Chapter 12

Define insolvency

Insolvency is the condition where one's liabilities exceed one's assets.

The Financial System

A financial system is a means of getting savers and borrowers together. This can benefit savers, borrowers, and others in the economy.

The Bank's Reserves and More

(Total) reserves equal the amount of cash in the bank's vault plus the value of funds held on account at the Federal Reserve System (the Fed). Neither vault cash nor money held on account at the Fed earns interest. Bank reserves may be separated into two categories: required reserves and excess reserves. Required reserves are the amount of reserves a bank must hold against deposits, as mandated by the Fed's required-reserve ratio. Excess reserves are any reserves held above and beyond the required amount. Banks may lend their excess reserves either to their customers or to other banks in order to earn interest on the loan.

Define the following: (a) Time deposit, (b) Money market mutual fund, (c) Money market deposit account, (d) Fractional reserve banking, (e) Reserves.

(a) A time deposit is an interest-earning deposit with a specified maturity date. (b) A money market mutual fund is an interest-earning deposit at a mutual fund company, usually offering limited check-writing privileges. (c) A money market deposit account is an interest-earning deposit at a bank or thrift institution, usually offering limited check-writing privileges. (d) Fractional reserve banking is a banking arrangement that allows banks to hold reserves equal to only a fraction of their deposit liabilities (e) Reserves are the sum of bank deposits at the Fed and vault cash.

Identify each of the following as either an adverse selection or a moral hazard problem: (a) Poor drivers apply for car insurance more than good drivers do. (b) The federal government promises to help banks that get into financial problems.(c) The federal government insures checkable deposits (promises to repay the holder of the checkable deposit if the bank fails).

(a) Adverse selection; (b) Moral hazard; (c) Moral hazard.

Three Functions of Money

1. Money as a Medium of Exchange If there were no money, goods would have to be exchanged through the process of barter; that is, goods would be traded for other goods in transactions arranged on the basis of mutual need. Money reduces the transaction costs that accompany arranging such trades. In a money economy, money, rather than goods, is the medium of exchange via which transactions are made. 2. Money as a Unit of Account In a money economy, all goods, services, and debts are valued in terms of money. As such, money is the unit of account—the common standard by which value is determined. 3. Money as a Store of Value The store of value function refers to money's ability to retain its value over time.

Explain why credit cards are not money.

2. Credit cards are not money, but rather are instruments that make it easier for the holder to borrow money. Borrowing money shifts around the existing quantity of money among individuals and firms, but does not change the total.

A bank's Business: Turning laibailities into assets

A bank's business is to turn its liabilities into assets. A bank wants liabilities because liabilities are its sources of funds for growing its assets. Your checkable deposit is a liability for your bank. Your bank turns the bulk of the funds in your checkable deposit account into an asset, for example by granting a loan to someone. The difference between a bank's assets and liabilities constitutes the bank's capital, or its net worth. Typically, a bank's capital is recorded on the liabilities side of its balance sheet, as shown in Exhibit 1 in the chapter. The bank's capital can be viewed as a cushion against insolvency, which exists when a bank's liabilities are greater than its assets. An insolvent bank has failed and can be shut down. The larger is a bank's capital, the bigger the cushion against bank failure or insolvency; the smaller is a bank's capital, the smaller the cushion against bank failure or insolvency.

Explain the difference between a bank's loans and its borrowings.

A bank's loans are assets while its borrowings are liabilities.

What is a financial system, and why would a country with a well-developed and fully functional financial system be better off than a country without it?

A financial system is a means of getting savers and borrowers together. A country with a well-developed and fully functional financial system is better off than a country without one because such a system leads to more lending and borrowing, which provides the financing for new businesses and the production of new products and production techniques and also because it permits individuals to enjoy the benefits of certain goods and services for a greater number of years than would be possible without lending and borrowing.

Money economies are likely to be richer than barter economies in both output and leisure. Do you agree or disagree? Explain your answer.

