Chapter 15 Money Banking and Central Banking Introduction

Chapter 15 Money, Banking, and Central Banking

Introduction Why is the Federal Reserve System clearing fewer checks, and what is its role in our nations financial system? In this chapter you will learn the answers, but first you will learn more generally about money and banking. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 2

Learning Objectives • Define the fundamental functions of money • Identify key properties that any goods that function as money must possess • Explain official definitions of the quantity of money in circulation Copyright © 2008 Pearson Addison Wesley. All rights reserved. 3

Learning Objectives (cont'd) • Understand why financial intermediaries such as banks exist • Describe the basic structure of the Federal Reserve System • Discuss the major functions of the Federal Reserve Copyright © 2008 Pearson Addison Wesley. All rights reserved. 4

Chapter Outline • The Functions of Money • Liquidity • Monetary Standards, or What Backs Money • Defining Money • Financial Intermediation and Banks • Banking Structures Throughout the World • The Federal Reserve System Copyright © 2008 Pearson Addison Wesley. All rights reserved. 5

Did You Know That. . . • Money includes not only coins and dollar bills, but also the balance in your checking account? • Anything widely accepted in exchange for items of value is considered to be money? Copyright © 2008 Pearson Addison Wesley. All rights reserved. 6

Money • Money § Any medium that is universally accepted in an economy both by sellers of goods and services and by creditors as payment for debts Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7

Table 15 -1 Types of Money Copyright © 2008 Pearson Addison Wesley. All rights

The Functions of Money • The functions of money § Medium of exchange § Unit of accounting § Store of value (purchasing power) § Standard of deferred payment Copyright © 2008 Pearson Addison Wesley. All rights reserved. 9

The Functions of Money (cont'd) • Medium of Exchange § Any item that sellers will accept as payment • Barter § The direct exchange of goods and services for other goods and services without the use of money Copyright © 2008 Pearson Addison Wesley. All rights reserved. 10

The Functions of Money (cont'd) • Medium of exchange § Money facilitates exchange by reducing transaction costs associated with means-of -payment uncertainty. Ø Permits specialization, facilitates efficiencies • Barter § Simply a direct exchange Ø Double coincidence of wants Copyright © 2008 Pearson Addison Wesley. All rights reserved. 11

The Functions of Money (cont'd) • Unit of Accounting § A measure by which prices are expressed § The common denominator of the price system § A central property of money Copyright © 2008 Pearson Addison Wesley. All rights reserved. 12

The Functions of Money (cont'd) • Store of Value § The ability to hold value over time § A necessary property of money § Money allows you to transfer value (wealth) into the future. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13

The Functions of Money (cont'd) • Standard of Deferred Payment § A property of an item that makes it desirable for use as a means of settling debts maturing in the future § An essential property of money Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14

Liquidity • Liquidity § The degree to which an asset can be acquired or disposed of without much danger of any intervening loss in nominal value and with small transaction costs § Money is the most liquid asset. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15

Figure 15 -1 Degrees of Liquidity Copyright © 2008 Pearson Addison Wesley. All rights

Liquidity (cont'd) • Question § What is the cost of holding money (its opportunity cost)? • Answer § It is the alternative interest yield obtainable by holding some other asset. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 17

Monetary Standards, or What Backs Money • Questions § What backs money? § Is it gold, silver, or the federal government? • Answer § Your confidence Copyright © 2008 Pearson Addison Wesley. All rights reserved. 18

Monetary Standards, or What Backs Money (cont'd) • Transactions Deposits § Checkable and debitable account balances in commercial banks and other types of financial institutions, such as credit unions and mutual savings banks § Any accounts in financial institutions on which you can easily transmit debit-card and check payments without many restrictions Copyright © 2008 Pearson Addison Wesley. All rights reserved. 19

Example: E-Gold Backed E-Money • The Internet has served as a breeding ground for various forms of e-money. • Gold-backed e-money effectively provides measures of the purchasing power, in terms of gold, of several major world currencies. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20

