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Medium
of Exchange vs. the Standard of Value Functions of Money |
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Salvatore Schiavo‑Campo, Economic Research Services
While talking in generalities at the beginning of your first lecture on the origins and meaning of money, absent‑mindedly shred a blank piece of white paper. Then, still talking, again as if just fiddling around, fish a dollar bill out of your pocket and tear it up very slowly. I guarantee strange looks and horrified gasps. Briefly pause, and ask: "What's the matter? Why should it seem normal to tear up a plain piece of paper but strange, almost sinful, to destroy a piece of green paper? Is it because it's green? (No, you would not have been shocked if it had been green notepaper). Is it because there is writing on it? (No, you would have been blasé if it had been a piece of old newspaper). Is it because the government printed it? (It would not have bothered them if you had torn up, e.g., a blank IRS Form 1040.) The essential difference is that you can exchange the green piece of paper with George Washington's picture on it for something that you may want, while nobody would accept the blank piece of white paper in exchange for anything useful. The normal lecture about the various functions of money as a medium of exchange and store of value can then take place, with frequent reminders that this special printed green paper is money because and only because people accept it as money. (An instructor who objects to destroying a dollar can, with a little practice, achieve the same effect by tearing it carefully in half and then taping it back together after class.)
Ralph T. Byrns
Many students erroneously perceive money as synonymous with wealth, income, or cash. One way to convey the idea that money has a fairly precise economic meaning is to ask for a show of hands from those who have too little money. Most will respond affirmatively. Then ask how many students have too much money. Feign astonishment when virtually no hands go up, and assert that this defies the laws of probability. Ask for those who have too little money to raise their hands once more. Select a student at random and ask if he or she currently possesses any cash. (If the answer is NO, choose another student.)
Now ask this student about his or her intentions for this cash. After the response that some of it will be spent on lunch, or gasoline, or whatever, later in the day, suggest that this answer indicates that the student has too much money and too little lunch, or gasoline, etc. People commonly trade things of which they have too much for things of which they have too little (e.g., the exchange of leisure for the income generated by work when people have surplus free time and "too little" money). Now ask for a show of hands from those whose income is too small. Respond that you believe the unanimous show of hands. Ask how many have too little wealth. Again respond that you believe this second unanimous show of hands. As an aside, ask how many are poor. If a number of hands go up, argue that they are broke (illiquid), not poor. Most students embody tremendous investments in human capital, but it, sadly, is notoriously illiquid!
Now repeat the question of how many have too little money. Select a student from those who persist in raising their hands, and ask what he or she would do if given a dollar. (A touch that renders classes dumbstruck is to simply give the lucky student a dollar.) When the student says something about how the dollar will be spent, repeat your point that an extra dollar would be "too much money" relative to whatever is purchased.
This brief discussion takes no more than 3‑4 minutes, and sets the tone for a discussion of the functions of money. It is especially effective when preceded by the exercise offered immediately above by Salvatore Schiavo‑Campo.
By Richard Schiming,
One way to
explore the definition of money is to stress that money is socially defined;
that whatever assets a society chooses to use as money are the money
assets. This principle can then be used
to discus the extremely wide variety of assets that have been used as money by
different societies at different times and places. There is also an important corollary to this
principle: no government can force a society to use any particular asset as
money. To illustrate this point, ask the
students to name two money assets that the
Daniel Levy,
Here's how I introduce the subject of money in the class:
I write on the board, WHAT IS MONEY? Then I tell the following story.
When I was young, I thought that money was the most important thing in a man's life, and, as I got older, I realized that it was true. Some people say, "Time is money." If this is so, I am very rich: I have lots of time. Some people say "Money is everything." But, money cannot be everything because if it were, what would we buy with it?
So, what is money? I take from my wallet one dollar bill and read the inscriptions on it. I say, "I am not going to pass this! Is this money?" Some students say, "Yes," while others say "No." Then I take a blank check from my checkbook and ask, "Is this money?" Some students say, "Yes," while others say "No." Then I take some credit cards from my wallet. I point at the American Express card and say, "This is a symbol of my social status in this country! Are these cards money?" Some students say, "Yes," while others say "No."