Agree. If a person spends three hours out of eight working hours in a barter economy in making exchanges, a person in a money economy may spend only one hour out of eight working hours in making exchanges. With the extra two hours to spare, the person in the money economy has the choice of either producing more output or consuming more leisure or dividing his spare time equally between increasing output and consuming leisure.

"A barter economy would have very few comedians." Do you agree or disagree with this statement? Explain your answer.

Agree. Specialization is very expensive in a barter economy.

"Money is a means of lowering the transaction costs of making exchanges." Do you agree or disagree? Explain your answer.

Agree. Without money, we operate in a barter economy and that requires the double coincidence of wants. We must find someone who has what we want and who wants what we have. The search process is likely to be long and ineffective. In a money economy it is unnecessary because I exchange what I have for money and then exchange the money for what I want.

Explain why gold backing is not necessary to give paper money value.

As long as people are willing to accept money in exchange for goods and services and in payment for debts, there is no need for any commodity, gold or otherwise, to back the money supply.

State the formula for finding a bank's capital, or its net worth.

Bank capital = assets - liabilities.

A bank's assets are $90 million, and its liabilities are $71 million. Its assets increase by 10 percent, and its liabilities increase by 6 percent. What is the percentage change in the bank's capital, or net worth?

Bank capital = assets - liabilities. Originally, bank capital = $90 million - $71 million = $19 million. After the changes, bank capital = $99 million - $75.26 million = $23.74 million. The percentage change in the bank's capital is ($23.74 million - $19 million)/$19 million = 0.2494 = 25%.

Where do Credit Cards fit in?

Credit cards are not money, but rather devices by which money is lent—money that must be paid back. If we count the value of credit card balances, as well as the value of the money that must be used to pay those balances off, we would be guilty of double counting.

Why isn't a credit card money?

Credit cards simply transfer the original spending of money from the consumer to the credit card company. Eventually the credit card company will have to be paid back by the consumer. So, a credit card just delays the use of money, it does not replace it.

"People in a barter economy came up with the idea of money because they wanted to do something to make society better off." Do you agree or disagree with this statement? Explain your answer.

Disagree. They came up with the idea of money to make themselves better off by reducing transactions costs.

The required reserve ratio is 9 percent, required reserves are $10 million, and (total) reserves are $50 million. How much do excess reserves equal? How much do checkable deposits equal?

Excess reserves = Reserves - Required reserves = $50 million - $10 million = $40 million. Checkable deposits = Required reserves/r = $10 million/0.09 = $111,111,111.11

If excess reserves are $2 million and required reserves are $22 million, then how much do reserves equal?

Excess reserves = Reserves − Required reserves Therefore, reserves = required reserves + excess reserves = $22 million + $2 million = $24 million.

Explain how financial intermediaries help to solve adverse selection problems and moral hazard problems when it comes to lending and borrowing.

Financial intermediaries help to solve adverse selection by collecting information on would-be borrowers and by requiring collateral, for example. They help to solve moral hazard by specifying that a loan can only be used for a particular purpose, by requiring that the borrower provide regular information on and evidence of how the borrowed funds are being used, or by giving out the loan in installments ($1,000 this month, $1,000 next month), for example.

Suppose the value of the dollar declines relative to other currencies. How does the decline affect the three functions of money?

Foreigners will reduce their use of the dollar in international exchange, thereby reducing its use as a medium of exchange. People will be less willing to hold dollars, thereby reducing its usefulness as a store of value. Internationally, the dollar's use as a unit of account will be reduced over time.

Explain how fractional reserve banking came to exist.

Fractional reserve banking came to exist when goldsmiths created money by lending out part of their customers' gold and/or printing receipts in excess of actual gold holdings.

Explain the process by which goldsmiths could increase the money supply

Goldsmiths increased the money supply when they began lending out part of their customers' gold and/or by printing receipts in excess of actual gold holdings.

Explain how money emerged out of a barter economy.

