CHAPTER

Money and Banks

his book is about money and banking, two subjects closely intertwined
with our daily lives and with the everyday functioning of our economy. On
a typical day, you encounter money and banks in many forms—from the
obvious contact made when you use dollar bills to buy lunch or “go to the
bank’ ’ to withdraw funds to the almost invisible contact via the investment
of your school’s endowment. When you write a check, withdraw funds at
the corner ATM, or use a credit card to purchase this book, you interact with
the banking system. If you work, you may be paid in the form of a check
or a direct deposit into your bank account. If your parents send you money
from home, it may arrive as cash delivered in person, as a check mailed
directly to you, as a check deposited directly into your account, or as a wire
transfer. If you have some savings, you may invest them in a savings account,
a money market mutual fund, or various forms of bonds or stocks. All of
these situations are interactions between you and the banking and financial
system.
Taking the larger view, money and banks, and the financial system as a
whole, play a vital role in the national economy. The total quantity of money
in the economy and the rate at which that quantity grows over time have
important implications for interest rates, inflation rates, and the economy’s
overall functioning. In later chapters, we will see how the federal government
has appointed a central bank to regulate and control the quantity of money
and oversee the health of the banking system and, to some extent, of the
entire financial system. We will also see how the central bank accomplishes
its tasks and how well it achieves its goals of low inflation rates and full
employment.
At this point, you may have little knowledge of how banks work or what
money really is. At the end of this course, however, you will have a much
greater understanding of the roles money and banks play, both on the indi¬
vidual level and in the economy overall. This chapter begins with an over¬
view of these roles and discusses the evolution of money and banks as we
know them today. We will see that money is not simply bills and coins; it
is anything widely used to pay for goods and services. Throughout the history
of humankind, numerous things have served as money, including shells,
stones, beads, sacks of grain, gold, cigarettes, paper bills, and checks. We
will also see that money is not synonymous with “wealth’’ or “income.”
 Money 3

An individual’s wealth refers to the stock of assets the individual owns, less
his or her debts. For example, your wealth includes the total value of your
holdings of real estate, stocks and bonds, cash on hand, money deposited in
banks or other financial institutions, cars, and even textbooks, minus the
amount you owe to others. In contrast, income refers to a flow of earnings
over some given time interval, say, a week, month, or year. Your wealth is
like an “inventory” of everything you own minus debts owed to others,
while your income represents the “change” in the inventory that occurs
during a given time period.
With these concepts in mind, we will now look more closely at the
nature and role of money in our economy and at the origin of money and
banks.

Money

Money is anything generally accepted as a medium of exchange. A medium

of exchange is virtually anything used to pay for goods and services or settle
debts. Thus, the distinguishing feature of money is that society widely ac¬
cepts it to settle transactions. In the United States, money takes many forms.
Obviously you use the dollar bills (more technically, Federal Reserve notes)
and coins in your pocket to pay for things like compact discs and restaurant
meals. Thus, Federal Reserve notes and coins minted by the U.S. Treasury
are money. In popular use, the term money is often a synonym for these two
media of exchange. Coins and dollar bills, however, are called currency and
comprise only part of the money supply. As Box 1.1 shows, traveler’s checks
and checks written against checking accounts at banks, savings and loans,
and credit unions are also commonly accepted as payment and are therefore
money.
Other financial assets, such as savings account balances, are sometimes
considered money. However, savings account balances clearly are not a
medium of exchange, since it is difficult to literally exchange your savings
account balance for a meal at a restaurant. Instead, you must first convert
your savings account into another asset, such as currency or a check, and
then exchange the currency or check for a meal. Some assets—your house,
for instance—cannot be quickly and easily converted into a medium of
exchange. It often takes substantial real estate commissions and time to
convert a house into currency or checkable deposits. Your automatic teller
machine (ATM) card is not money either, since you cannot directly purchase
a meal by handing over the card. You can, however, use your ATM card to
obtain money from your checking or savings account. Thus, ATM cards are
instruments that allow the user to convert checking or savings account bal¬
ances into currency.
Liquidity is the term economists use to describe how cheaply and easily
an asset may be converted into a medium of exchange. Savings account
4 Chapter 1 Money and Banks

The Data Bank Box 1.1

Components of the Money Supply

If you wished for all the money in the U.S. econ¬ Total U.S. Money Supply (Ml) in January 1993:
$1.04 Trillion
omy and your wish came true, what would you
get? The following chart, which is based on a
definition of the money supply the Federal Re¬ Other Checkable Deposits
($392.6 Billion)
serve System calls Ml, provides the answer:
Si .04 trillion. As you can see, money consists of
much more than the dollar bills and coins in
your pocket. The Ml money supply includes cur¬
rency in the hands of the public, demand depos¬
its (checking account balances at commercial
Traveler's Checks
banks), other checkable deposits (money market
($7.8 Billion)
deposit accounts and various checkable deposits
at savings and loans, credit unions, and mutual
savings banks), and traveler's checks. There are
also other official Federal Reserve System defini¬
tions of the money supply, such as M2 and M3,
which we discuss in more detail in Chapter 2.
Currency Demand Deposits
Of the roughly $1 trillion of Ml money in
($293.6 Billion) ($346.2 Billion)
the United States, only 28 percent is in the form
of currency. Demand deposits and other checka¬
ble deposits together comprise the lion's share
(71 percent).

Source for data: Board of Governors of the Federal Re¬

serve System, Federal Reserve Bulletin, various issues, and
Citibase electronic database.

balances are a liquid asset, since they can be quickly and easily converted
into a medium of exchange. Real estate, on the other hand, is not quickly
and easily convertible, and therefore is an illiquid asset. Dollars (i.e., cur¬
rency) and checkable deposits, the primary media of exchange in the United
States, are the most liquid of all assets.

Most dictionaries include variations of one or more of the following defi-

Exercise 1,1 I nitions of money: (1) portable pieces of metal used as a medium of exchange;
 Money 5

(2) currency and coins; (3) wealth. Comment on which, if any, of these
definitions corresponds with an economist’s definition of money.

Answer: These definitions are all deficient to an economist. The first

definition identifies money as a medium of exchange but limits money to
coins. This seems to exclude paper currency as well as checking accounts.
The second definition mentions coins and currency but does not mention
checkable deposits. The third definition treats money as being synonymous
with wealth; for example, “He’s got a lot of money” is a popular way of
saying “He’s wealthy.” Economists, however, do not use money as a syn¬
onym for wealth.

Functions of Money
You now have an overview of what money is and recognize the distinctions
among money, income, and wealth. We now examine four roles of money
in an economy. As we will see, money serves as a medium of exchange, a
unit of account, a store of value, and a standard of deferred payment.

