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Money and the Banking System: Definitions, Functions, and Creation of Money

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Money and the Banking System

Introduction

This chapter explores the definition of money, its functions, the evolution of monetary systems, and the mechanisms by which banks create money. It also discusses the regulation of banks, systemic risk, and the importance of monetary policy in stabilizing the economy.

Barter versus Monetary Exchange

Barter System

  • Definition: A system of exchange in which people trade one good for another without using money as an intermediate step.

  • Double Coincidence of Wants: Barter requires that both parties want what the other has, making transactions inefficient.

Monetary Exchange

  • Money acts as a medium of exchange, greatly increasing the efficiency and productivity of economic transactions.

The Nature and Functions of Money

Functions of Money

  • Medium of Exchange: The object used to buy and sell goods and services.

  • Unit of Account: The standard unit for quoting prices and recording debts.

  • Store of Value: An asset that allows wealth to be stored and retrieved over time.

Note: Money may not always be a good store of value if its purchasing power is unstable (e.g., during inflation).

What Serves as Money?

  • Historically, items such as cattle, stones, candy bars, cigarettes, woodpecker scalps, porpoise teeth, and large disk-shaped boulders have served as money in various societies.

Commodity Money

  • An object used as a medium of exchange that also has substantial value in alternative, nonmonetary uses (e.g., gold, silver).

  • To be useful as money, a commodity must be:

    • Easily divisible

    • Uniform or readily identifiable in quality

    • Storable and durable

    • High value per unit of volume and weight

Fiat Money

  • Money that is decreed as such by the government and has little or no intrinsic value as a commodity.

  • Maintains value because people have faith in the issuer and the supply is limited by policy.

Evolution of Money

  • Commodity Money → Full-bodied Paper Money → Partially Backed Money → Fiat Money

Measuring the Quantity of Money

Definitions of the Money Supply

  • M1 (Narrowly Defined Money Supply):

    • Coins and paper money in circulation

    • Traveler's checks

    • Conventional checking accounts and other checkable deposit balances

  • M2 (Broadly Defined Money Supply):

    • All of M1

    • Money market deposit accounts

    • Money market mutual funds

    • Savings accounts

Other Measures

  • M3 and Beyond: Includes even broader definitions, such as large time deposits.

  • Near Monies: Liquid assets that are close substitutes for money (e.g., savings accounts, money market funds).

  • Liquidity: The ease with which an asset can be converted into cash.

  • Credit Cards: Not considered money; they are a means of deferring payment.

Table: Main Components of M1 and M2

Measure

Main Components

M1

Currency outside banks, checking deposits, traveler's checks

M2

M1, savings deposits, money market funds, small time deposits

The Banking System

How Banking Began

  • Goldsmiths stored gold and issued paper receipts backed by gold.

  • Goldsmiths began lending out some of the gold, creating the basis for modern banking.

Fractional Reserve Banking System

  • Banks keep only a fraction of deposits as reserves; the rest is lent out.

Features of Fractional Reserve Banking

  1. Bank Profitability: Banks earn profit from the difference between interest on loans and interest paid on deposits.

  2. Discretion over Money Supply: By lending, banks create money; the amount depends on reserve holdings.

  3. Exposure to Runs: Banks must manage reserves carefully to avoid insolvency if many depositors withdraw funds simultaneously.

Principles of Bank Management

  • Banks must balance the pursuit of profit (through lending) with the need for safety (maintaining sufficient reserves).

Bank Regulation and Supervision

  • Regulation: Ensures depositor safety and controls the money supply.

  • Deposit Insurance: Guarantees depositors will not lose money if a bank fails (e.g., FDIC in the U.S.).

  • Bank Supervision: Periodic examinations, tighter regulations, and limits on risky activities.

  • Reserve Requirements: Minimum reserves banks must hold, proportional to deposits.

Systemic Risk and the "Too Big to Fail" Doctrine

Systemic Risk

  • Risks that threaten the entire banking or financial system, often due to interconnectedness of large institutions.

  • Bank runs and failures can spread through the system.

Too Big to Fail

  • Some institutions are so large or interconnected that their failure could destabilize the entire system (e.g., Lehman Brothers, AIG).

  • The Dodd-Frank Act (2010) gave the Federal Reserve powers to supervise these institutions and established tougher regulations and new procedures for failure.

The Origins and Creation of the Money Supply

Bank Balance Sheets

  • Banks keep balance sheets where assets (reserves, loans) equal liabilities (deposits) plus net worth.

  • Key equations:

    • Net Worth = Assets - Liabilities

    • Assets = Liabilities + Net Worth

Limits to Money Creation

  • Banks can lend only the portion of deposits above the required reserve ratio.

  • Multiple banks lending and redepositing funds leads to a multiplied expansion of the money supply.

Deposit Multiplier Formula

  • If the required reserve ratio is , the deposit multiplier is .

  • Change in deposits = change in reserves.

Example: If and reserves increase by , then change in deposits = .

Table: Chain of Multiple Deposit Creation (Simplified)

Round

Deposit

Required Reserve (20%)

Loan

1

$100,000

$20,000

$80,000

2

$80,000

$16,000

$64,000

3

$64,000

$12,800

$51,200

...

...

...

...

Total

$500,000

$100,000

$400,000

Oversimplification of the Deposit-Creation Formula

  • The formula assumes all cash is redeposited and banks hold only the minimum reserves.

  • If individuals or banks hold more cash or excess reserves, the multiplier effect is reduced and the money supply increases less.

  • After the 2008 financial crisis, banks held large excess reserves, reducing the effectiveness of monetary expansion.

The Need for Monetary Policy

Role of Government

  • The government (usually through the central bank) regulates the money supply to maintain economic stability.

During a Recession

  • Banks may reduce lending and increase reserves, shrinking the money supply.

  • Without intervention, this contraction can worsen the recession (as seen in the Great Depression and Great Recession).

During an Economic Boom

  • Banks may expand lending, increasing the money supply.

  • Without intervention, this can lead to inflation and economic instability.

Key Definitions

  • Run on a Bank: Many depositors withdraw cash simultaneously, risking bank failure.

  • Commodity Money: Money with intrinsic value (e.g., gold, silver).

  • Fiat Money: Money by government decree, little or no intrinsic value.

  • Fractional Reserve Banking: Banks keep only a fraction of deposits as reserves.

  • Deposit Insurance: Guarantees depositors' funds even if a bank fails.

  • Moral Hazard: When insured parties take greater risks.

  • Systemic Risk: Risk to the entire financial system.

  • Deposit Multiplier: Ratio of new deposits to new reserves ().

  • Liquidity: Ease of converting an asset to cash.

Conclusions

  • Money as a medium of exchange is more efficient than barter.

  • Money also serves as a unit of account and store of value.

  • Fractional reserve banking allows banks to create money but exposes them to risks.

  • Bank regulation, deposit insurance, and monetary policy are essential for economic stability.

  • The money supply is influenced by the behavior of banks, individuals, and government policy.

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