Money and Banking.
The Four Jobs of Money.
The four jobs of money are:
(1) medium of exchange
(2) standard of value
(3) store of value
(4) standard of deferred payment

Medium of Exchange.
Money makes it much easier to buy and sell because money is universally acceptable. With money I can go out and buy whatever I want--provided, of course, I have enough of it. Similarly, a seller will sell to anyone who comes along with enough money; he won't have to wait for a buyer who's willing to trade something the seller needs.
Standard of Value.
Store of Value.
Over the long run, and particularly since World War II, it has been a very poor store of value. However, over relatively short periods of time, say , a few weeks or months, money does not lose much of its value. More significantly, during periods of price stability, money is an excellent store of value.

Standard of Deferred Payment.
Many contracts promise to pay fixed sums of money well into the future. A corporate bond may pay a specified amount of interest every quarter for 30 years and then, upon maturity, pay out the principal as well. A 20-year mortgage obligates the homeowner to send the bank a monthly payment covering interest and principal for the next 240 months. These contracts call for all the payment of money years into the future, illustrating how money functions as a standard of deferred payment.
Money versus Barter.
Without money, the only way to do business is by bartering. "How many quarter sections of beef do you want for that car?" or "Will you accept four pounds of sugar for that 18-ounce steak?
Our Money Supply.
M1 = currency, demand deposits, travelers checks, and other checkable deposits. M1 + savings, small-denomination time deposits, and money market funds = M2. By adding savings deposits, small-denomination time deposits, and money market mutual funds to M1, we get M2. You know what savings deposits are. Time deposits hold funds that must be left in the bank for a specified period of time--a week, a month, three months, a year, five years, or even longer. M2 + large-denomination time deposits = M3. We get from M2 to M3 by adding large-denomination time deposits. How large is large? The dividing line between small-denomination and large-denomination time deposits is $100,000. Any deposit of less than $100,000 is small.
Here's a recap of how we get from M1 to M2 and then from M2 to M3. M1 consists of three main items: currency, demand deposits, and check line deposits. M1 plus savings deposits, small-denomination time deposits, and money market mutual funds equals M2. M2 plus large-denomination time deposits equals M3. Note two more things: M1 is part of M2, and M2 is the biggest part of M3.

The Keynesian Motives for holding Money.

John Maynard Keynes said people have three motives for holding money. First we'll look at the transactions motive. Individuals have day-to-day purchases for which they pay in cash or by check. You take care of your rent or mortgage payment, car payment, monthly bills, and major purchases by check. Cash is needed for groceries, gasoline, most restaurant meals, the movies, and nearly every other small purchase. Businesses, too, need to keep substantial checking accounts to pay their bills and to meet their payrolls.
Next we have the precautionary motive. People will keep money on hand just in case some unforeseen emergency arises. They do not actually expect to spend this money, but they want to be ready if the need arises.
Speculative motive--when interest rates are very low-- as they were during the Great Depression when Keynes was writing-- you don't stand to lose much by holding your assets in the form of money. The speculative demand for money is based on the belief that better opportunities will come along and that, in particular, interest rates will rise.

Four Influences on the Demand for Money. The amount of money we hold is influenced by four factors: (1) the price level, (2) income, (3) interest rates, and (4) credit availability. Changes in these factors change how much money we hold.
(1) The Price Level. As prices rise you need more money to take care of your day-to-day transactions. As the price level rises, people need to hold higher money balances to carry out their day-to-day transactions. Assume a constant inflation rate of 10 percent so that the price level rises by exactly 10 percent every year. The cost of living would double every seven years. So you would need to carry double the money balance in 2003 that you did in 1996 to handle exactly the same transactions. On the other hand, with a 10 percent rate of inflation, the longer you hold assets in the form of money, the less that money will buy. Even though there is an inflation penalty for holding money for relatively long periods of time, you will surely keep enough on hand to take care of your day-to-day transactions. And if you compared your money balance in 1996 with that of 2003, you'd find that in 2003 you would be holding about double what you held in 1996, all other things remaining the same.

(2) Income.
The more you make, the more you spend, and the more you spend, the more money you need to hold as cash or in your checking account. Therefore, as income rises, so does the demand for money balances.

(3) The Interest Rate.
The quantity of money demanded goes down as interest rates rise. The alternative to holding your assets in the form of money is to hold them in the form of bonds, money market funds, time deposits, and other interest-bearing securities. As interest rates rise, these assets become more attractive than money balances.

(4) Credit Availability.

We can now make Four generalizations:

1. As interest rates rise, people tend to hold less money.
2. As the rate of inflation rises, people tend to hold more money.
3. As the level of income rises, people tend to hold more money.
4. People tend to hold less money as credit availability increases.

Modern Banking.

Bank Lending.
Banking is based on one simple principle: Borrow money at low interest rates and lend that money out at much higher interest rates. They come right out and admit that they pay either zero or up to maybe 3 percent interest on deposit for a few years -- but they charge about 7 percent for fixed-rate mortgages, a bit more for most business loans, and about 18 percent on credit card loans.