Medium of Exchange. As mentioned earlier, the primary function of

money in an economy is to serve as a medium of exchange. This simply
means that when you buy goods, services, or financial instruments (such as
stocks or bonds), you pay with money. In the United States, people almost
always use money in the form of currency or checks as the medium of
exchange. Barter—the exchange of goods and services without the use of
money—is a possible but rare method of making transactions.
It is hard to envision life without money as the medium of exchange.
Imagine a barter economy—an economy that has no money in which goods
are traded directly for other goods. If a baker wants shoes, it is not enough
to find a shoemaker; the baker must find a shoemaker willing to trade shoes
for bread. Barter transactions require a double coincidence of wants: Each
individual must have something the other desires. If this happens, exchange
will take place; the shoemaker will get bread, and the baker will get shoes.
But if the baker does not want shoes, or vice versa, no exchange will take
place. In this case, the two parties will have to continue to search for someone
who wants what they have for trade.1
Thus, we see that barter is highly inefficient, since the baker would have
to spend considerable time searching for someone willing to accept bread as
payment for some other good. This search time is a transactions cost: a
cost borne in making an exchange. When money is used as the medium of
exchange, the baker can use money to buy shoes from the shoemaker even
if the shoemaker does not want bread. The shoemaker, in turn, can use the

1 Of course, intermediate exchanges might occur in which the baker first trades for apples and then
trades for shoes. Indeed, when one good becomes an acceptable intermediate exchange in all
transactions, that good has become money!
6 Chapter 1 Money and Banks

money received to buy whatever he or she desires from a third party. In

effect, in a monetary economy all individuals find money useful (and thus
want money); thus, money satisfies the double coincidence of wants. There¬
fore, one main advantage of a monetary economy—an economy that uses
money as a medium of exchange—is that it eliminates the problem of finding
a double coincidence of wants; that is, it reduces the transactions costs of
exchange. As we will see, monetary economies have other advantages.

Unit of Account. Money also serves as a unit of account: The values

of goods and services are stated in units of money, just as time is measured
in minutes and distance in feet. Accountants record the revenues and costs
of companies like AT&T in terms of money. Similarly, individuals budget
their expenditure and income flows in terms of money.
In a monetary economy, the medium of exchange nearly always also
serves as the unit of account. Because the medium of exchange is common
to virtually all transactions, it is convenient to state the prices of goods and
services in terms of the medium of exchange. In the United States, the unit
of account is the U.S. dollar, which is also the medium of exchange.
The use of money as the unit of account reduces the amount of infor¬
mation individuals need to make purchase decisions. In a monetary economy,
prices are quoted in terms of the unit of account (be it dollars, yen, or shells).
If there are 1,000 goods for sale, there are 1,000 prices—one for each good.
Each price specifies how many units of money must be given up to receive
one unit of each good. In a primitive monetary economy, one loaf of bread
might cost 1 shell, one cow might cost 100 shells, and so on. In the modem
U.S. economy, the U.S. dollar is the unit of account, and these prices are
quoted in dollars: $1.59 for one loaf of bread, $1,250 for one cow.
In the absence of a common unit of account, there would be more prices
than goods in the economy! To see this, imagine you live in a simple barter
economy with only four goods: apples, oranges, shoes, and bread. Apple
sellers would have to quote three different prices. One price tag would
indicate how many oranges it takes to buy an apple, a second price tag would
state how many pairs of shoes it takes to buy an apple, and a third price tag
would reveal how many loaves of bread it takes to buy an apple. Similarly,
orange sellers would have to specify how many apples, shoes, or loaves of
bread it takes to receive an orange. Of course, if millions of goods were
available, as in our economy, there would be millions of price tags to put
on each item.2 Imagine how costly it would be for you to figure out whether
you could afford to buy an item when each item had millions of price tags!

2 If there are n goods, the number of prices in a barter economy is given by the formula n X
(.n — l)/2. In our four-good economy, there are six prices. If n = 1,000, the number of prices is
499,500.
 Money 7

Fortunately, we live in a monetary economy, and we use money as a

unit of account. All prices are stated in terms of dollars, and thus each good
has a single price tag. The presence of money as a unit of account reduces
the amount of price information you need to buy goods in the marketplace,
and this too reduces the transaction’s costs associated with exchange.

Store of Value. Money also serves as a store of value: It is a means

of storing today’s purchasing power to purchase, say, a house or a car
tomorrow. In the absence of money or other assets as a store of value,
individuals and companies would have to maintain stocks of goods to use
to trade in the future. This approach would be inefficient for two reasons.
First, some commodities, like fruit and milk, are perishable and would be of
little or no value if stored for future use. Second, even when a commodity
is not perishable—a car, for instance—it can be very costly to use it to store
value over time. General Motors would find it very costly to maintain in¬
ventories of extra cars to use to pay their workers. GM workers, in turn,
would find it useless to be paid in engine parts or transmissions, for they
would have a difficult time finding someone willing to accept an engine part
or a transmission as payment for food or housing.
The absence of money as a store of value would also lead people to
hoard a variety of goods—even goods they did not personally wish to
consume (liver or licorice, perhaps?)—in the hope of locating another person
who offered something they wanted and required one of those goods as
payment. In contrast, in a monetary economy, people hold inventories of
money—not transmissions, liver, or licorice—to use to pay for goods and
labor services.
Of course, money is not the only store of value. Indeed, many other
assets—savings accounts, stocks, and bonds, to name just a few—are often
better stores of value than money. These assets pay interest or dividends,
whereas currency and many checkable deposits do not. Thus, while money
provides a convenient store of purchasing power, it is not wise to use money
as a store of value over long periods of time. However, money is unmatched
by other assets in its liquidity, which gives it an advantage over other assets
as a temporary store of value.

Standard of Deferred Payment. Finally, money serves as a stan¬

dard of deferred payment; that is, a payment that is deferred to the future
is usually stated as a sum of money. For example, if you owe money to a
friend and plan to pay it back in a week, you usually state the amount you
owe in money terms, such as $5. In the absence of money, you would have
to plan on making payment in terms of some other good. Having a common
standard for deferred payments, which is the same as the medium of
exchange and the unit of account makes it relatively easy to determine
exactly how much a deferred payment will be. There are efficiencies in
thinking of payments today and payments tomorrow or next year in terms
8 Chapter 1 Money and Banks

of a common item—money. However, we will see that just as money is a

store of value, but not the best store of value, money is a standard of deferred
payment, but not necessarily the best standard for all purposes.

The Origin of Money

The origins of money are little known. Historians believe money originated
as religious objects of value, which ultimately evolved into a medium of
exchange. By the ancient Babylonian, Greek, and Roman civilizations, mon¬
etary systems included coins.
After the fall of Rome, the medieval economies of Europe moved toward
a barter system. The feudal system was built largely on barter, with debts
between lord and vassal paid in terms of goods and/or services—most fre¬
quently labor services. Thus, a noble would owe military service to his lord,
and a serf would owe labor to his lord. Taxes were often collected in the
form of agricultural products or labor services.
However, barter was neither a permanent nor a worldwide phenomenon.
Indeed, in Byzantium (now Constantinople) the Eastern Roman Empire
survived until the eleventh century and with it the nomisa gold coin, which
was the standard currency of the Mediterranean world. In Europe, the feudal
system and the use of barter eventually diminished, and a monetary economy
gradually reemerged. By the eleventh century, there was a revival of trade
and a renewed growth of towns, and gold emerged as a medium of exchange.
After William the Conqueror won the Battle of Hastings in 1066 and became
ruler of England, he allowed only royal coinage to be used in his kingdom.
The presence of a monetary economy in Europe was not without con¬
troversy. Phillip IV allegedly debased the French currency during his rule
(1285-1314) by minting coins that contained a lower amount of gold or
silver than promised and substituting small amounts of lead to maintain the
weight and feel of the declared quantity of precious metal.3 Despite episodes
such as this, however, Europe gradually moved closer to the monetary econ¬
omy of today.

