Principles of Macroeconomics for AP® Courses 2e Chapter 14 Monetary Policy and Bank Regulation

Money and Banking FIGURE Cowrie Shell or Money ?

Is this an image of a cowrie shell or money ?

The answer is Both . For centuries , people used the extremely durable cowrie shell as a medium of exchange in various parts of the world , Credit of Shell ( by Creative Commons , BY ) CHAPTER OBJECTIVES In this chapter . you will learn about Money by Its Functions Measuring Money Currency , and The Role of Banks How Banks Create Money Introduction to Money and Banking HOME The Many Disguises of Money From to Crypto Here is a trivia question In the history of the world , what item did people use for money over the broadest geographic area and for the longest period of time ?

The answer is not gold , silver , or any precious metal . It is the cowrie , a mollusk shell found mainly off the Maldives Islands in the Indian Ocean . served as money as early as 700 . in China , By the , they were in widespread use across India and Africa . For several centuries after that , were the means for exchange in markets including southern Europe , western Africa , India , and China buying lunch or a ferry ride to paying for a shipload of silk or rice . were still acceptable as a

338 14 Money and Banking way of paying taxes in certain African nations in the early twentieth century . What made work so well as money ?

First , they are extremely a century or more . As the late economic historian Karl put it , they can be poured , sacked , shoveled , hoarded in heaps while remaining clean , dainty , stainless , polished , and Second , parties could use either by counting shells of a certain size , large measuring the weight or volume of the total shells they would exchange . Third , it was impossible to counterfeit a cowrie shell , but dishonest people could counterfeit gold or silver coins by making copies with cheaper metals . Finally , in the heyday of cowrie money , from the into the 18005 , governments , first the Portuguese , then the Dutch and English , tightly controlled collecting . As a result , the supply of grew quickly enough to serve the needs of commerce , but not so quickly that they were no longer scarce . Money throughout the ages has taken many different forms and continues to evolve even today with the advent of cryptocurrency . What do you think money is ?

The discussion of money and banking is a central component in studying . At this point , you should have in mind the main goals of from Welcome to economic growth , low unemployment , and low . We have yet to discuss money and its role in helping to achieve our goals . You should also understand and neoclassical for analysis and how we can embody these in the aggregate supply ( model . With the goals and for analysis in mind , the step is to discuss the two main categories of policy monetary policy , which focuses on money , banking and interest rates and policy , which focuses on government spending , taxes , and borrowing . This chapter discusses what economists mean by money , and how money is closely interrelated with the banking system . Monetary Policy and Bank Regulation this discussion . Defining Money by Its Functions LEARNING OBJECTIVES By the end of this section , you will be able to Explain the various functions of money Contrast commodity money and money Money for the sake of money is not an end in itself . You can not eat dollar bills or wear your bank account . Ultimately , the usefulness of money rests in exchanging it for goods or services . As the American writer and humorist Ambrose ( wrote in 1911 , money is a blessing that is of no advantage to us excepting when we part with Money is what people regularly use when purchasing or selling goods and services , and thus both buyers and sellers must widely accept money . This concept of money is intentionally , because money has taken a wide variety of forms in different cultures . Barter and the Double Coincidence of Wants To understand the usefulness of money , we must consider what the world would be like without money . How would people exchange goods and services ?

Economies without money typically engage in the barter system . trading one good or service for highly for trying to coordinate the trades in a modern advanced economy . In an economy without money , an exchange between two people would involve a double coincidence of wants , a situation in which two people each want some good or service that the other person can provide . For example , if an accountant wants a pair of shoes , this accountant must someone who has a pair of shoes in the correct size and who is willing to exchange the shoes for some hours of accounting services . Such a trade is likely to be to arrange . Think about the complexity of such trades in a modern economy , with its extensive division of labor that involves thousands upon thousands of different jobs and goods . Access for free at

Money by its Functions 339 Another problem with the barter system is that it does not allow us to easily enter into future contracts for purchasing many goods and services . For example , if the goods are perishable it may be to exchange them for other goods in the future . Imagine a farmer wanting to buy a tractor in six months using a fresh crop of strawberries . Additionally , while the barter system might work adequately in small economies , it will keep these economies from growing . The time that individuals would otherwise spend producing goods and services and enjoying leisure time they spend bartering . Functions for Money Money solves the problems that the barter system creates . We will get to its soon . First , money serves as a medium of exchange , which means that money acts as an intermediary between the buyer and the seller . Instead of exchanging accounting services for shoes , the accountant now exchanges accounting services for money . The accountant then uses this money to buy shoes . To serve as a medium of exchange , people must widely accept money as a method of payment in the markets for goods , labor , and capital . Second , money must serve as a store of value . In a barter system , we saw the example of the shoemaker trading shoes for accounting services . However , she risks having her shoes go out of style , especially if she keeps them in a warehouse for future value will decrease with each season . Shoes are not a good store of value . Holding money is a much easier way of storing value . You know that you do not need to spend it immediately because it will still hold its value the next day , or the next year . This function of money does not require that money is a of value . In an economy with , money loses some buying power each year , but it remains money . Third , money serves as a unit of account , which means that it is the ruler by which we measure values . For example , an accountant may charge 100 to file your tax return . That 100 can purchase two pair of shoes at 50 a pair . Money acts as a common denominator , an accounting method that thinking about trade offs . Finally , another function of money is that it must serve as a standard of deferred payment . This means that if money is usable today to make purchases , it must also be acceptable to make purchases today that the purchaser will pay in the future . Loans and future agreements are stated in monetary terms and the standard of deferred payment is what allows us to buy goods and services today and pay in the future . Thus , money serves all of these it is a medium of exchange , store of value , unit of account , and standard of deferred payment . Commodity versus Fiat Money Money has taken a wide variety of forms in different cultures . People have used gold , silver , cowrie shells , cigarettes , and even cocoa beans as money . Although we use these items as commodity money , they also have a value from use as something other than money . For example , people have used gold throughout the ages as money although today we do not use it as money but rather value it for its other attributes . Gold is a good conductor of electricity and the electronics and aerospace industry use it . Other industries use gold too , such as to manufacture energy glass for skyscrapers and is used in the medical industry as well . Of course , gold also has value because of its beauty and malleability in . As commodity money , gold has historically served its purpose as a medium of exchange , a store , and as a unit of account . currencies are dollar bills or other currencies with values backed up by gold or other commodities held at a bank . During much of its history , gold and silver backed the money supply in the United States . Interestingly , antique dollars dated as late as 1957 , have Silver printed over the portrait of George Washington , as Figure shows . This meant that the holder could take the bill to the appropriate bank and exchange it for a dollar worth of silver .