Monetary Standards, or What Backs Money (cont'd) • Fiduciary Monetary System § A system in which currency is issued by the government and its value rests on the public’s confidence that it can be exchanged for goods and services § The Latin fiducia means “trust” or “confidence. ” Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21

Monetary Standards, or What Backs Money (cont'd) • Currency and transactions deposits are money because of their § Acceptability § Predictability of value Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22

Defining Money • Money is important § Changes in the rate at which the money supply increases or decreases affect important economic variables (at least in the short run) such as inflation, interest rates, employment, and the level of real GDP. • Money Supply § The amount of money in circulation Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23

Defining Money (cont'd) • Economists use two basic approaches to define and measure money. § The transactions approach § The liquidity approach Copyright © 2008 Pearson Addison Wesley. All rights reserved. 24

Defining Money (cont'd) • Transactions Approach § A method of measuring the money supply by looking at money as a medium of exchange • Liquidity Approach § A method of measuring the money supply by looking at money as a temporary store of value Copyright © 2008 Pearson Addison Wesley. All rights reserved. 25

Defining Money (cont'd) • The transactions approach to measuring money: M 1 § Currency § Checkable (transaction) deposits § Traveler’s checks not issued by banks Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26

Figure 15 -2 Composition of the U. S. M 1 and M 2 Money

Defining Money (cont'd) • M 1 § Currency Ø Minted coins and paper currency not deposited in financial institutions Ø The bulk of currency “in circulation” actually does not circulate within the U. S. borders. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 29

Figure 15 -3 The Value of U. S. Currency in Circulation Outside the United

Defining Money (cont'd) • M 1 § Transactions deposits Ø Any deposits in a thrift institution or a commercial bank on which a check may be written or debit card used § Thrift Institution Ø Financial institutions that receive most of their funds from the savings of the public Copyright © 2008 Pearson Addison Wesley. All rights reserved. 31

Defining Money (cont'd) • M 1 § Traveler’s Checks Ø Financial instruments purchased from a bank or a nonbanking organization and signed during purchase that can be used as cash upon a second signature by the purchaser Copyright © 2008 Pearson Addison Wesley. All rights reserved. 32

Defining Money (cont'd) • The liquidity approach to measuring money: M 2 • Near Moneys § Assets that are almost money § Highly liquid § Easily converted to cash § Time deposits are an example Copyright © 2008 Pearson Addison Wesley. All rights reserved. 33

Defining Money (cont'd) • The liquidity approach: M 2 is equal to M 1 plus 1. Savings and small denomination time deposits 2. Balances in retail money market mutual funds 3. MMDAs Copyright © 2008 Pearson Addison Wesley. All rights reserved. 34

Defining Money (cont'd) • M 2 § Savings Deposits Ø Interest-earning funds that can be withdrawn at any time without payment of a penalty § Depository Institutions Ø Accept deposits from savers and lend those funds out Copyright © 2008 Pearson Addison Wesley. All rights reserved. 35

Defining Money (cont'd) • M 2 § Money Market Deposit Accounts (MMDAs) Ø Accounts issued by banks yielding a market rate of interest with a minimum balance requirement and a limit on transactions Ø They have no minimum maturity Copyright © 2008 Pearson Addison Wesley. All rights reserved. 36

Defining Money (cont'd) • M 2 § Time Deposit ØA deposit in a financial institution that requires notice of intent to withdraw or must be left for an agreed period Ø Early withdrawal may result in a penalty § CD Ø Time deposit with fixed maturity Copyright © 2008 Pearson Addison Wesley. All rights reserved. 37

Defining Money (cont'd) • M 2 § Money Market Mutual Funds Ø Funds obtained from the public that investment companies hold in common Ø Funds used to acquire short-maturity credit instruments q CD’s, U. S. government securities Copyright © 2008 Pearson Addison Wesley. All rights reserved. 38

Defining the U. S. Money Supply • Question § Which definition of money correlates best with economic activity? • Answer § M 2, although some businesspeople and policymakers prefer MZM Copyright © 2008 Pearson Addison Wesley. All rights reserved. 39