Summary Credit cards are often used to pay for items purchased at retailing outlets.
Exercise 1.2 Are credit cards “money”?

Answer: Believe it or not, this is a controversial question. To answer,

note that a credit card is not money; you do not give someone your plastic
card in exchange for a good. Instead, a credit card is a money substitute.

3 Debasement of coinage meant that the monarch could issue more coins from a given supply of
gold or silver and by so doing could buy more goods and services from the general public than
would have been possible otherwise. Thus, debasement was an attempt by Phillip IV to tax the
general public without their knowledge.
 Money 9

Using the card is taking out a loan from a preapproved line of credit. The
merchant receives a signed voucher from the buyer that can be exchanged
for money. If you paid the merchant with dollar bills or coins, the merchant
would directly receive money and could instantly use the bills or coins as a
medium of exchange in another transaction. In contrast, a credit card voucher
gives the merchant the right to collect a specified amount of money from
the credit card company at the end of the month. Thus, the credit card
voucher the merchant receives is an IOU that cannot be quickly converted
into a medium of exchange to use in another transaction. For this reason,
economists typically do not consider credit cards to be money.

Types of Money
Historically two types of money have been used as a medium of exchange.
The first type was commodity money—money backed by stores of a com¬
modity such as religious relics. Much later, a second type of money emerged:
fiat money. Marco Polo observed the Chinese using fiat money during his
famous travels in the thirteenth century. Fiat money is money that is not
“backed” by a commodity such as animal pelts or gold but is valuable as
money because of government pronouncement or fiat. Fiat is a Latin word
that means literally the pronouncement “let it be done.”

Commodity Money. The first type of money used by civilization-

religious relics—was a form of commodity money. Commodity money is
a physical commodity that is used as money but also has alternative, non¬
monetary uses. More recent examples of commodity money are gold and
silver coins. Gold and silver are used in jewelry and for other decorative
purposes and thus have value independent of their use as money. But when
they circulate as money, they are valuable as a medium of exchange, that is,
to purchase other commodities.
In addition to religious relics, gold and silver, numerous other goods
have served as commodity money in human history: live animals, sacks of
corn, and even huge stone wheels (See Box 1.2). The common characteristic
among all forms of commodity money is that something valuable to society
for its physical properties is chosen to perform a second function as the
medium of exchange.
A type of commodity money in which the commodity itself circulates
as money is called full-bodied money. As the term implies, the monetary
value of full-bodied money exactly equals its nonmonetary value. Animal
pelts, for example, were full-bodied money.
The most recent example of full-bodied money is the gold coins that
were minted by the U.S. Treasury until 1914. The value of the gold in each
coin was equal to the value of the coin as money. For instance, if the price
of gold was $1 per ounce, a $1 gold coin contained one ounce of gold. The
coin could then be used to purchase $1 worth of candy, or it could be melted
to extract one ounce of gold for use in jewelry.
10 Chapter 1 Money and Banks

International Banking Box 1.2

Money on the Yap Island

and Gold Transfers among Nations

The ancient inhabitants of the Yap island in the limited to the Yap Island; even today most gold
Pacific Ocean had a most peculiar full-bodied transfers among nations are conducted in un¬
medium of exchange: a large stone wheel called derground vaults such as those at the Federal
a fei. The fei was sculpted from limestone ob¬ Reserve Bank of New York. When a transaction
tained on an island hundreds of miles from Yap. that requires the transfer of gold from, say, the
The value of a fei depended in part on its size; it Netherlands to Germany occurs, the gold is not
had a diameter that often exceeded the height actually shipped from one country to the other.
of an average man. Smaller fei were carried on Instead, it is merely moved from the vault that
wooden poles placed through the hole in the stores the Netherlands' gold to the vault that
middle, but large fei were seldom actually stores Germany's gold. This journey of a few
moved. Instead, when an islander made a pur¬ meters helps keep the ownership record intact
chase that required the payment of a huge fei, but is otherwise similar to the practice of the
the fei would remain in a fixed location and the Yap islanders, who merely transferred the ac¬
new owner would merely accept the acknowl¬ knowledgment of ownership rather than the
edgment of ownership as payment for the physical location of large fei.
goods.
You might find it odd that the fei served as
Sources: Norman Angell, The Story of Money (New York:
a medium of exchange without physically Garden City Publishing Company, 1929), 88-89; Journal
changing hands. This peculiarity, however, is not of Political Economy, 90 (August 1982), back cover.

In contrast to full-bodied money, representative full-bodied money is

paper money that represents a claim to a specific quantity of some commod¬
ity. The actual commodity is held as an inventory in a bank vault or other
depository and does not circulate. During the early part of this century, the
U.S. Treasury issued representative full-bodied money called gold certifi¬
cates. Gold certificates were pieces of paper that could be redeemed for a
specified amount of gold. For instance, if the price of gold was $35 per
ounce, a $1 gold certificate represented a claim to 1/35 ounces of gold.
Anyone holding such a gold certificate could convert it into 1/35 ounces of
gold on demand.
The advantage of representative full-bodied money is that the commodity
itself does not have to circulate; only the paper claim to the commodity does.
The innovation of representative full-bodied money significantly reduced the
 Money 11

need to carry around heavy bags of gold to use in exchange. Paper gold
certificates were much lighter and more practical. An interesting feature of
representative full-bodied money is that the actual item exchanged during
purchases (paper in the case of gold certificates) has negligible value as a
commodity.

Fiat Money. The use of representative full-bodied money accustomed

people to using paper money. The next innovation was the issuance of
unbacked money in the form of token coins and unbacked (fiat) paper money.
Fiat money has no value as a commodity and does not represent a claim to
any physical commodity. It is the type of money used in the United States
today. The United States went off the gold standard during the Great De¬
pression, and Federal Reserve notes (dollar bills) have been a fiat currency
ever since.
Token coins—the pennies, nickels, dimes, and quarters in your pocket—
resemble commodity money coins but contain less valuable metals such as
copper, nickel, or zinc instead of gold or silver. The physical value of these
coins as commodities is less than the value of what you can purchase with
them. In other words, if you went into the business of melting down quarters
and selling the resultant metal, you would end up in the poorhouse.
Fiat money also takes the form of unbacked paper money, usually fairly
small, rectangular pieces of paper with fancy engraving. Unlike representa¬
tive full-bodied money, however, fiat money is not backed by gold or silver
held in a depository. As a commodity, fiat money is worth only the paper it
is printed on. But fiat money is valuable as a medium of exchange, because
it can be used to purchase compact discs and other items. U.S. Federal
Reserve notes—the dollar bills in your pocket—are fiat money. Nothing is
held in a depository to back these paper dollars.
A final category of unbacked money is unbacked money issued by banks
and other financial institutions. The best-known example is checkable de¬
posits such as your checking account at your bank. You write checks and
businesses accept them as payment, even though the checks are backed by
no commodity. Instead, they are backed either by paper money held in the
bank vault or, more likely, by nothing tangible. We will say more about the
development of checks as money later in this chapter. As you will see, banks
can literally create money by creating checking account balances—balances
that are not even fully backed by holdings of paper dollars.
Does anything back fiat money? To answer this, consider gold coins.
You can always melt gold coins for their gold content. If the coins are full
bodied, the gold will equal their value as money. Even representative full-
bodied money, such as a gold certificate, is backed by the gold held in a
depository—gold that the owner of a gold certificate can obtain in exchange
for the certificate.
Fiat money, on the other hand, cannot be melted to yield an equivalent
value of metal, nor can it be exchanged for a commodity held in a depository.
12 Chapter 1 Money and Banks

Instead, fiat money is backed only by its general acceptance by society as

the medium of exchange. Without this acceptance, no one would value U.S.
dollar bills or accept them in exchange for goods and services. You accept
these Federal Reserve notes (or checks payable in Federal Reserve notes) as
payment for your work only because you are confident that your landlord
and your supermarket will accept these same notes in exchange for rent and
groceries. If all other people in society decided that Federal Reserve notes
were no longer acceptable as money, you would not accept them as payment
for your labor services.