340 14 Money and Banking nan . an ma I . FIGURE A Silver Certificate and a Modern Bill Until 1958 , silver were by silver , as indicated by the words Silver printed on the bill . Today , The Federal Reserve backs bills , but as money ( inconvertible paper money made legal tender by a government decree ) Credit One Dollar Bills . by Creative Commons , BY ) As economies grew and became more global in nature , the use of commodity monies became more cumbersome . Countries moved towards the use of money . Fiat money has no intrinsic value , but is declared by a government to be a country legal tender . The United States paper money , for example , carries the statement THIS NOTE IS LEGAL TENDER FOR ALL DEBTS , PUBLIC AND In other words , by government decree , ifyou owe a debt , then legally speaking , you can pay that debt with the currency , even though it is not backed by a commodity . The only backing of our money is universal faith and trust that the currency has value , and nothing more . LINK IT Watch this Video on the History of Measuring Money Currency , and LEARNING OBJECTIVES By the end of this section , you will be able to Contrast money supply and money supply Classify monies as money supply or money supply Cash in your pocket certainly serves as money however , what about checks or credit cards ?

Are they money , too ?

Rather than trying to state a single way of measuring money , economists offer broader of money based on liquidity . Liquidity refers to how quickly you can use a asset to buy a good or service . For example , cash is very liquid . You can use your 10 bill easily to buy a hamburger at lunchtime . However , 10 that you have in your savings account is not so easy to use . You must go to the bank or ATM machine and withdraw that cash to buy your lunch . Thus , 10 in your savings account is less liquid . The Federal Reserve Bank , which is the central bank of the United States , is a bank regulator and is responsible for monetary policy and money according to its liquidity . There are two of money and money supply . Historically , money supply included those monies that are very liquid such as cash , checkable ( demand ) deposits , and travelers checks , while money supply included those monies that are less liquid in nature included plus savings and time deposits , of deposits , and money market funds . Beginning in May 2020 , the Federal Reserve changed the and Access for free at

Measuring Money Currency , and 341 . The biggest change is that savings moved to be part of . money supply now includes cash , checkable ( demand ) deposits , and savings . money supply is now measured as plus time deposits , of deposits , and money market funds . money supply includes coins and currency in coins and bills that circulate in an economy that the Treasury does not hold at the Federal Reserve Bank , or in bank vaults . Closely related to currency are checkable deposits , also known as demand deposits . These are the amounts held in checking accounts . They are called demand deposits or checkable deposits because the banking institution must give the deposit holder his money on demand when the customer writes a check or uses a debit card . These items , and checking accounts in the of money known as , which the Federal Reserve System measures daily . As mentioned , now includes savings deposits in banks , which are bank accounts on which you can not write a check directly , but from which you can easily withdraw the money at an automatic teller machine or bank . A broader of money , includes everything in but also adds other types of deposits . Many banks and other institutions also offer a chance to invest in money market funds , where they pool together the deposits of many individual investors and invest them in a safe way , such as government bonds . Another ingredient of are the relatively small ( that is , less than about ) of deposit ( or time deposits , which are accounts that the depositor has committed to leaving in the bank for a certain period of time , ranging from a few months to a few years , in exchange for a higher interest rate . In short , all these types of are money that you can withdraw and spend , but which require a greater effort to do so than the items in . Fig should help in visualizing the relationship between and . Note that is included in the calculation .

342 14 Money and Banking Money Supply Money Market Funds of Deposit Money Supply Checkable Deposits Other Deposits Savings Deposits Coins and Currency in Circulation FIGURE The Relationship between and Money and money have several , ranging from narrow to broad . coins and currency in circulation checkable ( demand ) deposit savings deposits . money market funds of deposit other time deposits . The Federal Reserve System is responsible for tracking the amounts of and and prepares a weekly release of information about the money supply . To provide an idea of what these amounts sound like , according to the Federal Reserve Bank measure of the money stock , at the end of November 2021 , in the United States was trillion , while was 214 trillion . Table provides a breakdown of the portion of each type of money that comprised and in November 2021 , as provided by the Federal Reserve Bank . Components of in the ( November 2021 , Seasonally Adjusted ) billions Currency ! Demand deposits . Savings and other liquid deposits Total ( or trillion ) TABLE and Federal Reserve Statistical Release , Money Stock Measures ( Source Federal Reserve Statistical Release , Access for free at

