Macroeconomics

Module 12: Money and Banking

What is Money?
• Barter: literally, trading one good or service for another, without using money
• Commodity Money: an item that is used as money, but which also has value from its use as something
other than money
• Commodity-Backed Currencies: dollar bills or other currencies with values backed up by gold or
another commodity
• Double Coincidence of Wants: a situation in which two people each want some good or service that the
other person can provide
• Fiat Money: something used as money, but which has no intrinsic value besides that
• Medium of Exchange: whatever is widely accepted as a method of payment
Defining Money by its Functions

• Money solves the double coincidence of wants problem

• First, since money is generally accepted as a means of payment (or medium of exchange)
• Second, people are willing to sell something for money
• Third, money serves as a unit of account
• Money is anything that can serve all of these functions— it is a medium of exchange, a store
of value, a unit of account, and a standard of deferred payment
Commodity versus Fiat Money
• Money has taken a wide variety of forms in
different cultures
• Examples of commodity money is gold, silver,
cowrie shells, cigarettes, and even cocoa beans
• Fiat money has no intrinsic value, but is
declared by a government to be the legal
tender of a country
Measuring Money: Currency, M1, and M2
• Coins and Currency in Circulation: the coins and bills that circulate in an economy that
are not held by the U.S Treasury, at the Federal Reserve Bank, or in bank vaults
• Credit Card: immediately transfers money from the credit card company’s checking
account to the seller, and at the end of the month the user owes the money to the credit card
company; a credit card is a short-term loan
• Debit Card: like a check, is an instruction to the user’s bank to transfer money directly and
immediately from your bank account to the seller
• Demand Deposit: checkable deposit in banks that is available by making a cash withdrawal
or writing a check
• Liquidity: how quickly and easily an asset can be converted to a means of payment to make
a purchase
• M1 Money Supply: a narrow definition of the money supply that includes currency and
checking accounts in banks, and to a lesser degree, traveler’s checks.
Measuring Money: Currency, M1, and M2 cont.
• M2 Money Supply: a definition of the money supply that includes everything in M1, but
also adds savings deposits, money market funds, and certificates of deposit
• Money Market Fund: the deposits of many investors are pooled together and invested in a
safe way like short-term government bonds
• Savings Deposit: bank account where you cannot withdraw money by writing a check, but
can withdraw the money at a bank—or can transfer it easily to a checking account
• Smart Card: stores a certain value of money on a card and then one can use the card to
make purchases
• Time Deposit: account that the depositor has committed to leaving in the bank for a certain
period of time, in exchange for a higher rate of interest; also called certificate of deposit
M1 and M2
M1
• M1 is the most narrow
definition of the money supply
• Includes coins and currency
in circulation
M2
• A broader definition of money,
M2 includes everything in M1
but also adds other types of
deposits
• Includes savings deposits,
money market funds,
certificates of deposit, etc.
M1 and M2: Image
Credit

• When you make a purchase using money that you don’t have, you are using credit
• Credit is someone else’s money that they have lent to you
• Typically you use credit to buy something like a car, a house, or college expenses, “big-
ticket items” that will benefit you for a long time
• Instead of saving up and only then paying for them, credit allows you to buy now and pay
for them over time
• Sometimes people obtain credit in advance so that in the future when opportunities or needs
arise they will be able to buy something
Credit cont.

• Credit comes in many forms, including loans, bonds, notes, or lines of credit (like home
equity loans)
• All are essentially IOUs: that is, promises to repay with interest
• Debt is accumulated credit, less what has been repaid
• If you look at a credit card statement, each purchase you make using a credit card is a loan
from the credit card company to you
• Your total debt is the sum of money you have borrowed from all your creditors
Financial Markets and Assets

