Key Concepts and Summary

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 the future T-account a balance sheet with a two-column format, with the T-shape 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 certificate of deposit transaction costs the costs associated with finding 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

14.1 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 of wants—that is, each party has a specific 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 fiat money, which has no intrinsic value, but is declared by a government to be the country's legal tender.

14.2 Measuring Money: Currency, M1, and M2

We measure money with several definitions: M1 includes currency and money in checking accounts (demand deposits). Traveler’s checks are also a component of M1, but are declining in use. M2 includes all of M1, plus savings deposits, time deposits like certificates of deposit, and money market funds.

14.3 The Role of Banks

Banks facilitate using money for transactions in the economy because people and firms 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 financial capital market, banks are financial intermediaries; that is, they operate between savers who supply financial capital and borrowers who demand loans. A balance sheet (sometimes called a T-account) is an accounting tool which lists assets in one column and liabilities in another. The bank's liabilities are its deposits. The bank's assets include its loans, its ownership of bonds, and its reserves (which it does not loan out). We calculate a bank's 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 asset-liability time mismatch in which the bank is receiving a low interest rate on its long-term 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. If banks hold only a fraction of their deposits as reserves, then the process of banks’ lending money, re-depositing those loans in banks, and the banks making additional loans will create money in the economy.

14.4 How Banks Create Money

We define the money multiplier as the quantity of money that the banking system can generate from each $1 of bank reserves. The formula for calculating the multiplier is 1/reserve 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. When banks choose to hold only limited reserves, the network of banks making loans, people making deposits, and banks making more loans creates much of the money in an economy. Given the macroeconomic dangers of a malfunctioning banking system, Monetary Policy and Bank Regulation will discuss government policies for controlling the money supply and for keeping the banking system safe.

Self-Check Questions

1 . In many casinos, a person buys chips to use for gambling. Within the casino's 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? 2 . Can you name some item that is a store of value, but does not serve the other functions of money? 3 . If you are out shopping for clothes and books, what is easiest and most convenient for you to spend: M1 or M2? Explain your answer. 4 . For the following list of items, indicate if they are in M1, M2, or neither: a. Your $5,000 line of credit on your Bank of America card b. $50 dollars’ worth of traveler’s checks you have not used yet c. $1 in quarters in your pocket d. $1200 in your checking account e. $2000 you have in a money market account 5 . Explain why the money listed under assets on a bank balance sheet may not actually be in the bank? 6 . 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 financial services company. Explain why you would be willing to pay more or less for a given loan if: a. The borrower has been late on a number of loan payments b. Interest rates in the economy as a whole have risen since the bank made the loan c. The borrower is a firm that has just declared a high level of profits d. Interest rates in the economy as a whole have fallen since the bank made the loan

Review Questions

7 . What are the four functions that money serves? 8 . How does the existence of money simplify the process of buying and selling? 9 . What is the double-coincidence of wants? 10 . What components of money do we count as part of M1? 11 . What components of money do we count in M2? 12 . Why do we call a bank a financial intermediary? 13 . What does a balance sheet show? 14 . What are a bank's assets? What are its liabilities? 15 . How do you calculate a bank's net worth? 16 . How can a bank end up with negative net worth? 17 . What is the asset-liability time mismatch that all banks face? 18 . What is the risk if a bank does not diversify its loans?