Measuring Money Currency , and 343 Components of in the ( November 2021 , Seasonally Adjusted ) billions money supply time deposits 120 Retail money market fund balances Total ( or 20 trillion ) TABLE and Federal Reserve Statistical Release , Money Stock Measures ( Source Federal Reserve Statistical Release , The lines separating and can become a little blurry . Sometimes businesses do not treat elements alike . For example , some businesses will not accept personal checks for large amounts , but will accept traveler checks or cash . Changes in banking practices and technology have made the savings accounts in more similar to the checking accounts in . For example , some savings accounts will allow depositors to write checks , use automatic teller machines , and pay bills over the internet , which has made it easier to access savings accounts . As with many other economic terms and statistics , the important point is to know the strengths and limitations of the various of money , not to believe that such are as cut to economists as , say , the of nitrogen is to chemists . Where does plastic money like debit cards , credit cards , and smart money into this picture ?

A debit card , like a check , is an instruction to the user bank to transfer money directly and immediately from your bank account to the seller . It is important to note that in our of money , it is checkable deposits that are money , not the paper check or the debit card . Although you can make a purchase with a credit card , the institution does not consider it money but rather a short term loan from the credit card company to you . When you make a credit card purchase , the credit card company immediately transfers money from its checking account to the seller , and at the end of the month , the credit card company sends you a bill for what you have charged that month . Until you pay the credit card bill , you have effectively borrowed money from the credit card company . With a smart card , you can store a certain value of money on the card and then use the card to make purchases . Some smart cards used for purposes , like phone calls or making purchases at a campus bookstore and cafeteria , are not really all that smart , because you can only use them for certain purchases or in certain places . In short , credit cards , debit cards , and smart cards are different ways to move money when you make a purchase . However , having more credit cards or debit cards does not change the quantity of money in the economy , any more than printing more checks increases the amount of money in your checking account . One key message underlying this discussion of and is that money in a modern economy is notjust paper bills and coins . Instead , money is closely linked to bank accounts . The banking system largely conducts policies concerning money . The next section explains how banks function and how a banking system has the power to create money . LINK IT UP Read a brief article Sweden on the monetary challenges in Sweden .

344 14 Money and Banking The Role of Banks LEARNING OBJECTIVES By the end of this section , you will be able to Explain how banks act as intermediaries between savers and borrowers Evaluate the relationship between banks , savings and loans , and credit unions Analyze the causes and Somebody once asked the late bank robber named Willie Sutton why he robbed banks . He answered where the money is . While this may have been true at one time , from the perspective of modern economists , Sutton is both right and wrong . He is wrong because the overwhelming majority of money in the economy is not in the form of currency sitting in vaults or drawers at banks , waiting for a robber to appear . Most money is in the form of bank accounts , which exist only as electronic records on computers . From a broader perspective , however , the bank robber was more right than he may have known . Banking is intimately interconnected with money and consequently , with the broader economy . Banks make it far easier for a complex economy to carry out the extraordinary range of transactions that occur in goods , labor , and capital markets . Imagine for a moment what the economy would be like if everybody had to make all payments in cash . When shopping for a large purchase or going on vacation you might need to carry hundreds of dollars in a pocket or purse . Even small businesses would need stockpiles of cash to pay workers and to purchase supplies . A bank allows people and businesses to store this money in either a checking account or savings account , for example , and then withdraw this money as needed through the use of a direct withdrawal , writing a check , or using a debit card . Banks are a critical intermediary in what we call the payment system , which helps an economy exchange goods and services for money or other assets . Also , those with extra money that they would like to save can store their money in a bank rather than look for an individual who is willing to borrow it from them and then repay them at a later date . Those who want to borrow money can go directly to a bank rather than trying to someone to lend them cash . Transaction costs are the costs associated with a lender or a borrower for this money . Thus , banks lower transactions costs and act as bring savers and borrowers together . Along with making transactions much safer and easier , banks also play a key role in creating money . Banks as Financial Intermediaries An intermediary is one who stands between two other parties . Banks are a is , an institution that operates between a saver who deposits money in a bank and a borrower who receives a loan from that bank . Financial intermediaries include other institutions in the market such as insurance companies and pension funds , but we will not include them in this discussion because they are not depository institutions , which are institutions that accept money deposits and then use these to make loans . All the deposited funds mingle in one big pool , which the institution then lends . Figure illustrates the position as intermediaries , with deposits into a bank and loans out . Of course , when banks make loans to , the banks will try to funnel capital to healthy businesses that have good prospects for repaying the loans , not to that are suffering losses and may be unable to rep ay . Access for free at

The Role of Banks Deposits Loans Withdrawals Repayment of loans Interest payments Interest payments FIGURE Banks as Financial Intermediaries Banks act as intermediaries because they stand between savers and borrowers . Savers place deposits with banks , and then receive interest payments and withdraw money . Borrowers receive loans from banks and repay the loans with interest . In turn , banks return money to savers in the form of withdrawals , which also include interest payments from banks to savers . CLEAR IT UP How are banks , savings and loans , and credit unions related ?