Summary Determine whether the following episodes involve full-bodied money, rep¬
Exercise 13 j resentative full-bodied money, or fiat money: (a) During World War II,
prisoners of war used cigarettes as the medium of exchange and unit of
account for chocolate candy, cookies, and other items, (b) Yap islanders,
tired of hauling around stone wheels as the medium of exchange, decided to
use verbal acknowledgments of the ownership of stone wheels as the medium
of exchange, (c) The U.S. government decreed that its paper bills are legal
tender for all debts, both public and private.

I Answer: (a) In the POW camps, cigarettes were full-bodied commodity

money, (b) Verbal acknowledgments of ownership of stone wheels are rep¬
resentative full-bodied money, (c) The paper bills are fiat money, since they
are valuable as a medium of exchange only by government decree.

Physical Properties of Money

Our discussion of the roles of money provides numerous reasons money—
be it animal pelts, gold coins, or paper—tends to emerge in even the most
primitive societies. The numerous commodities that have served as money
throughout history, as well as the fiat money currently used in the United
States and other industrialized countries, all have certain desirable physical
properties. What makes a commodity a good choice to serve as money?
Ideally, money should be portable, divisible, durable, and of recognizable
value.

Portability. For ease of use in transactions, money should be portable.

The easier it is to carry around, the more effective it is as a medium of
exchange. Thus, commodity money should generally be a substance that is
valuable in small quantities. This explains why early humankind quickly
turned to gold and silver as forms of money. Even small quantities of these
rare metals are valuable enough to be used for large purchases. In contrast,
lead makes a poor choice as a medium of exchange, since large purchases
would require large amounts of lead.
 Money 13

Divisibility. To permit transactions of various sizes, money should be

made of a commodity that is divisible into smaller units to facilitate making
“change.” Gold and silver also serve well in this respect, since small coins
can be minted to facilitate small transactions. In contrast, diamonds, which
are very portable (due to their high value per unit of weight) are not easily
divisible, making them a poor choice for a medium of exchange.

Money should be durable; that is, it should not wear out in

use and should not depreciate quickly when not in use. Gold and silver also
meet this criterion. Eggs, obviously, would serve poorly as a medium of
exchange.

Money should have easily recognizable value;

that is, it should be easy for people engaged in exchange to agree to the
value of the good used as money. Part of the motivation for coining gold
was to provide this property. In the days of gold coins, the coins were
stamped with a face value equal to the value in weight of the gold they
contained. In addition, each coin was stamped with the seal of the govern¬
ment or the “face” of the king as a guarantee of the coin’s authenticity and
weight. This practice made it difficult for unscrupulous individuals to snip
off portions of gold or manufacture “counterfeit” money. It also reduced
the uncertainty regarding whether a particular coin was indeed worth the
value stated by the individual wishing to exchange it, thus increasing the
acceptability of gold coins as payment.
A desire for recognizable value is also behind efforts to foil counter¬
feiting of fiat currency. Modern paper currency has complicated engraving,
rare papers and inks, and sometimes embedded metal strips. All of these
attributes make it easier to recognize genuine currency and more difficult to
produce counterfeit bills.
Box 1.3 describes a commodity that possessed all four physical prop¬
erties of money: cigarettes in a World War II POW camp.

Summary Do modern-day checks satisfy the desired properties of money?

Exercise 1.4
Obviously checks are easy to carry around (portable), can be
written in various amounts (divisible), and are reasonably durable. However,
checks are not always of recognizable value. If a stranger offers you a
$30,000 check for your car, chances are you will not hand over the keys.
The problem is that you do not recognize the true value of the check—it
may bounce, in which case you are out one car. Recent advances in electronic
check verification, however, are making it easier for some check recipients
(primarily businesses) to verify checks quickly.
14 Chapter 1 Money and Banks

Inside Money Box 1.3

Cigarettes as Money
in a Prisoner of War Camp

During World War II, Allied prisoners in a Ger¬ in terms of the number of cigarettes needed to
man POW camp developed a monetary system buy the goods. Even nonsmoking prisoners were
in which cigarettes served as the medium of willing to sell chocolates in exchange for ciga¬
exchange. Cigarettes played a dual role in this rettes, which they could then use to purchase
POW camp: They could be used as a commodity items of value from a third party.
(smoked) or to purchase other goods. The Because cigarettes were useful as money,
choice of cigarettes as the medium of exchange few cigarettes were actually smoked. While the
stemmed from their attributes. They were divisi¬ camp received a fairly steady supply of new cig¬
ble, from carton to pack to individual cigarette. arettes, a stock of unsmoked cigarettes circu¬
They were also durable, portable, and of easily lated as money. Smokers would have enjoyed
recognizable value. seeing all of the money go up in smoke, but
The prisoners received fixed weekly rations they did not because cigarettes were valued as
from the Red Cross, which included various the medium of exchange. The use of a com¬
foodstuffs in addition to cigarettes. They could modity money (like cigarettes) solves the double
trade the food among themselves to reallocate coincidence of wants problem, but it reduces
the rations according to their preferences for the consumption of the good used as money.
various items, but this practice required a
double coincidence of wants. When cigarettes
emerged as the medium of exchange, prices of Source: R. A. Radford, "The Economic Organization of a
chocolates and other goods began to be stated P.O.W. Camp," Economica (November 1945), 189-201.

The Evolution of Banks

Soon after society recognized the benefits of using money as a medium of
exchange, it recognized the need for a safe place to store it. This “safe
place” ultimately evolved into the banks of today—financial institutions that
accept deposits and make loans. The remaining chapters of this book will
explain in more detail the operation of modern banks and other financial
institutions such as savings and loan associations, credit unions, and mutual
savings banks. For now, bear in mind that all of these institutions are similar
in that they accept deposits and make loans. The remainder of this chapter
offers some background on how these institutions originated and evolved
into today’s banking system.
 The Evolution of Banks 15

Banks as Depositories
Banking existed in Babylonia and in ancient Greece and Rome. During the
Middle Ages, gold and silver (known as specie, from the Latin for “in-
kind”) served as a full-bodied medium of exchange. People naturally wanted
to store their specie in a location safe from theft, fire, and other hazards.
Such a location required some sort of safe or strongbox, and the town
goldsmith was one place that invariably offered such accommodations. Other
wealthy individuals or businesses also had strongboxes for their own valu¬
ables and leased space in them to others, but goldsmiths of necessity had
strongboxes to store the gold they used in their trade.

