Money and Banking

“Money is whatever is generally

accepted in exchange for goods and
services—accepted not as an object to
be consumed but as an object that
represents a temporary room of
purchasing power to be used for
buying still other goods and services.”
-- Milton Friedman
What is Money?
Money is anything that is generally
acceptable to sellers in exchange for
goods and services.

A liquid asset is an asset that can

easily (i.e., quickly, cheaply,
conveniently) be exchanged for
goods and services.
What is Money?
Functions of Money
1) Medium of exchange
2) Unit of account
3) Store of value
4) Standard of Deferred Payment
Medium of Exchange (1)
 The use of money as a medium of
exchange (to make transactions) lowers
transactions costs.
 Trade without money, directly exchanging
goods for goods, is called barter.
– Barter requires a double coincidence of wants
—each party to the exchange has to want what
the other has to trade.
– Finding someone else who wants what you
have to trade and who has what you want is
time-consuming and costly.
Medium of Exchange (2)
A medium of exchange must be:
– Widely accepted for payment
– Portable: easy to transport and transfer
to the seller
– Divisible: measurable in both small and
large units
Unit of Account
 Money acts as a common unit of
measurement.
 This allows us to compare the values
of very dissimilar things.
 It makes accounting possible.
 As a result of these things, it lowers
information costs.
Store of Value
 Money makes it possible to carry buying power
forward into the future.
 Therefore, for money to be a store of value, it
must be durable.
– Durability is the ability to retain value over time.
– Inflation can reduce the effectiveness of money as a
store of value.
– This can lead to currency substitution—the use of
foreign money as a substitute for domestic money when
the domestic economy has a high rate of inflation.
Standard of Deferred Payment
 Debt is denominated in money terms.
 The standard for repayment is money.
 There is a difference between money and
credit:
– Money is what you use to pay for goods and
services.
– Credit is available savings that are lent to
borrowers to spend.
– Credit is debt, something you owe.
Money Supply
Money Today consists of:
– Currency is the bills and coins that we
use.
– Deposits are also money because they
can be converted into currency and are
used to settle debts.
What is Money?
 The narrowest and most liquid measure of the
money supply.
– It includes financial assets that are immediately
available for spending on goods and services.
 includes:
– Currency
– Travelers’ Checks
– Demand Deposits (checking accounts)
– Other Checkable Deposits (interest-bearing checking)
 Demand Deposits and Checkable Deposits are
called transactions accounts—these are checking
accounts that can be drawn upon to make
payments.
About Currency
 Currency generally blocked by gold or
silver but U.S. currency today is not
backed by gold or silver.
– It is backed only by the confidence and trust of
the public.
– It is a fiduciary monetary system. (“Fiducia”
means “trust” in Latin.)
 Moneybacked by gold or silver (or
something else of value) is called
commodity money.
Problems with Commodity Money
 Attimes, the precious metal in gold or
silver coins may be worth more than the
face value of the coins.
– In such situations, the public will begin to
hoard the coins.
– According to Gresham’s Law, if two coins
have the same face value but different intrinsic
(commodity) values, the cheaper coin will be
used to make transactions and the other coin
will be hoarded. “Bad money drives out good.”
What is Money?—
 Lessliquid assets that can be
converted to assets quickly and at
low cost.
Adds:
– Savings deposits
– Small denomination time deposits (CDs)
– Retail money market mutual funds
Global Money
 An international reserve asset is an asset used to settle
debts between governments. Today gold is not the most
common Int’l Reserve Asset, national currencies serve this
function.
 Thus these currencies are referred to as international
reserve currencies.
 A composite currency is an artificial unit of account that is
an average of the values of several national currencies.
– SDR: Special Drawing Right, average of the values of U.S.
dollar, the euro, the Japanese Yen, and the U.K. pound.
Created by the IMF in 1970 as an int’l reserve asset.
– ECU: European Currency Unit. Replaced by the Euro.
Financial Intermediaries
Financial intermediaries are firms
that take deposits from households
and firms and make loans to other
households and firms.
Financial Intermediaries
Four Types of Financial Intermediaries

1) Commercial banks
2) Savings and loan associations
3) Savings banks and credit unions
4) Money market mutual funds
Financial Intermediaries
 Commercial Banks
– Financial institutions that offer deposits on which
checks can be written. The make loans to households
and businesses. They are corporations.
– Originally only commercial banks could offer (non-
interest-bearing) checking accounts.
 Thrifts (Saving) Institutions
– Savings and Loan Associations, Credit Unions, Mutual
Savings Banks.
– Created to encourage saving, hence “thrift”.
– Until 1980, these institutions could offer higher interest
rates on savings accounts than banks.
– Now “thrifts” can offer many of the same services as
commercial banks.
International Banking (1)
 Eurocurrency market or “offshore
banking”: the market for deposits and
loans generally denominated in a currency
other than the currency in which the
transaction occurs.
– For example, a U.S. firm may borrow U.S.
dollars from a bank in London.
– Because foreign banks do not operate under
U.S. legal restrictions, they may offer better
interest rates on deposits and loans.
– On the other hand, foreign banking laws do
apply and may cause other problems.
International Banking (2)
 International Banking Facilities (IBFs)
were legalized in December 1981.
 An IBF is a division that is allowed to
receive deposits from and make loans to
nonresidents without the restrictions that
apply to domestic banks.
 This allows domestic banks to compete
more fairly with offshore banks.
Informal Markets
in Developing Countries
 ROSCA—Rotating of Savings and
Credit Associations
– Operate like savings clubs
– Example: 12 members contribute every
month, and then every 12th month each
member receives the full amount
contributed by everyone.
Fractional Reserve Banking
A system in which banks keep less
than 100 percent of the deposits
available for withdrawal.
 An outgrowth of goldsmith practices.
How Banks Create Money
Reserves: Actual and Required
– The reserve ratio is the portion of a bank’s
total deposits that are held in reserves.
– The required reserves ratio is the ratio of
reserves to deposits that banks are required,
by regulation, to hold. Required reserves are
those reserves which must be kept on hand or
on deposit with the Central Bank in order to
comply with the reserve requirements.
– Excess reserves are the cash reserves beyond
those required, which can be loaned.