Chapter 14

Money and Banking

Sayed Hossain
What is money?

Anything that performs the functions of money is

money.
 FUNCTIONS OF MONEY
Four functions of money
1. Medium of exchange 2. Unit of account 3. Store of
value and 4. Standard deferred payment.

Medium of Exchange
Money can be used for buying and selling goods and services.

Unit of Account
Money is a unit of account, by which we measure the values
of goods and services being exchanged.

It is the ruler by which values are measured example, an

accountant may charge $100 to file your tax return.
 FUNCTIONS OF MONEY

Store of Value
It is the most liquid (spendable) of all assets, a convenient
way to store wealth in money form.

In order to be a medium of exchange, money must hold its

value over time. But it may not be the best store value due
to inflation. Inflation cuts the value of money or purchasing
power.

Commodities such as gold and other forms of metal are

good stores of value whereas a good such as milk is a
terrible store of value due to its spoilage nature.
 FUNCTIONS OF MONEY

Standard Deferred Payment

Buy now, pay later.

A number of transactions involve deferred

payments--buy now, pay later.

The good goes from seller to buyer today, but the

money goes from buyer to seller tomorrow. For
example, when you buy the car today and pay it over
the years by installment.
Commodity Money

Money has taken a wide variety of forms in different

cultures. Gold, silver, cowrie shells, cigarettes, and
even cocoa beans have been used as money. These
items are used as commodity money.
Fiat Money
As economies grew and became more global in nature,
the use of commodity monies became more
cumbersome.

Countries moved towards the use of fiat money. All

currency in use today is fiat money

Fiat money has no intrinsic value, but is declared by

government to be the legal tender of a country. US
dollar is the best example of fiat money.

The United States’ paper money, for example, carries

the statement: “THIS NOTE IS LEGAL TENDER FOR
ALL DEBTS, PUBLIC AND PRIVATE.”
Barter
How would people exchange goods and services?

Economies without money typically engage in the barter

system.

Barter—literally trading one good or service for another

—is highly inefficient for trying to coordinate the trades in
a modern advanced economy.

Suppose 1 cow can be exchanged with 100kg of rice.

THE SUPPLY OF MONEY
 SUPPLY OF MONEY
Money can be defined in many ways, that is M1
and M2.

M1: Narrow Money – Highly liquid

M1- money supply includes those monies that
are very liquid meaning that you can withdraw
money any time from bank and can buy goods
and services by a check. We also call it demand
deposit (checkable deposit). As soon as money
is demanded by a bank’s customer by a check,
bank will pay immediately.
 SUPPLY OF MONEY
M1 includes :
1.Currency (coins and paper money) in the hands of
public. Outside the banks.

2. All demand or checkable deposits (money available in

checking account and savings account)

3. Travellers check

M1 = currency + all demand or checkable deposit

(checking account + savings account)
 SUPPLY OF MONEY
M2 : Broader definition of money- Realatively less liquid.

M2 = M1 (Liquid) + Near Monies (time deposits, money

market funds etc. They are less liquid in nature).

Near Monies are also liquid financial assets but not as liquid
as M1.

A certificate of deposit, or CD, is an example of a time

deposit. If you open a CD, you won’t be able to transfer
money easily and you will have to wait until your term is over.
Money market fund is involved in stock investment. It is also
less liquid, simply can not convert it into cash money form
very fast.
 DATA ON M1 and M2

United States Money Supply M1 was reported at

19,641.000 USD bn in Jan 2023


United States Money Supply M2 was reported at
21,267.100 USD bn in Jan 2023
Balance Sheet
A Bank’s Balance Sheet
A balance sheet is an accounting tool that lists assets
and liabilities.

An asset is something of value that is owned and can

be used to produce something. For example, the cash
you own can be used to pay your tuition. If you own
a home, this is also considered an asset.

A liability is a debt or something you owe. Many

people borrow money to buy homes. In this case, a
home is the asset, but the mortgage is the liability.

The net worth is the asset value minus how much is

owed (the liability).
A Bank’s Balance Sheet
A bank’s balance sheet operates in much the same
way. A bank’s net worth is also referred to as bank
capital.

Assets= Liabilities + Net Worth.

When net worth is positive, you are

financially solvent. You can expect loan
from the banks.
A Bank’s Balance Sheet
Figure 14.5 illustrates a hypothetical and simplified
balance sheet for the Safe and Secure Bank.

Because of the two column format of the balance

sheet, with the T-shape formed by the vertical line
down the middle and the horizontal line under
“Assets” and “Liabilities,” it is sometimes called a T-
account.

