Eco 200 – Principles of

Macroeconomics

Chapter 13:Money and Banking

Money
 Money = any item that is generally accepted
as a means of payment for goods and services
 Common functions of money:
 medium of exchange
 unit of account
 store of value
 standard of deferred payment
 Money does not always serve in the last three
of these functions.
Monetary aggregates: M1
 M1 = those items that serve as a medium of
exchange
 M1 = currency (including coins) + checkable
deposits + traveler’s checks
 Note that credit does not serve as money
 Commodity money
 Token money
 Fiat money (legal tender)
 Gresham’s law – “bad money drives out good”
M2 and M3
 M2 = M1 + savings deposits + small
denomination (< $100,000) time
deposits + retail money market mutual
fund balances
 M3 = M2 + repurchase agreements +
Eurodollar deposits
Global money
 Sales among industrialized countries usually
conducted in the currency of the seller
 Sales between industrialized and developing
countries are usually conducted in the
developed country’s currency
 Currencies of industrialized countries dominate
international transactions
 International reserve currency – used to settle
debts between governments (dollar, pound,
euro, and yen are most commonly used)
Composite currencies
 ECU – introduced in 1979 – value tied
to weighted average of national
currencies of EU – (replaced by the
euro)
 Special drawing rights – average of the
values of the dollar, euro, yen, and
pound – created in 1970 by the IMF
Banking
 Commercial banks – traditionally offered
only checking accounts
 Thrift institutions – traditionally offered
only savings accounts
 Financial deregulation in the 1980s
eliminated the last remaining
distinctions between commercial banks
and thrift institutions
Financial intermediation
 Direct finance – loans made directly from lenders to
borrowers
 Financial intermediation – banks (and other financial
intermediaries) accept deposits and make loans
 Financial intermediaries receive profits fr5om the
difference in interest rates on loans and deposits
 Reasons for financial intermediation:
 economies of scale

 lowers transaction costs

 Savers and borrowers have different time horizons

U.S. Banking
 Dual banking system: national and state
chartered banks
 Multistate branching is a recent
phenomenon
Bank failures
 High failure rates in the 1930s and
1980s
 Federal Deposit Insurance Corporation
(FDIC) – created in 1933 – insures
deposits up to $100,000
International banking
 Eurocurrency markets – deposits held in
currencies that differ from the currency of the
country in which the bank is located
 Eurocurrency deposits are not subject to U.S.
banking laws and offer higher interest rates
(along with higher risk)
 International banking facilities – since 1981-
bookkeeping systems that allow U.S. banks to
participate in offshore banking activities
Fractional reserve banking
system
 Banks create money whenever a loan is issued.
 Reserve requirement (set by Federal Reserve
Board) = fraction of deposits that must be held
as reserves
 Reserves = vault cash + deposits at Fed
 Banks may loan their excess reserves
 Required reserves = reserve requirement x
deposits
 Excess reserves = total reserves – required
reserves
T-accounts and deposit
multiplier
 Initial assumptions:
 no currency holdings
 no excess reserves
 Deposit expansion multiplier = 1/reserve
requirement (shown on board)
 Actual expansion is less due to:
 excess reserve holdings
 currency holdings