Then I show them a plastic bag of shredded dollars which are available from the Bureau of Engraving and Printing and many regional Federal Reserve Banks. I read what is written on the bag. "THIS PACKAGE CONTAINS SHREDDINGS OF $150.00 IN GENUINE UNITED STATES CURRENCY." I digress by telling the students that I bought 10 such packages sent them to my family and told them over the phone that $1,500.00 is in the mail. They were very happy! Is this money? Some students say, "Yes," while others say "No."
So, what is money? Let's try to characterize money. Let's try to write down features of money. I will start.
a. Money is dead. Money is not a live creature. It is a dead object.
b. Money is green. American dollars (the paper money) is green.
c. Money is rectangular. American dollar bills are rectangular objects.
A student asks, "But, why is it important? Not all the money in the world is green. Does paper money have to be rectangular?"
I obviously agree. So, these are some features of money, but they are not the features that make it unique. What are the features that make money unique? Here they might have some suggestions. If not, I help them by telling some stories. Imagine that tomatoes were used as money Can you imagine how a modern economy would function, how transactions would take place in that case? How would you pay in cash in order to but a TV set? To buy a car in cash, you will need several pickup trucks. So,
d. Money is portable.
In the world where tomatoes serve as money, banks would be giant refrigerators. In modern economy we can always take the cash, put it under the mattress or in a wallet and spend it after a month. Therefore,
e. Money is storable.
f. Money is durable.
Imagine a situation where cows serve as money and you go shopping. You take with you 4 cows which you somehow manage to put on a pickup truck. Suppose that you buy something for which you have to pay three cows. You start pushing the cows from the truck: first the white, then the black and finally the blue cow. And the seller says, "Ooo, not the blue cow. I want the red one!" The moral of this story is that unlike cows or tomatoes
g. money is homogeneous.
Again imagine the above economy and the cashier in a supermarket saying that you should pay 78/100 of a cow. How do you pay that? With modern money we do not have such a problem since
h. Money is divisible.
I continue in this manner to explain why something that serves as money should also be
i. scarce,
j. accepted and
k. difficult to counterfeit.
To make the class discussion entertaining, I ask students questions such as:
1. Why does money make people happy?
2. Can you buy a $15,000 new car from a car dealer using only pennies?
Steven T. Petty, Northwestern
I like to start my money and banking unit off with a discussion of how goods and services were exchanged before money was developed. I emphasize the fact that in the early days before money, there existed far fewer goods and services. The level of technology was low and output was produced by hand. Surpluses were small in size and rare in occurrence. Barter was a convenient way of exchanging goods and services and transferring surpluses from one household to another. "Coincidence of wants" and "the large number of relative prices" were not much of a problem in this simple setting.
As the level of technology advanced, economic systems grew. More varieties of goods and services were being mass-produced and exchanged. Coincidence of wants became a problem. This problem of "matching up with someone who wanted what you had and had what you wanted" became pronounced. Also, the time period, location, amounts, and quality all had to coincide in order for barter to take place.
The large number of relative prices to deal with also became a big problem. At this point I like to show students how a simple four-good economy leads to six relative prices. I start by assuming values for four goods (e.g., 1A = 2B = 3C = 4D) and then set up a four by four matrix and find the exchange value for each good in terms of other goods. Next, I introduce the formula for finding the number of relative prices. The formula is: THE NUMBER OF RELATIVE PRICES = n(n-1)/2, where n equals the number of goods to be exchanged in the economic system. I then relate the formula back to the matrix. The (n-1) part of the formula relates to the fact that the middle diagonal in the matrix contains 1 to 1 comparisons of goods to themselves. This row is so basic that the formula "throws it out". Next, I show students that the middle diagonal divides the matrix in half and that each half is the inverse of the other. Since 1/2 essentially means the same thing as 2/1 when examining rates of exchange between goods, the /2 part of the formula "throws out" one complete half of the matrix. I then do a few examples using the formula to show how quickly the number of relative prices increases in economic systems where many goods and services are exchanged.
