Money and banks


Before discussing macroeconomic models we must define what we mean by money. Money has a long and interesting history and an understanding of how we came to use money is useful for any macroeconomist. Unfortunately, there is not enough space to describe how money was “invented” and how it evolved over time. There are, however, many excellent descriptions on the Internet.

Money” in economics is actually not as simple to understand as you may think and many use the term money in a way inconsistent with how it is defined in economics. Money is defined as any commodity or token that is generally accepted as payment of goods and services.

Two types of money

In most countries, one can identify two “types of money”:

  • Currency and coins
  • Bank deposits

The total value of all the money in a country at a given point in time is called the money supply and this is an important macroeconomic variable. The reason for the importance of the money supply is that it measures how much is available for immediate consumption. There is an important relationship between the supply of money and inflation, which will be investigated later on in the book.

What is money and what is not money

If you are trying to determine if something is money, simply consider whether it would be accepted in most stores as payment. You then realize that stocks, bonds, gold or foreign currency are not money.

These must first be exchanged for the national currency before you can use them for consumption. Note that in some cases, foreign currency will be money. For example, in some border towns, the currency of the bordering country may be accepted virtually everywhere.

You also realize that some bank deposits are money. If you have money in an account in a bank and a debit card, you can pay for goods and service using the card in most places. Funds are withdrawn directly from your account when you make the purchase, which makes the deposits as good as cash in your pocket. Counting deposits as money is also consistent with the idea that money measures how much is available for immediate consumption.

Not all deposits can be counted as money. With most savings accounts, you cannot connect the account to a debit card and these deposits should not be counted as money. We also note that what ismoney has nothing to do with the commodity or token itself:

  • USD is money in the United States but not in the U.K.
  • Gold is not money but gold was money in some countries in the middle ages. Historically, such diverse commodities as cigarettes and sharks’ teeth have been used as money insome places.
  • A national currency may suddenly cease to be money in a country. This may happen if inflation is so high that people shift to another foreign currency.

Money, wealth and income

Money is not the same as wealth. An individual may be very wealthy but have no money (for example by owning stocks and real estate). Another individual may have a lot of money but no wealth. This would be the case if an individual with no wealth borrows money from a bank. She will have money (for example in the form of a deposit in the bank) but no wealth since this deposit exactly matches the outstanding debt. Be careful with this distinction: do not say “Anna has a lot of money” if you mean that Anna is wealthy.

Money is not the same as income and income is not the same as wealth. Income is a flow (for example is currency units per month) while money or wealth is a stock (measured at a particular point in time).

Again, it is very possible to have a high income but no money and no wealth, or to be very wealthy and have a lot of money but no income. This is another distinction to be careful with. Do not say that “Sam makes a lot of money” if you mean that Sam has a high income. Money has a very precise definition in economics!

Economic functions of money

Money is generally considered to have three economic functions:

  • A medium of exchange . This is its most important role. Without money we would live in a barter economy where we would have to trade goods and services for other goods and services. If I had fish but wanted bread, I would need to find someone who was in the precise opposite situation. In a monetary economy I can trade fish for money with one individual and money for bread with another. Money solves what is called the double coincidence of wants.
  • A unit of account . In a monetary economy, all prices may be expressed in monetary units which everyone may relate to. Without money, prices must be expressed in units of other goods and comparing prices are more difficult. You may find that a grilled chicken costs 2 kilos of cod in one place and 4 kilos of strawberries in another. Finding the cheapest grilled chicken is not easy.
  • Store of value . If you are a fisherman and have a temporary surplus of fish that you want to store for the future, storing the fish might not be a great idea. Money, on the other hand, stores well. Other commodities, such as gold, have this feature as well.

