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 wantsthat 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). Travelers 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 m.
14.1 Defining Money by Its FunctionsMoney is what people in a soci.pdf
1. 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 wantsthat 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). Travelers 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
2. 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 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.
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