In a barter economy, goods are traded for other goods or services. Over time, a particular good attains more acceptability for trading purposes and hence people tend to hold that good even if they do not consume it themselves. As the good becomes widely accepted, it helps in reducing transaction costs and becomes money.

If bank deposits at the Fed equal $40 million and reserves equal $43 million, then how much does vault cash equal?

Reserves = bank deposits at the Fed + vault cash Therefore, vault cash = reserves − bank deposits at the Fed = $43 million − $40 million = $3 million.

Direct and Indirect Finance

In direct finance, borrowers and lenders come together in a market setting, such as the bond market. In indirect finance, funds are loaned and borrowed through a financial intermediary, such as a commercial bank. A financial intermediary channels saved funds to borrowers.

Explain the difference between direct finance and indirect finance.

In direct finance, borrowers and lenders come together in a market setting, while in indirect finance, funds are loaned and borrowed through a financial intermediary.

Adverse Selection Problems and Moral Hazard Problems

Lending and borrowing often present the risk of adverse selection and moral hazard, both of which are the result of asymmetric information. Asymmetric information occurs when one side of a transaction has information that the other side does not have. Adverse selection occurs before the transaction occurs, while moral hazard problems occur afterward. Adverse selection occurs when the parties on one side of the market, who have information not known to others, self-select in a way that adversely affects the parties on the other side of the market. Moral hazard is a condition that exists when one party to a transaction changes his or her behavior in a way that is hidden from and costly to the other party. The inability to solve adverse selection and moral hazard problems reduces the chance that a transaction will occur. In the market for loans, a financial intermediary can help reduce these problems.

M1

M1 = Currency held outside banks + Checkable deposits + Traveler's checks Currency held outside banks includes coins minted by the U.S. Treasury and paper money, which is the legal tender of the U.S. government; about 99 percent consists of Federal Reserve Notes issued by the Federal Reserve district banks. Checkable deposits are funds on which checks can be written. Traveler's checks are treated as currency.

Currency held outside banks is $400 billion, checkable deposits amount to $350 billion, traveler's checks are $2 billion, and money market mutual funds (retail) are $100 billion. What does M1 equal?

M1 = Currency held outside banks + Checkable deposits + Traveler's checks Therefore, M1 = $400 billion + $350 billion + $2 billion = $752 billion.

Can M1 fall as M2 rises? Can M1 rise without M2 rising too? Explain your answers.

M1 can fall as M2 rises if some other unique factor of M2 (such as savings deposits) increases by more than enough to offset the decrease in M1. M1 can rise without M2 rising too if some other unique factor of M2 falls by an amount equal to or larger than the increase in M1.

If $4 million is transferred from checkable deposits into money market mutual funds (retail), what happens to both M1 and M2?

M1 consists of currency held outside banks, checkable deposits, and traveler's checks. M2consists of M1 plus savings deposits (including money market deposit accounts), small-denomination time deposits, and money market mutual funds (retail). If $4 million is transferred from checkable deposits into money market mutual funds: (a) M1 will decline by $4 million. (b) M2 will remain unchanged as $4 million is subtracted from M1 and added in money market mutual funds (retail).

Compare M1 and M2.

M1 consists of currency held outside banks, checkable deposits, and traveler's checks. M2 consists of M1 plus savings deposits (including money market deposit accounts), small-denomination time deposits, and retail money market mutual funds.

If currency held outside banks is $200 billion and M1 is $600 billion, do we know for sure how much checkable deposits equal? Why or why not?

M1 includes not only currency held outside banks and checkable deposits, but also traveler's checks. Hence, without knowing the value of traveler's checks, we cannot know for sure the value of checkable deposits.

