Money and Banking

This is Unit Eleven of Principles of Macroeconomics: money and banking. It builds the apparatus unit twelve uses, by asking what money is and where it comes from. Carry one idea through. Money is whatever is ready to be spent, a test about readiness rather than worth, and the banking system creates it by lending. Every step of that creation is bounded, and the bound the arithmetic rests on has been zero since twenty twenty. By the end you will classify an item as M1, M2 or neither, build a T-account and test solvency, follow a deposit through successive banks, compute the largest change in deposits and in the money supply, and say what limits lending now.

Three entries on why money exists at all, and the jobs it has to do.

What banks are for.

MAC 1001 Banks as Financial Intermediaries

A financial intermediary gathers funds from people who have them and passes them to people who want them. Banks do this by accepting deposits and making loans, earning the difference between the two interest rates, and pension funds, insurers and mutual funds are intermediaries too. The bank's service is lowering the cost of finding a counterparty, not storing cash.

The problem money solves.

MAC 1002 Barter and the Double Coincidence of Wants

Without money, every trade needs a double coincidence of wants: each side must want what the other has. Finding that match costs time, and the time comes out of production. A grocer in a barter economy would have to agree in advance to accept whatever you brought. Barter is not merely inconvenient: the searching is a real cost to the whole economy.

What money has to do.

MAC 1003 The Functions of Money

Money does four jobs. It is a medium of exchange, accepted in payment; a store of value between earning and spending; a unit of account; and a standard of deferred payment. The fourth follows from the second, since money can denominate a debt because it holds value. Some texts list three, folding deferred payment into store of value.

Two entries on what money can be made of, and what happens when two kinds circulate together.

Three kinds of money.

MAC 1004 Commodity, Commodity-Backed and Fiat Money

Commodity money has other uses, such as gold or silver. Commodity-backed currency is redeemable for such a thing. Fiat money has no intrinsic value and is money by declaration and acceptance: a dollar bill calls itself legal tender for all debts, public and private. Fiat money works on confidence. Cryptocurrency is not central-bank issued, so it is not fiat.

A problem commodity money has.

MAC 1005 Gresham's Law

When two kinds of commodity money circulate at the same official value but differ in quality, people spend the poorer and keep the better. This is Gresham's law. Where horses settled debts, the lame ones were handed over and the sound ones kept. The law needs a fixed official rate: without one, the two trade at different prices.

Four entries on how money gets measured, and on one thing in your pocket that is not money.

How money gets measured.

MAC 1006 Liquidity Orders the Measures

Liquidity is how quickly an asset can be spent without loss. Currency is perfectly liquid, a checking balance nearly so, an office building barely at all, and the measures are ordered by liquidity. Each measure answers how much purchasing power is ready to be spent. Wealth and money differ: assets can be large while money held is small.

The two measures used here.

MAC 1007 M1 and M2

M1 is currency in circulation plus checkable and savings deposits. M2 is M1 plus small time deposits and retail money market funds. Savings deposits moved into M1 in May twenty twenty, so older sources place them in M2. M1 sits inside M2, so the two are nested rather than separate. The central bank no longer steers by any single measure.

Sorting items between them.

MAC 1008 M1, M2 or Neither

Two questions settle it. Is this a means of payment or nearly one? Then M1. Is it a close substitute that takes a step to spend? Then M2 but not M1. Neither? Then not money at all, however valuable. A twenty-dollar note and a checking balance are M1, and a savings deposit has been M1 since May twenty twenty. A small certificate of deposit is M2, committed for a term, and a retail money market fund likewise. A share of stock is neither: it is wealth, and selling it takes time and carries price risk. The trap is treating value as the test. A house is worth a great deal and is not money, while a small current-account balance is.

The card in your pocket.

MAC 1009 Cards Are Not Money

A debit card is an instruction to move a checkable deposit: the deposit is the money and the card is a message. A credit card is a short-term loan, so it is not money either. Issuing more cards of either kind does not change the quantity of money. Both fail the test, for different reasons.

Four entries on what a bank owns and owes, and the system built on holding only a fraction of it.

What a bank owns and owes.

MAC 1010 The Bank Balance Sheet

A bank's assets are its reserves, loans and bonds. Its liabilities are its deposits, because it owes them back. Net worth is assets minus liabilities, also called bank capital, and on the sheet assets always equal liabilities plus net worth. A loan is an asset to the bank and a liability to the borrower.

Building one, and testing it.

MAC 1011 Building a T-Account and Testing Solvency

Assets on the left, liabilities on the right, total each side and subtract. A bank is solvent while net worth is positive and insolvent the moment it turns negative. Take the course's bank: reserves six hundred, loans three thousand nine hundred, bonds five hundred, against deposits of four thousand five hundred, in millions. Assets are five thousand, so net worth is five hundred and the bank is solvent. Now let borrowers holding seven hundred of those loans default: assets fall to four thousand three hundred while deposits are unchanged, so net worth is negative two hundred. Deposits never moved — the asset side failed. Net worth is computed, not held, which is why a bank can be insolvent while cash still crosses the counter.

The reserves on that sheet.

MAC 1012 Required and Excess Reserves

Reserves are funds a bank holds rather than lends. Required reserves are what a rule obliges it to hold, and excess reserves are anything above that; together they are total reserves. A bank holding exactly its requirement is described as loaned up. Excess reserves are the only funds a bank can lend, not the whole new deposit.

The system built on this.

MAC 1013 Fractional Reserve Banking

A bank holds reserves worth only a fraction of the deposits claimed against them, because depositors do not all withdraw at once. This is fractional reserve banking, and it works on the arithmetic of averages rather than on every claim being met at once. The same feature makes a run possible: a crisis of confidence, not of assets.