I wrap up my "before money" discussion by explaining the ways in which money solves many of the problems found in barter systems. As economic systems became technologically advanced, hundreds of thousands of different goods and services began to be produced. A convenient and efficient way of transferring surpluses from one household to another was needed. A convenient and efficient method of exchange was realized when money began to be used to execute transactions. Coincidence of wants was no longer a problem as money became acceptable by all. The large number of relative prices were replaced with a smaller number of money prices. Now my students are ready to fully understand what is meant by "medium of exchange", "story of value", and "measure of value".
Up-to-Date Economic Statistics
By Steven T. Petty,
Northwestern
Typically, the principles student's first exposure to macroeconomics occurs when covering the topics of GDP, unemployment, and inflation. All three of these topics give rise to statistics and measures that students are unfamiliar with. If the student is unable to achieve a firm understanding of macro measures, then that student will experience difficulties later in Keynesian employment theory and monetary theory.
Besides reviewing the underlying mechanics of macro measures (e.g., explaining that some macro measures are rates of change and that others are comparing one value to another value and that some measures yield percentages and some do not) I feel that it is very important for students to be able to understand how currently reported measures are calculated.
In order to
keep my students and myself up to date on current macro measures I have found
two excellent monthly publications from the Federal Reserve Bank of
Although the graphs and tables are very suitable for overheads, I have elected to post the measures in my classroom. This has proven to be very convenient. While many textbooks provide good historical data for examples in class, my posted information allows the class to calculate current measures. For example: in the past I have referred to my posted data for the current GDP deflator and the current nominal GDP figures. I used these numbers to calculate current real GDP. I then compared our calculation to the Fed's measure and came up with the same number. Students liked this and began to trust their abilities in calculating macro measures. The current measures seem to have more meaning to students than the historical data found in most texts.
What Do You Know About The Money In Your Pocket?
Frank Whitesell,
One subject that interests every student is money. I have found that even the students who normally display little interest in economics can be drawn into a discussion about the money in their pockets. A good place to start is with some basic facts about our current coinage. You will be surprised at how few people can answer these questions.
Q: Why are the dimes, quarters, half‑dollars and dollars made since 1964 of the sandwich type, with nickel‑copper outer layers and a pure copper core?
A: The copper core is necessary for electrical conductivity, required by many vending machines. This requirement was fulfilled by the old silver coins. A solid nickel‑copper coin (such as a five‑cent piece) is not conductive.
Q: All
A: There is no practical reason for this reeding today. Originally, coins made of silver or gold were reeded to prevent the undetected scraping of metal from the rims.
Q: Why did the Treasury issue Susan B. Anthony dollars in 1979, and what happened to them?
A: They were issued to save the government money, predicted to be $30 million a year. Even though they cost slightly more to make than paper dollars, a coin circulates for several decades, versus an average lifetime of 18 months for a dollar bill.
Because of poor planning, the Anthony dollars are easily confused with quarters. (This is one answer that everyone in the class will know.) But there is another point: Americans have never accepted large‑denomination coins. Even hundred‑year old silver dollars are very common in uncirculated condition today because they have spent most of their lives in Treasury vaults and have never entered general circulation.
Over 850 million Anthony dollars were minted, but they never effectively circulated. The series was discontinued after 1981.
Q: What happened to the silver coins that the Treasury issued until 1964, then replaced with today's clad coins?
A: This is a good example to use in
discussing
Someone invariably asks what a silver dime or quarter is worth now. The answer is found by multiplying the current price per ounce of silver by the face value of the coin times 0.72. For example, if silver is $6 an ounce, a pre‑1965 silver quarter has a bullion value of $1.08.
