Chapter 13: Money and Banks

Chapters 13, 14, and 15 examine the role of money in the economy, which includes the governments role in determining how much money is in circulation. Modeling the role of money is crucial to building a model of the macroeconomy. In this chapter we look at the functions, measures and creation of money.

I.  What is money?

A. Defining the functions of money

To put is simply, money is anything commonly accepted in exchange for goods or services. Throughout the history of the world, many things have served at money: gold, silver, cows, horses, cigarettes, and more. Money has several functions:

There are two types of money: commodity money and fiat money. Commodity money is money with its own value as a good. Gold coins are commodity money because the gold is worth something. Fiat money has no value other that given to it as money. The U.S. dollar today is fiat money. A $10 bill is worth something because the federal government says so, and because we accept it in exchange for goods and services. Fiat money is more efficient because commodity money has an opportunity cost: the gold in a gold coin could be used for something else, like jewelry.

B. Measuring money

Money comes in many different forms and these differ in terms of how easily they convert to cash. The U.S. has four measures of its money supply:

These measures get larger and larger because they include the measure below it. M1 contains the most liquid assets, i.e. assets easily converted to cash. We add assets less and less liquid assets for the broader measures of money. The most-watched measures of the money supply are M1 and M2.

However, the behavior of these two measures of money can be quite different.  As the graphs below show, M2 has grown much faster than M1.

II.  Banks and the Creation of Money

The currency you hold in your wallet was literally created by the U.S. Dept. of the Treasury, Bureau of Engraving, in Washington D.C. and the coins at mints in Philadelphia and Denver. However, most money in circulation is created by transferring balances electronically. When a bank makes a loan, it simply credits an account and that account is counted in M2. So banks have the power to create money.

We can demonstrate money creation through the use of a T account that shows a banks assets and liabilities. A bank's assets are the way a bank uses its funds. A bank's liabilities are the sources of a banks funds.
Suppose I empty my son Timmy's piggy bank (actually his bank looks like a Noah's Ark, but I digress...) and start a savings account for him. Suppose there is $100 in change in the piggy bank (it's a big bank). The banks balance sheet will change when I open the account:

Note that assets must equal liabilities.
The bank receives the $100 in coins and puts it in their vault, increasing its assets by $100.
The bank opens my son's account, which is a liability, since Timmy can withdraw the money at any time.
Note how this has changed the money supply. M1 has fallen by $100 because the coins are out of circulation, but M2 has remained unchanged because savings deposits have increased by $100, offsetting the decrease in M1.

U.S. banks operate on a fractional reserve banking system. This means that banks are required to keep only a fraction of deposits on hand to satisfy withdrawals. The bank then lends out the remaining fraction of deposits. The assets kept by the bank are known as reserves. Banks are required by law to keep a certain % of deposits as reserves. This is known as the required reserve ratio.

Back to our example, suppose the required reserve ratio is 20%. This means the bank must keep $20 of Timmy's deposit, but can lend out the other $80:

Suppose the bank uses the $80 to loan to Bob, crediting Bob with $80 in his account. With $180 in deposits, the bank must keep 20%, or $36 and is free to lend the excess:

Suppose the bank lends the excess $64 to Ed, increasing deposits to $180 + $64 = $244. Required reserves are (.2 x $244 = $48.80):

The bank can then lend the $51.20, and the process continues. But look at the T-account above, and you see that Timmy's deposit and the banks use of it has increased the money supply, M2 by $244 which is $144 MORE than the initial $100 increase in bank reserves

If we carried this example through, how much money can be created from the initial $100 in reserves? This depends on the required reserve ratio.

the money multiplier = 1 / (required reserve ratio)

and

potential deposit creation = initial excess reserves x money multiplier

In our example, there was an initial deposit of $100, so initial excess reserves are $80. The money multiplier is 1/.2 = 5. Then total deposit creation is 5 x $80 = $400. The $100 deposit creates $400 in new lending capacity (see table 13.4, page 266 for a demonstration).

The money multiplier allows use to calculate only potential money creation. In reality, money creation may be smaller because

As we have seen in this example, banks are not only a safe place to store money, but they act as a financial intermediary, transferring money from savers (by accepting deposits) to borrowers (by making loans).

In the next chapter, we take a look at the largest regulator of banks and financial markets in the U.S., the Federal Reserve System.

FYI: Related Links

A Comparative Chronology of Money from Ancient Times to the Present Day

The History of Money A brief discussion of commodity vs. fiat money by the Federal Reserve Bank of Minneapolis

Dollars and Sense: Fundamental Facts about U.S. Money From the Federal Reserve Bank of Atlanta