Money & Banking Chapter 14 When the monetary system is working properly, it provides the lifeblood of the circular flows of income & expenditures. A well-operating monetary system helps the economy achieve both full employment & the efficient use of resources. 9/21/2018

Functions of Money Medium of exchange Usable for buying goods & services Readily acceptable as payment Allows society to escape the complications of barter Unit of account – society uses monetary units (dollars) as a yardstick for measuring the relative worth of products Store of value – enables people to transfer purchasing power from the present to the future…most liquid (spendable) of all assets 3. When inflation is nonexistent or mild, holding money is a relatively risk-free way to store your wealth for later use. 9/21/2018

Components of the Money Supply Money is a “stock” of some item or group of items Societies have used many items as money 2. I.E. whales’ teeth, circular stones, elephant-tail bristles, gold coins, furs, & pieces of paper…Anything that is widely accepted as a medium of exchange can serve as money. In the U.S., certain debts of government & of financial institutions are used as money, as you will see. 9/21/2018

M1 Consists of: Currency: coins + paper money Checkable deposits Token money Federal Reserve Notes Checkable deposits Institutions that offer checkable deposits Commercial banks Thrift institutions (S&L’s, credit unions, etc.) supplement commercial banks M1=currency + checkable deposits 1.1 – government & government agencies supply coins & paper money…token money – all coins in circulation…the value of the metal contained in the coin itself, is less than the face value of the coin. This prevents people from melting down the coins for sale as a “commodity.” Most of the nation’s currency is paper money. This “folding currency” consists of Federal Reserve Notes…issued by the Federal Reserve system with the authorization of Congress. Figure 12.1a states that 54% of the M1 money supply is currency 1.2 – all deposits in commercial banks or savings institutions on which checks of any size can be drawn…since the check writer must endorse the check, there is less concern if the checks are lost compared to losing actual cash….also more convenient when making large purchases than paying in cash. 46% of M1 is checkable deposits. 1.3 commercial banks- primary depository institutions. They accept the deposits of households & businesses, keep the money safe until it is demanded via checks, and in the meantime use it to make available a wide variety of loans. Commercial bank loans provide short-term financial capital to businesses, and they finance consumer purchases of automobiles & other durable goods. 9/21/2018

M2 Near monies – certain highly liquid financial assets that do not function directly or fully as a medium of exchange but can be readily converted into M1. Three categories Savings deposits Small time deposits Money market mutual funds held by individuals (MMMF) M2=M1+savings deposits+MMDA’s+small time deposits+MMMF held by individuals 2.1- a depositor can easily withdraw funds from a savings account at a bank or simply request that the funds be transferred from a savings account to a checkable account. 2.2- Funds from time deposits (CD’s) become available at their maturity. Since you have to wait to use the money, the bank will pay you a higher interest rate…if you “cash in” the CD early, you will pay a large penalty. 2.3- By making a telephone call, using the Internet, or writing a check for $500 or more, a depositor can redeem shares in a money market mutual fund offered by a mutual fund company. Such companies use the combined funds of individual shareholders to buy interest-bearing short-term credit instruments such as CD’s & US Govt securities. In summary, M2 includes the immediate medium-of-exchange items (currency & checks) that constitute M1 plus certain near-monies that can be easily converted into currency & checkable deposits. 9/21/2018

MZM Reported by the Federal Reserve Bank of St. Louis Focuses exclusively on monetary balances that are immediately available, at zero cost, for household & business transactions Economists make two adjustments to M2 MZM=M2-Small time deposits + MMMF’s held by businesses 9/21/2018

What “Backs” the Money Supply? Money as debt Value of money Acceptability Legal tender Relative scarcity Money & prices The purchasing power of the dollar ($V=1/P) Inflation & acceptability Stabilizing money’s purchasing power First…The money supply in the US essentially is “backed” by government’s ability to keep the value of money relatively stable. Nothing more! The major components of the money supply-paper money & checkable deposits-are debts, or promises to pay. In the US, paper money is the circulating debt of the Federal Reserve Banks. Checkable deposits are the debts of commercial banks 2.1 people accept currency & checkable deposits as money 2.2 the government has designated currency as legal tender. Look at a dollar bill. The statement means that paper money is a valid & legal means of paying a debt. 2.3 The value of money, like the economic value of anything else, depends on its supply and demand. 3.1 The amount a dollar will buy varies inversely with the price level. IE when the cost-of-living rises, the dollar value falls. More dollars are needed to buy a particular amt of g&s…V=dollar value, p=price level see top of page 234. 3.2 High levels of inflation will depreciate the value of money. This will cause it to not be used as a medium of exchange. Without money, the economy may revert back to barter or a more stable currency (US dollar or European euro) 4. To keep money’s purchasing power stable, the price level needs to be stable as well (2-3% inflation). This requires good management of the nation’s money supply & interest rates (Monetary policy) 9/21/2018

The Federal Reserve & the Banking System Historical background Board of Governors (BOG) Central authority of the US money & banking system. The 12 Federal Reserve Banks Serves as the nation’s “central bank.” These banks also serve as bankers’ banks. Our bank is in Chicago. FOMC (Federal Open Market Committee) Aids the BOG in conducting monetary policy and is made up of 12 individuals. Commercial Banks & Thrifts There are about 7600 commercial banks and 11,400 thrift institutions (mostly credit unions) First…In the US, the “monetary authorities” are the members of the Board of Governors of the Federal Reserve System. The Board directs the activities of the 12 Federal Reserve Banks, which in turn control the lending activity of the nation’s banks. Early in the 20th century, Congress decided that centralization & public control were essential for an efficient banking system. US President, with confirmation of the Senate, appoints the seven Board members. Terms are 14 years & staggered so that one member is replaced every 2 years. 12 individuals…seven members of the BOG, President of the NY Federal Reserve Bank, Four of the remaining presidents of Federal Reserve, Banks on a 1-year rotating basis 9/21/2018

FED Cont. Functions & the Money Supply Federal Reserve Independence Issuing currency (Federal Reserve Notes) Setting reserve requirements & holding reserves Lending money to banks & thrifts Discount rate Providing for check collection Acting as a fiscal agent Supervising banks Controlling the money supply (Most important) Federal Reserve Independence Protects the Fed from political pressures so that it could effectively manage the money supply & maintain price stability 2. The Fed sets reserve requirements, which are the fractions of checking account balances that banks must maintain as currency reserves. 3. From time to time, the Fed lends money to banks & thrifts & charges them an interest rate called the discount rate. In times of financial emergencies, the Fed serves as a lender of last resort to the US banking industry. 4. The Fed provides the banking system with a means for collecting checks and adjust the reserves of the banks that are involved in the transaction. 5. Government collects huge sums through taxation, spends equally large amounts, & sells & redeems bonds. 6. The Fed supervises the operations of banks. It makes periodic examinations to assess bank profitability 7. They regulate the supply of money & this in turn enables it to influence interest rates. 9/21/2018

Recent Developments in Money & Banking Relative decline of Banks & Thrifts Consolidation among Banks & Thrifts Convergence of Services Provided by Financial Institutions Globalization of Financial Markets Electronic Payments Other types of companies (i.e. money market, insurance, pension funds, etc.) have expanded their share of financial assets. Many banks have purchased bankrupt thrifts or have merged with other banks. Banks, thrifts, pension companies, insurance companies, & securities firms can now merge with one another & sell each other’s products. Major foreign financial institutions now have operations in the US, and US financial institutions do business abroad. Several electronic-based means of making payments and transferring funds have pushed currency & checks aside. 9/21/2018