Financial Intermediaries.
Financial intermediaries channel funds from savers to borrowers. Basically they repackage the flow of deposits, insurance premiums, pension contributions, and other forms of savings into larger chunks-$10,000, $1 million, $50 million, or even more-for large business borrowers. The main financial intermediaries are banks (a category that includes commercial banks, savings banks, savings and loan associations, and credit unions). Traditionally, banks lent money for very short-term commercial loans, but in the last few decades they have branched out into consumer loans, as well as commercial and residential mortgages.

The Creation and Destruction of Money.
To create money, banks must increase either currency held by the public or checkable deposits. The way banks do this is by making loans. A businessman walks into Bank Of America and requests a loan of $10,000. Later that day he calls the bank and finds out that his loan is granted. Because he already has a checking account at Bank of America, the bank merely adds $10,000 to his balance. In return he signs a form promising to pay back the loan with interest on a specified date. That's it. Money has been created. Checking deposits have just increased by $10,000.

The Destruction of Money.
He who creates can usually destroy as well. That's what happens when the businessman pays back his loan. He'll probably write a check on his account for $10,000 plus the interest he owes, and when the bank deducts that amount from his account, down goes the money supply.

Limits to Deposit Creation.
Why can't bankers keep issuing loans by increasing the checking accounts of their customers? The first limit would be prudence. Most banks would try to keep about 2 percent of their demand deposits on reserve in the form of vault cash; in case some of their depositors came in to cash checks, there would be enough money on hand to pay them. Thus, if left to their own devices, bankers would expand their loans only up to the point at which they had just 2 percent cash reserves, or a reserve ratio of 2 percent. Of course, most bankers would more prudently opt for reserve ratios of 3 or 4 percent. But no banker has that choice. The Federal Reserve sets legal requirements to which the banks must adhere, and, as I've already mentioned, these limits are substantially higher than those that might be set by the most prudent of bankers.

The Federal Deposit Insurance Corporation.
After the massive bank failures of the 1930's, Congress set up the FDIC--another case of closing the barn door after the horses had run off. This organization taxes its members from 0 to 27 cents for every $100 of deposits in exchange for insuring all member bank deposits of up to $100,000. The amount insured has progressively been raised, the last time in 1980, when ceiling was raised from $40,000. The whole idea of the FDIC is to avert bank panics by assuring the public that the federal government stands behind the bank, ready to pay off depositors if it should fail. The very fact that the government is ready to do this has apparently provided enough confidence in the banking system to avoid any situation that could lead to widespread panic.

The Savings and Loan Debacle.
In early 1990 the financial press was calling this the greatest financial scandal in the history of the United Sates. But the roots of the problem date to the 1950's and 1960's, when the nation's 3,000 savings and loan associations were handing out millions of 30-year mortgages at 4,5 and 6 percent fixed interest rates. This was good business-at that time- because the S&Ls were paying just 2 or 3 percent interest to their shareholders. When interest rates went through the roof from the late 1970's through the early 1980's, the shareholders rushed in to withdraw their money. Why didn't the savings and loan associates simply pay them more interest? Because they were legally barred from doing so.

In 1980 the law was changed to allow the savings and loan associations to pay much higher rates of interest. In addition, they were freed from making primarily home mortgage loans. What the S&L's did, then, with their newfound freedom was go out and borrow funds at very high interest rates and lend them out at still higher interest rates. The only trouble was that the loans they tended to make were very risky ones. Borrowers defaulted on their loans, and the S&Ls were stuck with large holdings of real estate, which they had to sell in a depressed market. In short, scores of S&Ls-- most notably in Texas and Oklahoma-- lost their shirts. Real estate developers, many of them based in California, Florida, and Texas, brought control of many S&Ls and poured billions of dollars into shopping malls, office parks, condos, and other ventures of dubious merit. And so another wave of S&Ls was taken to the cleaners. Still another aspect of the S&L debacle revolved around junk bonds, which were used extensively to finance corporate takeovers or, alternatively, to stave off hostile takeovers. To raise billions of dollars quickly, corporate raiders-or the boards of the corporations facing hostile bids-would issue bonds given very low credit ratings. Why did anyone want to buy them? Because they paid relatively high interest rates. Among the biggest buyers of these junk bonds were failing S&Ls. And so, using their shareholder's money, they helped feed the speculative corporate takeover frenzy that dominated Wall Street during the 1980's.
When the prices of many of these bonds plunged steeply in the late 1980's, in the wake of the stock market crash of October 1987, several hundred more S&Ls were ruined. The government has already spent a total of more than $150 billion on paying off S&L depositors and reorganizing the failed S&Ls so they could be reopened under new management. Why is the government paying hundreds of billions of dollars to bail out the S&L industry? Because the government had placed its full faith and credit in the savings and loan associations. Remember that every shareholder was insured up to $100,000. So when the S&Ls failed, the government had to pay off every shareholder up to $100,000.