Chapter 27 – Money and Banking

Money is one of humanity’s greatest social inventions. From cowrie shells to cryptocurrency, money enables the complex web of transactions that make modern economies work. This chapter explores what money is, how we measure it, how banks function as financial intermediaries, and the remarkable process by which banks literally create money through lending.

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1. Defining Money by Its Functions

1.1 The Problem of Barter

Without money, economies rely on barter — directly trading one good or service for another. Barter is highly inefficient because it requires a double coincidence of wants: each party must have exactly what the other wants, at the right time, in the right quantity.

1.2 The Four Functions of Money

Money solves barter’s problems by serving four essential functions:

Function	Definition	Example
Medium of exchange	Widely accepted method of payment	Using dollars to buy groceries
Store of value	Preserves purchasing power over time	Saving $1,000 in a bank account for next year
Unit of account	Common ruler for measuring value	Pricing shoes at $50 and haircuts at $25
Standard of deferred payment	Enables future agreements	Taking out a 30-year mortgage

1.3 Commodity Money vs. Fiat Money

Type	Description	Examples
Commodity money	Has intrinsic value beyond its use as money	Gold, silver, cowrie shells, cigarettes, cocoa beans
Commodity-backed currency	Paper money redeemable for a commodity	U.S. Silver Certificates (pre-1958): exchangeable for silver at a bank
Fiat money	No intrinsic value; declared legal tender by government	Modern U.S. dollar bills: “THIS NOTE IS LEGAL TENDER FOR ALL DEBTS, PUBLIC AND PRIVATE”

As economies grew and globalized, commodity money became cumbersome, driving the transition to fiat money. Today, the U.S. dollar and virtually all major currencies are fiat money.

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2. Measuring Money: Currency, M1, and M2

2.1 Liquidity: The Key Concept

The Federal Reserve Bank (the U.S. central bank) defines money using two measures based on liquidity:

2.2 M1 Money Supply (Narrow Money)

M1 includes the most liquid forms of money:

Component	Description
Coins and currency in circulation	Physical money not held by the Treasury, Fed, or bank vaults
Checkable (demand) deposits	Checking accounts — money available “on demand” via checks or debit cards
Savings deposits	Bank accounts from which you can easily withdraw (added to M1 in May 2020)

2.3 M2 Money Supply (Broad Money)

M2 = M1 + less liquid deposits:

Component	Description
Everything in M1	Currency + checking + savings
Money market funds	Pooled deposits invested in safe short-term instruments (e.g., government bonds)
Certificates of deposit (CDs) / Time deposits	Funds committed for a set period (months to years) in exchange for higher interest; typically < $100,000

2.4 Plastic Money — Credit Cards, Debit Cards, and Smart Cards

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3. The Role of Banks

3.1 Banks as Financial Intermediaries

Banks provide critical services:

• Payment system — enabling exchanges via checks, debit cards, and electronic transfers
• Reducing transaction costs — connecting savers and borrowers without each needing to find the other
• Pooling deposits — all deposited funds mingle in one big pool, which the bank then lends

Related institutions:

Institution	Key Feature
Commercial banks	Accept deposits, make various loans (4,374 in U.S. in 2020)
Savings institutions (thrifts)	Historically focused on housing-related loans
Credit unions	Nonprofit, member-owned; ~4,990 in U.S. with $2.0 trillion in assets (Sept. 2021)

3.2 A Bank’s Balance Sheet (T-Account)

3.3 Bank Assets in Detail

Asset Type	Description
Loans	Largest asset category; valued at what another institution would pay in the secondary loan market
Bonds	Typically U.S. government bonds — low risk, low return, steady income stream
Reserves	Money kept on hand and not lent out; includes required reserves (mandated by the Fed) and any excess reserves

3.4 How Banks Go Bankrupt

A bank becomes bankrupt when it has negative net worth (assets < liabilities). This can happen through:

1. Unexpected loan defaults:

• A well-run bank factors in some expected defaults
• During recessions, defaults spike far above expectations
• If Safe and Secure Bank’s loans drop from $5M to $3M due to defaults → net worth becomes −$1M

2. Asset-liability time mismatch:

• Depositors can withdraw funds quickly (short-term liabilities)
• Loans are repaid over years or decades (long-term assets)
• If interest rates rise, the bank faces a dilemma:
  • Don’t raise deposit rates → depositors leave for competitors
  • Raise deposit rates → bank pays more on deposits than it earns on old loans

3.5 How Banks Protect Themselves

Strategy	How It Helps
Diversify loans	Lend across industries, geographies, and borrower types — defaults in one area offset by repayments in others
Sell loans in secondary market	Transfer risk to other institutions
Hold more bonds and reserves	More liquid, lower-risk assets cushion against loan losses

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4. How Banks Create Money

4.1 The Core Insight

When banks hold only a fraction of their deposits as reserves (fractional reserve banking), the process of making loans → re-depositing → lending again creates new money in the economy.

4.2 Money Creation Step by Step

The following diagram illustrates how fractional reserve banking creates money through successive rounds of lending:

4.3 The Money Multiplier Formula

In a system of limited reserves, the total money creation follows a geometric series that converges to:

\[\text{Money Multiplier} = \frac{1}{\text{Reserve Ratio}}\] \[\text{Total Money Created} = \text{Money Multiplier} \times \text{Excess Reserves}\]

4.4 Cautions About the Money Multiplier

The multiplier is a theoretical maximum. In practice, the actual money expansion is smaller because:

Factor	Effect on Multiplier
Banks hold excess reserves	During recessions, banks voluntarily hold more than required → less lending
Fed changes reserve requirements	Higher requirements → lower multiplier
Cash leakage	If people hold cash (“mattress savings”) instead of redepositing → money exits the banking system
Loan demand	Even with available reserves, banks need willing, creditworthy borrowers

Effective Multiplier with Cash Leakage

When a fraction $c$ of each round’s loans is held as cash instead of redeposited, the effective multiplier becomes:

\[\text{Effective Multiplier} = \frac{1}{r + c}\]

Where $r$ = reserve ratio and $c$ = cash-drain ratio (fraction of each deposit round withdrawn as cash).

4.5 Money and Banks — Benefits and Dangers

4.6 From Cowries to Crypto

The evolution of money continues. Cryptocurrency (e.g., Bitcoin, Ethereum, Binance Coin) is digital currency not controlled by any single government or entity. Transactions are maintained in a decentralized manner, and value is determined primarily by supply and demand.

For cryptocurrency to function as true money, it must satisfy all three core requirements:

Requirement	Status
Store of value	Partially — extreme volatility is a concern
Unit of account	Can express value in terms of other currencies
Medium of exchange	Limited — accepted for some transactions, but not widespread for everyday purchases

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5. Key Takeaways

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6. Practice Questions

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7. Glossary

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