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, services, or repayment of debts. Before money, economies relied on barter, which required a double coincidence of wants and limited specialization.

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

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

The Four Primary Functions of Money

• Medium of exchange: Widely accepted for payment of goods and services.

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

• Store of value: Maintains value over time, allowing deferred consumption.

• Standard of deferred payment: Facilitates exchanges across time, assuming stable purchasing power.

Characteristics of Good Money

• Acceptable to most people

• Standardized quality

• Durable

• Valuable relative to weight

• Divisible for various transaction sizes

Examples of Commodity Money

• Cowrie shells in Asia

• Precious metals (gold, silver)

• Animal pelts in colonial North America

• Cigarettes in prisons

Paper Money and Fiat Money

• Paper money originated in China and was initially exchangeable for commodities like gold.

• Modern economies use fiat money, which is authorized by a central bank and not backed by a commodity.

• The Federal Reserve is the U.S. central bank; U.S. currency is fiat money.

Advantages and Disadvantages of Fiat Money

• Advantage: Flexibility for central banks to create money.

• Disadvantage: Relies on public confidence; if lost, fiat money loses value.

Application: Cashless Transactions

• Firms are not legally required to accept cash for purchases (except for debts).

• Trends toward cashless payments accelerated during the Covid-19 pandemic.

14.2 How Is Money Measured in the United States Today?

Definitions of the Money Supply

• M1: Currency in circulation + checking account deposits + savings account deposits.

• M2: M1 + small-denomination time deposits + noninstitutional money market fund shares.

Size and Composition of the Money Supply

• As of September 2023: M1 ≈ $18.1 trillion; M2 ≈ $20.8 trillion.

• About 13% of M1 is currency; 75% of U.S. paper currency is 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 similar; both include checking and savings balances.

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

Debit and Credit Cards

• Debit cards access checking accounts, but the card itself is not money.

• Credit cards are not money; they represent short-term loans.

Application: Is Bitcoin Money?

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

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

14.3 The Role of Banks in the Economy

How Banks Operate

Banks are profit-making 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	Total liabilities: $2,035
Total assets: $2,300	Stockholders' equity: $265
	Total liabilities & equity: $2,300

Reserves

• Deposits kept as cash in vaults or at the Federal Reserve.

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

Economic Importance of Bank Lending

• Reduces transaction costs through economies of scale.

• Reduces information problems (asymmetric information) by evaluating borrower risk.

• Relationship banking: Banks use private information to assess credit risk.

Application: Fintech and Interest Rate Ceilings

• Fintech firms facilitate peer-to-peer lending online.

• Proposals to cap credit card interest rates may limit access for high-risk borrowers.

14.3 (cont.) How Do Banks Create Money?

Money Creation Process

• When a deposit is made, reserves and deposits increase equally; no net change in money supply yet.

• Banks lend out a portion of deposits (fractional reserve banking), creating new deposits and expanding the money supply.

Example: T-Account for Deposit

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

When the bank lends out $900 (keeping 10% as reserves):

Assets	Liabilities
+ $900 Loans	+ $900 Deposits

This process continues as loans are redeposited, leading to a multiple expansion of deposits (money multiplier effect).

*Additional info: The money multiplier is affected by reserve ratios and the public's preference for holding cash versus deposits.*