Part 3 topics Goals: – to develop an understanding of monetary policy – Develop the ability to solve problems using both monetary and fiscal policies – Focus on problem solving Money and banking - How banks and thrifts create money - Monetary policy - Economic growth – Deficits, surpluses, and the public debt

Money and Banking Please listen to the audio as you work through the slides.

Money and Banking Learning Objectives: Students will be able to thoroughly and completely explain: 1.M1 and M2 of the Money Supply. 2.The Demand for Money – transaction demand and asset demand for money. 3.The impact on interest rates of changes in the demand and supply of money. 4.The organization of the Federal Reserve System, and the functions of the Federal Reserve

Functions of Money Medium of Exchange It’s what sellers generally accept and buyers generally use to pay for goods and services. Unit of Account A standard unit that provides a consistent way of quoting prices. Store of Value An asset that can be used to transport purchasing power from one time period to another Liquidity It is portable and readily accepted and thus easily exchanged for goods and services. Money is liquid.

Money Supply Currency – Coins Federal Reserve Notes Little Intrinsic Value Checkable Deposits in: Commercial Banks Thrift Institutions - An organization formed as a depository for primarily consumer savings. Savings and Loan Associations (S&L’s), Credit Unions Definition…

Money Supply = Plus... Near-monies Savings Deposits – including: Money Market Deposit Accounts (MMDAs) bank products – interest bearing accounts Smaller Time Deposits < $100,000 “CD’s” Money Market Mutual Funds (MMMFs) Mutual Fund products

Money Defined M1M1M2M2 56% 44% M1M1 18% Savings Deposits, Including Money Market Deposit Accounts Small Time Deposits Money Market Mutual Funds Held By Individuals Currency Checkable Deposits 16% 14% 52% $1,365 Billion $7,499 Billion January 2008 Totals Source: Federal Reserve System

What about credit cards? Is this money?

Money Supply What “backs” the Money Supply? – Nothing tangible! – The full faith and credit of the USA Why is money valuable? – Acceptability – we accept it – Legal tender – Government designated – Relative scarcity – relative to its utility 31-9

Money and Prices Prices affect purchasing power of money Hyperinflation renders money unacceptable Key goal: Stabilizing money’s purchasing power – Intelligent management of the Money Supply – monetary policy – Appropriate fiscal policy

The Demand for Money What do we want to do with money? To make purchases with it To hold it as an asset – or acquire interest bearing assets with it: corporate bonds – earn interest Stocks – increase in value “we hope” private or government bonds – earn interest or money – earns no interest but is most liquid Advantage of holding money as and asset Liquidity Less Risk relative to bonds, stocks or other interest bearing assets Disadvantages of holding money as an asset It earns little or no interest

Demand for Money Transactions demand, D 1 – Determined by nominal GDP – Independent of the interest rate Asset demand, D 2 – Money as a store of value – Varies inversely with the interest rate – Downward sloping demand curve Total money demand, D m Bonds are assumed as a typical asset with lower prices associated with higher interest rates

Asset Demand for Money Explained: We have a choice of which assets to hold: money, or bonds. Money earns no interest while bonds do earn interest. When interest rates are low we recognize that the opportunity cost of holding bonds is low, so we choose to hold (demand) large amounts of money. When interest rates are high, the opportunity cost of holding money is high, so we choose to hold (demand) less money (more bonds). Hence there is an inverse relationship between interest rates and the asset demand for money.

Demand for Money Rate of interest, i percent Amount of money demanded (billions of dollars) Amount of money demanded (billions of dollars) Amount of money demanded and supplied (billions of dollars) = + (a) Transactions demand for money, D t (b) Asset demand for money, D a (c) Total demand for money, D m and supply DtDt DaDa DmDm SmSm 5

Interest Rates Equilibrium interest rate – Changes with shifts in Money Supply and money demand Interest rates and bond prices – Inversely related – Bond pays fixed annual interest payment – Lower bond price will raise the interest rate

Rate of interest, i (percent) Amount of money demanded (billions of dollars) DmDm ieie SmSm The Money Market Interaction of bond prices, interest rates, And Money Supply Suppose the money supply is decreased from $200 billion, S m, to $150 billion S m1. Assume that we hold both money and bonds at the same time.