Banks have a couple of close cousins savings institutions and credit unions . Banks , as we explained , receive deposits from individuals and businesses and make loans with the money . Savings institutions are also sometimes called savings and loans or They also take loans and make deposits . However , from the until the , federal law limited how much interest savings institutions were allowed to pay to depositors . They were also required to make most of their loans in the form of loans , either to or to developers and builders . A credit union is a institution that its members own and run . Members of each credit union decide who is eligible to be a member . Usually , potential members would be everyone in a certain community , or groups of employees , or members of a certain organization . The credit union accepts deposits from members and focuses on making loans back to its members . While there are more credit unions than banks and more banks than savings and loans , the total assets of credit unions are growing . In 2008 , there were banks . Due to the bank failures of and bank mergers , there were banks in the United States at the end of the fourth quarter in 2014 . By 2020 , there were commercial banks and 627 savings institutions . According to the National Credit Union Association , as of September 2021 there were credit unions with assets totaling trillion . A day of Transfer Your Money took place in 2009 out of general public disgust with big bank bailouts . People were encouraged to deposits to credit unions . This has grown into the ongoing Move Your Money Project . Consequently , some now hold assets with a total value as large as 111 billion . A Bank Balance Sheet A balance sheet is an accounting tool that lists assets and liabilities . An asset is something of value that you own and you can use to produce something . For example , you can use the cash you own to pay your tuition . If you own a home , this is also an asset . A liability is a debt or something you owe . Many people borrow money to buy homes . In this case , a home is the asset , but the mortgage is the liability . The net worth is the asset value minus how much is owed ( the liability ) A bank balance sheet operates in much the same way . A bank net worth as bank capital . We also refer to a bank has assets such as cash held in its vaults , monies that the bank 345

346 14 Money and Banking holds at the Federal Reserve bank ( called reserves ) loans that it makes to customers , and bonds . Figure illustrates a hypothetical and balance sheet for the Safe and Secure Bank . Because of the format of the balance sheet , with the formed by the vertical line down the middle and the horizontal line under Assets and Liabilities , we sometimes call it a . Assets Liabilities Net Worth Loans 85 million Deposits 10 million US . Government Securities ( 84 million Reserves million Net Worth million FIGURE A Balance Sheet for the Safe and Secure Bank The in a separates the assets of a , on the left , from its liabilities , on the right . All use , though most are much more complex . For a bank , the assets are the instruments that either the bank is holding ( its reserves ) or those instruments where other parties owe money to the loans made by the bank and Government Securities , such as treasury bonds purchased by the bank . Liabilities are what the bank owes to others . the bank owes any deposits made in the bank to those who have made them . The net worth of the bank is the total assets minus total liabilities . Net worth is included on the liabilities side to have the account balance to zero . For a healthy business , net worth will be positive . For a bankrupt , net worth will be negative . In either case , on a bank , assets will always equal liabilities plus net worth . When bank customers deposit money into a checking account , savings account , or a of deposit , the bank views these deposits as liabilities . After all , the bank owes these deposits to its customers , when the customers wish to withdraw their money . In the example in Figure , the Safe and Secure Bank holds 10 million in deposits . Loans are the category of bank assets in Figure . Say that a family takes out a mortgage loan to purchase a house , which means that the borrower will repay the loan over the next 30 years . This loan is clearly an asset from the bank perspective , because the borrower has a legal obligation to make payments to the bank over time . However , in practical terms , how can we measure the value of the mortgage loan that the borrower is paying over 30 years in the present ?

One way of measuring the value of a loan or anything by estimating what another party in the market is willing to pay for it . Many banks issue home loans , and charge various handling and processing fees for doing so , but then sell the loans to other banks or institutions who collect the loan payments . We call the market where institutions make loans to borrowers the primary loan market , while the market in which institutions buy and sell these loans is the secondary loan market . One key factor that affects what institutions are willing to pay for a loan , when they buy it in the secondary loan market , is the perceived riskiness of the loan that is , given the borrower characteristics , such as income level and whether the local economy is performing strongly , what proportion of loans of this type will the borrower repay ?

The greater the risk that a borrower will not repay loan , the less that any institution will pay to acquire the loan . Another key factor is to compare the interest rate the institution charged on the original loan with the current interest rate in the economy . If the original loan requires the borrower to pay a low interest rate , but current interest rates are relatively high , then a institution will pay less to acquire the loan . In contrast , if the original loan requires the borrower to pay a high interest rate , while current interest rates are relatively low , then a institution will pay more to acquire the loan . For the Safe and Secure Bank in this example , the total value of its loans if they sold them to other institutions in the secondary market is million . The second category asset is bonds , which are a common mechanism for borrowing , used by the federal and local government , and also private companies , and organizations . A bank takes some of the money it has received in deposits and uses the money to buy bonds issued that the Access for free at

The Role of Banks 347 government issues . Government bonds are because the government is virtually certain to pay off the bond , albeit at a low rate of interest . These bonds are an asset for banks in the same way that loans are an asset The bank will receive a stream of payments in the future . In our example , the Safe and Secure Bank holds bonds worth a total value of million . The entry under assets is reserves , which is money that the bank keeps on hand , and that it does not lend or invest in thus does not lead to interest payments . The Federal Reserve requires that banks keep a certain percentage money on reserve , which means either in their vaults or at the Federal Reserve Bank . We call this a reserve requirement . Monetary Policy and Bank Regulation will explain how the level of these required reserves are one policy tool that governments have to bank behavior ) Additionally , banks may also want to keep a certain amount of reserves on hand in excess of what is required . The Safe and Secure Bank is holding million in reserves . We net worth of a bank as its total assets minus its total liabilities . For the Safe and Secure Bank in Figure , net worth is equal to million that is , 11 million in assets minus 10 million in liabilities . For a healthy bank , the net worth will be positive . If a bank has negative net worth and depositors tried to withdraw their money , the bank would not be able to give all depositors their money . LINK IT UP For some concrete examples ofwhat banks do , watch this video I makin sense from Paul Making Sense of Financial How Banks Go Bankrupt A bank that is bankrupt will have a negative net worth , meaning its assets will be worth less than its liabilities . How can this happen ?