Demand Deposits
A convenient way to illustrate the operation of banks as depositories is
depicted in Table 1.1, which is called a T-account. In a T-account, the bank’s
assets are listed on the left side and its liabilities are listed on the right side.
In this T-account, individuals have deposited $75 in gold, which are held in
reserve in the bank’s vault. This represents the bank’s assets. Notice that the
gold on deposit is not a “gift” to the bank; the depositors are free to
withdraw it whenever they choose. The obligation to give back $75 in gold
to depositors at their demand represents a liability to the bank. For this
reason, even today checkable deposits at banks are called demand deposits.
Demand deposits account for the $75 in liabilities on the right-hand side of
the T-account in Table 1.1.
At first, goldsmiths merely provided safekeeping for specie deposits and
charged depositors a fee for this service. When depositors wanted the use of
their gold or silver deposits, they went to the goldsmith’s place of business
and asked for their specie. However, it became apparent that it was not really
necessary to make a trip to the goldsmith to obtain specie for purchasing
goods. Instead, a depositor could use a written order to pay for goods. In
effect, a person with deposits at a goldsmith would trade this written order
for goods and services.
The written order to pay would state that the depositor was authorizing
the goldsmith to pay a specified amount of specie to the person named on

Table 1.1
A Bank Holding Demand Deposits

Assets Liabilities

Reserves (gold in vault) $75 Demand Deposits $75

16 Chapter 1 Money and Banks

the order. These orders to pay were the precursor of today’s familiar checks.
Consider the check you probably wrote to pay for your books at the begin¬
ning of the semester. On that check you indicated who was to be paid (XYZ
Bookstore), the amount to be paid, and the date, and you signed the check
to verify that it was you who wrote it. The bookstore was then free to present
the check to your bank, and your bank gave the bookstore the indicated
funds from your checking account. Except for the facts that goldsmiths held
gold deposits and written orders to pay indicated that gold was to be paid,
the early checking account arrangements worked just like today’s checking
accounts.
The innovation of the written order to pay made it easier to buy goods.
A shopper no longer had to visit the goldsmith to obtain gold before shop¬
ping; she or he could write checks for purchases once inside a store. Shoppers
were also less likely to be robbed, since they did not have to carry gold on
shopping trips.
The original written orders to pay were along the lines of “I, Jane K.
Depositor, order Gary Goldsmith to pay Sam J. Shoemaker X amount of
gold.” As we noted, these written orders to pay were very convenient, and
Sam J. Shoemaker actually had several options when he received such a
check. He could turn in the check to Gary Goldsmith and receive the indi¬
cated gold from Jane’s account; he could turn in the check to Gary and ask
him to take the gold out of Jane’s account and put it in his own account; or
he could endorse the back of the check and pass it on in a subsequent
exchange, perhaps with Theresa Tanner. In the latter case, Theresa Tanner
had the same options Sam did. Notice, however, that if Sam wanted to
simply endorse the check and use it to pay Theresa, the value of the purchase
had to be the same as the amount specified on the check from Jane to Sam.
Otherwise, Sam or Theresa would have had to “make change” from the
amount stated on the check. This inconvenience limited the number of times
any check would change hands before being presented at the bank for
redemption.
Box 1.4 shows the recent growth in currency and checking account
balances in the United States.

Bank Notes
Another innovation was the bank note, a document written by the early
banks (goldsmiths) promising to pay a sum of specie to the bearer on de¬
mand. A bank note stated something like “I, Gary Goldsmith, promise to
pay the bearer X amount of gold upon demand.” Bank notes were issued in
convenient denominations and could be used to buy goods and services.
Thus, when Jane K. Depositor deposited gold with the goldsmith, she could
elect to exchange some of the gold for bank notes. She then used these bank
notes as money, and anyone who received them could exchange them for
gold at Gary Goldsmith’s or use them to buy something.
 The Evolution of Banks 17

Inside Money
Where Are All the Dollars?

The figure below plots currency and checking rency balances is individuals who participate in
account balances per capita in the United States the "underground economy," especially those
between 1980 and 1992. Notice that in 1992, who buy and sell illegal drugs. Currency, unlike
the average checking account contained almost checks, cannot be traced and is thus the pre¬
$3,000 per person and the average amount of ferred medium of exchange for people involved
currency held per person was nearly $1,000. in illegal activities.
The large amount of currency held per person is Another group holding U.S. currency is resi¬
something of a puzzle: How many families of dents of foreign countries. The U.S. government
four do you know who keep $4,000 ($1,000 for does not keep records of its currency held out¬
each person) in their home or pockets? side the United States, but the Federal Reserve
Most households hold a minimal amount of System estimates that as much as two-thirds of
currency, but businesses hold larger amounts to U.S. currency is held abroad.
use in making change. However, businesses and
households alone cannot account for the large
Source for data: Board of Governors of the Federal Re¬
amount of currency per person in the United serve System, Federal Reserve Bulletin, various issues and
States. One more likely group holding large cur¬ Citibase electronic database.

Dollar Value of Currency and Checkable Deposits per Capita in the United States, 1980 - 1992

0
'80 '81 ’82 ’83 ’84 '85 '86 '87 '88 '89 '90 '91 '92
18 Chapter 1 Money and Banks

Notice that bank notes, like modern-day checks and currency, serve as
money. The main difference is that bank notes and checks are supplied by
banks rather than by the government. Moreover, bank notes have one big
advantage over checks: They are issued in convenient denominations that
facilitate their use in trade and thus stay in circulation for a longer time than
checks do. A check written for a specific amount to a particular person is
more difficult to use in a second transaction, and therefore the payee usually
takes it to the bank for redemption.
Bank notes do have one disadvantage compared to checks. Since bank
notes pay the bearer on demand instead of indicating payment to a particular
person, they are much more prone to theft than checks are. Using stolen
bank notes to make purchases is as easy as using gold, whereas it is difficult
for Joe Thief to cash a check payable to Hank Tanner.
Today two types of bank notes are issued in the United States. The more
prevalent type is the fiat currency issued by the Federal Reserve System, the
central bank of the United States established by the U.S. government to
manage the nation’s money supply. In contrast to the early bank notes, which
were issued by private banks and backed by gold, Federal Reserve notes are
not backed by gold or any other commodity. The second type of bank note
commonly used today, although comprising less than 1 percent of all money
used, is traveler’s checks. These bank notes are issued by major banks and
are redeemable for Federal Reserve notes on demand.
The effect of issuing bank notes can be visualized using the bank’s T-
account. Suppose the bank we examined in Table 1.1 issues $25 in new bank
notes in exchange for $25 in gold. This increases the reserves of the bank
(gold in the vault) from $75 to $100, which is reflected on the asset side of
the T-account in Table 1.2. Since the bank notes are redeemable for gold,
they reflect a $25 liability for the bank. This accounts for the additional entry
on the liability side of the T-account.

