Chapter Fourteen: Module Summary -- Money and Banking

  • A barter system is one in which goods and services are exchanged directly for goods and services. It requires a double coincidence of wants.
  • A monetary system uses some universally recognized currency to facilitate transactions.
  • To an economist, money and income are very different things. Income is the flow of revenue over a particular time period. Money, on the other hand, serves as a medium of exchange, a unit of account, and a store of value.
  • Money is measured in terms of its liquidity, how easily it can be converted into cash.
  • The narrowest measure of money which includes only the most liquid assets is called M1. M1 includes: Currency, Demand Deposits (no-interest checking accounts), Other Checkable Deposits, and Traveler's Checks.
  • M2 is slightly broader than M1. M2 includes M1, savings deposits, small time deposits, and money market deposit accounts.
  • Our banking system is called a Fractional Reserve System which means that banks must only keep a fraction of the deposits they hold on hand. Currently, the Required Reserve Ratio (RRR) is 10 percent.
  • There are two problems with a fractional reserve system. First, the financial system is susceptible to bank runs. This problem is solved by deposit insurance. Second, banks have incentives to make risky loans in order to earn higher rates of return. To reduce this problem, we have developed an extensive system of bank regulation.
  • To a bank, an asset is an item of value that a bank owns. Common assets are reserves, government securities, and loans outstanding. A liability is an item of value that a bank owes. Common bank liabilities are its deposits.
  • Banks (in combination with the Federal Reserve) are unique in their ability to create money. They do not create the physical money that we touch, but they do create M1.
  • Banks create money by carrying out their lending activities. When funds are deposited, only a fraction of those funds must be held at the bank as reserves. The rest can be loaned out. In the process of making these loans, M1 increases.
  • The maximum change in the money supply is equal to the Money Multiplier x the Initial Change in Excess Reserves. The Money Multiplier is equal to 1/RRR.
  • This money multiplier formula calculates the maximum possible expansion of M1 because it assumes that everyone deposits their new loans into a checking account at a bank, and banks hold no excess reserves. If either of these assumptions is violated, less M1 is created.

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