Kay Johnson, CFP Penn State-Erie
A pile of money attracts
student attention! To introduce the
topic of money and financial markets, I bring an envelope of money to class and
dump it on my desk. When I ask for a
volunteer to come to the front of the class and select what money he/she would
like to have, I always get an immediate response. The volunteer often gets a surprise, though,
in that only a small portion of the currency and coins is from the
Jeffrey S. Bader,
Students easily grasp how money is used and why they want it, but most find it difficult to understanding why money exists and precisely what it is. To illustrate the concept of money, I play a trading game with roughly four students in front of the class. Their task is to attempt to trade four different goods, which I represent by giving each of them a piece of differently colored chalk. The game is first conducted without money to illustrate a barter system, and the students quickly see the difficulty of trying to coordinate a coincidence of wants to ensure that all trades take place. The second time each person begins with a piece of colored chalk and $1. The students readily discover that while it is difficult to trade chalk for chalk, exchanging money for chalk poses few problems. The role of money as a medium of exchange is visually presented to the class.
This brief, but effective exercise enables the class to discuss several aspects of money:
a. Students quickly see the pressure for a monetary system to evolve from a barter system because the introduction of money efficiently reduces the transaction cost of trading goods. These benefits are more evident when students begin thinking about trying to trade wheat, coats, and refrigerators in a community setting rather than pieces of colored chalk in a classroom.
b. Students also discover that what distinguishes money from any other good is that it is the medium of exchange. This leads into why some things are classified as money and why some are not, i.e., the monetary aggregates and the difference between M‑1 and M‑2.
c. The third lesson that students learn is that money need not have intrinsic value. Its role as the medium of exchange exists simply because it is generally accepted by the public. This leads us into a discussion of the evolution of money from gold and silver coin to Federal Reserve notes.
Loren Guffey,
The functions of money described in macro principles courses too often become a meaningless list that students memorize but don't really understand. After explaining that the primary requirement for money is that it be acceptable as a medium of exchange, I move on to other functions of money. Here is an example that I use to emphasize that money serves as a measure of the relative values of heterogeneous items. (I teach vocabulary as well as Economics!)
Many of my students have a commitment to Christian beliefs and revere the Bible, while others like their spirits in a different form. To illustrate money as a measure of value, I pick the extreme example of a bottle of whiskey and a Bible. First I ask if anyone considers them of equal value. No one in the class ever believes that these two items are of equal value. Then I specify that each is on sale for eight dollars.
Once students realize that even emotionally charged examples succumb to economic laws, they have made a giant step towards understanding economics. The collective values of all members of society determine that these items, priced equally, are of equal value. When students understand that society can value even radically different goods equally without any individual valuing them equally, they not only perceive the role of money as a standard of value, they also get a glimpse of the magic of a market system.
The Historical Parlance of Money
Anthony J. Greco,
I begin by mentioning that money is anything generally accepted in payment. I remind students that the acceptable means of payment have taken many forms in different times and places. When I point out that such things as bread, clams, and dough have been used and that this is why we still use such slang terms to represent money, they chuckle and tend to easily remember this function of money.
Dennis C. McCornac,
Students usually consider their passbook savings account to be the same as cash. They are somewhat confused as to why the passbook savings account is not a medium of exchange. To illustrate the difference, I offer the student a dollar bill or my passbook savings account book to use to go to the student union to purchase a cup of coffee. None has ever chosen the savings account book.
Paul G. Coldagelli,
Economists at times announce a need for greater saving. The following proposal apparently encourages saving and helps solve the federal deficit financing problem without "crowding out" private borrowing: Suppose firms were required to pay workers 20% of their take home pay in the form of U.S. Savings bonds. The other 80% could be paid in conventional money (cash or check).
How would households respond if this imposed saving was more than they cared for? Given the supply of savings bonds, and their general acceptance, we would likely see consumers offering savings bonds as a medium of exchange, and firms (grocery stores and other retailers especially) gladly accepting these bonds, for they would permit consumer purchases. Those who wanted to save could hold bonds; those who wanted to spend could do so by "spending" their bonds in exchange for goods and services. Society has transformed bonds into "money"!
