Chapter 26 — Money and Banking

What Money Is and Why Banks Are Fragile

What is money? The question sounds simple. You carry it in your wallet, check it in your banking app, earn it from your job, and spend it on everything from coffee to college. But money is stranger than it appears. A $100 bill is a piece of paper with no intrinsic value. A bank deposit is a number in a database. Neither is backed by gold, silver, or any physical commodity. Yet both function as money — accepted by virtually everyone in exchange for virtually everything — because of a social agreement that they will continue to be accepted.

Money is a social technology. It works because everyone agrees it works. When that agreement breaks down — as it did in Zimbabwe (Chapter 23), in Weimar Germany, or during the 2008 financial crisis — the consequences are devastating.

This chapter covers what money is, how banks create it, why the Federal Reserve exists, and why the system is more fragile than it appears.

26.1 The three functions of money

Medium of exchange: money is accepted in transactions. You can buy things with it.

Unit of account: money is the measuring stick for prices. We quote prices in dollars, not in chickens.

Store of value: money holds its value over time (at least approximately). You can save it today and spend it later.

Anything that performs all three functions well is money. The U.S. dollar does all three well (though inflation erodes the store-of-value function over time). Gold performs some functions (store of value, historically medium of exchange) but not others well (try buying a latte with a gold coin). Bitcoin performs some functions poorly (volatile store of value, limited medium of exchange, almost never used as unit of account). We'll evaluate crypto more carefully in Chapter 37.

The evolution of money

Barter → commodity money → representative money → fiat money.

Barter (direct exchange of goods) requires a "double coincidence of wants" — I have what you want AND you have what I want. This is so restrictive that barter economies are rare and limited.

Commodity money (gold, silver, shells, salt, tobacco): the money itself has intrinsic value. Gold coins work as money because gold is valuable, scarce, durable, portable, and divisible. But commodity money is heavy, hard to transport in large amounts, and the money supply depends on the commodity supply (gold discoveries cause inflation; gold shortages cause deflation).

Representative money (paper backed by gold): governments issue paper notes that can be exchanged for a fixed amount of gold or silver. This is lighter and more convenient but still tied to the commodity.

Fiat money (paper and electronic money with no intrinsic value): the money works because the government declares it legal tender and everyone accepts it. The U.S. dollar has been fiat money since 1971 (when Nixon ended the dollar's convertibility to gold). Virtually all modern money is fiat.

The key insight: fiat money works because of trust. You accept dollars because you trust that others will accept them from you. The moment that trust breaks down (hyperinflation, currency collapse), fiat money stops working. Central banks exist partly to maintain that trust.

26.2 How banks create money: fractional reserve lending

Banks don't just store money. They create it — through a process called fractional reserve lending.

Here's how it works:

Step 1: You deposit $1,000 in Bank A. Bank A holds a fraction in reserve (say, 10% = $100) and lends the remaining $900 to someone else.

Step 2: The borrower spends the $900. The recipient deposits $900 in Bank B. Bank B holds 10% ($90) in reserve and lends $810.

Step 3: The $810 is spent and deposited in Bank C. Bank C holds $81 and lends $729.

And so on. Each round, the deposit shrinks by the reserve ratio. The total money created from the initial $1,000 deposit is:

Total money = Initial deposit × (1 / Reserve ratio) = $1,000 × (1/0.10) = $10,000

This is the money multiplier: 1 / reserve ratio. With a 10% reserve ratio, $1 of new deposits creates up to $10 of money in the banking system.

The money supply measures: - M1: currency in circulation + checking deposits + other liquid deposits. The narrowest definition of money. - M2: M1 + savings deposits + money market accounts + small time deposits. A broader definition.

As of 2024, U.S. M2 was about $21 trillion — vastly more than the amount of physical currency ($2.3 trillion). Most money exists as electronic entries in bank databases, created through the lending process described above.

26.3 The Federal Reserve System

The Federal Reserve (the "Fed") is the central bank of the United States. It was created in 1913 after a series of bank panics (particularly the Panic of 1907) demonstrated the need for a lender of last resort.

Structure: - Board of Governors (7 members, appointed by the President, confirmed by the Senate, 14-year terms). The Chair (currently Jerome Powell, as of 2025) is the most powerful economic policymaker in the world after the President. - 12 regional Federal Reserve Banks (New York, Chicago, San Francisco, etc.). Each serves its region and participates in monetary policy. - Federal Open Market Committee (FOMC): the 7 governors + 5 regional bank presidents (rotating). The FOMC sets the federal funds rate — the interest rate that drives monetary policy.

The dual mandate: Congress has given the Fed two goals: 1. Maximum employment — keep unemployment as low as possible 2. Stable prices — keep inflation low and predictable (the Fed targets 2% inflation)

These two goals sometimes conflict: cutting rates to reduce unemployment can increase inflation; raising rates to fight inflation can increase unemployment. Managing this tension is the Fed's primary challenge. We'll see the tools it uses in Chapter 27.