Five entries on how lending makes money, how far the chain runs, and the ceiling on it.

What lending does.

MAC 1014 Lending Creates Money

When a bank makes a loan it credits the borrower's account. That balance is a checkable deposit, and deposits are money, so lending creates money and repayment destroys it. Nothing was printed: a number was written and the money supply rose. No single bank keeps what it creates, because the borrower spends it elsewhere.

Following it through the system.

MAC 1015 Following a Deposit Through the Banking System

At each step the receiving bank keeps the required fraction and lends the rest, the borrower spends it, and the money lands at another bank, which does the same. At a twenty percent ratio, a two thousand cash deposit leaves the first bank keeping four hundred and lending sixteen hundred. The second keeps three hundred and twenty and lends one thousand two hundred and eighty; the third keeps two hundred and fifty-six and lends one thousand and twenty-four. The loans form a shrinking chain. Each bank lends its excess reserves, never the whole deposit — lending the full two thousand would put the first bank below its requirement as soon as the cheque cleared.

The formula that sums it.

MAC 1016 The Money Multiplier

The multiplier is one divided by the required reserve ratio, and it gives the largest change in deposits a given change in reserves can support. Some texts call it the deposit multiplier; it is the same number. With a ratio of twenty percent, the multiplier is one divided by nought point two, which is five. A higher ratio means a smaller multiplier.

Computing the total.

MAC 1017 Computing the Maximum Change

Two routes, and they must agree. Multiply the whole change in reserves by the multiplier for the change in deposits, or the excess reserves by the multiplier for the new money lending creates. Take the two thousand deposit at a twenty percent ratio, so the multiplier is five: deposits can rise by ten thousand. Excess reserves are sixteen hundred, and five times that is eight thousand of new deposits, which with the original two thousand gives the same ten thousand. The cash left circulation for the vault, so the money supply rises by eight thousand. Deposits and the money supply do not rise by the same amount, and that gap is the cash now in a vault.

Why the real figure is smaller.

MAC 1018 Why the Real Change Is Smaller

The multiplier gives a ceiling, not a forecast. Three things hold the result below it: banks may keep excess reserves, borrowers may not spend everything, and cash held outside banks stops the chain. Banks hold more excess reserves in a recession, which is when lending is most wanted. Every step assumed loans are made and the proceeds redeposited, and neither is guaranteed.

Three entries on the requirement the arithmetic rests on, and on the two ways a bank sinks.

The requirement it is built on.

MAC 1019 The Reserve Requirement Is Now Zero

The multiplier is built on a required reserve ratio. In the United States that ratio is zero: the Federal Reserve Board cut it to zero percent effective the twenty-sixth of March, twenty twenty. The earlier regime charged nothing on a first tranche, three percent on the next and ten percent above. Set to zero is not abolished, because the Board keeps the authority, and unit twelve covers how policy works now.

What goes wrong for a bank.

MAC 1020 How Banks Fail

Two things sink a bank. Unexpected defaults cut the value of its loans below what the balance sheet assumed. Or a maturity mismatch bites: deposits can leave at once while loans repay over decades. Diversifying loans across customers, industries and regions defends against the first. A broad recession defeats diversification, because the losses arrive together.

Telling the causes apart.

MAC 1021 Why Did This Bank Fail

Name the cause: defaults, a maturity mismatch, or a failure to diversify. The test is which side of the balance sheet moved and why. Defaults and concentration destroy asset value; a mismatch destroys earnings while the assets are sound. A bank lending almost entirely to one industry loses heavily when that industry contracts: the loans were sound individually and the portfolio was not. A bank funded by deposits that can leave tomorrow, holding thirty-year loans at low fixed rates, pays out more than it takes in when rates rise: a mismatch, with nobody defaulting. The three often arrive together, so naming one starts the analysis. What it buys is knowing which defence would have helped.

One entry to close the unit: the whole mechanism assembled, and every bound on it named.

The mechanism, and its limits.

MAC 1022 How Banks Create Money, and What Limits It

Here the unit's governing idea is at work. The claim that banks create money sounds like a trick and is not one. A bank takes a deposit, holds part as reserves, and lends the rest by crediting a borrower's account — and that credited balance is itself a checkable deposit, which is money by the definition this unit started from. The borrower spends it, the payment lands at another bank, and that bank repeats the operation with a smaller sum. No bank keeps what it created, which is why each can honestly report creating nothing, and the creation is real because it happens in the system rather than in any one institution. Repayment runs it backwards, so money is destroyed as loans are repaid. Three things keep the economy below the ceiling: banks may hold excess reserves, borrowers may not spend everything, and cash held outside a bank breaks the chain. Three cautions. The required ratio this calculation rests on has been zero in the United States since March twenty twenty, so the model is the limited-reserves case the exam asks for, not current policy. With the ratio at zero, one divided by it has no finite answer, and what limits lending is a bank's capital, its judgement about risk, and what the central bank pays it to hold reserves — all unit twelve. And deposit insurance cuts both ways: it stops the run that would fail a healthy bank, and it reduces the reason for depositors to examine how carefully their bank lends. The witness calls that a dilemma with no clean resolution, and the course leaves it there.

Look at what you can now do. You can classify an item as M1, M2 or neither, by asking about readiness to be spent rather than about worth. You can build a T-account and test solvency, remembering that net worth is computed rather than held. You can follow a deposit through successive banks, lending only excess reserves at every step. You can compute the largest change in deposits and in the money supply, by two routes that have to agree. And you can say why the real change falls short, and what limits lending now that the requirement is zero. Unit twelve turns to the institution standing behind all of this.