Defining Money (cont'd) • MZM (money-at-zero-maturity) • MZM entails adding deposits without set maturities to M 1. • MZM includes all MMFs but excludes all deposits with fixed maturities. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 40

Financial Intermediation and Banks • Most nations have a banking system that encompasses two types of institutions. 1. One type consists of private banking institutions. 2. The other type of institution is a central bank. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 41

Financial Intermediation and Banks (cont'd) • Central Bank § A banker’s bank, usually an official institution that also serves as a country’s treasury’s bank § Central banks normally regulate commercial banks. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 42

Financial Intermediation and Banks (cont'd) • Direct finance § Individuals purchase bonds from a business • Indirect finance § Individuals hold money in a bank § The bank lends the money to a business Copyright © 2008 Pearson Addison Wesley. All rights reserved. 43

Financial Intermediation and Banks (cont'd) • Financial Intermediation § The process by which financial institutions accept savings from businesses, households, and governments and lend the savings to other businesses, households, and governments Copyright © 2008 Pearson Addison Wesley. All rights reserved. 44

Figure 15 -4 The Process of Financial Intermediation Copyright © 2008 Pearson Addison Wesley.

Financial Intermediation and Banks (cont'd) • Question § Why might people wish to direct their funds through a bank instead of lending directly to a business? • Answers § Asymmetric information § Adverse selection § Moral hazard § Larger scale and lower management costs Copyright © 2008 Pearson Addison Wesley. All rights reserved. 46

Financial Intermediation and Banks (cont'd) • Asymmetric Information § Information possessed by one party in a financial transaction but not by the other • Adverse Selection § The likelihood that borrowers may use their borrowed funds for high-risk projects Copyright © 2008 Pearson Addison Wesley. All rights reserved. 47

Financial Intermediation and Banks (cont'd) • Moral Hazard § The possibility that a borrower might engage in riskier behavior after a loan has been obtained • Larger scale and lower management costs § People can pool funds in an intermediary, reducing costs, risks. § Pension funds and investment companies are examples. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 48

Financial Intermediation and Banks (cont'd) • Liabilities § Amounts owed § The sources of

Financial Intermediation and Banks (cont'd) • Assets § Amounts owned § The uses of

Table 15 -2 Financial Intermediaries and Their Assets and Liabilities Copyright © 2008 Pearson

Financial Intermediation and Banks (cont'd) • Payment Intermediaries § Institutions that facilitate transfers of funds between depositors who hold transactions deposits with those institutions Copyright © 2008 Pearson Addison Wesley. All rights reserved. 52

Figure 15 -5 How a Debit-Card Transaction Clears Copyright © 2008 Pearson Addison Wesley.

Financial Intermediation and Banks (cont'd) • Capital Controls § Legal restrictions on the ability of a nation’s residents to hold and trade assets denominated in foreign currencies • International Financial Intermediation § Financing investment projects in more than one country Copyright © 2008 Pearson Addison Wesley. All rights reserved. 54

Table 15 -3 The World’s Largest Banks Copyright © 2008 Pearson Addison Wesley. All

Financial Intermediation and Banks (cont'd) • World Index Fund § A portfolio of bonds issued in various nations whose individual yields generally move in offsetting directions, thereby reducing the overall risk of losses Copyright © 2008 Pearson Addison Wesley. All rights reserved. 56

Banking Structures Throughout the World • The ways that banks around the world differ § Size Ø United States has banks of various sizes Ø Europe and Japan have a few large banks § Legal Ø Universal banking Ø Limits on financial services such as insurance and bank stock ownership § Importance in financial system Ø Major importance Ø Part of a varied financial system (United States) Copyright © 2008 Pearson Addison Wesley. All rights reserved. 57

Banking Structures Throughout the World (cont'd) • Universal Banking § An environment in which banks face few or no restrictions on their powers to offer a full range of financial services and to own shares of stock in corporations Copyright © 2008 Pearson Addison Wesley. All rights reserved. 58