Table 1.2
A Bank Issuing Bank Notes

Assets Liabilities

Reserves (gold in vault) $100 Bank Notes $25

Demand Deposits $75

Fractional Reserve Banking

Initially goldsmiths functioned solely as depositories and issuers of bank
notes in exchange for specie, honoring requests for redemption of both bank
 The Evolution of Banks 19

notes and demand deposits. In this function, the banks held specie in their
vaults to cover all possible redemptions of bank notes and demand deposits.
This practice is called 100 percent reserve banking, since the bank holds
reserves (in this case, specie in the vault) equal to the total value of outstand¬
ing bank notes and demand deposits. Reserves, being 100 percent of deposit
and note liabilities, fully cover the hypothetical situation in which all deposits
and bank notes are withdrawn on the same day.
Under 100 percent reserves, banks earn profits by charging a fee to store
deposits and to trade specie for bank notes. However, banks soon realized
that most of the specie in their vaults was never withdrawn; it sat idle while
demand deposits and bank notes circulated as money. These early banks
realized that they could in fact loan out some of their reserves and earn
additional profits on loans. This approach led to fractional reserve banking,
in which bank reserves equal only a fraction of outstanding demand deposits
and bank notes. With fractional reserve banking, banks held some deposits
as reserves in the vault but loaned out the remainder to people in need of
funds. In fact, a bank would actually lend in the form of bank notes, issuing
more such notes than there was gold in the vault. The bank would charge
interest on this loan and hence had a second source of revenue in addition
to the storage charges assessed on deposits.
To see the impact of fractional reserve banking, suppose the bank in
Table 1.2 decides to keep only 20 percent of its bank note deposits in reserve
instead of 100 percent. Thus, for every $100 in liabilities, the bank decides
to keep $20 in reserve and loan out the remaining $80 in gold. The bank’s
rationale for doing this is simple. Since it is unlikely that all depositors will
withdraw their gold on the same day, much of its previous reserves sat idle
in the vault. By loaning out a fraction of these reserves—keeping enough to
cover expected withdrawals but loaning out the rest at a profitable interest
rate—the bank can profit. The bank in Table 1.2 had $100 in liabilities, so
it keeps 20 percent ($20) in reserve and issues loans of $80. This leads to
the T-account in Table 1.3, where the bank has assets consisting of $20 in
reserves and $80 in loans. Its liabilities are still $25 in bank notes and $75
in demand deposits; the bank simply converted one form of an asset (re¬
serves) into a different asset (loans).

Table 1.3
A Bank Issuing Loans

Assets Liabilities

Reserves (gold in vault) $20 Bank Notes $25

Loans $80 Demand Deposits $75

20 Chapter 1 Money and Banks

Note what happens to the available supply of money due to banking

activities. Suppose the public has $100 of gold. With no banking, the money
supply is $100 in the form of gold that circulates as the medium of exchange.
When banks issue demand deposits and bank notes but keep 100 percent in
reserves, as in Tables 1.1 and 1.2, the money supply in the hands of the
public is still only $100. The only difference is that with demand deposits
and bank notes, the gold that used to circulate as the medium of exchange
is placed in a bank vault and paper circulates as the medium of exchange.
In contrast, consider what happens with fractional reserve banking, the
situation in Table 1.3. Here the money supply in the hands of the public
consists of $25 in bank notes, $75 in demand deposits, and $80 in gold that
was placed back in the hands of the public when the bank issued the loan.
The total money supply is now $180. Of this, $25 is in the form of bank
notes, $75 is in the form of demand deposits, and $80 is in the form of gold.
By engaging in fractional reserve banking, the bank has created $80 in
additional money—seemingly out of nothing—by loaning out a fraction of
deposits and bank notes!
The story does not end here, however. The borrower who has obtained
$80 in gold from the local bank is not likely to have borrowed those funds
just to keep them idle. Instead, she will probably spend them. Once she
has, what will the new holder of the $80 in gold do with it? If he holds
on to the gold, the money supply will stay at $180. However, if he deposits
the $80 in the bank, the bank’s gold reserves will increase by $80 to $100.
Its demand deposits will also increase by $80 to $155, leading to the T-
account in Table 1.4.

Table 1.4
A Bank Gets New Deposits

Assets Liabilities

Reserves (gold in vault) $100 Bank Notes $25

Loans $80 Demand Deposits $155

The bank is willing to lend out 80 percent of the value of its liabilities,
keeping only 20 percent in reserve. The new demand deposits at the bank
allow it to make additional loans. In particular, 80 percent of its current
liabilities of $180 is $144, but the bank has issued only $80 in loans. Thus,
the bank can increase its loans by $64 and still have reserves equal to 20
percent of its outstanding liabilities. Assuming the bank makes this loan, it
ends up with the T-account in Table 1.5.
 The Evolution of Banks 21

Table 1.5
A Bank Issues New Loans

Assets Liabilities

Reserves (gold in vault) $36 Bank Notes $25

Loans $144 Demand Deposits $155

Notice in Table 1.5 that the bank has gold reserves of $36 and loans of
$144 for total assets of $180. What is the value of the money supply in the
hands of the public? There are $25 in bank notes and $155 in demand
deposits, and the bank just made a $64 loan of gold that some individual
holds, making a $244 money supply. (Note that we do not count the original
loan of $80, since that loan is now included in the demand deposits in Tables
1.4 and 1.5.) Thus, with just two loans, the bank has transformed a money
supply consisting of $100 in gold into a $244 money supply!
This is still not the end of the story. The person who obtained the last
loan for $64 in gold is almost sure to spend it, and the person receiving the
$64 in payment for goods and services is likely to deposit it in the bank.
Compared with Table 1.5, demand deposits would increase by $64 to $219,
and reserves would likewise increase by $64 to $100 of gold. Then, of
course, the bank would have $244 of liabilities and can loan out up to 80
percent of those liabilities, or $195.20. With $144 of loans already made,
the bank can lend $51.20 while still meeting its self-imposed 20 percent
reserve rule. In fact, the bank can keep making loans, as long as the gold
eventually gets redeposited in the bank after the borrower spends it, until
the T-account looks like Table 1.6.
In Table 1.6, the bank has $500 of liabilities and, under its 80 percent
rule, has made loans of $400 while maintaining gold in the vault equal to
20 percent of liabilities, or $100. At this point, the bank is “fully loaned

Tablel.6
A "Fully Loaned-Out" Bank

Assets Liabilities

Reserves (gold in vault) $100 Bank Notes $25

Loans $400 Demand Deposits $475

22 Chapter 1 Money and Banks

out’ ’; it can no longer make a loan without violating its 20 percent reserve
rule and thus can no longer create money. However, notice what the money
supply has become under fractional reserve banking. Money in the hands of
the public is $500 ($25 in bank notes and $475 in demand deposits). Notice
that all of the original $100 of gold is again in the bank vault, just as it was
under 100 percent reserves. However, with 20 percent fractional reserve
banking, the $100 of gold in the vault “creates” a money supply of $500.
Under fractional reserve banking, if all deposits and bank notes were
presented for redemption in a single day, the bank would be unable to honor
its pledge of redemption. Indeed, the bank in Table 1.6 is obligated to redeem
“paper” for $500 in gold but has only $100 in gold in the vault. If this
happened, the bank would not be bankrupt in the sense that it had a negative
net worth. Instead, it would be illiquid—unable to honor its obligations.
Note the difference between illiquidity and bankruptcy. Illiquidity is a
situation in which a bank cannot redeem its deposits on demand. In bank¬
ruptcy, the bank’s assets—the value of its reserves and the loans it has
made—are less than its liabilities—the value of the deposits it has accepted.
A bank can be illiquid but not bankrupt, and a bank can be bankrupt without
being illiquid.
If the bank were unable to honor its obligation to redeem demand de¬
posits and bank notes “on demand,” it would have to stop redeeming
deposits and notes. When a bank faces a long line of depositors and note
holders demanding redemption, we say that a “run on the bank” has oc¬
curred. Under a fractional reserve banking system, such an event is very
dangerous even to otherwise healthy banks, because no bank in such a system
can actually honor all its obligations to pay on demand if they are all
redeemed at the same time.
The U.S. banking system today is in fact a variation of the fractional
reserve banking system just described. Modern banks issue loans and hold
checkable deposits (demand deposits) that far exceed their actual reserves.
Figure 1.1 compares the level of reserves financial institutions hold and the
level of checkable deposits depositors could withdraw on demand. The total
reserves in January 1993 were $56.01 billion, which is considerably less
than the $738.8 billion in checkable deposits.
In later chapters, we will say much more about fractional reserve bank¬
ing, money creation by banks, and government regulation of fractional re¬
serve banks. Now you should have a basic understanding of how banks
evolved from depository institutions into fractional reserve banks and how
fractional reserve banking increases the amount of money used as a medium
of exchange.

