12 Money and the Banking System Money is a machine for doing quickly and commodiously what would be done though less quickly and commodiously without it JOHN STUART MILL Contents Contents The The Nature Nature of of Money Money How How the the Quantity Quantity of of Money Money isis Measured Measured The The Banking Banking System System The The Origins Origins of of the the Money Money Supply Supply Banks Banks and and Money Money Creation Creation Why Why the the Deposit Deposit Creation Creation Formula Formula Is Is Oversimplified Oversimplified The The Need Need for for Monetary Monetary Policy Policy Copyright 2006 South Western Thomson Learning All rights reserved The The Nature Nature of of Money Money Barter Barter versus versus Monetary Monetary Exchange Exchange A Abarter barter system system with with no no money money would would be be awkward awkward and and extremely extremely inefficient inefficient Money Money greases greases the the wheels wheels of of exchange exchange and and thus thus makes makes the the whole whole economy economy more more productive productive Copyright 2006 South Western Thomson Learning All rights reserved The The Nature Nature of of Money Money The The Conceptual Conceptual Definition Definition of of Money Money The The functions functions of of money money Medium Mediumof ofexchange exchange Unit Unit of of account account Store Store of of value value Money Money whatever whatever serves serves as as the the medium medium of of exchange exchange Copyright 2006 South Western Thomson Learning All rights reserved The The Nature Nature of of Money Money What What Serves Serves as as Money Money Societies Societies have have gradually gradually moved moved from from the the use use of of commodity commodity monies monies to to the the use use of of money money that that has has no no commodity commodity backing backing at at all all Copyright 2006 South Western Thomson Learning All rights reserved How How the the Quantity Quantity of of Money Money is is Measured Measured There There isis no no single single obvious obvious place place to to draw draw the the line line between between money money and and near near money money M1 M1 coins coins and and paper paper money money in in circulation circulation plus plus checkable checkable deposits deposits M2 M2 M1 M1 money money market market deposit deposit accounts accounts money money market market mutual mutual funds funds and and savings savings accounts accounts Copyright 2006 South Western Thomson Learning All rights reserved FIGURE FIGURE 2 2 Two Two Definitions Definitions of of the the Money Money Supply Supply January January 2005 2005 Currency Outside banks 710 billion Checking deposits In commercial Banks 330 billion Other checkable deposits 321 billions M1 1361 billion Savings deposits 4378 billion M1 1361 billion M2 6443 billion Money market mutual funds 704 billion Copyright 2006 South Western Thomson Learning All rights reserved The The Banking Banking System System How How Banking Banking Began Began Fractional Fractional reserve reserve banking banking began began when when goldsmiths goldsmiths realized realized they they could could profitably profitably lend lend out out aa portion portion of of the the gold gold that that had had been been deposited deposited with with them them for for safekeeping safekeeping Copyright 2006 South Western Thomson Learning All rights reserved The The Banking Banking System System How How Banking Banking Began Began Three Three important important features features of of the the fractional fractional reserve reserve banking banking system system Bank Bank profitability profitability Banks Banks discretion discretion over over the the money money supply supply Exposure Exposure to to bank bank runs runs Copyright 2006 South Western Thomson Learning All rights reserved The The Banking Banking System System Principles Principles of of Bank Bank Management Management Profits Profits versus versus Safety Safety To To make make aa profit profit aa banker banker must must take take risks risks But But because because the the business business isis risky risky the the same same banker banker must must also also emphasize emphasize safety safety The The heart heart of of banking banking isis to to be be torn torn between between the the two two principles principles Copyright 2006 South Western Thomson Learning All rights reserved FIGURE FIGURE 1 1 Bank Bank Failures Failures in in the the United United States States 1915 2003 1915 2003 2 200 FDIC established 2 000 1 800 1 600 1 400 1 200 1 000 200 800 160 600 120 400 Great Depression begins 200 0 1915 1920 1925 1930 1935 1940 1945 Year a 80 40 0 1945 1955 1965 1975 b 1985 1995 03 Copyright 2006 South Western Thomson Learning All rights reserved The The Banking Banking System System Bank Bank Regulation Regulation Deposit Deposit insurance insurance FDIC FDIC Eliminates Eliminates the the motive motive for for customers customers to to withdraw withdraw funds funds because because of of bad bad news news regarding regarding the thebank s bank s finances finances Moral Moral hazard hazard When When an an individual individual isis insured insured against against risk risk he she he she puts puts forth forth little little effort effort to to avoid avoid risk risk FDIC FDICcould could make make the the banking banking system systemless less safe safe Copyright 2006 South Western Thomson Learning All rights reserved The The Banking Banking System System Bank Bank Regulation Regulation Bank Bank Supervision Supervision Needed Needed to toreduce reducemoral moral hazard hazardproblem problem Ensures Ensures banks banks take take only only sensible sensible defensible defensible risks risks Controls Controls the the money money supply supply Reserve Reserve Requirements Requirements Helps Helps control control the the money money supply supply Copyright 2006 South Western Thomson Learning All rights reserved The The Origins Origins of of the the Money Money Supply Supply How How Bankers Bankers Keep Keep Books Books Banks Banks keep keep balance balance sheets sheets Assets Assets liabilities liabilities net net worth worth Assets Assets include include Reserves Reserves Loans Loans Liabilities Liabilities include include Deposits Deposits owed owed to tocustomers customers Copyright 2006 South Western Thomson Learning All rights reserved TABLE TABLE 1 1 Balance Balance Sheet Sheet of of BankBank a