Money, Banking, and the Money Supply

Introduction: The Fragility of Banking

The banking system is a critical component of the modern economy, but it is inherently fragile and subject to risks that require government supervision. Recent events, such as the failure of Silicon Valley Bank (SVB) in March 2023, highlight the importance of deposit insurance and regulatory oversight to maintain stability in the financial system.

• Bank failures can have widespread economic consequences, making government intervention crucial.

• The Federal Deposit Insurance Corporation (FDIC) insures deposits to protect consumers and prevent bank runs.

The Nature and Functions of Money

What Is Money?

Money is one of the most important inventions in economic history. Economists define money as any asset that people are generally willing to accept in exchange for goods and services or for the repayment of debts.

• Asset: Anything of value owned by a person or a firm.

• Money serves as a medium of exchange, a unit of account, a store of value, and a standard of deferred payment.

Why Do We Need Money?

Before the invention of money, people relied on barter, trading goods and services directly. This system required a double coincidence of wants, making trade inefficient. The introduction of money facilitated trade and economic specialization.

• Commodity money: Goods used as money that have value independent of their use as money (e.g., gold, silver, animal skins).

• The existence of money makes trading easier and supports economic growth.

Primary Functions of Money

Money performs several essential functions in the economy:

• Medium of exchange: Money is widely accepted as payment for goods and services.

• Unit of account: Money provides a standard measure of value.

• Store of value: Money allows people to transfer purchasing power from the present to the future.

• Standard of deferred payment: Money facilitates transactions over time, making future payments predictable.

What Can Serve as Money?

For a good to serve as an acceptable medium of exchange, it should have the following characteristics:

• Acceptability: Usable by most people.

• Standardized quality: Any two units are identical.

• Durability: Value is not lost by wearing out.

• Valuable relative to weight: Easily transported in large quantities.

• Divisibility: Usable for both low- and high-priced goods.

Types of Money

Commodity Money

Commodity money has value independent of its use as money. Examples include:

• Sea shells in Asia

• Precious metals (gold, silver)

• Animal pelts and skins in colonial North America

• Cigarettes in prisons and prisoner-of-war camps

From Commodity to Fiat Money

Paper money originated in China and spread globally. Initially, paper money was exchangeable for commodities like gold. Today, most economies use fiat money, which is not backed by a physical commodity but is authorized by a government or central bank.

• The Federal Reserve is the central bank of the United States.

• Fiat money is valuable as long as people have confidence in its value.

Definition: Fiat money is any money, such as paper currency, that is authorized by a governmental body and does not have to be exchanged for some other commodity money.

Advantages and Disadvantages of Fiat Money

• Advantages: Flexibility for central banks, not limited by commodity reserves.

• Disadvantages: Relies on public confidence; if confidence is lost, fiat money can become worthless.

Measuring the Money Supply

Definitions of the Money Supply

The money supply is measured using different aggregates:

• M1: Currency in circulation, checking account deposits, and traveler’s checks.

• M2: Includes M1 plus savings accounts, small-denomination time deposits, and non-institutional money market fund shares.

As of December 2023:

• M1 ≈ $18.1 trillion

• M2 ≈ $20.7 trillion

• About $2.3 trillion of M1 is currency, mostly in $100 bills.

Currency Holdings and the Underground Economy

• U.S. currency is widely held internationally, especially in countries with unstable local currencies or large underground economies.

Which Measure to Use?

• Both M1 and M2 are used in economic analysis; the choice depends on the context.

• Both include checking and savings account deposits, which play a key role in the money supply.

Debit and Credit Cards

• Debit cards: Directly access checking accounts; the money is part of M1.

• Credit cards: Provide short-term loans; not included in the money supply.

Electronic Money (E-Money) and Cryptocurrencies

• Forms of e-money (e.g., PayPal, Apple Pay) are increasingly trusted by consumers.

• Cryptocurrencies (e.g., Bitcoin) are not currently included in official measures of the money supply.

