Econ: Money and Banking

The concept of money and the usage and the amount of money in circulation are ideas that most people take for granted. Without money, people would have to barter, or exchange goods and services for other goods and services. Early money included shells, dog teeth, feathers, and miniature iron spears. Anything can be used as money as long as it is accepted as payment. Products and services have been obtained through bartering, commodity money, representative money or fiat money.

All money serves three functions in the economy. It is a medium of exchange, meaning it can be used to buy products. It is also a unit of account which can be used to measure the relative values of products in the economy. Money also serves as a store of value, allowing people to save purchasing power to buy more products in the future.

There are six characteristics of money: durable, portable, divisible, stable in value, scarce, and accepted. The gold standard, which made all currency convertible into gold on demand, was adopted in 1900 but was abandoned by 1934. The money supply consists of not only bills and coins but also checking and savings deposits and certain other liquid investments. We use both narrow and broad definitions of the money supply to measure the amount of money in circulation. M1 is the narrow definition and includes moneys that can be spent immediately and against which checks can be written. M2 is the broad definition and includes M1 plus near moneys, such as savings deposits and money market deposit accounts.

The United States banking system uses a fractional reserve system, which means that only a small part of the checking account deposits are actually backed up by cash in the bank vault; banks loan out the rest of the deposits to other customers. This allows the money supply to grow far beyond the amount of physical currency in the country, but it can also result in bank runs if people feel insecure about the bank’s stability. For this reason, the Federal Deposit Insurance Corporation (FDIC) was created to guarantee bank customers’ deposits.

The Federal Reserve sets reserve requirements for banks, requiring banks to hold a certain percentage of deposits in vault cash or on account with the Federal Reserve regional bank. Banks must be careful to avoid loaning so much money that they fall short of the reserve requirement. If they do, they must borrow from other banks overnight to meet the requirement, paying the banks back with interest known as the federal funds rate. When banks make loans, they actually create money.

If the reserve requirement is 20%, when Customer A deposits $1000 into his checking account, the bank must hold $200 in required reserves. The other $800 constitutes excess reserves, which the bank can now loan out to Customer B. Customer B then makes an $800 purchase from Customer C, who deposits that money into her own bank account. As a result, the money supply has increased by $800. But then the bank is required to hold $160 of that deposit in reserve and can re-loan $640 to Customer D, who makes a purchase from Customer E, who re-deposits the funds, creating another $640 in the money supply.



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