Asset= Liability + Net Worth

Both side must be equal always in a balance sheet
 A Bank’s Balance Sheet.

Depositors deposited $10 million at this bank which is a liability for this bank as
need to pay them back with interest. It means that this $10 million should not be kept
idle by bank but must be invested.

This $10 million is invested by this bank in this manner. The bank gives loan ($5
million) to customers to get interest income, buy US Government securities or bond
($4 million) to get some interest income and the rest is kept as reserve, $2 million,
either in the bank’s vault or with FED, to meet reserve requirement, which is 20
percent of deposit now by FED (the reserve requirement rate vary time to time
according to the need of the economy) This reserve, $2 million, is an idle money, to
meet customers’ daily withdrawal, can not be loaned out as per FED guideline.

Assets ($11 million)= Liabilities + Net Worth ($10 mil+$1 million=$11 million)
Net Worth = Asset-Liabilities =$11million-$10 million= $1 million
How banks create money?
This table about a balance sheet.

xyz
FIGURE 14.6. SINGLETON BANK

Start with a hypothetica bank called Singleton Bank. The bank has $10 million in deposits (as customers have deposited
money in the bank for interest income). The T-account balance sheet for Singleton Bank, when it holds all of the deposits in
its vaults or reserve or with FED, is shown in Figure 14.6.
At this stage, Singleton Bank is simply storing money of the depositors and will use these deposits to make loans. As the
bank needs to pay interest to depositors, the bank can not keep the money idle. Bank must invest it to get an income, higher
than they will pay to depositors.
FIGURE 14.7: SINGLETON BANK xyz

Singleton Bank is required by the Federal Reserve (FED) to keep $1 million on reserve ( assuming that it is10% of total deposits). That is 10% of the total deposit should be
kept idle as reserve and the rest can be loaned out. So Singleton bank can give loan $9 million. That is excess reserve= $10-$1= $9 million can be loaned out to customers
to earn interest income.
Singleton Bank lends $9 million to Hank’s Auto Supply. The bank records this loan by making an entry on the balance sheet to indicate that a loan has been made. This
loan is an asset for the bank, because it will generate interest income for the bank.
But the loan officer is not going to let Hank walk out of the bank with $9 million in cash. The bank issues Hank’s Auto Supply a cashier’s check (a check) for the $9 million.
What Hank will do with this $9 million dollar check?
 This table about a balance sheet.

FIGURE 14.8: FIRST NATIONAL BANK xyz

Hank has a checking account with First National Bank. Hank deposits the loan in his
regular checking account .
The deposits at First National rise by $9 million and its reserves or money in the bank’s
value also rise by $9 million, as Figure 14.8 shows.
FIGURE 14.9: FIRST NATIONAL BANK

First National must hold 10% of additional deposits as required reserves (set by FED) but is free to loan out the rest.

That is, 10% of 9 million (0.9 million) should be kept idle in the bank’s vault or reserve and the rest can be loaned
out.

That is excess reserve, $9 million -0.9 million= $8.1 million can be loaned out by First National Bank to customer to
earn interest income.

In this way, banks will continue to give loan to their customers in order to earn interest income.
HOW BANKS CREATE MONEY?
Banks create new money whenever they make loans which
can increase money supply. The money that banks create isn't the
paper money but It's the electronic money trough accounting
system.

In other words, bank create money during their

normal operations of accepting deposits and
making loans. More the loans, more the M1 and
M2.
It is possible because there are multiple banks in the financial system, they are required to hold only a fraction of their deposits as reserve (as per FED guideline)
and loans end up deposited in other banks, which increases checkable deposits (M1 and M2) and, in essence, the money supply.

Whenever a person borrows money from a bank by a check, the person deposits the check in his own back which increases M1 and ultimately M2 too. It
increases the money supply as M1 and M2 both are indicator of money supply (creating money).
 MONEY CREATION
Through the money multiplier process, money can be created multiple times. What is the money multiplier formula?
Money Multiplier= 1/reserve requirement= 1/0.1=10
Total Change in the M1 money supply = (1/reserve requirement) x excess reserve
= (1/0.1) X $9 million = 10 X $9=$90 million

How much money has been created finally through money

multiplier process from our last Singleton Bank example? At that
time, reserve requirement was 10% (0.1) and excess reserve was
($10-$1=$9 million) which was loaned to Hank’s Auto Supply.

As a result, initial $9 million loaned to Hank’s Auto Supply

generated $90 million quantity of money after all rounding of
lending by various banks.
Thank you for your patience