Central banks

A central bank is a public authority that is responsible for monetary policy for a country or a group of countries. Two important central banks are the European Central Bank (for countries that are members in the European Monetary Union) and the Federal Reserve of the United States. Central banks have a monopoly on issuing the national currency, and the primary responsibility of acentral bank is to maintain a stable national currency for a country (or a stable common currency for a currency union). Stability is sometimes specified in terms of inflation and /or growth rate in the money supply.

Other important responsibilities include providing banking services to commercial banks and the government and regulating financial markets and institutions. In this sense, a central bank is the “bankers’ bank” – other banks can borrow from or lend money to the central bank. Therefore, all banks in a country have an account in the central bank. When a commercial bank orders currency from the central bank, the corresponding amount is withdrawn from this account. This account is also used for transfers between commercial banks. Central banks also manage the country’s foreign exchange and gold reserves.

Monetary base

The monetary base is defined as the total value of all currency (banknotes and coins) outside the central bank and commercial banks’ (net) reserves with the central bank. The monetary base is a debt in the balance sheet of the central bank. Its assets are mostly comprised of the foreign exchange and gold reserves and bonds issued by the national government. Currency inside the central bank has no value – it is comparable to an “I owe you” written by yourself and held by yourself.

Since the central bank has a monopoly on issuing currency, it is in complete control of the monetary base. In Monetary base and the supply of money we will describe exactly how they change the monetary base. However, the central bank does not completely control the money supply. This is due to the second component of the money supply – bank deposits – which it cannot control. Fortunately, it has methods of influencing the total money supply and these methods will be discussed in Interest rate.

In many countries, the central bank imposes reserve requirements. This means that commercial banks are obliged to hold a certain percentage of deposits as reserves either as currency in their vaults or as a deposit at the central bank. Reserve requirements are usually rather small (typically between 0% and 10%) which means that the monetary base is quite close to the value of all currency outside the central bank.

Commercial banks

Currency inside banks is not money

The fact that currency inside commercial banks is not money may strike you as odd, but it is an important principle. The 100 dollar bill in the ATM will become money only at the instant you withdraw it. The reason is this. We want the money supply to measure how much is available for immediate consumption. But currency inside a bank cannot be used for consumption and this is why it is not counted in the money supply. Cash in the bank is not money, but the binary bits in the bank’s computer system representing the balance in your checking account are!

An example may also illustrate this important fact:

  • Eric has 100 euro – this amount is obviously part of the money supply as it is immediately available for consumption.
  • Eric deposits 100 euro into his checking account. He still has 100 euro available for immediate consumption using his debit card and the money supply should not be changed by this deposit (it is not – deposits are included in the money supply).
  • Eric’s bank now has 100 euro more than before deposit. If we count currency inside the bank as money, the money supply would have increased by 100 euro by his deposit. This does not make sense as the amount available for immediate consumption has not changed.
  • In the same way, withdrawing money from the ATM does not affect the money supply. When you withdraw money, currency outside banks increases while your checking balance decreases by the same amount.

Even though currency inside a bank is not money, it is still part of the monetary base. 100 euro inside the bank is obviously still worth 100 euro to the bank even though we do not include it in the money supply.

How commercial banks “create money”

Commercial banks obviously cannot influence the amount of currency in the economy or the monetary base, since they are not allowed to print money. They can, however, influence the money supply through the second component of the money supply - the deposits. A bank will increase the money supply simply by lending money to a customer. In the same way, when a loan is repaid or amortized, the money supply decreases.

It may sound odd that the money supply increases by 1 million the same instant a bank agrees to lend this amount. The bank has created money but no wealth (keep in mind that these are different concepts). The bank has simply converted one asset (cash) into another (the promise of repayment), while there is no change in the individual’s net wealth. However, after the loan, there is an additionalone million available for immediate consumption. It makes no difference if the borrower keeps the money in her account or withdraws them in the form of currency.

If, for example, the borrower uses the money to buy an apartment, the funds are transferred to the seller of the apartment. This will not affect the money supply – now it is the seller of the apartment that has a million available for consumption. If the seller uses the funds to repay the loan he got when he bought the apartment, the money supply will again decrease.