This example can also be used to differentiate consumers' decisions to spend/save from their decisions to hold their wealth in relatively liquid/illiquid forms. Reducing liquidity (shrinking the conventional money supply) may not increase saving!
Jim Cobbe,
There are two anecdotes that illustrate different aspects of Gresham's law. First, which money is bad may depend on the individual. In 1945, after the atom bombs ended World War II, Indonesia (the Netherlands East Indies) was occupied by a British Military Administration (BMA) that took the surrender of the Japanese occupying forces. For a while there were four different paper moneys in circulation: pre‑War NEI Guilders, the only currency which the returning and released Dutch would accept; Occupation Japanese money, which was available in abundance and had been the official money for three and a half years; British Military scrip in which the British troops were paid and with which the BMA paid for its purchases; and new rupiahs, issued by the rebels fighting for independence from the Dutch, acceptance of which was encouraged by the rebels' guns. Vendors typically quoted prices in the money they were most willing to accept, or that they thought the purchaser was most likely to proffer; prices were always negotiable, and the exchange rates between moneys varied between individuals and from day to day. Allegedly, some members of the occupying British forces were able to acquire substantial quantities of goods starting with very small amounts of BMA scrip and then completing long series of cross‑transactions between different moneys with different individuals; others found themselves holding large nominal sums in, e.g., Japanese occupation money or rebel rupiahs, which became almost worthless as the Dutch authorities reestablished themselves. But which money was bad depended on individuals; Japanese troops continued to regard their money as good, and rebels and their sympathizers regarded theirs as good, even after most of the population was refusing to accept them. Hence, the opportunities exist to gain by roundabout transactions.
The second anecdote concerns the failure of the first attempt to introduce paper currency in Tanganyika (now Tanzania). It failed, not because the currency did not maintain its purchasing power but for the much simpler reason that the paper itself was not sufficiently durable in the environmental conditions. It was liable to rot, attack by insects, and general physical deterioration; it did not represent a reliable store of value because it was too likely to literally fall apart and become unacceptable. Hence, paper money was the bad money, driven out of circulation by coins, which were physically more durable, even though in purchasing power terms the two moneys remained at par with each other.
Walton M. Padelford, Union University
While working in Bolivia several years ago, I noticed an example of Gresham's Law operating in paper currency. Bolivian paper notes were printed by the Thomas LaRue Co. of London, but unlike the U.S. dollar, there was no simple mechanism for destroying old notes and issuing new ones. This resulted in some paper currency becoming very worn and tattered, often raggedly repaired with tape. Bills that became too worn would eventually circulate only at a discount. That is, if one day you will present a worn 10 peso bill to a merchant, he might have offered you only 8 pesos credit for it. This resulted in a game of paper money‑musical chairs. The object of the game was to pass bad currency as soon as possible. Bad money then circulated much faster than good money; or as Gresham would have it, bad money drives good money out of circulation.
James A. Kurre, The
A good example of Gresham's Law, which states that bad money drives out good money, can be found in a typical poker game. Although they constitute only a small proportion of the coins on the table, the Canadian coins continually show up in the pot. While a Canadian nickel has a face value of five cents, its value in terms of American money is less (and it just might jam in a vending machine, too) so Canadian nickels are the first ones thrown into the pot. The last winner of the evening is the one who takes home most of the Canadian money.
Another way to show Gresham's Law at work is to ask the students to pull out all their coins and look at the dates. They will regularly find pennies and nickels with pre-1965 dates but no higher denomination coins with those dates. This is due, of course, to the fact that the higher denomination coins had some silver content before 1965, and increases in the price of silver made the intrinsic/metallic value of those coins greater than their face value. As a result, silver coins disappeared into hoards or were melted, leaving the bad or cheap money to be used for day-to-day transactions.
