?

• 14.4 The Federal Reserve System

• 14.5 The Quantity Theory of Money

14.1 What Is Money, and Why Do We Need It?

Definition and Functions of Money

Money is a fundamental economic invention, defined as any asset that people are generally willing to accept in exchange for goods and services or for payment of debts. Before money, economies relied on barter, which required a double coincidence of wants. The introduction of money enabled easier trade and economic specialization.

• Asset: Anything of value owned by a person or a firm.

• Commodity money: Goods used as money that also have value independent of their use as money (e.g., animal skins, precious metals).

The Four Primary Functions of Money

• Medium of exchange: Accepted by a wide variety of parties as payment for goods and services.

• Unit of account: Provides a standard measure of value.

• Store of value: Allows people to defer consumption by storing value; money is especially useful because it is liquid.

• Standard of deferred payment: Facilitates exchanges across time, assuming its value remains predictable.

Characteristics of Good Money

• Acceptable to most people

• Standardized quality (units are alike)

• Durable (does not wear out easily)

• Valuable relative to its weight (easy to transport)

• Divisible (usable for both small and large transactions)

Types of Money

• Commodity Money: Examples include cowrie shells, precious metals, animal pelts, and cigarettes in prisons.

• Paper Money to Fiat Money: Paper money was originally exchangeable for commodities like gold. Today, most economies use fiat money, which is authorized by a central bank and not backed by a physical commodity.

Fiat Money: Advantages and Disadvantages

• Advantage: Central banks can create money flexibly without needing to exchange it for gold or other commodities.

• Disadvantage: Fiat money relies on public confidence; if people lose faith in its value, it becomes useless.

Application: Cashless Transactions

• Some businesses (e.g., Dig Inn) do not accept cash, preferring digital payments for efficiency and security.

• Legal context: Firms are not required to accept cash for purchases, though debts are a different matter.

• Trend: The Covid-19 pandemic accelerated the move toward cashless, contactless payments.

14.2 How Is Money Measured in the United States Today?

Definitions of the Money Supply

• M1: The sum of currency in circulation, checking account deposits, and savings account deposits in banks (narrow definition).

• M2: Includes M1 plus small-denomination time deposits and noninstitutional money market fund shares (broader definition).

Size of the Money Supply (as of September 2023)

• M1: $18.1 trillion

• M2: $20.8 trillion

• About 13% of M1 is currency ($2.3 trillion), with 75% of U.S. paper currency in $100 bills.

• High U.S. currency holdings are partly due to use in other countries and underground economies.

M1 vs. M2

• Recent changes have made M1 and M2 more similar; both include checking and savings balances as well as currency.

• Banks play a key role in the money supply by managing deposits.

Debit and Credit Cards

• Debit cards: Access checking accounts directly, but the card itself is not money.

• Credit cards: Provide short-term loans; not considered money until the loan is paid off.

Application: Is Bitcoin Money?

• Bitcoins are a form of e-money, not issued by governments but by decentralized systems.

• Currently, bitcoins are not included in official measures of the money supply.

14.3 The Role of Banks in the Economy

How Banks Operate

Banks are profit-making private firms that play a critical role in the economy by creating money and facilitating financial transactions.

Bank Balance Sheet Example

Assets (in billions)	Liabilities & Stockholders' Equity (in billions)
Reserves: $135	Deposits: $1,000
Loans: $900	Short-term borrowing: $400
Securities: $700	Long-term debt: $360
Buildings & equipment: $15	Other liabilities: $275
Other assets: $550	Stockholders' equity: $265
Total assets: $2,300	Total liabilities & equity: $2,300

Reserves

• Deposits kept as cash in the bank's vault or on deposit with the Federal Reserve.

• Previously, banks were required to hold a fraction of deposits as reserves; as of March 2020, the reserve requirement is 0% for checking deposits.

Economic Importance of Bank Lending

• Reduces transaction costs: Banks use economies of scale and specialization to lower the costs of lending and borrowing.

• Reduces information problems: Banks address asymmetric information through statistical analysis and relationship banking.

Application: Fintech and Interest Rate Ceilings

• Fintech companies facilitate peer-to-peer lending online, charging fees but not taking on loan risk.

• Debate exists over capping credit card interest rates; some argue caps could restrict access to credit for higher-risk borrowers.

How Banks Create Money

• When a deposit is made, the bank's reserves and deposits increase by the same amount.

• Banks keep only a fraction of deposits as reserves (fractional reserve banking) and lend out the rest, creating new deposits and expanding the money supply.

Example: T-Account for Deposit Creation

Assets	Liabilities
+ $1,000 Reserves	+ $1,000 Deposits

When the bank lends out $900 (keeping 10% as reserves), new deposits are created elsewhere in the banking system, leading to a multiple expansion of deposits.

*Additional info: The process continues as each bank lends out a portion of new deposits, multiplying the effect on the money supply.*