Money, Banking, and the Financial System: Study Notes

Money, Banking, and the Financial System

Money Defined

Money is a fundamental concept in macroeconomics, serving as the backbone of modern economies. It is any good that is widely accepted for purposes of exchange and in the repayment of debt.

• Money: Any item that is generally accepted as payment for goods and services and repayment of debts.

• Barter: The direct exchange of goods and services without the use of money.

Example:

Trading wheat for shoes is barter; using dollars to buy shoes is a monetary transaction.

Functions of Money

Money performs several key functions in the economy:

• Medium of Exchange: Money is accepted in exchange for goods and services, facilitating trade.

• Unit of Account: Money provides a common measure for valuing goods and services.

• Store of Value: Money can be saved and used for future purchases, retaining value over time.

Example:

Money allows you to compare the price of apples and oranges, and to save earnings for future use.

From Barter to a Money Economy

Money evolved to make exchange easier and less time-consuming than barter, which requires a double coincidence of wants—each party must have what the other wants.

• Double Coincidence of Wants: The situation in barter where two parties each possess an item the other wants.

• Money eliminates this requirement, making transactions more efficient.

• Historically, items like gold, silver, cattle, and shells have served as money.

What Gives Money Its Value?

Modern money derives its value from its general acceptability in exchange and payment of debts, rather than intrinsic value.

• Fiat Money: Money without intrinsic value, established as money by government regulation.

The Money Supply

The money supply is measured in different ways, primarily M1 and M2.

M1

• Currency held outside banks

• Checkable deposits

• Traveler's checks

Formula:

$M1 = ext{Currency held outside banks} + ext{Checkable deposits} + ext{Traveler's checks}$

M2

• All of M1

• Savings deposits (including money market accounts)

• Small denomination time deposits

• Money market mutual funds (retail)

Formula:

$M2 = M1 + ext{Savings deposits} + ext{Small denomination time deposits} + ext{Money market mutual funds}$

Definitions:

• Savings Deposit: Interest-earning account at a bank or thrift institution.

• Money Market Deposit Account: Interest-earning account with limited check writing privileges.

• Time Deposit: Interest-earning deposit with a specified maturity date.

• Money Market Mutual Fund: Interest-earning account at a mutual fund company.

Are Credit and Debit Cards Money?

• Credit Cards: Represent loans; not part of the money supply.

• Debit Cards: Provide access to checkable deposits, which are part of the money supply.

Early Banking

Early banking involved goldsmiths storing gold and issuing warehouse receipts, which became a form of money.

• Gold coins used as medium of exchange.

• Receipts for stored gold circulated as money.

Fractional Reserve Banking

Fractional reserve banking began when goldsmiths lent out some of the stored gold, issuing more receipts than gold held.

• Fractional Reserve Banking: Banks hold reserves equal to only a fraction of their deposit liabilities.

The Federal Reserve System

The Federal Reserve is the central bank of the United States, with the chief function of controlling the money supply.

• Central Bank: Institution that manages a state's currency, money supply, and interest rates.

Bank Reserves

Banks are required to hold a portion of deposits as reserves, either at the Federal Reserve or as vault cash.

• Reserves: Bank deposits at the Fed plus vault cash.

• Required Reserve Ratio (r): Percentage of deposits that must be held as reserves.

• Required Reserves: Minimum reserves mandated by the Fed.

• Excess Reserves: Reserves held beyond the required amount.

Formulas:

• $ext{Reserves} = ext{Bank deposits at the Fed} + ext{Vault cash}$

• $ext{Required reserves} = r imes ext{Checkable deposits}$

• $ext{Excess reserves} = ext{Reserves} - ext{Required reserves}$

The Financial System

The financial system connects savers (those with surplus funds) and borrowers (those with a shortage of funds).

• Direct Finance: Borrowers and lenders interact directly, e.g., in the bond market.

• Indirect Finance: Financial intermediaries (e.g., banks) facilitate lending and borrowing.

• Financial Intermediary: Institution that transfers funds from lenders to borrowers.

Adverse Selection and Moral Hazard

Information asymmetries in financial markets can lead to adverse selection and moral hazard.

• Asymmetric Information: One party has more or better information than the other.

• Adverse Selection: Occurs when one side of the market self-selects in a way that harms the other side due to hidden information.

• Moral Hazard: Occurs when one party changes behavior after a transaction in a way that is hidden and potentially costly to the other party.

A Bank's Balance Sheet

A bank's balance sheet summarizes its assets, liabilities, and capital (net worth).

• Assets: Reserves, loans, and other investments.

• Liabilities: Checkable deposits, non-transaction deposits, borrowings.

• Bank Capital (Net Worth): The difference between assets and liabilities; serves as a cushion against insolvency.

Insolvency:

• Occurs when liabilities exceed assets.

• Bank capital is a buffer against insolvency.

Self-Test Questions and Answers

• Why did money evolve out of a barter economy? To make trading easier and less time-consuming by eliminating the need for a double coincidence of wants.

• If funds are moved from checkable deposits to money market accounts, will M1 fall and M2 rise? M1 will fall, but M2 will remain constant, as the decrease in M1 is offset by an increase in the money market accounts component of M2.

• How does money reduce transaction costs? Money eliminates the need for a double coincidence of wants, making transactions faster and more efficient.

• If a bank reduces its deposits at the Fed by $5 million and increases its vault cash by $5 million, what happens to reserves? Total reserves remain constant.

• If a bank has $87 million in checkable deposits and is required to hold $6 million in reserves, what is the required reserve ratio? $r = rac{6}{87} = 0.0689$ (or 6.89%)

• If excess reserves are $4 million and total reserves are $6 million, what do required reserves and checkable deposits equal (with an 8% required reserve ratio)? Required reserves = $2 million; Checkable deposits = $25 million ($2 million / 0.08)

Summary Table: Money Supply Components

Component	M1	M2
Currency outside banks	✔	✔
Checkable deposits	✔	✔
Traveler's checks	✔	✔
Savings deposits		✔
Money market accounts		✔
Small time deposits		✔
Money market mutual funds		✔

Additional info:

• These notes cover core macroeconomic concepts from Chapter 12: Money, Banking, and the Financial System, including definitions, functions, and institutional details relevant for exam preparation.