12CHAPTER Money, Banking, and the Financial System

Money, Banking, and the
Financial System
12
CHAPTER
Money: What Is It and How Did It Come to
Be?
Money: A Definition
To the layperson, the words income, credit, and wealth are synonyms
for money. In each of the next three sentences, the word money is
used incorrectly; the word in parentheses is the word an economist
would use.
1. How much money (income) did you earn last year?
2. Most of her money (wealth) is tied up in real estate.
3. It sure is difficult to get money (credit) in today’s tight mortgage
market.
In economics, the words money, income, credit, and wealth are not
synonyms. The most general definition of money is any good that
is widely accepted for purposes of exchange (payment for goods
and services) and the repayment of debt.
Money: What Is It and How Did It Come to
Be?
Three Functions of Money
Money has three major functions; it is a:
 Medium of exchange
 Unit of account
 Store of value
Money: What Is It and How Did It Come to
Be?
Medium of Exchange
A medium of exchange is an object that is generally
accepted in exchange for goods and services.
In the absence of money, people would need to exchange
goods and services directly, which is called barter.
Barter requires a double coincidence of wants, which is
rare, so barter is costly – it requires either much search, or
lots of specialized middle-men.
Money: What Is It and How Did It Come to
Be?
Unit of Account
In a money economy, a person
doesn’t have to know the price of an
apple in terms of oranges, pizzas,
chickens, or potato chips, as in a
barter economy. A person needs only
to know the price in terms of money.
A unit of account is an agreed
measure for stating the prices of
goods and services.
This Table illustrates how money
simplifies comparisons.
Because all goods are denominated in
money, determining relative prices is
easy and quick.
Money: What Is It and How Did It Come to
Be?
Store of Value
The store of value function is related to a good’s
ability to maintain its value over time. This is the least
exclusive function of money because other goods—for
example, paintings, houses, and stamps—can store value
too. At times, money has not maintained its value well,
such as during high-inflationary periods. For the most part,
though, money has served as a satisfactory store of value.
This function allows us to accept payment in money for our
productive efforts and to keep that money until we decide
how we want to spend it.
Money: What Is It and How Did It Come to
Be?
From a Barter to a Money Economy: The Origins of
Money
 How did we move from a barter to a money economy? Did a
king or queen issue an edict: “Let there be money”? Actually,
money evolved in a much more natural, market-oriented
manner.
 Making exchanges takes longer (on average) in a barter
economy than in a money economy because the transaction
costs are higher in a barter economy since it requires double
coincidence of wants.
 In a barter economy, some goods are more readily accepted
than others in exchange.
Money: What Is It and How Did It Come to
Be?
From a Barter to a Money Economy: The Origins of
Money
 Suppose that, of 10 goods A–J, good G is the most marketable (the
most acceptable) of the 10. On average, good G is accepted 5 of
every 10 times it is offered in an exchange, whereas the remaining
goods are accepted, on average, only 2 of every 10 times.
 Given this difference, some individuals accept good G simply because
of its relatively greater acceptability, even though they have no plans
to consume it.
 The more people accept good G for its relatively greater acceptability,
the greater its relative acceptability becomes, in turn causing more
people to accept it.
Money: What Is It and How Did It Come to
Be?
From a Barter to a Money Economy: The Origins of
Money
 This is how money evolved. When good G’s acceptance
evolves to the point that it is widely accepted for
purposes of exchange, good G is money.
 Historically, goods that have evolved into money include
gold, silver, copper, cattle, salt, cocoa beans, and shells.
 In many of the World War 2 prisoner of war (POW)
camps, the cigarette was being used as money among
the prisoners.
Money: What Is It and How Did It Come to
Be?
Money, Leisure, and Output
 Exchanges take less time in a money economy than in a
barter economy because a double coincidence of wants is
unnecessary: Everyone is willing to trade for money.
 The movement from a barter to a money economy therefore
frees up some of the transaction time, which people can use
in other ways.
 Some will use them to work, others will use them for leisure,
and still others will divide the available time between work and
leisure.
Money: What Is It and How Did It Come to
Be?
Money, Leisure, and Output
 Thus, a money economy is likely to have both more output
(because of the increased production) and more leisure time
than a barter economy.