Banks as Financial Intermediaries

Financial markets link savers and borrowers. This link is accomplished
through either direct finance or indirect finance. Direct finance occurs when
 The Evolution of Banks 23

Source: Board of Governors of the Federal Reserve System, Federal Reserve Bulletin, various
issues and Citibase electronic database.

savers lend funds directly to borrowers. For example, if you ask a classmate
to loan you money to buy a new car and she agrees, you are engaging in
direct finance. No third party matched you (the borrower) with your class¬
mate (the lender). In fact, however, direct finance most often involves the
assistance of a third party, such as a broker, who brings buyer and seller
together. When IBM issues new bonds, it uses the services of various spe¬
cialists in the financial markets. The exact procedure need not concern us
here; simply note that the ultimate buyers of the IBM bonds will usually
engage the services of a broker to arrange the sale. This is one way financial
markets facilitate direct finance.
In contrast, indirect finance involves a particular type of middleman—
a third party who stands between the borrower and the lender. This middle¬
man is called a financial intermediary, and his or her role is to accumulate
funds from various savers and lend those funds to borrowers. Banks are
financial intermediaries because they accept deposits and lend those funds
to borrowers. Credit unions and savings and loan associations also are fi¬
nancial intermediaries. Less obviously, life insurance companies and pen-
24 Chapter 1 Money and Banks

sions accumulate savings and lend those funds to borrowers, thus performing
the role of financial intermediaries.
In all these cases, the financial intermediary borrows funds from savers
and lends them to borrowers. If you obtain a car loan from a bank, the bank
is actually loaning you money that other people have on deposit there. The
depositors receive interest from the bank; you pay the bank interest on the
loan. The bank is in the middle, earning a profit on the difference (margin)
between the rate you pay for the loan and the rate it pays depositors.
There is an important distinction between the function of a financial
intermediary and that of a broker. A broker brings together a buyer and a
seller of a financial instrument such as a bond, but does not personally issue
a bond or otherwise lend to the borrower; instead, the broker facilitates the
transaction without personally creating a financial instrument. In contrast, a
financial intermediary accumulates savers’ funds and lends them to borrow¬
ers by making a loan from itself. Thus, a bank makes a loan to a borrower
instead of merely introducing the borrower to one or more depositors and
brokering a loan between the two.
Thus, banks and other financial intermediaries are a special kind of
middleman. They profit on the difference between the interest rate they pay
on deposits and the interest rate they collect on loans. Their function is to
repackage depositors’ savings into loans to borrowers in the same way a
retailer might purchase produce in bulk from produce dealers and repackage
it for sale at the supermarket produce counter.
Figure 1.2 indicates the flow of funds between lenders and borrowers
under direct and indirect finance. With direct finance, the final lender (here
Ross Perot) provides funds directly to the borrower (AT&T). In this case,
the role of financial markets is to facilitate the transaction, and Ross Perot
will probably rely on a broker to carry it out. With indirect finance, Ross
Perot would deposit money in a financial intermediary such as NationsBank,
which in turn would make a loan to AT&T. Note that in this case, the
financial intermediary is both a borrower (from depositors) and a lender.
Why don’t depositors skip intermediaries and engage in direct finance?
After all, since a bank charges a higher rate on a loan than it pays depositors,
it would seem that a depositor could do better by making a direct loan to a
borrower or a borrower could get a lower rate by borrowing directly from a
saver. The answer to this question lies in the role intermediaries play in an
economy. Notice that we could also ask this question about product markets:
Why don’t consumers buy directly from factories instead of from retailing
outlets? The answer, of course, is that the benefits derived from using inter¬
mediaries exceed the extra cost of dealing with them.
What benefits do depositors (savers) and borrowers obtain from banks
that make it worth the extra cost? First, banks match up savers who want to
lend funds for short time periods with borrowers who want to borrow funds
for long time periods. Another way to say this is that financial intermediaries
are in a position to borrow short and lend long. Banks, for example, effec-
 The Evolution of Banks 25

tively borrow funds from savers when they accept savers’ deposits. These
deposits are often redeemable on demand, or at least on relatively short
notice. Funds in checking accounts, for example, are redeemable on demand.
In contrast, banks often loan funds for fixed terms, and these terms may vary
from months (car loans) to years (home mortgages). The bank performs the
valuable function of converting funds that savers are willing to lend for only
short periods of time into funds that the bank itself is willing to lend to
borrowers for longer periods. Of course, a bank could get in severe trouble
if a depositor demanded redemption of her or his demand deposits while the
deposited funds were loaned out in a 15-year loan. If unable to come up
with the funds to redeem the demand deposits, the bank would be illiquid.
Banks are able to avoid illiquidity while borrowing short and lending
long by using several business practices. First, a bank seeks a widely diver¬
sified set of depositors so that no one depositor is likely to cause a liquidity
problem by withdrawing funds on short notice. Also, with a large number
of depositors, the odds are that on most days the dollars added to some
accounts and withdrawn from others will roughly cancel each other out,
leaving total deposits fairly stable. Second, a bank keeps a small amount of
deposits as reserves against sudden withdrawals and, more important, estab¬
lishes several lines of credit with other banks and with government regulators
26 Chapter 1 Money and Banks