• Bills: short term (less than one year) debt instruments

• Bonds: long term (greater than 10 years) debt instruments
• Debt Instruments: IOUs
• Equities or Stocks: Ownership in a private company (unlike debt which conveys no
ownership)
• Initial Public Offering (IPO): original sale of stock by a corporation
• Notes: intermediate term (1-10 year) debt instruments
• Securities: synonym for financial assets
Financial Markets and Assets cont.
• Where do individuals put their savings, and where do businesses obtain the funding for
investment expenditure? The answer to both of these questions is financial markets.
• Financial markets include the banking system, equity markets like the New York Stock
Exchange, or the NASDAQ Stock Market, bond markets, commodity markets and more.
• Financial markets are global, Americans put their savings into foreign as well as domestic
bank accounts, foreign and domestic stocks and foreign and domestic bonds.
• All financial assets are called securities.
Financial Markets, Supply and Demand, and Interest
• Interest Rate: the “price” of borrowing in the financial market; a rate of return on an
investment.
• Intertemporal Decision Making: the study of how people make choices about what and
how much to do at various points in time; when choices at one time influence the
possibilities available at other points in time.
• Financial markets are made up of a large number of markets for different types of securities:
equities, bonds, credit cards, etc.
• Each financial asset is a substitute for every other financial asset (to greater or lesser extent),
and thus, all financial markets are linked, directly or indirectly.
The Commercial Banking System
• Checking Account: a bank account that typically pays little or no interest, but that give easy
access to money either by writing a check or by using a “debit card”
• Credit Union: a nonprofit financial institution that its members own and run
• Debit Card: a card that lets the person make purchases, and the financial institution
immediately deducts cost from that person’s checking account
• Depository Institution: institution that accepts money deposits and then uses these to make
loans
• Financial Intermediary: an institution that operates between a saver with financial assets to
invest and an entity who will borrow those assets and pay a rate of return
• Payments System: system by which buyers and sellers exchange money for goods, services
and financial capital.
The Commercial Banking System cont.

• Savings Account: a bank account that pays an interest rate, but withdrawing money
typically requires a trip to the bank or an automatic teller machine
• Transaction Costs: the costs associated with finding a lender or a borrower for money
The Role of Banks as Financial Intermediaries

• Banks play two key roles in the functioning of the economy,

• first by facilitating the payments system and
• second by serving as financial intermediaries.
• Banks make it far easier for a complex economy to carry out the extraordinary range of transactions that
occur in goods, labor, and financial capital markets
• Banks lower transactions costs
Banking Assets and Liabilities
• Asset: item of value that a firm or an individual owns
• Asset—Liability Time Mismatch: customers can withdraw a bank’s liabilities in the short
term while customers repay its assets in the long term
• Balance Sheet: an accounting tool that lists assets and liabilities
• Bank Capital: a bank’s net worth
• Diversify: making loans or investments with a variety of firms, to reduce the risk of being
adversely affected by events at one or a few firms
• Liability: any amount or debt that a firm or an individual owes
• Net Worth: the excess of the asset value over and above the amount of the liability; total
assets minus total liabilities
• Reserves: funds that a bank keeps on hand and that it does not loan out or invest in bonds
Banking Assets and Liabilities cont.

• T-Account: a balance sheet with a two-column format, with the T-shape formed by the
vertical line down the middle and the horizontal line under the column headings for “Assets”
and “Liabilities”
• Treasury Securities: government debt obligations in which the government sells short term
bills, intermediate term notes and long term bonds to raise money
• The “T” in a T-account separates the assets of a firm, on the left, from its liabilities, on the
right
• All firms use T-accounts, though most are much more complex
How Banks Create Money

• Banks create money through making loans.

• Money Multiplier: ratio of total money in the economy divided by the amount of reserves,
or the ratio of change in the total money in the economy divided by a change in the amount
of reserves; formula for the money multiplier is 1/(required reserve ratio)
• Required Reserve Ratio: percentage of total deposits a bank must hold as reserves
Quick Review

• What are the functions of money?

• Contrast commodity money and fiat money
• Contrast and classify monies as either M1 money supply and M2 money supply
• What is credit?
• What are financial markets and their assets, including securities?
• What are the types of financial markets and how they are linked
• How are market forces determined by interest rates in financial markets?
More Quick Review

• How do banks act as intermediaries between savers and borrowers?

• What is the difference between banks and credit unions?
• What is a bank’s assets and liabilities in a T-account
• Analyze the causes of bankruptcy and recessions
• How do banks create money?
• How do you calculate how banks create money using the money multiplier formula?