 In other words, a money economy is likely to be richer in both
goods and leisure than a barter economy.
 A person’s standard of living depends, to a degree, on the
number and quality of goods consumed and on the amount of
leisure consumed. We would expect the average person’s
standard of living to be higher in a money economy than in a
barter economy.
Money: What Is It and How Did It Come to
Be?
Finding Economics with William Shakespeare in
London (1595)
 It is 1595, and William Shakespeare is sitting at a desk writing the
Prologue to Romeo and Juliet. Where is the economics? More
specifically, what is the connection between Shakespeare’s writing a
play and the emergence of money out of a barter economy?
 For Shakespeare, living in a barter economy would mean writing
plays all day and then going out and trying to trade what he had
written that day for apples, oranges, chickens, and bread.
 Would the baker trade two loaves of bread for two pages of Romeo
and Juliet?
Money: What Is It and How Did It Come to
Be?
Finding Economics with William Shakespeare in London
(1595)
 Had Shakespeare lived in a barter economy, he would have soon
learned that he did not have a double coincidence of wants with many
people and that if he were going to eat and be housed, he would need to
spend time baking bread, raising chickens, and building a shelter
instead of thinking about Romeo and Juliet.
 In a barter economy, trade is difficult; so people produce for themselves.
In a money economy, trade is easy, and so individuals produce one
thing, sell it for money, and then buy what they want with the money.
 A William Shakespeare who lived in a barter economy no doubt spent
his days very differently from the William Shakespeare who lived in
England in the sixteenth century. Put bluntly: Without money, the world
might never have enjoyed Romeo and Juliet.
Money: What Is It and How Did It Come to
Be?
Components of Money
Money consists of
 Currency
 Deposits at banks and other depository institutions
Currency is the notes and coins held by households and
firms.
Money: What Is It and How Did It Come to
Be?
Official Measures of Money
The two main official measures of money are M1 and M2.
M1 consists of currency and traveler’s checks and
checking deposits owned by individuals and businesses.
M2 consists of M1 plus time, saving deposits, money
market mutual funds, and other deposits.
Money: What Is It and How Did It Come to
Be?
The figure illustrates
the composition of
M1…
and M2.
It also shows the
relative magnitudes of
the components.
Money: What Is It and How Did It Come to
Be?
Are M1 and M2 Really Money?
All the items in M1 are means of payment. They are
money.
Some saving deposits in M2 are not means of payments—
they are called liquid assets.
Liquidity of an asset measures how quickly the asset can
be converted into cash (a means of payment) with little/no
loss of value.
Money: What Is It and How Did It Come to
Be?
Deposits are Money but Checks Are Not
In defining money, we include, along with currency, deposits
at banks and other depository institutions.
But we do not count the checks that people write as money.
A check is an instruction to a bank to transfer money.
Credit Cards Are Not Money
Credit cards are not money.
A credit card enables the holder to obtain a loan, but it must
be repaid with money.
How Banking Developed
Just as money evolved, so did banking.
The Early Bankers
 Our money today is easy to carry and transport, but it was not
always so portable.
 For example, when money consisted principally of gold coins,
carrying it about was neither easy nor safe.
 Gold was not only inconvenient for customers to carry, but it was
also inconvenient for merchants to accept - gold is heavy.
 Gold is unsafe to carry around - can easily draw the attention of
thieves.
 Storing gold at home can also be risky.
How Banking Developed
The Early Bankers
 Most individuals therefore turned to their local goldsmiths for help
because they had safe storage facilities.
 Goldsmiths were thus the first bankers. They took in other people’s
gold and stored it for them.
 To acknowledge that they held deposited gold, goldsmiths issued
receipts, called warehouse receipts, to their customers.
 Once people’s confidence in the receipts was established, they used
the receipts to make payments instead of using the gold itself.
 In time, the paper warehouse receipts circulated as money.
How Banking Developed
The Early Bankers
 At this stage of banking, warehouse receipts were fully backed by
gold; they simply represented gold in storage.
 Goldsmiths later began to recognize that, on an average day, few
people redeemed their receipts for gold. Many individuals traded the
receipts for goods and seldom requested the gold itself.
