Key Terms

Key Terms

ample reserves when banks are holding an amount of reserves significantly above the minimum required amount; generally a choice made by banks during and after the Great Recession asset item of value that a firm or an individual owns asset–liability time mismatch customers can withdraw a bank’s 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’s 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 U.S 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 commodity-backed 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’s 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 short-term loan debit card like a check, is an instruction to the user’s 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 firms, to reduce the risk of being adversely affected by events at one or a few firms 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's legal tender financial intermediary an institution that operates between a saver with financial assets to invest and an entity who will borrow those assets and pay a rate of return liability any amount or debt that a firm or an individual owes limited reserves when banks are holding an amount of reserves that are at or only slightly above the minimum required amount; generally a choice made by banks before the Great Recession M1 money supply a narrow definition of the money supply that includes currency and checking accounts in banks, and to a lesser degree, traveler’s checks. M2 money supply a definition of the money supply that includes everything in M1, but also adds savings deposits, money market funds, and certificates 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 of value, 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 short- term government bonds money multiplier formula formula used to determine the total amount of M1 money supply created in the banking system; equal to 1/reserve ratio 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 financial assets reserves funds that a bank keeps on hand and that it does not loan out or invest in bonds savings deposit bank account where you cannot withdraw money by writing a check, but can withdraw the money at a bank—or 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 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