Banking Structures Throughout the World (cont'd) • Central banks and their roles 1. Perform banking functions for their nations’ governments 2. Provide financial services for private banks 3. Conduct their nations’ monetary policies Copyright © 2008 Pearson Addison Wesley. All rights reserved. 59

The Federal Reserve System • The Fed § The Federal Reserve System; the central bank of the United States § The most important regulatory agency in the U. S. monetary system § Established in 1913 by the Federal Reserve Act Copyright © 2008 Pearson Addison Wesley. All rights reserved. 60

The Federal Reserve System (cont'd) • Organization of the Fed § Board of Governors Ø 7 members, 14 -year terms § Federal Reserve Banks (12 Districts) Ø 25 branches § Federal Open Market Committee (FOMC) Ø BOG plus 5 presidents of district banks Copyright © 2008 Pearson Addison Wesley. All rights reserved. 61

Figure 15 -6 Organization of the Federal Reserve System Copyright © 2008 Pearson Addison

Figure 15 -7 The Federal Reserve System Copyright © 2008 Pearson Addison Wesley. All

The Federal Reserve System (cont'd) • Depository institutions § 7, 500 commercial banks § 1, 300 savings and loans § 11, 000 credit unions • All may purchase Fed services Copyright © 2008 Pearson Addison Wesley. All rights reserved. 64

The Federal Reserve System (cont'd) • Functions of the Fed 1. Supplies the economy with fiduciary currency 2. Provides a payment-clearing system 3. Holds depository institutions’ reserves 4. Acts as the government’s fiscal agent 5. Supervises depository institutions 6. Acts as a “lender of last resort” 7. Regulates the money supply Copyright © 2008 Pearson Addison Wesley. All rights reserved. 65

Issues and Applications: Check Clearing—A Rapidly Diminishing Fed Function • The volume of checks cleared by the Fed grew rapidly during the 1980 s. • So why has the Fed’s check clearing speed dropped since the 1990 s? Copyright © 2008 Pearson Addison Wesley. All rights reserved. 66

Issues and Applications: Check Clearing—A Rapidly Diminishing Fed Function (cont'd) • The reason is not due to inefficiency; rather, checks are falling out of favor. • Government transfers are transmitted electronically—Social Security, Medicare, Medicaid. • Electronic payments by households and businesses—debit cards, Internet bill pay, Web based services. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 67

Figure 15 -8 The Volume and Value of Federal Reserve Check Clearings Since 1985

Summary Discussion of Learning Objectives • The key functions of money 1. Medium of exchange 2. Unit of accounting 3. Store of value 4. Standard of deferred payment • Important properties of goods that serve as money § Acceptability, confidence, and predictable value Copyright © 2008 Pearson Addison Wesley. All rights reserved. 69

Summary Discussion of Learning Objectives (cont'd) • Official definitions of the quantity of money in circulation § M 1: the narrow definition, focuses on money’s role as a medium of exchange § M 2: a broader one, stresses money’s role as a temporary store of value Copyright © 2008 Pearson Addison Wesley. All rights reserved. 70

Summary Discussion of Learning Objectives (cont'd) • Why financial intermediaries such as banks exist § Asymmetric information can lead to adverse selection and moral hazard problems § Savers benefit from the economies of scale • The basic structure of the Federal Reserve System § 12 district banks with 25 branches § Governed by Board of Governors § Federal Open Market Committee Copyright © 2008 Pearson Addison Wesley. All rights reserved. 71

Summary Discussion of Learning Objectives (cont'd) • Major functions of the Federal Reserve § Supply the economy with currency § Provide systems for transmitting and clearing payments § Holding depository institutions’ reserves § Acting as the government’s fiscal agent § Supervising banks § Acting as a “lender of last resort” § Regulating the money supply § Intervening in foreign exchange markets Copyright © 2008 Pearson Addison Wesley. All rights reserved. 72

End of Chapter 15 Money, Banking, and Central Banking