Chapter 26 — Key Takeaways
Three functions of money
- Medium of exchange — accepted in transactions
- Unit of account — measuring stick for prices
- Store of value — holds value over time (imperfectly, due to inflation)
Evolution: barter → commodity money (gold) → representative money (gold-backed paper) → fiat money (trust-backed, no intrinsic value). All modern money is fiat.
Fractional reserve banking and money creation
Banks hold a fraction of deposits as reserves and lend the rest. Each loan becomes a new deposit elsewhere. Money multiplier = 1 / reserve ratio. With 10% reserves, $1 of deposits creates up to $10 of money.
M1 (currency + checking) ≈ narrow money. M2 (M1 + savings + money markets) ≈ broad money. U.S. M2 ≈ $21 trillion.
The Federal Reserve
- Structure: Board of Governors (7) + 12 regional banks + FOMC (sets rates)
- Dual mandate: maximum employment + stable prices (2% inflation target)
- Independence: insulated from political pressure (14-year terms, can't be fired)
Bank runs and Diamond-Dybvig
Banks are fragile because of maturity mismatch (short-term deposits fund long-term loans). A bank run is a self-fulfilling prophecy: if you expect others to run, you should run too. Two equilibria: trust (good) or panic (bad).
FDIC deposit insurance ($250K) eliminates the run incentive. But creates moral hazard (banks take more risk knowing they're backstopped).
2008 as a shadow bank run
The 2008 crisis was a run on the shadow banking system (investment banks, repo markets, MBS) — entities that had the maturity mismatch of banks without the safety net (no FDIC, no Fed access). When confidence broke, Bear Stearns, Lehman, and AIG collapsed.
Themes
- Markets power+imperfect — banking fragility is structural
- Behavioral — bank runs are coordination failures driven by expectations
- Affects daily life — your deposits, your mortgage, your economy