<<

. 73
( 126 .)



>>

printed paper and limit ever evaporated, dollar bills would cease serving as a medium of exchange and, given that
their production. they make ugly wallpaper, would become virtually worthless.
But don™t panic. This series of events is hardly likely to occur. Our current monetary
system has evolved over hundreds of years, during which commodity money was first
replaced by full-bodied paper money”paper certificates that were backed by gold or silver
of equal value held in the issuer™s vaults. Then the full-bodied paper money was replaced
by certificates that were only partially backed by gold and silver. Finally, we arrived at our
present system, in which paper money has no “backing” whatsoever. Like hesitant swim-
mers who first dip their toes, then their legs, then their whole body into a cold swimming
pool, we have “tested the water” at each step of the way”and found it to our liking. It is
unlikely that we will ever take a step back in the other direction.



HOW THE QUANTITY OF MONEY IS MEASURED
Because the amount of money in circulation is important for the determination of national
product and the price level, the government must know how much money there is. Thus
we must devise some measure of the money supply.
Our conceptual definition of money as the medium of exchange raises difficult ques-
tions about just which items to include and which items to exclude when we count up the
money supply. Such questions have long made the statistical definition of money a subject
of dispute. In fact, the U.S. government has several official definitions of the money sup-
ply, two of which we will meet shortly.
Some components are obvious. All of our coins and paper money”the small change of
our economic system”clearly should count as money. But we cannot stop there if we want
to include the main vehicle for making payments in our society, for the lion™s share of our
nation™s payments are made neither in metal nor in paper money, but by check.
Checking deposits are actually no more than bookkeeping entries in bank ledgers.
Many people think of checks as a convenient way to pass coins or dollar bills to some-
one else. But that is not so. For example, when you pay the grocer $50 by check, dollar
bills rarely change hands. Instead, that check normally travels back to your bank, where
$50 is deducted from the bookkeeping entry that records your account and $50 is added
to the bookkeeping entry for your grocer™s account. (If you and the grocer hold accounts
at different banks, more books get involved, but still no coins or bills will likely move.)
The volume of money held in the form of checkable deposits far exceeds the volume of
currency.


M1
So it seems imperative to include checkable deposits in any useful definition of the money
supply. Unfortunately, this is not an easy task nowadays, because of the wide variety of
ways to transfer money by check. Traditional checking accounts in commercial banks are
the most familiar vehicle. But many people can also write checks on their savings ac-
counts, on their deposits at credit unions, on their mutual funds, on their accounts with
stockbrokers, and so on.
One popular definition of the money supply draws the line early and includes only
coins, paper money, traveler™s checks, conventional checking accounts, and certain other
checkable deposits in banks and savings institutions. In the official U.S. statistics, this

Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:

Chapter 12 247
Money and the Banking System



narrowly defined concept of money is called M1. The upper part of FIGURE 2
Figure 2 shows the composition of M1 as of December 2007. Two Definitions of the Money Supply,
December 2007

M2 Currency Checking deposits
outside banks in commercial
But other types of accounts allow withdrawals by check, so they are $750 billion banks $306 billion
also candidates for inclusion in the money supply. Most notably,
money market deposit accounts allow their owners to write only a few
checks per month but pay market-determined interest rates. Con-
Other
sumers have found these accounts attractive, and balances in them checkable
now exceed all the checkable deposits included in M1. deposits
$310 billion
In addition, many mutual fund organizations and brokerage
houses offer money market mutual funds. These funds sell shares and M1 = $1366 billion
use the proceeds to purchase a variety of short-term securities. But the
important point for our purposes is that owners of shares in money
market mutual funds can withdraw their funds by writing checks.
Thus, depositors can use their holdings of fund shares just like check-
M1
ing accounts.
$1366 billion
Finally, although you cannot write a check on a savings account,
modern banking procedures have blurred the distinction between Savings
checking balances and savings balances. For example, most banks deposits
$4852 billion
these days offer convenient electronic transfers of funds from one


SOURCE: Federal Reserve
account to another, by telephone, Internet, or by pushing a button on
an automatic teller machine (ATM). Consequently, savings balances Money market
can become checkable almost instantly. For this reason, savings ac- mutual funds
$803 billion
counts are included”along with money market deposit accounts and
M2 = $7021 billion
money market mutual fund shares”in the broader definition of the
money supply known as M2.
The composition of M2 as of December 2007 is shown in the lower
part of Figure 2. You can see that savings deposits predominate, dwarfing M1. Figure 2
illustrates that our money supply comes not only from banks but also from savings insti-
tutions, brokerage houses, and mutual fund organizations. Even so, banks still play a pre-
dominant role.


