Chapter 27

Money and
Banking

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 In this chapter you will learn to

1. Describe the various functions of money, and how money

has evolved over time.

2. Describe the roles of commercial banks and central banks

in modern banking systems.

3. Explain how commercial banks create money through the

process of taking deposits and making loans.

4. Describe the M1 and M2 measures of the money supply.

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The Nature of Money

What Is Money?

Money is a medium of exchange.

If there were no money, goods would have to be exchanged in

a system of barter.

Barter is very inefficient due to the double coincidence of

wants. Money makes it unnecessary.

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The Nature of Money

Money is also used as a store of value.

- without high inflation, money retains its value
Finally, money is used as a unit of account.
- used to keep our financial accounts

LESSONS FROM HISTORY 27.1

Hyperinflation and the Value of
Money

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The Origins of Money

Money has evolved over time, taking various different forms:

Metallic money:
- years ago, the market value of the metal was equal to
the face value of the coin
- this led to debasing  Gresham’s Law
Paper money:
- paper money was initially backed by precious metal
- often referred to as bank notes (issued by banks)

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The Origins of Money

Fractionally backed paper money:

- goldsmiths and banks began to issue more notes than
the amount of gold held in their vaults

Fiat money:
- money that is neither backed by nor convertible into
anything else
- decreed by the government to be legal tender

Today, almost all currency is fiat money.

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Modern Money: Deposit Money

Money held as deposits with commercial banks and other

financial institutions is called deposit money.

 Bank deposits are an important part of the money supply.

As in the past, banks create money by issuing more promises

to pay (deposits) than they have in cash reserves.

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 The Banking System

Most banking systems have:

- a central bank
- many financial intermediaries

A central bank acts as a bank to the banking system:

- usually a government-owned institution
- through it, the government conducts monetary
policy

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The Federal Reserve System

Created by an act of Congress in 1913.

The basic functions of the Fed are to:
• act as banker to commercial banks
• act as banker for the federal government
• regulate the money supply
• regulate, support, and monitor financial
institutions and markets

Most of our discussion will focus on the Fed’s role in

controlling the money supply  monetary policy
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Table 27.1 The Balance Sheet of the
Federal Reserve System, End of January
2007 (millions of dollars)

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Commercial Banks

A commercial bank is a privately owned, profit-seeking institution that

provides a variety of financial services:
- accepts deposits
- makes loans
- provides credit-card services
- offers wealth-management services

APPLYING ECONOMIC CONCEPTS 27.1

The Structure of the Federal Reserve
System

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Table 27.2 Consolidated Balance Sheet
of U.S. Commercial Banks,
December 2006 (billions of dollars)

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Reserves

Banks’ cash reserves are normally quite small because only a

small fraction of depositors want their money at any time.

A bank’s reserve ratio is the fraction of deposit liabilities that it

actually holds as reserves
- either vault cash or deposits with the central bank

A bank’s target reserve ratio is the fraction of deposits it

wishes to hold as reserves.

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Fractional Reserve Banking

The U.S. banking system is a fractional-reserve system

Any reserves in excess of target reserves are called excess

reserves
- these are central to the process of “money creation”

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 Money Creation by the Banking
System

Some Simplifying Assumptions

Suppose:
- banks invest only in loans
- there are only demand deposits
- all banks have a fixed target reserve ratio
- there is no cash drain from the banking system

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Table 27.3 The Initial Balance
Sheet of Incidental Bank (IB)

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Table 27.4 IB’s Balance Sheet
Immediately after a New Deposit of $100

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Table 27.5 IB’s Balance Sheet
after Making a New Loan of $80

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Table 27.6 Changes in the Balance
Sheets of Second-Round Banks

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 The Creation of Deposit Money

A single new deposit begins a long sequence of deposit

creation.
With the target reserve ratio of 20%, the new deposit of
$100 creates a total expansion of deposits of $500.

With no cash drain, a banking system with a target reserve

ratio of v will change its deposits by 1/v times any change in
reserves (the new deposit).

ΔDeposits = (1/v) ΔReserves

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Table 27.7 The Sequence of Loans and
Deposits after a Single New Deposit of $100

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Table 27.8 Change in the Combined Balance
Sheets of All the Banks in the System Following
the Multiple Expansion of Deposits

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Excess Reserves and Cash Drains

Deposit creation does not happen automatically; it depends on

the decisions of bankers.

A cash drain:
- if households hold a fraction of their deposits in
cash, the deposit-creation process is dampened

If c is the currency-deposit ratio, the final change in deposits

will be given by:

Δ Re serves
ΔDeposits =
c +v
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The Money Supply

The money supply is the total quantity of money that is in the

economy at any time
- several definitions of “money”

In general,
Money supply = Currency + Deposits

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Kinds of Deposits

The long-standing distinction between money and other

highly liquid assets was:
- money was a medium of exchange that did not earn
interest
- other assets earned interest but were not a medium
of exchange

Today this distinction is very blurred.

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 Definitions of the Money Supply

The narrowest definition of money is M1:

M1 = currency + checkable deposits

A broader definition is M2:

M2 = M1 + saving deposits + money market
deposit accounts

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Table 27.9 Two Measures of the Money
Supply in the United States, December
2006 (billions of dollars)

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Near Money and Money
Substitutes
Near money:
- assets that are a store of value and are readily
converted into a medium of exchange
- short-term bonds
- term deposits
Money substitutes:
- things that serve as a temporary medium of exchange
but are not a store of value
- credit cards
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Money Measures and the Fed

Choosing a Measure
There is no single, timeless definition of money.
New financial assets are continually being developed that
serve some of the functions of money.

The Role of the Federal Reserve

We have seen how commercial banks can expand reserves
into deposit money.
The Federal Reserve has great influence over the amount of
reserves in the banking system.

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