Again , looking at the balance sheet helps to explain . A bank will assume that a small percentage will not repay their loans on time , or at all , and factor these missing payments into its planning . Remember , the calculations of the banks expenses every year include a factor for loans that borrowers do not repay , and the value of a bank loans on its balance sheet assumes a certain level of riskiness because some customers will not repay loans . Even if a bank expects a certain number of loan defaults , it will suffer if the number of loan defaults is much greater than expected , as can happen during a recession . For example , if the Safe and Secure Bank in Figure experienced a wave of unexpected defaults , so that its loans declined in value from million to million , then the assets of the Safe and Secure Bank would decline so that the bank had negative net worth . CLEAR IT UP What led to the financial crisis ?

Many banks make mortgage loans so that people can buy a home , but then do not keep the loans on their books as an asset . Instead , the bank sells the loan . These loans are , which means that they are bundled together into a security that a institution sells to investors . Investors in these securities receive a rate of return based on the level of payments that people make on all the mortgages that stand behind the security . Securitization offers certain advantages . If a bank makes most of its loans in a local area , then the bank may be vulnerable if the local economy declines , so that many people are unable to make their payments . However , if a bank sells its local loans , and then buys a security based on home loans in many parts of the country , it can avoid exposure to local risks . In the simple example in the text , banks just own In reality , banks can own a number of instruments , as long as these investments are safe enough to satisfy the government bank regulators . From the standpoint of a local , securitization offers

348 14 Money and Banking he benefit that a local bank does not need to have extra funds to make a loan , because the bank is only to hold that loan for a short time , before selling the loan so that it can pool it into a security . However , securitization also offers one potentially large disadvantage . If a bank plans to hold a mortgage loan as an asset , the bank has an incentive to scrutinize the borrower carefully to ensure that the customer is likely to repay he loan . However , a bank that plans to sell the loan may be less careful in making the loan in the place . The sank will be more willing to make what we call subprime loans , which are loans that have characteristics like low or zero , little scrutiny of whether the borrower has a reliable income , and sometimes low payments or the first year or two that will be followed by much higher payments . Economists dubbed some of the subprime made by institutions in the NINJA loans loans that financial institutions made even hough the borrower had demonstrated No Income , No Job , or Assets . Financial institutions typically sold these subprime loans and turned them into with a twist . The idea was that if losses occurred on these securities , certain investors would agree to take the , say , of such losses . Other investors would agree to take , say , the next of losses . By this approach , still other investors would not need to take any losses unless these financial securities lost 25 or 30 or more of their total value . These complex securities , along with other economic factors , encouraged a large expansion of subprime loans in the . The economic stage was now set for a banking crisis . Banks thought they were buying only securities , because even though the securities were ultimately backed by risky subprime mortgages , the banks only invested in the part of those securities where they were protected from small or moderate levels of losses . However , as housing prices fell after 2007 , and the deepening recession made it harder for many people to make their mortgage payments , many banks found that their assets could be worth much less than they had so the banks were faced with staring bankruptcy . In the period , 318 banks failed in the United States . The risk of an unexpectedly high level of loan defaults can be especially for banks because a liabilities , namely it customers deposits . Customers can withdraw funds quickly but many of the bank assets like loans and bonds will only be repaid over years or even decades . This time ability for customers to withdraw bank liabilities in the short term while customers repay its assets in the long cause severe problems for a bank . For example , imagine a bank that has loaned a substantial amount of money at a certain interest rate , but then sees interest rates rise substantially . The bank can find itself in a precarious situation . If it does not raise the interest rate it pays to depositors , then deposits will flow to other institutions that offer the higher interest rates that are now prevailing . However , if the bank raises the interest rates that it pays to depositors , it may end up in a situation where it is paying a higher interest rate to depositors than it is collecting from those past loans that it at lower interest rates . Clearly , the bank can not survive in the long term if it is paying out more in interest to depositors than it is receiving from borrowers . How can banks protect themselves against an unexpectedly high rate of loan defaults and against the risk of an time mismatch ?

One strategy is for a bank to diversify its loans , which means lending to a variety of customers . For example , suppose a bank specialized in lending to a niche , making a high proportion of its loans to construction companies that build in one downtown area . If that one area suffers an unexpected economic downturn , the bank will suffer large losses . However , if a bank loans both to consumers who are buying homes and cars and also to a wide range of in many industries and geographic areas , the bank is less exposed to risk . When a bank its loans , those categories of borrowers who have an unexpectedly large number will tend to be balanced out , according to random chance , by other borrowers who have an unexpectedly low number of defaults . Thus , of loans can help banks to keep a positive net worth . However , if a widespread recession occurs that touches many industries and geographic areas , will not help . Along with diversifying their loans , banks have several other strategies to reduce the risk of an unexpectedly Access for free at