 In short, the receipts had become money, widely accepted for
purposes of exchange.
 Sensing opportunity, goldsmiths began to lend some of the stored
gold, realizing that they could earn interest on the loans without
defaulting on their pledge to redeem the warehouse receipts when
presented.
How Banking Developed
The Early Bankers
 In most cases, however, the gold borrowers also preferred warehouse
receipts to the actual gold. Thus the warehouse receipts came to
represent a greater amount of gold than was actually on deposit.
 Consequently, the money supply increased, now measured in terms of
gold and the paper warehouse receipts issued by the Goldsmith/bankers.
 Thus fractional reserve banking had begun. In a fractional reserve
system, banks create money by holding on reserve only a fraction of the
money deposited with them and lending the remainder. Our modern-day
banking operates within such a system.
Direct and Indirect Finance
Lenders can get together with borrowers directly or indirectly; that is,
there are two types of finance: direct and indirect.
Direct finance
 In direct finance, the lenders and borrowers come together in a market
setting, such as the bond market. In the bond market, people who
want to borrow funds issue bonds.
 For example, company A might issue a bond that promises to pay an
interest rate of 10 percent annually for the next 10 years. A person with
funds to lend might then buy that bond for a particular price.
 The buying and selling in a bond market are simply lending and
borrowing. The buyer of the bond is the lender, and the seller of the
bond is the borrower.
Direct and Indirect Finance
Indirect finance
 In indirect finance, lenders and borrowers go through a financial
intermediary, which takes in funds from people who want to save
and then lends the funds to people who want to borrow.
 For example, a commercial bank is a financial intermediary, doing
business with both savers and borrowers.
 Through one door the savers come in, looking for a place to deposit
their funds and earn regular interest payments. Through another
door come the borrowers, seeking loans on which they will pay
interest.
 The bank, or the financial intermediary, ends up channeling the
saved funds to borrowers.
Depository Institutions
A depository institution is a firm that accepts deposits
from households and firms and uses the deposits to make
loans to other households and firms.
The deposits of three types of depository institution are
part of the nation’s money:
 Commercial banks
 Thrift institutions
 Money market mutual funds
Depository Institutions
Commercial Banks
A commercial bank is a private firm that is licensed to
receive deposits and make loans.
A commercial bank’s balance sheet summarizes its
business and lists the bank’s assets, liabilities, and net
worth.
The objective of a commercial bank is to maximize the net
worth of its stockholders, by making profits.
Adverse Selection and Moral Hazard
Problems
 When it comes to lending and borrowing, both adverse
selection and moral hazards can arise. Both are the result of
asymmetric information.
 Asymmetric information relates to one side of a transaction
having information that the other side does not have.
 Suppose Rahima is going to sell her house. As the seller of
the house, she has more information about the house than
potential buyers. Rahima knows whether the house has
plumbing problems, cracks in the foundation, and so on.
Potential buyers do not.
Adverse Selection and Moral Hazard
Problems
The effect of asymmetric information can be either an adverse selection
problem or a moral hazard problem. The adverse selection problem
(hidden type) occurs before the loan is made, and the moral hazard
problem (hidden action) occurs afterward.
Before the loan is made
 An adverse selection problem occurs when the parties on one side
of the market, having information not known to others, self-select in
a way that adversely affects the parties on the other side of the
market.
 Think of it this way: Two people want a loan. One person is a good
credit risk, and the other is a bad credit risk. The person who is the
bad credit risk is the person more likely to ask for the loan.
Adverse Selection and Moral Hazard
Problems
Before the loan is made
 Suppose two people, Selim and Salina, want to borrow Tk. 100,000 ,
and Malek has Tk. 100,000 to lend.
 Salina wants to borrow the Tk. 100,000 to buy a piece of equipment for
her small business. She plans to pay back the loan, and she takes her
loan commitments very seriously. She is the Good type.
 Selim wants to borrow the Tk. 100,000 so that he can gamble. He will
pay back the loan only if he wins big gambling. He is not the type of
person who takes his loan commitments seriously. He is the Bad type.