M2

M2 = M1 + savings deposits (including money market deposit accounts) + small-denomination time deposits + l money market mutual funds (retail) A savings deposit is an interest-earning account at a commercial bank or thrift institution. A money market deposit account is an interest-earning account at a bank or thrift institution that usually requires a minimum balance and that offers limited check-writing privileges. A time deposit is an interest-earning deposit with a specified maturity date, and is subject to penalty for early withdrawal. Small-denomination time deposits have a value of less than $100,000. A money market mutual fund is an interest-earning account at a mutual fund company. Only retail (money market mutual fund) MMMFs are part of M2. MMMF accounts held by institutions are not counted in M2.

Currency held outside banks is $100 billion, money market mutual funds (retail) are $120 billion, small-denomination time deposits are $50 billion, and savings deposits (including money market deposit accounts) are $200 billion. How much does M2 equal?

M2 = M1 + savings deposits (including money market deposit accounts) + small-denomination time deposits + retail money market mutual funds M2 = $100 billion + $120 billion + $50 billion + $200 billion = $470 billion. (Note: The value of M1 includes currency held outside banks + checkable deposits + traveler's checks. However, since there is no information on the other components of M1, it has been assumed that currency held outside banks = M1)

From a Barter Economy to a Money Economy: The Origins of Money

Making exchanges takes longer (on average) in a barter economy than in a money economy, because the transaction costs of making exchanges are higher in a barter economy than they are in a money economy. In a barter economy a double coincidence of wants is a necessary condition for trade to take place. Two people have a double coincidence of wants if what the first person wants is what the second person has and what the second person wants is what the first person has. Even though barter involved trading goods for goods, some goods—those that were commonly needed—were more readily accepted than others. Over time, as people began to accept one or more particular item(s) in trade—even when they had no particular use for them, but felt they could always trade these goods for what they did need—these items became money.

Evaluate why using money is generally preferable to bartering.

Money is generally preferable to bartering since the transaction costs of making exchanges are higher in a barter economy than they are in a money economy.

Does inflation, which is an increase in the price level, affect the three functions of money? If so, how?

Money is less of a store of value when inflation makes each dollar worth less. As a medium of exchange, it will be more in demand as prices rise, because more will be required to function from day to day. As a unit of account it might fail, as rising prices make comparisons of data from one point in time not comparable to those from other times.

A bank currently has $100 million checkable deposits, $4 million in reserves, and $8 million in securities. If the required reserve ratio is 10 percent, is the bank meeting its legal reserve requirements? Explain.

No, since its required reserves are equal to $100 million × 0.10 = $10 million, which must be held as vault cash or deposits at the Fed. The bank is only holding $4 million in reserves.

Money is more than currency

People often equate money and currency. To an economist, though, money is more than just currency. According to the M1 definition, money is currency, checkable deposits, and traveler's checks.

If you were on an island with 10 other people and there were no money, do you think that money would emerge on the scene? Why or why not?

Probably, though with 10 people it might not. In prisoner of war camps during World War II, cigarettes were used as money. People instinctively try to maximize their utility, which implies that they will try to minimize the costs of transactions, and money can aid in doing that.

If checkable deposits are $100 million and the required reserve ratio is 7 percent, then what do required reserves equal?

Required reserves (RR) = r (required reserve ratio) × checkable deposits RR = 7% × $100 million Required reserves equal $7 million.

The required reserve ratio is 10 percent, a bank has checkable deposits of $200 million and excess reserves of $100 million. Assuming the bank is meeting its reserve requirement, what amount is the bank holding in reserves?

Required reserves (RR) = r (required reserve ratio) × checkable deposits RR = 10% × $200 million RR = $20 million Excess reserves = Reserves(R) − Required reserves $100 million = R − $20 million R = $120 million The bank is holding $120 million in reserves.

Checkable deposits are $50 million, and required reserves are $4 million. What is the required reserve ratio?

Required reserves = r × checkable deposits $4 million = r × $50 million Solving for r, the required reserve ratio is 8%.

If checkable deposits are $20 million and the required reserve ratio is 15 percent, how much do required reserves equal?

Required reserves = required reserve ratio ×checkable deposits Therefore, required reserves = 0.15 × 20,000,000 = 3,000,000 = $3 million.