How Banks Create Money 349 large number of loan defaults . For example , banks can sell some of the loans they make in the secondary loan market , as we described earlier , and instead hold a greater share of assets in the form of government bonds or reserves . Nevertheless , in a lengthy recession , most banks will see their net worth decline because customers will not repay a higher share of loans in tough economic times . How Banks Create Money LEARNING OBJECTIVES By the end of this section , you will be able to Utilize the money multiplier formulate to determine how banks create money Analyze and create balance sheets Evaluate the risks and of money and banks Banks and money are intertwined . It is not just that most money is in the form accounts . The banking system can literally create money through the process of making loans . Let see how . Money Creation by a Single Bank Start with a hypothetical bank called Singleton Bank . The bank has 10 million in deposits . The balance sheet for Singleton Bank , when it holds all of the deposits in its vaults , is in Figure . At this stage , Singleton Bank is simply storing money for depositors and is using these deposits to make loans . In this example , Singleton Bank can not earn any interest income from these loans and can not pay its depositors an interest rate either . Assets Liabilities Net Worth Reserves 10 million Deposits 10 million FIGURE Singleton Bank Balance Sheet Receives 10 million in Deposits The Federal Reserve requires Singleton Bank to keep million on reserve ( 10 of total deposits ) It will loan out the remaining million . By loaning out the million and charging interest , it will be able to make interest payments to depositors and earn interest income for Singleton Bank ( for now , we will keep it simple and not put interest income on the balance sheet ) Instead of a storage place for deposits , Singleton Bank can become a intermediary between savers and borrowers . This change in business plan alters Singleton Bank balance sheet , as Figure shows . Singleton assets have changed . It now has million in reserves and a loan to Hank Auto Supply of million . The bank still has 10 million in deposits . Assets Liabilities Net Worth Reserves million Deposits 10 million Loan to Hank Auto Supply 89 million FIGURE Singleton Bank Balance Sheet 10 Reserves , One Round of Loans Singleton Bank lends million to Hank Auto Supply . The bank records this loan by making an entry on the balance sheet to indicate that it has made a loan . This loan is an asset , because it will generate interest income for the bank . Of course , the loan will not allow let Hank to walk out of the bank with million in cash . The bank issues Hank Auto Supply a cashier check for the million . Hank deposits the loan in his regular checking account with First National . The deposits at First National rise by million and its reserves also rise by million , as Figure shows . First National must hold 10 of additional deposits as required reserves but is free to loan out the rest

350 14 Money and Banking Assets Liabilities Net Worth Reserves million Deposits million FIGURE First National Balance Sheet Making loans that are deposited into a demand deposit account increases the money supply . Remember the of includes checkable ( demand ) deposits , which one can easily use as a medium of exchange to buy goods and services . Notice that the money supply is now 19 million 10 million in deposits in Singleton bank and million in deposits at First National . Obviously as Hank Auto Supply writes checks to pay its bills the deposits will draw down . However , the bigger picture is that a bank must hold enough money in reserves to meet its liabilities . The rest the bank loans out . In this example so far , bank lending has expanded the money supply by million . Now , First National must hold only 10 as required reserves ( but can lend out the other 90 ( million ) in a loan to Jack Chevy Dealership as Figure 149 shows . Assets Liabilities Net Worth Reserves 900000 Deposits million Loans million FIGURE First National Balance Sheet deposits the loan in its checking account at Second National , the money increased by an additional million , as Figure 1410 shows . Assets Liabilities Net Worth Reserves 81 million Deposits 381 million FIGURE Second National Bank Balance Sheet How is this money creation possible ?

It is possible because there are multiple banks in the system , they are required to hold only a fraction of their deposits , and loans end up deposited in other banks , which increases deposits and , in essence , the money supply . LINK IT UP Watch this video to learn more about how banks create money . The Money Multiplier and a System In a system with multiple banks , Singleton Bank deposited the initial excess reserve amount that it decided to lend to Hank Auto Supply into First National Bank , which is free to loan out million . If all banks loan out their excess reserves , the money supply will expand . In a system , institutions determine the amount of money that the system can create by using the money multiplier . This tells us by how many times a loan will be multiplied as it is spent in the economy and then in other banks . Fortunately , a formula exists for calculating the total of these many rounds of lending in a banking system . The money multiplier formula is Reserve Requirement We then multiply the money multiplier by the change in excess reserves to determine the total amount of money supply created in the banking system . See the Work it Out feature to walk through the multiplier calculation . Access for free at

How Banks Create Money 351 Using the Money Multiplier Formula Using the money multiplier for the example in this text Step . In the case of Singleton Bank , for whom the reserve requirement is 10 ( or ) the money multiplier is divided by , which is equal to 10 . Step . We have that the excess reserves are million , so , using the formula we can determine the total change in the money supply . Excess Requirement Total Change in the Money Supply Reserve million million 90 million Step . Thus , we can say that , in this example , the total quantity of money generated in this economy after all rounds of lending are completed will be 90 million . Cautions about the Money Multiplier The money multiplier will depend on the proportion of reserves that the Federal Reserve Band requires banks to hold . Additionally , a bank can also choose to hold extra reserves . Banks may decide to vary how much they hold in reserves for two reasons conditions and government rules . When an economy is in recession , banks are likely to hold a higher proportion of reserves because they fear that customers are less likely to repay loans when the economy is slow . The Federal Reserve may also raise or lower the required reserves held by banks as a policy move to affect the quantity of money in an economy , as Monetary Policy and Bank Regulation will discuss . The process of how banks create money shows how the quantity of money in an economy is closely linked to the quantity of lending or credit in the economy . All the money in the economy , except for the original reserves , is a result of bank loans that institutions repeatedly and loan . Finally , the money multiplier depends on people the money that they receive in the banking system . If people instead store their cash in boxes or in shoeboxes hidden in their closets , then banks can not recirculate the money in the form of loans . Central banks have an incentive to assure that bank deposits are safe because worry that they may lose their bank deposits , they may start holding more money in cash , instead it in banks , and the quantity of loans in an economy will decline . Low income countries have what economists sometimes refer to as mattress savings , or money that people are hiding in their homes because they do not trust banks . When mattress savings in an economy are substantial , banks can not lend out those funds and the money multiplier can not operate as effectively . The overall quantity of money and loans in such an economy will decline . LINK IT UP Watch a Video of Jem discussing The Money Money and and Dangers Money and banks are marvelous social inventions that help a modern economy to function . Compared with the alternative of barter , money makes market exchanges vastly easier in goods , labor , and markets . Banking makes money still more effective in facilitating exchanges in goods and labor markets . Moreover , the