(e.g., the Federal Reserve System). These lines of credit can be used to meet
unexpectedly large withdrawals of deposits. Third, a bank makes long-term
loans to only a small fraction of its loan clients. For example, banks make
a very small proportion of housing loans relative to their total loan portfolios.
Finally, a bank “lends” a portion of its funds by purchasing government
bonds, which are relatively easy to convert into currency. In this way, a
portion of the bank’s loan portfolio is kept in highly liquid assets, which can
be sold to obtain funds to meet unexpected withdrawals.
The second valuable function banks perform as intermediaries in finan¬
cial markets is pooling many small deposits to make relatively large loans
to borrowers. If you have only $1,000, you cannot make a $100,000 loan to
someone seeking a mortgage. But with a bank serving as an intermediary,
you and other individuals can deposit your small sums in a bank to earn
interest. The bank, in turn, can pool the numerous small deposits into a
sizable quantity of funds to make the $100,000 mortgage.
The third function banks serve is helping depositors reduce risk. Small
depositors, and even relatively large depositors, often find it difficult to
minimize the risk they face in lending funds directly to borrowers. If Natalie
lends her entire life’s savings to a single borrower who defaults, she loses
everything. While this may be an unlikely occurrence, it is not impossible.
An alternative for Natalie is to lend out her life savings in smaller amounts
to a large number of borrowers so that if one borrower defaults, all is not
lost. This alternative is called diversifying: The saver lends his or her funds
to a diverse group of borrowers so that all is not lost if one or even several
borrowers default. It is difficult to engage in diversification without a finan¬
cial intermediary; borrowers typically want large sums of money, and small
depositors usually cannot supply large sums to a diverse group of borrowers.
Thus, banks provide a way for savers, especially small savers, to diversify.
Each depositor bears only a small risk, since default by one or even several
borrowers will have relatively little impact on the bank or its depositors.
Finally, financial intermediaries economize on transactions costs relative
to those that would occur with direct finance. We have seen that transactions
costs are the costs borne in making an exchange, such as the time and legal
costs associated with a mortgage contract. One major transactions cost in
making loans is the cost of checking the creditworthiness of a potential
borrower. If individual savers attempt to diversify without using a financial
intermediary such as a bank, each will make small-denomination loans to a
number of borrowers. In so doing, each saver will want to personally verify
the creditworthiness of the borrower, and a duplication of effort will result.
For example, suppose a borrower wants to borrow $10,000 from each of 10
individual savers. Each saver will want to check the borrower’s creditwor¬
thiness. Thus, 10 separate credit checks will be done before the borrower
obtains $100,000 in loans. In contrast, a bank can borrow $10,000 from each
of the 10 savers, pool their funds, and make a single $100,000 loan to the
 CONCL USION 27

borrower. This will require only a single credit check, saving the time and
effort involved in the nine extra credit checks that would be necessary under
direct finance.
Another transactions cost associated with lending is the cost of moni¬
toring the borrower. This involves ensuring that payments are current and,
more important, that the borrower stays in relatively good financial health.
Again, 10 savers engaged in direct finance would each have to bear these
costs, while a bank that pooled these 10 savers’ funds would have to bear
these costs only once. Moreover, banks specialize in making loans, and this
specialization leads to greater knowledge and efficiency in conducting credit
checks and monitoring loans. Obviously the average individual saver cannot
perform these tasks as efficiently as a bank can.

Summary How did bank loans evolve?

Exercise 7.5
Answer: As society began using commodity money as a medium of
exchange, a need for a safe place to deposit money developed. Early banks
were depositories in which individuals paid a fee for the privilege of depos¬
iting commodity money such as gold. Due to the transactions costs associated
with having to go to the bank to obtain gold to use in transactions, demand
deposits (checking accounts) and bank notes emerged. As these forms of
“paper money” became widely accepted as the medium of exchange, banks
recognized they had much more gold in their vaults than they needed to
honor demands for gold by depositors. Consequently, they began loaning
out a fraction of their deposits to earn additional profits in the form of interest
payments. Today, banks function as middlemen, or intermediaries, in finan¬
cial markets by (1) borrowing short and lending long, (2) pooling small
deposits into large loans, (3) diversifying risk, and (4) economizing on
ii transactions costs relative to engaging in direct finance.

Conclusion

This chapter examined what money and banks are and the economic reasons
for their existence. Money is not synonymous with income or wealth; rather,
it is anything that is widely and generally accepted as the medium of
exchange. Money is the most liquid of all types of assets; that is, it can easily
be converted into other assets or commodities. In addition to serving as a
medium of exchange, money serves as a unit of account, a store of value,
and a standard of deferred payment.
While various types of money have been used as a medium of exchange
in the history of humankind, societies learned very quickly that money
28 Chapter 1 Money and Banks

should consist of something durable, divisible, portable, and easily recog¬

nizable in value. The first type of money civilization used was full bodied
commodity money—a commodity with nonmonetary value that circulated
as the medium of exchange. Representative full-bodied money (paper money
that is “backed” by some commodity) was a predecessor to the current fiat
money (unbacked paper money) used today. Individuals accept fiat money
for payment only because they believe other individuals and businesses will
in turn accept it from them as payment for goods and services.
The emergence of money as a medium of exchange led to the need for
banks as depositories. Demand deposits (checks) and bank notes developed
out of a need to reduce the transactions costs of having to be physically
present to withdraw money from depositories before making purchases. This
development led to fractional reserve banking, wherein banks hold a fraction
of deposits in reserve and make loans to depositors in need of funds. Frac¬
tional reserve banking exists in the United States today and provides a means
by which banks actually “create money” and function as financial inter¬
mediaries.

KEY TERMS

money full-bodied money

medium of exchange representative full-bodied money
Federal Reserve note gold certificate
currency fiat money
liquidity specie
barter demand deposit
double coincidence of wants bank note
transactions cost fractional reserve banking
unit of account direct finance
store of value indirect finance
standard of deferred payment financial intermediary
commodity money

Questions and Problems

1. Look up the definition of money in your with an economist’s definition? Why or

dictionary. Does this definition agree why not?
 Questions and Problems 29

2. On the island of Maka, the government 7. What would happen to your bank if all
has been unable to control the counterfeit¬ depositors showed up at 9:00 a.m. next
ing of its bills. Consequently, individuals Thursday and demanded payment for their
and merchants rely almost exclusively on deposits?
barter as a means of exchange. Why do
you think counterfeiting would lead indi¬ 8. Your brother-in-law wants to borrow
viduals to shun money and turn to barter? $1,000. Relationship aside, why might
you prefer to deposit the $ 1,000 in a sav¬
3. Discuss the advantages and disadvantages ings and loan and have your brother-in-
of using the following commodities as law borrow the funds there instead of
money. loaning him the $1,000 directly?

(a) . Bricks 9. In the example of fractional reserve bank¬

(b) . Wine ing presented in the chapter, the bank de¬
(c) . Com cided to keep only 20 percent of its lia¬
(d) . Pearls bilities in reserve. What would the final
(e) . Platinum T-account look like if the bank decided to
(f) . Uranium keep only 10 percent of its liabilities in
reserve?
4. Suppose you live in Llano, Texas, a small
10. Explain why money reduces transactions
town with a population of 2,500. Rank the
costs. Are there any other advantages to a
following assets from most liquid to least
monetary economy? Are there any disad¬
liquid, and explain why you ranked them
vantages?
as you did.

(a) . One hundred shares of IBM stock 11. Explain how the banking system reduces
(b) . A house in Llano, Texas transactions costs. Are there any other ad¬
(c) . A used computer vantages to the banking system? Are there
(d) . A used car any disadvantages?
(e) . One British pound (the medium of
12. What is the difference between full-bodied
exchange in Britain)
money and representative full-bodied
(f) . A roll of quarters
money? Between representative full-
bodied money and fiat money?
5. How would your answers to Problem 4
change if you lived in London, England? 13. Is one dollar or one dollar’s worth of gold
more valuable? Explain carefully.
6. In the early days of banking, goldsmiths
promised to pay a specified quantity of 14. “U.S. dollars are backed by the gold in
gold to anyone presenting a bank note or Fort Knox, Kentucky.” Is this statement
an endorsed check at their place of busi¬ true or false? Explain.
ness. What does your bank promise to pay
15. Can something serve as money without
you if you present the following?
serving as the unit of account? (Hint: How
(a) . An endorsed check many checks does it take to buy a shirt? A
(b) . A Federal Reserve note suit? A house?)