Other Definitions of the Money Supply The narrowly defined
money supply, usually
Some economists do not want to stop counting at M2; they prefer still broader definitions abbreviated M1, is the sum
of money (M3, and so on), which include more types of bank deposits and other closely of all coins and paper
related assets. The inescapable problem, however, is that there is no obvious place to stop, money in circulation, plus
no clear line of demarcation between those assets that are money and those that are merely certain checkable deposit
balances at banks and sav-
close substitutes for money”so-called near moneys.
ings institutions.3
If we define an asset™s liquidity as the ease with which its holder can convert it into
cash, there is a spectrum of assets of varying degrees of liquidity. Everything in M1 is com- The broadly defined money
pletely liquid, the money market fund shares and passbook savings accounts included in supply, usually abbreviated
M2 are a bit less so, and so on, until we encounter items such as short-term government M2, is the sum of all coins
and paper money in circu-
bonds, which, while still quite liquid, would not be included in anyone™s definition of the
lation, plus all types of
money supply. Any number of different Ms can be defined”and have been”by drawing
checking account balances,
the line in different places.
plus most forms of savings
And yet more complexities arise. For example, credit cards clearly serve as a medium account balances, plus
of exchange. Should they be included in the money supply? Of course, you say. But shares in money market
how much money does your credit card represent? Is it the amount you currently owe mutual funds.
on the card, which may be zero? Or is it your entire line of credit, even though you may
Near moneys are liquid
never use it all? Neither choice seems sensible. Furthermore, you will probably wind
assets that are close substi-
up writing a check (which is included in M1) to pay your credit card bill. These are two tutes for money.
reasons why economists have so far ignored credit cards in their definitions of money.
An asset™s liquidity refers
to the ease with which it
can be converted into cash.
This amount includes travelers™ checks and NOW (negotiable order of withdrawal) accounts.
3




Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:
Part 3
248 Fiscal and Monetary Policy



We could mention further complexities, but an introductory course in economics is not
the place to get bogged down in complex definitional issues. So we will simply adhere to
the convention that:
“Money” consists only of coins, paper money, and checkable deposits.



THE BANKING SYSTEM
Now that we have defined money and seen how to measure it, we turn our attention to
the principal creators of money”the banks. Banking is a complicated business”and get-
ting more so. If you go further in your study of economics, you will probably learn more
about the operations of banks. But for present purposes, a few simple principles will suf-
fice. Let™s start at the beginning.

How Banking Began
When Adam and Eve left the Garden of Eden, they did not encounter an ATM. Banking
had to be invented. With a little imagination, we can see how the first banks must have
begun.
When money was made of gold or other metals, it was inconvenient for consumers and
merchants to carry it around and weigh and assay its purity every time they made a trans-
action. So the practice developed of leaving gold in a goldsmith™s safe storage facilities and
carrying in its place a receipt stating that John Doe did indeed own 5 ounces of gold. When
people began trading goods and services for the goldsmiths™ receipts, rather than for the
gold itself, the receipts became an early form of paper money.
At this stage, paper money was fully backed by gold. Gradually, however, the gold-
smiths began to notice that the amount of gold they were actually required to pay out in
a day was but a small fraction of the total gold they had stored in their warehouses. Then
one day some enterprising goldsmith hit upon a momentous idea that must have made
him fabulously wealthy.
His thinking probably ran something like this: “I have 2,000 ounces of gold stored away
in my vault, for which I collect storage fees from my customers. But I am never called
upon to pay out more than 100 ounces on a single day. What harm could it do if I lent out,
say, half the gold I now have? I™ll still have more than enough to pay off any depositors
who come in for withdrawals, so no one will ever know the difference. And I could earn
30 additional ounces of gold each year in interest on the loans I make (at 3 percent inter-
est on 1,000 ounces). With this profit, I could lower my service charges to depositors and
so attract still more deposits. I think I™ll do it.”
With this resolution, the modern system of fractional reserve banking was born. This
Fractional reserve
banking is a system under system has three features that are crucially important to this chapter.
which bankers keep as
reserves only a fraction of
Bank Profitability By getting deposits at zero interest and lending some of them out
the funds they hold on
at positive interest rates, goldsmiths made profits. The history of banking as a profit-
deposit.
making industry was begun and has continued to this date. Banks, like other enterprises, are
in business to earn profits.