How much money can banks create?

Does this mean that banks can create an unlimited amount of money? The answer is no – that would require them to lend an unlimited amount of money and that is not possible. Banks use deposits to create new loans but there is an important difference between deposits and loans. When individuals deposit money in a bank, they can withdraw the money whenever they like. A bank, on the other hand, has no right to cancel a loan and get their money back whenever they like.

Banks therefore need reserves so that they can deal with large withdrawals. A bank with small reserves will therefore be less inclined to lend money.

The multiplier effect

Deposits and loans in banks give rise to an important multiplier effect. We use a simple example to illustrate this effect. Consider the bank K-bank with total deposits of 10,000 (millions or whatever). Kbank is aiming for a reserve ratio of 10% of deposits. At the moment it has lent 9,000 and has 1,000 in reserve – exactly meeting their desired reserve ratio.

Emma makes a deposit:

Emma has 1,000 in her mattress and decides to deposit it in K-bank. The deposit will not affect the money supply but K-bank now has 11,000 in deposits, 9,000 in loans and 2,000 in reserves.

K-bank lends money:

With deposits equal to 11,000, K-bank wants reserves to be 1,100, not 2,000. The bank therefore wants to lend 900, that is, 90% of the amount Emma deposited. The bank now lends 900 to Ashton.

Ashton borrows money:

At the same moment K-bank lends 900 to Ashton, the money supply increases by 900. Emma’s decision to transfer 1,000 from the mattress to the bank has the effect of increasing the money supply by 900. There are three ways Ashton can use the funds borrowed from K-bank. He can withdraw the funds in cash and keep the cash, he can keep them in his account at K-bank or he can spend them (or a combination of all three).

Ashton withdraws the money:

If Ashton withdraws the funds in cash, K-bank will have 11,000 in deposits, 9,900 in loans and 1,100 in reserves. Thus, it will prefer not to lend any money until deposits increase.

Ashton keeps the funds in his account:

If Ashton decides to keep his funds with K-bank the deposits will increase by 900 the same instant it lends Ashton the money. K-bank will now have 11,900 in deposits, 9,900 in loans and 2,000 in reserves.

K-bank lends money again:

In the case where Ashton keeps his funds in his account at K-bank, the bank will want to increase lending further. In the next step, it will want to lend 90% of 900 or 810. When it lends 810, money supply will increase by 900 + 810 = 1,710 because of the deposit made by Emma. If the second borrower also decides to keep the funds in the bank, the bank can lend money a third time. In the third step it will lend 90% of 810 or 729. Note that the amount in each step will be smaller and smaller and if you add them, you will always end up with a finite amount (see exercises).

…and we have a multiplier effect:

If all or some of the borrowers keep the borrowed funds in the bank, a deposit will generate an increase in the money supply which is larger than the initial deposit and this is what we call the multiplier effect. Remember that this effect is not guaranteed – had Ashton withdrawn the borrowed funds in cash, he would have broken the chain and the increase in money supply would have been equal to the deposit.

Ashton spends the money:

We had a third possibility: Ashton may spend the borrowed funds. Let’s say that Ashton buys a stamp collection from Brittney for 900. If Brittney uses the same bank as Ashton, the funds will simply be transferred to Brittney’s account. However, to K-bank, this makes no difference. K-bank will still want to increase its lending.

…will not disturb the multiplier effect:

If Brittney has a different bank, funds will be transferred from K-bank to Brittney’s bank. In this case, K-bank will not be interested in lending any more money. However, in this case, deposits have increased in Brittney’s bank and the multiplier effect continues in her bank. The only way the chain of the multiplier effect may be broken is if someone withdraws funds in cash and keeps the cash (if the cash is spent and it goes into an account – the multiplier effect will take off again). If some of the funds are withdrawn, the multiplier effect is weakened but not broken.

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