Chapter 13

  • November 30, 2020

Chapter 13


  • Money is an asset that is widely accepted as a means of payment in the economy
  • Asset: something of value that is owned by someone
  • Means of payment: Anything acceptable as payment for goods and services
  • Debit cards and credit cards are not money, they are means of payments
  • Checking account funds are assets

Money Supply

  • Cash in the hands of the public: Currency and coins held by the non-bank public
  • Checkable deposits: accounts held by households and business firms at commercial banks
  • Demand deposits: most basic checking account, on demand be paid in cash
  • Automatic transfers from savings accounts: interest-paying savings accounts that automatically transfer funds into demand deposit accounts as you write checks
  • Traveler’s checks: specially printed checks that you can buy from banks or other private companies
  • Money supply = cash in the hands of the public + checking account deposits + traveler’s checks

M1 vs. M2

  • Cash, checkable deposits, and traveler’s checks = M1
  • M2: includes all of M1 plus additional types of deposits that can fairly easily be turned into cash or checking deposits
  • M2 examples: savings deposits, money market deposits, money market funds, certificates of deposits under $100,000
  • M2 is much larger than M1

Functions of Money

  • Means of payment: how the payment is actually made
  • Store of value: a form in which wealth can be held
  • Unit of account: common unit for measuring how much something is worth, refers to the way we think about and record transactions

History of the Dollar

  • Federal Reserve System: The monetary authority of the United States, charged with creating and regulating the nation’s supply of money

Why Paper Currency is accepted as a Means of Payment

  • Commodity money: furs or jewels, had important uses other than a means of payment
  • People were willing to accept paper money because the currency could be exchanged for a valuable commodity such as gold or silver and because the issuer could print new money only when it acquired new gold or silver
  • Fiat money: something that serves as a means of payment by government declaration

Banking System

  • Financial intermediaries: business firms that specialize in brokering between savers and borrowers
  • Intermediary can reduce the risk to savers by spreading loans among a number of different borrowers
  • Depository institutions: accept deposits from the general public and end the deposits to borrowers
  • Commercial banks: largest group of depository institutions

Commercial Banks

  • Private corporation that provides services to the public
  • Most important service is to provide checking accounts

Balance Sheet: two-column list that provides information about the financial condition of a bank at a particular point in time

  • One side are assets: everything of value that it owns
  • Liabilities: the amount that the bank owes

Bank’s Assets

  • Bond: promise to pay funds to the holder of the bond, issued by a corporation or government agency when it borrows money, gradually or all at once in the future
  • Loan: promises, signed by households or non-corporate businesses to pay back funds
  • Bank’s cash does not pay any interest at all
  • The bank must always be prepared to honor its obligations for withdrawals, so it must have some cash on hand to meet these requirements
  • Reserves: Vault cash plus balances held at the Fed
  • Required reserves: the minimum amount of reserves a bank must hold, depending on the amount of its deposit liabilities
  • Required reserve ratio: the minimum fraction of checking account balances that banks must hold as reserves
  • Excess reserves: reserves in excess of required reserves

Bank’s Liabilities

  • Checking account deposits
  • Other deposits: funds that households and firms hold at the bank in some form other than checking accounts, such as savings accounts or certificates of deposit
  • Bank borrowing: Banks themselves sometimes borrow funds by taking out loans from other banks, or by issuing their own bonds

Shareholders’ Equity

  • = total assets – total liabilities

Federal Reserve System

  • Central bank: the nation’s principal monetary authority responsible for controlling the money supply
  • Instead of a single central bank, the US is divided into 12 Federal Reserve districts

Federal Open Market Committee

  • Establishes monetary policy

Functions of the Fed

  • Supervising and regulating banks
  • Acting as a “bank for banks”
  • Discount rate: the interest rate the Fed charges on loans to banks
  • Issuing paper currency
  • Check Clearing: transferring funds from one bank’s reserve account to another’s
  • Guiding the Macro economy
  • Dealing with Financial Crises: lender of last resort to make sure that banks have enough reserves to meet their obligations to depositors

The Fed and the Money Supply

  • Open market operation: the Fed buys or sells government bonds in the bond market

How an Open Market Purchase can increase the Money Supply

  • Banks never hold excess reserves
  • Households and businesses do not withdraw or deposit cash

Money Multiplier

  • Number by which we multiply the injection of reserves to get the total change in the money supply
  • Money multiplier = 1/RRR
  • Money Supply = 1/RRR x Reserves

How an Open Market Sale Can Decrease the Money Supply

  • Selling government bonds

Important Provisos about the money multiplier

  • Changes in the public’s cash holdings: smaller increase in lending and checking accounts
  • Increased Reserve Holdings: money multiplier smaller than it would be

Other Fed Actions that Change Money Supply

  • Changes in the Required Reserve Ratio
    • Raise the ratio = money supply decreases
  • Changes in the Discount rate
    • Rise in the discount rate = decrease in money supply
    • Lower discount rate = increase in money supply
  • Changes in the interest rate on reserves
    • Increase in IOR rate = decrease in money supply

Banking Panics

  • Fractional reserve system: its reserves are only a fraction of its total deposits

Bank Insolvency

  • Insolvent: condition of a firm when total assets are less than total liabilities
  • Reasoning: bankruptcies of businesses and households that have borrowed money from the bank

Banking Panic

  • Run on the bank: an attempt by many of a bank’s depositors to withdraw their funds
  • Banking panic: a situation in which fearful depositors attempt to withdraw funds from many banks simultaneously
  • In the past, a banking panic would force many banks to “close their doors” even if they were solvent

End of Banking Panics

  • Federal Reserve is ready to inject reserves
  • FDIC had a major impact on psychology of banking public
  • FDIC protection comes with costs: must pay insurance, higher rates on loans and higher fees for their services

Role of Regulation

  • Bank capital: another name for shareholders’ equity in a bank
  • Capital ratio: a bank’s capital as a percentage of its total assets

Non-Banks and the Shadow Banking System

  • Shadow Banking system: the entire collection of non-bank financial intermediaries
  • Non-bank: a financial intermediary less strictly regulated than a bank and with no government-guaranteed deposits