Independence: the Fed operates independently of the President and Congress. The Chair can't be fired for making unpopular decisions. This independence is designed to insulate monetary policy from short-term political pressure — a lesson learned from historical episodes where political interference led to bad monetary policy (Nixon pressuring Fed Chair Arthur Burns to keep rates low before the 1972 election, contributing to the 1970s inflation).

26.4 Bank runs and the Diamond-Dybvig model

Banks are inherently fragile because of a fundamental mismatch: they take in short-term deposits (which depositors can withdraw at any time) and make long-term loans (mortgages, business loans, which can't be called back quickly). This mismatch is called maturity transformation — and it is the source of both the banking system's value (it channels short-term savings into long-term investment) and its vulnerability.

A bank run occurs when many depositors try to withdraw their money at the same time. The bank can't pay everyone because its assets (loans) are illiquid — they can't be turned into cash quickly without large losses. Even a perfectly solvent bank (one whose assets exceed its liabilities) can fail if it faces a run, because it can't liquidate its loans fast enough to meet withdrawal demands.

The Diamond-Dybvig model (1983) formalizes this: bank runs are a self-fulfilling prophecy. If you believe other depositors will run, your best response is to run too (before the bank runs out of cash). If everyone believes this, everyone runs, and the bank fails — even if it would have been fine if everyone had stayed calm.

The model has two equilibria: 1. Good equilibrium: everyone trusts the bank, no one runs, the bank operates normally 2. Bad equilibrium: everyone panics, everyone runs, the bank fails

Both are rational. The difference is expectations — which equilibrium obtains depends on what depositors believe about what other depositors will do.

Deposit insurance: solving the run problem

The solution: deposit insurance (FDIC in the U.S., established 1933). The government guarantees deposits up to $250,000 per account. If a bank fails, the FDIC pays depositors.

Deposit insurance eliminates the incentive to run: if your deposits are guaranteed, you have no reason to panic even if other depositors panic. The bad equilibrium is eliminated. Bank runs on insured deposits have been essentially zero since FDIC was established.

The moral hazard: deposit insurance creates a new problem. If depositors know they're protected, they don't monitor the bank's risk-taking. And if banks know they're backstopped by the government, they may take excessive risks (because the profits are theirs but the losses are the government's). This is the moral hazard of the safety net — and it is one of the reasons banks are regulated (capital requirements, stress tests, lending standards).

26.5 The 2008 crisis as a modern bank run

The 2008 financial crisis was, at its core, a bank run — but not on traditional FDIC-insured banks. It was a run on the shadow banking system: the parts of the financial system (investment banks, money market funds, repo markets, mortgage companies) that performed bank-like functions (maturity transformation) without being formally regulated as banks and without deposit insurance.

When housing prices fell and mortgage defaults rose in 2007–2008: 1. Investors in mortgage-backed securities demanded their money back 2. Short-term funding markets (repos, commercial paper) froze — lenders stopped lending to institutions they suspected were exposed to mortgage losses 3. Bear Stearns, Lehman Brothers, and AIG — all dependent on short-term funding — faced the equivalent of a bank run 4. Lehman filed for bankruptcy (September 15, 2008). AIG was rescued by the government ($182 billion). Bear Stearns was acquired by JPMorgan with Fed support.

The shadow banking system had the maturity mismatch of traditional banking (short-term funding, long-term assets) but without the safety net (no deposit insurance, no Fed lender-of-last-resort access). When confidence broke, the run was devastating.

Post-crisis reforms (Dodd-Frank) extended some banking regulation to shadow-banking entities and improved the Fed's ability to act as lender of last resort in a crisis. Whether these reforms are sufficient to prevent the next crisis is debated.

26.6 Where this is going

Chapter 27 will show you how the Fed uses monetary policy — interest rates, open market operations, quantitative easing — to manage the economy. Chapter 28 will show you the financial system more broadly (saving, investment, loanable funds). Chapter 29 will return to inflation from a monetary perspective (the quantity theory, the Phillips curve, the Volcker disinflation).

Key terms recap: money — anything that serves as medium of exchange, unit of account, and store of value fiat money — money with no intrinsic value, accepted because of trust and government backing fractional reserve banking — banks hold a fraction of deposits as reserves and lend the rest money multiplier — 1 / reserve ratio; the total money created from $1 of new deposits M1 / M2 — narrow and broad measures of the money supply Federal Reserve — the U.S. central bank; dual mandate (max employment + stable prices) bank run — depositors withdraw en masse; self-fulfilling prophecy Diamond-Dybvig model — bank runs as a coordination failure with two equilibria FDIC deposit insurance — government guarantee of deposits up to $250K; eliminates run incentive shadow banking — financial institutions performing bank-like functions without bank regulation

Themes touched: Markets power+imperfect (banking fragility is a structural feature), Behavioral (bank runs are a coordination/expectations problem), Affects daily life (your bank deposits, your mortgage, the 2008 crisis).