Describe some benefits of living in a world with financial intermediaries.

Some benefits of living in a world with financial intermediaries include more financing for new businesses, the production of new products and production techniques, and the ability of individuals to enjoy the benefits of certain goods and services for a greater number of years than would otherwise be possible.

Explain what gives the U.S. dollar its value.

The U.S. dollar's value is established by its general acceptability, not because it is backed by some precious metal.

Money makes trade easier. Would having a money supply twice as large as it currently is make trade twice as easy? Would having a money supply half its current size make trade half as easy?

The answer is dependent upon the current relationship between the supply of money and the demand for money for transactions. As long as there is enough money to fund all desired transactions, then doubling the money supply will have no noticeable effect on exchange. If there is a shortage of money for transactions purposes, then expanding the money supply will increase exchange. However, whether doubling the money supply would double the ease of transactions seems impossible to answer, but it is highly unlikely. Reducing the money supply will not noticeably affect exchange if the new, smaller money supply is still sufficient to cover transactions. If, however, the new money supply creates a shortage of money to fund transactions, then exchange will be hampered.

Write the formula used to calculate required reserves.

The formula used to calculate required reserves is required reserves = r × checkable deposits, where r is the reserve requirement.

"How much money did you make last year?" What is wrong with that statement?

The most general definition of money is any good that is widely accepted for purposes of exchange (payment for goods and services) and the repayment of debt. The money that a worker earns is termed 'income.

Explain why the standard of living is likely to be higher in a money economy than in a barter economy.

The standard of living is likely to be higher in a money economy than in a barter economy since a person's standard of living is dependent on the number and quality of goods he consumes and the amount of leisure he consumes. The use of money reduces transactions costs and makes more time available for leisure or the production of extra goods.

Define the three functions of money

The three functions of money are: a medium of exchange, a unit of account and a store of value. A medium of exchange is something that is generally accepted in exchange for goods and services. A unit of account is a common measurement in which values are expressed. A store of value is the ability to hold value over time.

List two types of asymmetric information problems.

The two types of asymmetric information problems are adverse selection and moral hazard.

Money, Leisure, and Output

There is likely to be both more output (because of increased production) and more leisure in a money economy than in a barter economy because exchanges take less time in a money economy. Since a person's standard of living is, to a degree, dependent on the number and quality of goods he consumes and the amount of leisure he consumes, we expect the average person's standard of living to be higher in a money economy than in a barter economy.

A thought Experiment: No financial intermediaries

There would be more lending and borrowing in a world with financial intermediaries than in one without them. Lending and borrowing not only provide the financing for new businesses and the production of new products, production techniques, and so on, but they also permit individuals to enjoy the benefits of certain goods and services for a greater number of years than would be possible without lending and borrowing.

MONEY: WHAT IT IS AND HOW DID IT COME TO BE? Money: A Definition

Though often confused with other things, such as income, wealth, and credit, money is any good that is widely accepted in exchange of goods and services, as well as in the repayment of debts.

DEFINING THE MONEY SUPPLY

Two of the most frequently used definitions of the money supply are M1 and M2.

The Bank's Balance Sheet

We can learn a lot about banks by looking at a bank's balance sheet, which lists the bank's assets and liabilities. An asset is anything of value that the bank owns or has claim to. A liability is anything that the bank owes to someone else.

The Early Bankers

When money consisted principally of gold coins, carrying it about was neither easy nor safe. Individuals turned to their local goldsmith for storage because he was already equipped with safe storage facilities. Goldsmiths issued warehouse receipts to their customers, which became a form of money accepted in lieu of the gold itself. The growing acceptance of receipts and the infrequency with which they were ever actually cashed in for the gold they represented led goldsmiths to believe that they could begin lending out part of their customers' gold and/or printing receipts in excess of actual gold holdings. In so doing, the system of fractional reserve banking, whereby banks create money by holding only a portion of their deposits on reserve was born.