352 14 Money and Banking process of banks making loans in capital markets is intimately tied to the creation of money . However , the extraordinary economic gains that are possible through money and banking also suggest some possible corresponding dangers . If banks are not working well , it sets off a decline in convenience and safety of transactions throughout the economy . Ifthe banks are under stress , because of a widespread decline in the value of their assets , loans may become far less available , which can deal a crushing blow to sectors of the economy that depend on borrowed money like business investment , home construction , and car manufacturing . The Great Recession illustrated this pattern . BRING IT HOME The Many Disguises of Money From to Crypto The global economy has come a long way since it started using cowrie shells as currency . We have moved away from commodity and paper money to fiat currency . As technology and global integration increases , the need for paper currency is diminishing , too . Every day , we witness the increased use of debit and credit cards . The latest creation and a new form of money is cryptocurrency . Cryptocurrency is digital currency that is not controlled by any single entity , such as a company or country . In this sense , it is not a currency because it is not issued by a central bank and is not necessarily supported by governments as legal tender . Instead , transactions and ownership are maintained in a decentralized manner , and the value ( say , the . dollar ) is determined primarily by market , supply and demand . Governments can affect the value of a cryptocurrency by regulating its use within their country boundaries , but in the end , the price of a cryptocurrency comes down to supply and demand . have come a long way since 2009 when Bitcoin was first invented , and the recent two to three years has seen an explosion of different being used across the globe . It is important to note that in order to be considered as money , cryptocurrency still needs to satisfy the three requirements it needs to be valid as a store of value , it needs to be valid as a unit of account , and it must be able to be used as a medium of exchange . While the first two of these requirements can be easily by expressing the currency in terms of another , such as the . dollar , and through its secure ownership rules , its use as a medium of be used to buy and sell goods and more complicated . While are used in many illicit transactions , it is less common to see them accepted as forms of payment for like groceries or your rent . Bitcoin is the most popular cryptocurrency , and thus the one most likely to be considered real money since it can be used to purchase the most goods and services . Other popular as of early 2022 ( in terms of trade volume ) are and Coin . Many other exist , but their more widespread adoption as a medium of exchange is yet to be seen . Access for free at

14 Key Terms 353 Key Terms asset item of value that a or an individual owns time mismatch customers can withdraw a bank liabilities in the short term while customers repay its assets in the long term balance sheet an accounting tool that lists assets and liabilities bank capital a bank net worth barter literally , trading one good or service for another , without using money coins and currency in circulation the coins and bills that circulate in an economy that are not held by the Treasury , at the Federal Reserve Bank , or in bank vaults commodity money an item that is used as money , but which also has value from its use as something other than money currencies dollar bills or other currencies with values backed up by gold or another commodity credit card immediately transfers money from the credit card company checking account to the seller , and at the end of the month the user owes the money to the credit card company a credit card is a loan debit card like a check , is an instruction to the user bank to transfer money directly and immediately from your bank account to the seller demand deposit checkable deposit in banks that is available by making a cash withdrawal or writing a check depository institution institution that accepts money deposits and then uses these to make loans diversify making loans or investments with a variety of , to reduce the risk ofbeing adversely affected by events at one or a few double coincidence of wants a situation in which two people each want some good or service that the other person can provide fiat money has no intrinsic value , but is declared by a government to be the country legal tender intermediary an institution that operates between a saver with assets to invest and an entity who will borrow those assets and pay a rate of return liability any amount or debt that a or an individual owes money supply a narrow of the money supply that includes currency and checking accounts in banks , and to a lesser degree , traveler checks . money supply a of the money supply that includes everything in , but also adds savings deposits , money market funds , and of deposit medium of exchange whatever is widely accepted as a method of payment money whatever serves society in four functions as a medium of exchange , a store , a unit of account , and a standard of deferred payment . money market fund the deposits of many investors are pooled together and invested in a safe way like term government bonds money multiplier formula total money in the economy divided by the original quantity of money , or change in the total money in the economy divided by a change in the original quantity of money net worth the excess of the asset value over and above the amount of the liability total assets minus total liabilities payment system helps an economy exchange goods and services for money or other assets reserves funds that a bank keeps on hand and that it does not loan out or invest in bonds savings account where you can not withdraw money by writing a check , but can withdraw the money at a can transfer it easily to a checking account smart card stores a certain value of money on a card and then one can use the card to make purchases standard of deferred payment money must also be acceptable to make purchases today that will be paid in the future store of value something that serves as a way of preserving economic value that one can spend or consume in

