Introduction to

Money and Banking

This chapter -- covers some basic
fundamentals on Money and
Banking. In this way, it helps us to
become more familiar with how
Monetary Policy works.
Money -- Facilitator of Trade.

Specific Roles of Money

as a Facilitator of Trade
Medium of Exchange -- Money is
exchanged for goods and services
Standard of Value -- Value is
measured in dollars (the price
tag)

 Standard of Deferred Payments -Loans and financial instruments

are denominated in terms of
money.
Store of Value -- People can use
money when they wish.

Definitions of Money
M1 = Currency held by the public
+ Travelers Checks
+ Checkable Deposits
M2 = M1 + Savings Deposits
+ Small Time Deposits
+ Money Market
Mutual Funds

Definitions of
Money Supply Components
Currency Held by the Public -- Paper
money and coin held by consumers
and firms.
Checkable Deposits -- bank deposits
which customers can write checks
upon.

Other Bank Deposits

Savings Deposits -- No checkable
privileges, but customers can withdraw
funds at any time without penalty.
Time Deposits -- A contract specifying
payment of principal and interest in an
explicit way over a given interval.
Withdrawal before maturity results in
penalty.

Money Market Mutual Funds

offered by private institutions (not banks)
pools investor funds
invests in short-term bonds
pays interest based upon overall
portfolio
restricted checkability (based upon
minimum size of check)

Quirks -- Defining Money

M1 emphasizes medium of exchange
function of money. M2 represents a
broader measure.
Checkable deposits, not checks, are
included in the money supply
definitions.
Credit card purchases are not
included in money supply definitions.

Liquidity of Financial Assets

Liquidity -- how easily an asset can
be converted into a medium of
exchange.
Ranking (most to least) based upon
liquidity: (1) Currency, (2) Checkable
Deposits, (3) Savings Deposits, (4)
Time Deposits.

The Role of Interest Rates

The Interest Rate -- compensates
financial investors for inconvenience due
to holding asset (e.g. loss of liquidity).
Ranking (most to least) based upon
interest rate: (1) Time Deposits, (2)
Savings Deposits, (3) Checkable
Deposits, (4) Currency.

Types of Banks
Commercial Banks (full service)
Savings and Loans (consumer
mortgages)
Savings Banks (consumer
mortgages and consumer loans)
Credit Unions (consumer loans)

Banks as
Financial Intermediaries
Financial Intermediary -- An
institution that borrows from
lenders, then loans to
borrowers.

The Role of
Financial Intermediaries
Takes advantage of institutional
fact of life -- lenders want to lend
small, but borrowers want to
borrow large.
Pools small savers funds into large
amount, available for private
borrowers (e.g. mortgages,
businesses).

The Banks Balance Sheet

Assets

Liabilities + Equity

Assets -- Market value of items in your

possession.
Liabilities -- Amounts owed to other
parties.
Equity = Assets - Liabilities

Working With Assets,

Liabilities, and Equity
Note: Definition of equity implies:
Assets = Liabilities + Equity
(Balance sheets balance!).

A Balance Sheet Example

Consider a house that you buy worth
$120,000. You take out a mortgage
of $100,000.
Assets
Liabilities + Equity
House $120,000 Mortgage
$100,000
Equity
$20,000

The Banks Major

Liabilities and Equity

(1) Deposits (D) -- Checking,

Savings, and Time Deposits of
bank customers.
(2) Borrowings (BORR) -- Funds
borrowed by banks, usually for
very short-term adjustments.
(3) Equity (E) = Total Assets
- Total Liabilities

The Banks Major Assets

(1) Reserves (R) -- vault cash of
banks plus deposits at the
Federal Reserve
-- Non-interest earning
-- Purpose: to back up customer
withdrawals from deposits

Fundamental
Balance Sheet Rule
Any customer withdrawal from any
of their deposits (checkable
deposits or savings and time
deposits) must be met with an
equal decrease in reserves.

An Example:
Customer Withdrawal
Customer withdraws $200 from
their savings deposit at Chase.
Chase
R - $200
D - $200

New Customer Deposits and

the Acquisition of Reserves
Example: Customer deposits $300
in their checkable deposit (D).
Chase
R + $300
D + $300

Other Assets
(2) Holdings of Bonds (B) -- source
of revenue from interest.
(3) Loans (L) -- revenue source
preferred to bonds.
-- less liquid
higher interest rate
-- more personal aspect

Inherent
Instabilities in Banking
Loan Default -- borrower fails to repay
loan, bank loses assets and equity.
Profits Versus Safety -- tradeoff
between having enough reserves to
meet depositors withdrawal needs
versus making sufficient profits from
loaning the funds.

Bank Regulation -- Dealing

With Banking Instabilities
Capital Requirements -- minimum
equity-asset ratio to absorb loan
defaults.
Discount Window -- Federal
Reserve serves as outlet for banks
to borrow reserves for emergency
withdrawal needs.

 Deposit Insurance (provided by the

Federal Deposit Insurance
Corporation, or FDIC) -- guarantees
reimbursement up to $100,000 per
depositor if their bank fails.
Reserve Requirements -- mandating a
minimum safety Level of reserves.

Reserve Requirements: The

Minimum Safety Level
Federal Reserve: issues a reserve
ratio on customer deposits (rD)
with the provision that, at any time
R > (rD)(D)

Decomposition of Reserves
Required Reserves (RR),
= (rD)(D)
Excess Reserves (ER),
ER = R - RR
Equivalent Ways to Express
Reserve Requirement
RR, or ER 0

RR

Bank Loaning -Balance Sheet Description

Consider the following example.
(rD = 0.10)

R
L
B

Chase
$4000 D $15000
$9000 E $1000
$3000

Computing Required and

Excess Reserves
Chase
R
L
B

$4000
$9000
$3000

rD = 0.10

D $15000
E $1000

RR = (rD)(D) = (0.10)($15000) = $1500

ER = R - RR = $4000 - $1500 = $2500

Chase Makes Loan of $2500

Step #1 -- Loan is
Approved
Chase
R
$4000
L
$11500
Bonds $3000

D $17500
E $1000

Borrower signs loan contract,

receives check from bank.

Step #2 -- Loan is Spent

R
L
B

Chase
$1500 D $15000
$11500 E $1000
$3000

Seller deposits check in her bank.

Fleet
R
+ $2500 D + $2500

Bank Loaning and the

Money Supply
Consider from previous example,
Fleet gets new deposits ($2500)
while Chase has the same as before.
Therefore M2 changes by $2500, the
amount of the loan.
Result bank loaning changes the
money supply by the amount of the
loan.

Loaning and the

Banking System
Seller deposits check in her bank.
Fleet
R
+ $2500 D + $2500
Fleet now can make a loan.
As funds from Fleets loan get
deposited in another bank, the process
continues