 Who is more likely to ask Malek for the loan, Selim or Salina?
 Selim is because he knows that he will pay back the loan only if he
wins big in gambling; he sees a loan as essentially “free money.”
Heads, Selim wins; tails, Malek loses!
Adverse Selection and Moral Hazard
Problems
Before the loan is made
 If Malek can’t separate the good types from the bad types, what can
he do? He might just decide not to give a loan to anyone. In other
words, his inability to solve the adverse selection problem may be
enough for him to decide not to lend to anyone.
 At this point, a financial intermediary can help. A bank does not
require Malek to worry about who will and who will not pay back a
loan. Malek needs simply to turn over his saved funds to the bank, in
return for the bank’s promise to pay him say a 5 percent interest rate
per year.
 Then, the bank takes on the responsibility of trying to separate the
good types from the bad ones. The bank will run a credit check on
everyone; the bank will collect information on who has a job and who
doesn’t; the bank will ask the borrower to put up some collateral on
the loan; and so on. In other words, the bank’s job is to solve the
adverse selection problem.
Adverse Selection and Moral Hazard
Problems
After the loan is made
 The moral hazard problem exists when one party to a transaction
changes his or her behavior in a way that is hidden from and costly to
the other party.
 Suppose you want to lend some saved funds. You give Selim a Tk.
100,000 loan because he promised you that he was going to use the
funds to help him get through university. Instead, once Selim receives
the money, he decides to use the funds to buy some clothes and take a
vacation to Thailand.
 Because of such potential moral hazard problems, you might decide to
cut back on granting loans. You want to protect yourself from borrowers
who do things that are costly to you.
Adverse Selection and Moral Hazard
Problems
After the loan is made
 Again, a financial intermediary has a role to play.
 A financial intermediary, such as a bank, might try to solve the
moral hazard problem by specifying that a loan can only be
used for a particular purpose (e.g., paying for university).
 It might require the borrower to provide regular information on
and evidence of how the borrowed funds are being used,
giving out the loan in installments (Tk. 10,000 this month, Tk.
10,000 next month), and so on.
Financial Regulation
There are four main balance sheet rules:
 Capital requirements
 Reserve requirements
 Deposit rules
 Lending rules
How Banks Create Money
To achieve its objective, a bank makes (risky) loans at an
interest rate higher than that paid on deposits.
But the banks must balance profit and prudence; loans
generate profit, but depositors must be able to obtain their
funds when they want them.
Banks’ funds come from their assets, which we divide into
two important parts: reserves and loans.
Reserves are the cash in a bank’s vault and the bank’s
deposits at Federal Reserve Banks.
Bank assets also include buildings and equipment, liquid
assets, investment securities, and loans.
How Banks Create Money
Reserves: Actual and Required
The fraction of a bank’s total deposits held as reserves is
the reserve ratio.
The required reserve ratio is the fraction that banks are
required, by regulation, to keep as reserves. Required
reserves are the total amount of reserves that banks are
required to keep.
Excess reserves equal actual reserves minus required
reserves.
How Banks Create Money
Creating Deposits by Making Loans in a One-Bank
Economy
When a bank receives a deposit of currency, its reserves
increase by the amount deposited, but its required
reserves increase by only a fraction (determined by the
required reserve ratio) of the amount deposited.
The bank has excess reserves, which it loans. These
loans can only end up as deposits in our one and only
bank, where they boost deposits without changing total
reserves, which creates money.
How Banks Create Money
This Figure
illustrates
how one
bank create
money by
making
loans.
How Banks Create Money
The Deposit Multiplier
The deposit multiplier is the amount by which an
increase in bank reserves is multiplied to calculate the
increase in bank deposits.
The deposit multiplier = 1/Required reserve ratio.
How Banks Create Money
Creating Deposits by Making Loans with Many Banks
With many banks, one bank lending out its excess
reserves cannot expect its deposits to increase by the full
amount loaned; some of the loaned reserves end up in
other banks.
But then the other banks have excess reserves, which
they loan.
Ultimately, the effect in the banking system is the same as
if there was only one bank, so long as all loans are
deposited in banks.
How Banks Create Money
This Figure
illustrates
money creation
with many
banks.