Harry G. Shaffer, The
One of the difficulties of barter is that things have different values; some are very valuable and some are not. Suppose we are living in a barter economy, and Mrs. Henry Ford Jr.'s cook tells her that they have run out of salt. Mrs. Ford decides to get it herself. She goes to the grocery store and says to the grocer:
"I need some salt."
"What do you have to offer in exchange?" he asks.
"Don't you know who I am?"
"No, I don't think I have had the pleasure."
"I am Mrs. Henry Ford Jr. and you know the business we are in."
"Oh yes, indeed," the grocer says. "If you give me a green Ford Maverick loaded with options, I'll give you 46,000 pounds of salt."
Of course, she doesn't want 46,000 pounds of salt. She wants two pounds. How can they trade? You might say that this is very funny, but after all, it would not be impossible. The grocer could simply keep book until the value of her purchases equals the value of the car he wants. Unfortunately, not even that is possible. Suppose that over a period of time Mrs. Henry Ford, Jr. buys (and I write on the blackboard):
467 extra large sirloin steaks 212 quarts of milk
59 loaves of bread 315 dozens of eggs . . .
How does one sum steaks and milk and bread and eggs? It can't be done without a common denominator to add up their values. If we know that steaks are $5.50 each, quarts of milk $.98 each, etc., then we can add them together until they equal the value of the automobile.
If Barter Is So Bad, Why Does It Still Exist?
Eric K. Steger,
Typically, after I discuss the usual costs associated with barter some student will say, "If barter is so bad, why does it still exist?" This is a worthwhile question to get students discussing. Answers generally given are (1) tax avoidance and /or evasion; (2) people need products and services and don't have enough money so they incur the costs of barter to receive the benefits from consuming these products and services received from barter.
Medium of Exchange vs. the Standard of Value Functions of Money
James A. Kurre, The
In a discussion of the functions of money, students sometimes have a difficult time distinguishing between the medium of exchange and the standard of value functions of money. The following example usually serves to make the point.
Consider two American students in the study‑abroad program. One is just completing a year of study in France and the other has just arrived to begin her year. The departing student wishes to sell his Peugeot, and the arriving student wishes to buy a car. It is possible that they will haggle over the price of the car in American dollars, but the ultimate exchange of currency would be in francs. In this case, the dollar serves as a standard of value while the franc is used as the medium of exchange.
John P. Cochran, Metropolitan State College‑Denver
Discuss the various measures of the money supply (M1, M2, M3, L), and point out that M2 and beyond are estimated because people may think of these less liquid accounts as money and plan their spending accordingly. Indicate that the relationship between money and spending is a major reason why money is a critical consideration in macroeconomics. If you want to anticipate coming materials a bit, you might mention that while Keynesians think spending is determined primarily by income, monetarists emphasize money holdings as the major determinant of spending.
Explaining the Money Multiplier
Donald T. Butler,
A new deposit of poker chips is the change in base for the first monetary expansion problem I give my students. Pile 100 chips, $1 each, on the desk at the students' left, then put a few half sheets of blank paper on the right side and keep the T‑account record on the board. Then ask, "With a reserve requirement of 15% and a cash drain of 5% of demand deposits, how much can the banking system lend?"
Lend $80, drop $5 worth of chips on the floor (cash drain), post a half sheet of paper as a Demand Deposit in the bank on the right half of the table and keep $15 in chips as reserve behind the demand deposits as required. You may want to keep loans of $80 on paper also. Repeat a sufficient number of times, and you will have $400 of demand deposits with $80 reserve (as required) and $20 currency in circulation. And the change in M1 Money Supply? Demand Deposits ($400) plus currency in circulation ($20) equals $420. This visualization of the reserves being used up in two places, quickly and efficiently teaches the basic concept.
Djehane Hosni,
Students are, typically, not at ease with the Money and Banking Section which is, in all standard textbooks, presented through a lengthy numerical example. To grasp the essence of the banking transactions and in order to follow the changes in the money supply, I summarize the banking transactions in a banking cycle format with a series of steps.
