The word money is used frequently, and its meaning is apparently understood by all. Although the word money is used in day-to-day life, however, it has two different definitions. When the word is used, it is usually possible to understand its meaning from the context.
Two accepted meanings for the word money are:
1. Currency (including bills and coins) – cash is a synonym for currency and will be used frequently later.
2. Money supply (money).
The money supply includes two components:
- Checking accounts balances.
Cash in the bank vault is not included in the money supply. It is included only when it passes from the bank vault to the hands of the public.
The total money supply (total amount of money) includes the sum of these two components.
- If Jack has $100 in cash and $500 in his checking account, the total money supply at his disposal is $600. In other words, the amount of money at his disposal totals $600 (from now on, money = the money supply).
- If Dennis has $10,000 in cash and another $20,000 in his checking account, the amount of money at his disposal totals $30,000.
- If Richard has $100 in cash and an overdraft of $600 in his checking account, the amount of money at his disposal totals minus $500.
A country’s money supply at any given time equals the total cash held by its inhabitants + the value of all their checking accounts in all of the banks.
Actually, when a person deposits cash in a checking account (for instance $1,000), $1,000 in cash is subtracted from the money supply at our disposal. In its place, however, $1,000 in our checking account is added to his money supply.
Checking Account Deposits
Other terms for checking account are demand deposits or current account deposits.
All three of these terms will be used interchangeably.
It was stated above that the source of the money in the bank’s vault is checking account deposits. That is indeed the main source, but there are other sources. These will not be discussed in detail, but it is important to know that they exist.
The other sources are:
1. Cash investments made by the bank’s owners made when the bank was set up, and at various times afterwards.
2. Public stock and bond offerings by the bank.
These concepts require more explanation, but this is not the place to discuss them in detail.
Money Changing Hands in the Economy
To understand Money Changing Hands in the economy, consider the example of Country A which has just one factory: A bakery.
The bakery employs 10 workers, each of whom earns $1,000 per month. The workers in Country A buy only bread with their money.
A distinction will be made below between two situations:
- Situation I – all the money of the inhabitants is deposited in checking accounts and they make payments exclusively with checks (or with credit cards).
- Situation II – 50% of the inhabitants’ money is held in cash at all times, and 50% in checking accounts.
The distinction between these two situations is important, since later, in the “Bank Lending” section, it will be seen how much the business potential of the banks grows when people decide to reduce their amount of cash on hand by depositing it in checking accounts.
On the 1st of every month, each of the ten workers receives a $1,000 salary and deposits all of it into a bank account. The aggregate total of everyone’s salary is therefore $10,000. During the month, the workers buy bread and pay for it with checks. The owner of the bakery, who receives the money in the form of checks, then deposits it into his bank account.
In the course of the month, money passes gradually from the workers’ bank accounts to the bank account of the bakery owner. By the end of the month, all of the money has passed from the workers to the bakery owner. The bank account balance of each worker falls to zero, and the bakery owner’s bank account balance is $10,000.
At the beginning of the following month, the workers are again paid an aggregate salary of $10,000 (the money comes from the bakery owner’s account). During the month, the workers buy bread, and pay by check. At the end of the month the bank account balance of each worker drops to zero, while $10,000 accumulates in the bakery owner’s bank account.
The cycle repeats itself: Every month, $10,000 change hands.
When the workers pay for bread by check, the bakery owner does not cash the check and deposit the cash into his bank account. Instead, the bank reduces the account balance of the person who wrote the check (the worker) by the amount written, while increasing the account balance of the receiver of the check (the bakery owner) by the same amount.
On the 1st of every month, each worker receives their $1,000 salary, i.e., a total of $10,000 for all employees’ salaries.The workers keep $5,000 in cash, and deposit $5,000 into their bank accounts. As before, the money passes gradually during the month from the workers to the owner of the bakery.
At the end of the month, the bakery owner has accumulated $5,000 in cash and $5,000 in his bank account, and the workers have nothing left; they have no remaining cash and no bank account balances.
In Situation 2, the same amount of money ($10,000) changes hands in the economy, but half is in cash and half is in bank accounts, while in Situation 1 all funds were in bank accounts.
In order to save space when writing zeroes we will make use of the letter K.
K is an abbreviation of Kilo = Thousand. For example: kilogram = 1,000 gram, kilometer = 1,000 meter. Adding K to the right of a numerical value indicates that the correct numerical value is 1,000 times larger than the value stated.
$5K is an abbreviation of $5,000.
$ 0.5K is an abbreviation of $500.
300K loaves of bread is an abbreviation of 300,000 loaves of bread