Money and Banks

August, 2021

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Money

Money: Anything generally accepted as a medium of exchange

(Medium of exchange is anything used to pay for goods and services
or settle debts).
Types of Money:
1 Commodity Money: Physical commodity used as money but having
alternative uses as well. Example: Gold and silver coins, live animals.
Full-bodied Money: A type of commodity money in which commodity
itself circulates as money. Monetary value of full-bodied money exactly
equals its non-monetary value.Example: Gold coins minted by U.S.
treasury until 1914, Animal pelts.
Representative full-bodied Money:Paper money representing a claim
to a specific quantity of some commodity. Actual commodity is held as
an inventory and does not circulate. Example: Gold certificates issued
by U.S. treasury.
2 Fiat Money: Has no value as commodity and does not represent a
claim to any physical commodity. Example: Most paper currencies in
circulation such as U.S. dollar and Indian rupee.

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Functions of Money

1 Medium of Exchange: Medium of exchange is anything used to pay

for goods and services or settle debts.
Remark: Barter-Exchange of goods and services without money
requires double coincidence of wants and is highly inefficient.
2 Unit of Account: It is used to state values of goods and services.
Remark:Without a common unit of account there would be more
prices than goods in the economy (one price for every pair of goods).
3 Store of value: Something that can be used to store today’s
purchasing power to purchase tomorrow.
4 Standard of Deferred Payment: Money serves as a standard of
deferred payment-a payment that is deferred to the future is usually
stated as a sum of money.

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Physical Properties of Money

Properties that makes a commodity a good choice to serve as money are

discussed below.
Portability: Property that makes money easy to carry around. It
should be valuable in small quantities.Example: Gold and silver.
Divisibility: Money should be made of commodity that is divisible in
smaller units to permit transactions of various sizes. Example: Gold
and silver.
Durability: Money should be durable; that is, it should not wear out
in use and should not depreciate quickly when not in use. Example:
Gold and silver.
Recognizable Value: That is, it should be easy for people to agree
to the value of the good used as money. This explains why gold coins
were stamped with face value equal to the value in weight of the gold
they contained.

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The Evolution of Banks

Banks as Depositories: People needed to store their specie in a safe

location. Goldsmiths (which acted as banks) started providing
safekeeping facility for specie deposits in exchange for a fee for this
service. Initially, goldsmiths only provided safekeeping services but
with time they also started providing services that are closer to the
ones provided by current banks.
Demand Deposits: Gold deposited with the goldsmith since
depositors are free to withdraw it whenever they want.
Written Order to Pay: Written order to pay would state that the
depositor was authorizing the goldsmith to pay certain amount of
specie to the person named on the order. Depositors could use written
order to pay for goods instead of using gold. Note that the written
order to pay worked similar to modern day checks.
Bank Notes: Document written by the goldsmith promising to pay a
sum of specie to the bearer on demand. Bank notes could be
exchanged for gold from goldsmith or used directly to buy things.

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Bank Notes vs Written Order to Pay

Bank Notes vs Written Order to Pay: Bank notes were issued in

convenient denominations which facilitated their use in trade whereas
a written order to pay was more difficult to use in a second
transaction. One disadvantage of bank notes was that since bank
notes promised to pay bearer on demand rather than indicating
payment to a particular person, they were more prone to thefts.

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Evolution of Banks: Fractional Reserve Banking

100 Percent Reserve Banking: Initially, banks held specie in their

vaults to cover all possible redemptions of bank notes and demand
deposits. This practice is known as 100 percent reserve banking.
Fractional Reserve Banking: Since mostly bank notes and demand
deposits circulated as money and most of the specie in banks sat idle,
banks realized that banks could loan out some of their reserves and
earn interest on these loans. This approach is known as fractional
reserve banking.
Banks would lend in the form of bank notes by issuing more notes
then the gold in the vault.

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Discussion Using Bank’s Account

Table 1.1: Bank holding $75 in demand deposits.

Table 1.2: Bank in Table 1.1 issues $25 in new bank notes in
exchange for $25 in gold. Total Money Supply?
Table 1.3: Bank in Table 1.2 decides to keep only 20 percent($20) of
its deposits in reserve instead of 100 percent. It issues loans of
remaining 80 percent($80). Total Money Supply?
Table 1.4: The loan issued by bank in Table 1.3 is deposited back in
the bank (Case when borrower spends the gold and new holder of
gold deposits it back).Total Money Supply?
Table 1.5: Balance sheet of bank in Table 1.4 after making additional
loans of $64 (maintaining 20 percent reserve) post receiving new
deposits. Total Money Supply?
Table 1.6: Balance sheet of fully loaned out bank. Total Money
Supply?

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Banks as Financial Intermediaries

Financial markets link savers and borrowers. This is done either through
direct finance or indirect finance.
Direct Finance: When savers lend funds directly to borrowers
without the involvement of any third party in the matching process.
Example: Lending by friends and relatives.
Indirect Finance: Indirect Finance involves a third party standing
between the borrower and the lender whose role is to accumulate
funds from savers and lend them to borrowers.These third parties are
called financial intermediaries (Example: Banks, Credit Unions).
Broker Vs Financial Intermediary: Broker brings together a buyer
and seller of a financial instrument but does not personally issue it or
lend to borrowers whereas financial intermediaries collect funds from
savers and lend funds to borrowers personally.

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Role of Banks

Why don’t depositors skip intermediaries and engage in direct finance

given banks charge a higher loan on interest than it pays depositors?
Banks match up savers lending funds for short time periods with
borrowers lending funds for long time periods.
Banks pool small deposits to make relatively large loans.
Banks help depositories to reduce risk by lending to large number of
borrowers (diversification).
Banks help economize on transaction costs. Transaction costs are
costs borne in making an exchange such as time, legal cost, cost in
verifying creditworthiness and cost of monitoring the borrowers.

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References

1 M.R. Baye and D.W. Jansen(1996). Money, Banking and Financial

Markets AITBS, 1996.

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