I. Availability
of Excess Reserves (ER)
1. Calculate Required Reserves (RR as = Required Reserve Ratio % X Demand Deposits)
2. Check for Excess Reserves
ER = Legal Reserves ‑ RR
If ER > 0, The bank can extend a loan.
II. Banking
Transaction Assets Liabilities
*Loan Transaction: Extension Loan Demand Deposits
Repayment Loan ¯ Demand Deposits ¯
Check Withdrawal Reserves Demand Deposits ¯
Check Deposit Reserves ¯ Demand Deposits
III. Have Excess Reserves been created?
If ER > 0, The bank can extend a loan and the cycle repeats itself.
If ER = 0, The bank is fully loaned up (no loan can be extended).
* A common error by students is to skip the loan transaction step and omit its effect on the balance sheet. You will mess up your computation if you jump to the check withdrawal step.
Robert F. Schlack,
Does money grow on trees? Can banks create money? Regrettably, I sometimes think that students find it easier to believe in the former rather than the latter. Yet, as teachers of principles, we likely would agree that fractional reserve banking and the money multiplier are two basic ideas that students should have mastered by the time they leave the macro course. How might we explicate these highly nonintuitive concepts to a generation which, we are told, prefers pictorial over algebraic manipulation?
While most principles texts contain ample evidence in support of the utility of graphical approaches, I find no attempt to use graphical modes of analysis to explain deposit creating and the money multiplier. This seems unfortunate for all we need do is apply, with minor changes, a concept and technique already familiar to students--the notion and representation of trade-offs.
Consider the following ("Dr. Schlack's Money Tree"). Suppose $1,000 in new reserves enters the banking system (the proverbial "found hoard" is deposited in an account). Initially, the first round bank is at $1,000 on axis labeled "Reserves" (as shown). Assuming fractional reserve practices, however, the bank will want to trade-off the safety of holding reserves for the income from extending loans (via deposit creation). This means, in graphical terms, that the bank moves along a 45 degree line that is akin to the familiar production-possibilities curve until its preferred combination of safety (reserves) and income (loans) is reached. For the moment we can assume that the bank feels comfortable being fully "loaned up" (the ratio of required reserves to deposits is taken to be 0.20).
In a second round, the situation is similar for other banks (but note that the maximum--$800--on each axis is less). The loans extended by the first round bank enters the second round banks as new reserves (see dotted arrow). Again there is a trade-off and these new banks move down another 45 degree line (solid arrow) until an optimum combination of safety and income is reached (again assume it is the legal ratio).
The process repeats a third, fourth, and a success of other times, with each additional round adding less and less to the money supply (the triangles get smaller and smaller). The cumulative change in the money supply (as a result of deposit expansion--"banks creating money") is shown by the horizontal movement of the succession of triangles.
The model also lends itself nicely to showing, very graphically, how the maximum potential expansion (as given by the legal reserve ratio) would not be realized should either 1) banks wish to hold some excess reserves, or 2) the public desires to hold more currency. In the first case, the movement down the line is halted before the points indicated above (and all subsequent triangles are smaller). In the second case, the currency withdrawal causes the relevant 45 degree line to shift inward (and again the triangles for this and subsequent rounds will be smaller).
While students, along with the rest of us, may still wish to believe that "money grows on trees." the model offered above may help to convince doubting neophytes that the trees are planted and nurtured by banks (making the Fed, with its powers to increase or decrease reserves, equivalent to the sun). Now I only wish that I could convince these "powers that be" to plant just a little one of these trees in my own backyard!
Figure 12-1
Ralph T. Byrns
Appoint a student as the class banker, and use the standard T‑account process to show the money expansion process. Place other student names on accounts and IOUs in this money creation process, being sure to emphasize that your `banker' seems to be creating money out of thin air when making loans.