354 14 Key Concepts and Summary the future a balance sheet with a format , with the formed by the vertical line down the middle and the horizontal line under the column headings for Assets and Liabilities time deposit account that the depositor has committed to leaving in the bank for a certain period of time , in exchange for a higher rate of interest also called transaction costs the costs associated with a lender or a borrower for money unit of account the common way in which we measure market values in an economy Key Concepts and Summary Defining Money by Its Functions Money is what people in a society regularly use when purchasing or selling goods and services . If money were not available , people would need to barter with each other , meaning that each person would need to identify others with whom they have a double coincidence is , each party has a good or service that the other desires . Money serves several functions a medium of exchange , a unit of account , a store of value , and a standard of deferred payment . There are two types of money commodity money , which is an item used as money , but which also has value from its use as something other than money and money , which has no intrinsic value , but is declared by a government to be the country legal tender . Measuring Money Currency , and We measure money with several includes currency and money in checking accounts ( demand deposits ) Traveler checks are also a component of , but are declining in use . includes all of , plus savings deposits , time deposits like of deposit , and money market funds . The Role of Banks Banks facilitate using money for transactions in the economy because people and can use bank accounts when selling or buying goods and services , when paying a worker or receiving payment , and when saving money or receiving a loan . In the capital market , banks are intermediaries that is , they operate between savers who supply capital and borrowers who demand loans . A balance sheet ( sometimes called a ) is an accounting tool which lists assets in one column and liabilities in another . The bank liabilities are its deposits . The bank assets include its loans , its ownership , and its reserves ( which it does not loan out ) We calculate a bank net worth by subtracting its liabilities from its assets . Banks run a risk of negative net worth if the value of their assets declines . The value of assets can decline because of an unexpectedly high number of defaults on loans , or if interest rates rise and the bank suffers an time mismatch in which the bank is receiving a low interest rate on its loans but must pay the currently higher market interest rate to attract depositors . Banks can protect themselves against these risks by choosing to diversify their loans or to hold a greater proportion of their assets in bonds and reserves . hold only a fraction of their deposits as reserves , then the process of banks lending money , those loans in banks , and the banks making additional loans will create money in the economy . How Banks Create Money We the money multiplier as the quantity of money that the banking system can generate from each of bank reserves . The formula for calculating the multiplier is ratio , where the reserve ratio is the fraction of deposits that the bank wishes to hold as reserves . The quantity of money in an economy and the quantity of credit for loans are inextricably intertwined . The network of banks making loans , people making deposits , and banks making more loans creates much of the money in an economy . Given the dangers ofa malfunctioning banking system , Monetary Policy and Bank Regulation will discuss government policies for controlling the money supply and for keeping the banking system safe . Access for free at

14 Questions 355 Questions . In many casinos , a person buys chips to use for gambling . Within the Casino walls , customers often can use these chips to buy food and drink or even a hotel room . Do chips in a gambling casino serve all three functions of money ?

Can you name some item that is a store of value , but does not serve the other functions of money ?

Ifyou are out shopping for clothes and books , what is easiest and most convenient for you to spend or ?

Explain your answer . For the following list of items , indicate if they are in , or neither a . 57 Your line of credit on your Bank of America card 50 dollars worth of travelers checks you have not used yet in quarters in your pocket 1200 in your checking account 2000 you have in a money market account Explain why the money listed under assets on a bank balance sheet may not actually be in the bank ?

Imagine that you are in the position of buying loans in the secondary market ( that is , buying the right to collect the payments on loans ) for a bank or other services company . Explain why you would be willing to pay more or less for a given loan if The borrower has been late on a number of loan payments Interest rates in the economy as a whole have risen since the bank made the loan The borrower is a that has just declared a high level Interest rates in the economy as a whole have fallen since the bank made the loan Review Questions . What are the four functions that money serves ?

How does the existence of money simplify the process of buying and selling ?

What is the of wants ?

10 . 11 . 12 . 13 . 14 . 15 . 16 . 17 . 18 . 19 . 20 . What components of money do we count as part of ?

What components of money do we count in ?

Why do we call a bank a intermediary ?

What does a balance sheet show ?

What are a bank assets ?

What are its liabilities ?

How do you calculate a bank net worth ?

How can a bank end up with negative net worth ?

What is the time mismatch that all banks face ?

What is the risk ifa bank does not diversify its loans ?

How do banks create money ?

What is the formula for the money multiplier ?

356 14 Critical Thinking Questions Critical Thinking Questions 21 . The Bring it Home Feature discusses the use of cowrie shells as money . Although we no longer use cowrie shells as money , do you think other forms of commodity monies are possible ?

What role might technology play in our definition of money ?

22 . Imagine that you are a barber in a world without money . Explain why it would be tricky to obtain groceries , clothing , and a place to live . 23 . Explain why you think the Federal Reserve Bank tracks and . 24 . The total amount of currency in circulation divided by the US . population comes out to about per person . That is more than most of us carry . Where is all the cash ?

25 . Explain the difference between how you would characterize bank deposits and loans as assets and liabilities on your own personal balance sheet and how a bank would characterize deposits and loans as assets and liabilities on its balance sheet . 26 . Should banks have to hold 100 of their deposits ?

Why or why not ?

27 . Explain what will happen to the money multiplier process if there is an increase in the reserve requirement ?

28 . What do you think the Federal Reserve Bank did to the reserve requirement during the Great Recession ?

Problems 29 . Ifyou take 100 out of your piggy bank and deposit it in your checking account , how did change ?

Did change ?

30 . A bank has deposits of 400 . It holds reserves of 50 . It has purchased government bonds worth 70 . It has made loans of 500 . Set up a balance sheet for the bank , with assets and liabilities , and calculate the bank net worth . 31 . Humongous Bank is the only bank in the economy . The people in this economy have 20 million in money , and they deposit all their money in Humongous Bank . Humongous Bank decides on a policy of holding 100 reserves . Draw a for the bank . Humongous Bank is required to hold of its existing 20 million as reserves , and to loan out the rest . Draw a for the bank after it has made its round of loans . Assume that Humongous bank is part ofa system . How much will money supply increase with that original 19 million loan ?

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