The Role of Banks in the Economy

Banks as Financial Intermediaries

Banks are profit-making private firms that accept deposits and make loans. They play a critical role in the creation of money and the functioning of the economy.

• Banks use deposited money to make loans and buy securities.

• Deposits are liabilities for banks; loans and reserves are assets.

Bank Balance Sheets

A bank’s balance sheet lists assets (e.g., reserves, loans) on the left and liabilities (e.g., deposits) and stockholders’ equity on the right. The two sides must always balance.

Fractional Reserve Banking

Banks keep only a fraction of deposits as reserves and lend out the rest. This system is called fractional reserve banking.

• Historically, banks were required to hold a certain percentage of deposits as reserves, but this requirement was eliminated in 2020.

• Banks now hold reserves to meet other regulatory requirements and to ensure liquidity.

Economic Importance of Bank Lending

• Banks reduce transactions costs and information problems (asymmetric information) in lending.

• Banks specialize in evaluating credit risk and processing loans efficiently.

Fintech and Interest Rate Ceilings

• Fintech companies facilitate peer-to-peer lending but may increase risk.

• Interest rate caps can make loans less accessible to high-risk borrowers.

How Banks Create Money

The Money Creation Process

When a bank receives a deposit, it keeps a fraction as reserves and lends out the rest, creating new deposits in the process. This is the basis of the money multiplier effect.

• Example: A $1,000 deposit with a 10% reserve ratio allows the bank to lend $900, creating new money.

Money Multiplier Formula

• The simple money multiplier is given by:

• In practice, the multiplier fluctuates due to changes in reserve holdings and currency preferences.

Bank Runs and Panics

If many depositors try to withdraw funds simultaneously, a bank run can occur. Multiple bank runs can lead to a bank panic.

• The Federal Reserve acts as a lender of last resort to prevent panics.

• The FDIC insures deposits to maintain public confidence.

The Federal Reserve System

Structure of the Federal Reserve

• Governed by a Board of Governors (7 members, 14-year terms).

• 12 regional Federal Reserve Banks.

• The Federal Open Market Committee (FOMC) manages monetary policy.

Monetary Policy and Open Market Operations

The Fed manages the money supply primarily through open market operations—the buying and selling of U.S. Treasury securities.

• Buying securities increases the money supply.

• Selling securities decreases the money supply.

The Shadow Banking System and Financial Crises

The Shadow Banking System

Non-bank financial firms (e.g., investment banks, money market funds, hedge funds) play a growing role in the financial system. These firms are less regulated and often highly leveraged, making them vulnerable to financial crises.

• Securitization: The process of transforming loans into securities that can be traded.

The Financial Crisis of 2007-2009

• Falling housing prices led to defaults on mortgage-backed securities.

• Highly leveraged shadow banks suffered large losses, leading to a credit crunch.

• The Fed and Treasury intervened to stabilize the system.

The Quantity Theory of Money and Inflation

Quantity Theory of Money

The quantity theory of money links the money supply to the price level and inflation.

• = Money supply

• = Velocity of money

• = Price level

• = Real GDP

In growth rates:

• If money supply grows faster than real GDP, inflation occurs.

• If money supply grows slower, deflation occurs.

Hyperinflation

• Hyperinflation: Inflation rates above 50% per month, usually caused by excessive money supply growth.

• Examples: Zimbabwe (2000s), Venezuela (2010s).

Application: Money Supply and Bank Balance Sheets

Sample Balance Sheet Transactions

When the borrower spends the loan and the recipient deposits it in another bank (e.g., Citibank):

The net effect is an increase in the money supply by the amount of new deposits created through lending.

Summary Table: What Counts as Money?

Example: Effect of Withdrawing Currency

• Withdrawing $100 from a checking account does not change M1, as both currency and checking deposits are included in M1.

Example: Money Creation Process

• Depositing $2,000 in currency increases deposits by $2,000 but decreases currency by $2,000—no net effect on M1.

• When the bank lends out $1,600, M1 increases by $1,600 (new deposits created).

• Transferring deposits between banks does not change the total money supply.

Formula:

In the example, the money supply increased by $1,600.