After arriving at the standard result that the monetary base times 1/rr equals the potential money supply, point out that this money multiplier (1/rr) parallels the autonomous spending multiplier (1/MPS) discussed in the Keynesian material, that the monetary base is analogous to autonomous spending, and that the money supply is calculated in the same manner that equilibrium was computed in the simple Keynesian model; i.e.:
1/rr x MB = MS and 1/MPS x A = Y.
This reassures mathephobic students, and shows them that learning a little math can pay double dividends; they have more of an incentive to learn this because they will be able to apply the same mechanics to both monetary and Keynesian concepts.
Now suggest to a number of students who have "bank accounts" that there is less in reserve than they cumulatively have deposited. Set up a run on the bank. Ask your banker if there is any solution short of absconding to Brazil with all reserves. Some student will suggest selling some IOUs to another bank. (You might ask if anyone has ever borrowed from one institution and wound up paying another to point out that "factoring" debt instruments is common. Some student almost invariably has had this experience on a car loan.) Then ask, "What will happen if runs on banks become widespread? (Financial collapse.) This sets the stage for the upcoming discussion of the FED and its role as "a lender of last resort."
Fractional Reserve Banking in the Salad Oil Trade
Stanley Kaish,
When I teach the fractional reserve banking system I remind the students that banking is the only profession in which you can sell the same thing twice and not get arrested. When you lend excess reserves, you have sold the right to demand the same deposits to both the original depositor and the borrower.
Back in the 1960's Anthony DeAngelis, known as the Salad Oil King, practiced fractional reserve banking with his salad oil inventories. He learned, as did the early goldsmiths, that 1) the commodity deposited is fungible, and 2) not everyone wanted to withdraw it at the same time. Mr. DeAngelis ran Allied Crude Vegetable Oil Company which was a tank farm, i.e., a warehouse for salad oil. When some 1 billion pounds of oil were deposited with him to store he issued warehouse receipts which guaranteed the presence of the oil and, not unlike bank pass books, could be used as collateral for loans by the owner depositors of the oil. Mr. DeAngelis then sold 90%* of the oil left in his trust to other buyers, in effect treating it as excess reserves. The other 10% he kept as required reserves to show any owner who came to check up on his oil, assuring the person examining it that the oil being shown did indeed belong to him. As long as all the owners didn't want their oil at once, the fractional reserve system worked as well in oil as it did in banking. Alas, one day all the owners did want the oil, and while the bankers enjoy their country clubs, fractional reserve banking ended up putting the Salad King in jail.
Explaining Bank Liquidity Plus Money Creation
Charles E. Hegji Auburn University at
Students sometimes have a difficult time understanding how banks can create demand deposits "out of thin air," so to speak. If the students have already been exposed to the bank expansion multiplier from a principles class, they also may be under the misconception that bank reserve problems are solely related to Federal Reserve reserve requirements against deposits. This example cures both problems.
I begin showing a bank a T-account on the board after a customer deposits $1000 in cash in the bank by opening a checking account. The bank usually has my name.
Assets Liabilities
$1000 cash assets $1000 demand deposits
I purposely use the term "cash assets," since it gets away from the students thinking in terms of the Federal Reserve, and actual bank financial statements use this term or something like it. I then show how cash assets would be transferred to other banks when the above customer spends his or her demand deposits.
I then ask a student if he or she would like to borrow some money, and how much, encouraging a large amount. Suppose the amount is $50,000. I take a piece of paper and write up a loan agreement, get him or her to sign it, and put it in my pocket. I also give the student a make believe checkbook in return. Then I write up the new T-account after the transaction.
Assets Liabilities
$1000 cash assets $1000 demand deposits
$50,000 loans $50,000 demand deposits
We have just exchanged something of value. I have the student's IOU and the student has his or her demand deposit. And, the bank has created money "out of thin air." Why don't banks do this ad-infinitum, however? The problem, as I point out, is that the borrower would want to spend his or her money which would drain cash from the bank. Hence, we have a liquidity problem, independent of the Federal Reserve.
I think it is an important concept, and it seems to work.