Rate of interest, i (percent) Amount of money demanded (billions of dollars) DmDm ieie SmSm A decrease in the supply of money creates a temporary shortage of money. We will require the sale of some assets to meet the need. S m1 The Money Market 1.People and institutions try to gain More money by selling bonds. 2.The supply of bonds increase, and the prices of bonds decrease. 3.Interest rates increase. 4.At higher interest rates, people reduce the amount of money they want to hold

Rate of interest, i (percent) Amount of money demanded (billions of dollars) DmDm ieie SmSm The Money Market Suppose the money supply is increased from $200 billion, S m, to $250 billion S m2.

Rate of interest, i (percent) Amount of money demanded (billions of dollars) DmDm ieie SmSm S m2 The Money Market A temporary surplus of money will require: 1. the purchase of some assets to meet the de- sired level of liquidity. 2. Increased demand for Bonds causes the price of Bonds to rise and interest rates To fall. 3. We re-adjust our holdings of money and bonds to fit our Liquidity preference.

Centralization and Public Control Board of Governors – 7 members, appointed by president & confirmed by Senate, 14 year terms. Assistance & Advice Federal Open Market Committee (FOMC) – 12 people advise on the buying & selling bonds Meet every 6 weeks The 12 Federal Reserve Banks Central Bank Role Quasi-Public Banks Banker’s Banks Supervise Commercial Banks & Thrifts The Federal Reserve and the Banking System

Federal Reserve System Commercial Banks Thrift Institutions (Savings and Loan Associations, Mutual Savings Banks, Credit Unions) The Public (Households and Businesses) 12 Federal Reserve Banks Board of Governors Federal Open Market Committee

Federal Reserve System The 12 Federal Reserve Banks Source: Federal Reserve Bulletin

FED Functions & the Money Supply Issuing Currency (not manufacturing it) Setting Reserve Requirements & Holding Reserves Lending Money to Banks & Thrifts Discount Rate Providing for Check Collection Acting as Fiscal Agent for the Government Supervising Banks Controlling the Money Supply

Some recent developments in the financial services sector. Relative Decline of Banks and Thrifts – decline in their % of assets held Financial Services Industry – changes in composition Consolidation Among Banks and Thrifts Convergence of Services Provided by Financial Institutions Globalization of Financial Markets Electronic transactions Deregulation and creation of new products

Major US financial institutions Commercial banks Bank of America, Wells Fargo JPMorgan Chase Bank Thrifts – S&L’s, mutual saving banks, credit unions Insurance companies – Prudential, New York Life, Mutual fund companies – Fidelity, Putnam, and many more Pension funds TIAA-CREF, Teachers Insurance and Annuity Association, College Retirement Equities Fund (TIAA-CREF), Teamsters union CalPERS – California Public Employees Securities firms Merrill Lynch (part of Bank of America), Charles Schwab, Bear Stearns, Goldman Sachs – global investment banking and securities firm.

History of banking regulation

1913: Federal Reserve Act creates national banking system. 1914: Federal Trade Commission Act prohibits unfair or deceptive business practices. 1933: With memories of 1929 stock crash still fresh, Glass-Steagall Act separates "commercial banks" focusing on consumer activities (checking, savings) from "investment banks," which deal with speculative trading and mergers.

Sept 1987: Drexel Burnham Lambert, home to "junk- bond king" Michael Milken, creates "collateralized debt obligations" (CDOS)—securities made up of myriad loans and bonds with different risk levels. April 1998: Citicorp and Travelers announce biggest- ever corporate merger ($70 billion); transaction technically illegal under Glass-Steagall; CEO Sandy Weill launches $12 million campaign to repeal law. June 1998: Conseco purchases mobile home lender turned subprime powerhouse Green Tree in $6 billion deal.

Nov 1999: Gramm-Leach-Bliley Act guts Glass-Steagall, setting off wave of megamergers among banks and insurance and securities companies. Driving force is Sen. Phil Gramm (R-Texas), who has received $4.6 million from FIRE sector over previous decade. Dec 14: As Congress heads for Christmas recess, Sen. Gramm attaches 262-page amendment to an omnibus appropriations bill. Commodity Futures Modernization Act will deregulate derivatives trading, give rise to Enron debacle, and open door to an explosion in new, unregulated securities April : Fed chair Alan Greenspan signals concern with "abusive lending practices that target vulnerable segments of the population and can result in unaffordable payments, equity stripping, and foreclosure."

Oct : Swiss investment bank UBS announces that Sen. Gramm is joining it to "advise clients on corporate finance issues and strategy"; he will also lobby Congress, Treasury, and Fed on banking and mortgage issues as industry pushes to eliminate predatory-lending rules.

The Recent Financial Crisis Topics Causes Impacts Government responses