Bank Discretion over the Money Supply When goldsmiths decided to keep only
fractions of their total deposits on reserve and lend out the balance, they acquired the
ability to create money. As long as they kept 100 percent reserves, each gold certificate
represented exactly 1 ounce of gold. So whether people decided to carry their gold or
leave it with their goldsmiths did not affect the money supply, which was set by the vol-
ume of gold.
With the advent of fractional reserve banking, however, new paper certificates
appeared whenever goldsmiths lent out some of the gold they held on deposit. The loans,
in effect, created new money. In this way, the total amount of money came to depend on



Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:

Chapter 12 249
Money and the Banking System



the amount of gold that each goldsmith felt compelled to keep in his vault. For any given
volume of gold on deposit, the lower the reserves the goldsmiths kept, the more loans they
could make, and therefore the more money would circulate.
Although we no longer use gold to back our money, this principle remains true today.
Bankers™ decisions on how much to hold in reserves influence the supply of money. A substantial
part of the rationale for modern monetary policy is, as we have mentioned, that profit-
seeking bankers might not create the amount of money that is best for society.

Exposure to Runs A goldsmith who kept 100 percent reserves never had to worry
about a run on his vault. Even if all his depositors showed up at the door at once, he could
always convert their paper receipts back into gold. But as soon as the first goldsmith
decided to get by with only fractional reserves, the possibility of a run on the vault became
a real concern. If that first goldsmith who lent out half his gold had found 51 percent of
his customers at his door one unlucky day, he would have had a lot of explaining to do.
Similar problems have worried bankers for centuries. The danger of a run on the bank has
induced bankers to keep prudent reserves and to lend out money carefully.
Runs on banks are, for the most part, a relic of the past. You may have seen the famous
bank-run scene in Frank Capra™s 1946 movie classic It™s a Wonderful Life, with Jimmy
Stewart playing a young banker named George Bailey. But you™ve probably never seen an
actual bank run. In September 2007, however, quite a few people in England did see one
when depositors “ran” Northern Rock, a large mortgage bank. (See the box “It™s Not Such
a Wonderful Life” below.) As we observed earlier, avoiding bank runs is one of the main
rationales for bank regulation.




It™s Not Such a Wonderful Life
The subprime mortgage crisis of 2007 (described in greater detail tion. “But I don™t want to be the mug left without my savings,”
later on page 251) quickly spread beyond the borders of the United he said.
States. One of its victims was a large British mortgage lender called [Other] customers said they were not concerned about the
Northern Rock. In mid-September, rumors that the bank was in stability of the bank but had been forced to act over fears of
trouble precipitated the first bank run in England since the nine- a bank run. Paul De Lamare, a 46-year-old consultant, said:
teenth century. Here is the scene as described in the online version “. . . I don™t think the Bank of England would allow anything to
of The Times (of London) on September 14, 2007: happen. But I™m just trying to avoid getting caught short, so I™ve
taken out cash.”
Long queues formed outside branches of Northern Rock today
as anxious customers waited to withdraw savings after the bank
was forced to seek an emergency bailout from the Bank of
England. Savers went in person to Northern Rock™s branches to
withdraw their money, after facing difficulties contacting the
bank on the phone or via the internet.
William Gough, 75, arriving at a Northern Rock branch in
Central London this morning, said he did not believe the bank™s
assurances that his savings were safe and intended to withdraw
his funds. “. . . At the time I put the money in I wouldn™t have
SOURCE: © AP Images/Andrew Milligan/PA




imagined something like this would happen,” Mr Gough said
while joining the back of a 40-strong queue.

<<

. 73
( 126 .)



>>