10 C H A P T E R Money and Banking

What is money? Examples of Money Cattle, cigarettes, shells, stones, gold, pepper, wampum, and even beer as money So what is Money? Money is anything that does what money does

Six Characteristics of Money Durability Portability Divisibility Uniformity Limited Supply Acceptability

Medium of Exchange Unit of Account Store of Value FUNCTIONS OF MONEY Money can be used for buying and selling goods and services without money we have the problems of barter and the coincidence of wants money allows for greater specialization and trade and productive efficiency Unit of Account Prices are quoted in dollars and cents. Store of Value money allows us to transfer purchasing power from present to future. it is the most liquid (spendable) of all assets a convenient way to store wealth.

Why Monetary Side is Important Without money there would be barter. Barter is the direct exchange of goods and services for other goods and services.

BARTER a. Definition: the exchange of one good or service for another good or service b. Problems with barter: coincidence of wants: a situation in which the good or services that one trader desires to obtain is the same as that which another desires to give up and an item that the second trader wishes to acquire is the same as that which the first trader desires to surrender you have to find somebody who wants to trade the item that you want to get AND who also wants the item that you have that you want to trade   With barter there will be less specialization because of the difficulty of overcoming the coincidence of wants. If you can't find someone to trade with, you will have to produce it yourself Less specialization means less output and MORE SCARCITY

What problems does barter entail? REVIEW What problems does barter entail? Barter requires the "double coincidence of wants." If someone wants something, he or she will have to find someone who wishes to part with that good and at the same time wishes to exchange the good for something that the first party wishes to part with.

WHAT ABOUT CREDIT CARDS? Credit cards are not money, but their use involves short-term loans; their convenience allows you to keep M1 balances low because you need less for daily purchases.

Money’s Value Commodity money = objects that have value in themselves and that are also used as money (salt, cattle, gems, etc) Representative Money = objects that have value because the holder can exchange them for something else of value Fiat Money = valuable because the government says its valuable “legal tender”

WHAT BACKS THE MONEY SUPPLY? Money as Debt The government's ability to keep its value stable provides the backing. People cannot convert paper money into a fixed amount of gold or any other precious commodity Value of Money Acceptability Legal Tender - fiat money Relative Scarcity Money and Prices Value of the Dollar D = 1/Price Level Inflation and Acceptability

MONEY SUPPLY Definition… Currency Checkable Deposits Token Money Federal Reserve Notes Intrinsic Value Checkable Deposits Commercial Banks Thrift Institutions Review: If I take $10 from my wallet and put it into my checking account, what happens to M1?

= Plus... MONEY SUPPLY M2 M1 Near-monies Savings Deposits Money Market Deposit Accounts (MMDAs) Smaller Time Deposits Money Market Mutual Funds (MMMFs) Review: If I take $10 out of my wallet and put it into my savings account what happens to M1? what happens to M2?

REMEMBER The following are NOT part of M1: currency in banks currency and checkable deposits owned by the government currency and checkable deposits owned by the Federal Reserve Banks

= Plus... MONEY SUPPLY Illustrated… Large Time Deposits $100,000.00 or more Illustrated…

MONEY SUPPLY M1 M2 M3 plus Checkable deposits equals M1 Currency (coins & paper money) plus Checkable deposits equals M1 $1101 2000 Data (billions of dollars)

MONEY SUPPLY plus Savings deposits, M1 M2 M3 plus Checkable deposits Currency (coins & paper money) plus Checkable deposits equals M1 plus Savings deposits, including MMDA’s plus Small time deposits plus Money market mutual fund (MMMF) balances equals M2 $1101 $4827 2000 Data (billions of dollars)

MONEY SUPPLY plus Savings deposits, plus Savings deposits, Currency (coins & paper money) plus Checkable deposits equals M1 plus Savings deposits, including MMDA’s plus Small time deposits plus Money market mutual fund (MMMF) balances equals M2 Currency (coins & paper money) plus Checkable deposits equals M1 plus Savings deposits, including MMDA’s plus Small time deposits plus Money market mutual fund (MMMF) balances equals M2 plus Large time deposits equals M3 $1101 $4827 2000 Data (billions of dollars) $6853

What is not money? currency and checkable deposits of the government, Federal Reserve, and banks income is not money income is a FLOW concept: you earn income over time (e.g.. $500 a week) money is a STOCK concept: you have a given amount at a point in time ( e.g. $500 in your wallet and checking account right now) when we talk about "money demand" we will mean a demand for more liquidity (more in my wallet) NOT an increase in my income Can you get an increase in your income and have less money? YES, if you put more of your income in the stock market and less in your checking account

Stable Value! through... So, What Backs the Money Supply? Appropriate Fiscal Policy Intelligent Management of the Money Supply

illustrated... Transactions Demand, Dt Asset Demand, Da THE DEMAND FOR MONEY Transactions Demand, Dt varies directly with nominal GDP Asset Demand, Da varies inversely with the interest rate illustrated...

Rate of interest, i (percent) THE DEMAND FOR MONEY + Transactions Demand, Dt Rate of interest, i (percent) Amount of money demanded (billions of dollars) Dt 10 7.5 5 2.5 0 50 100 150 200 250 300

Rate of interest, i (percent) Rate of interest, i (percent) THE DEMAND FOR MONEY + = Transactions Demand, Dt Asset Demand, Da Rate of interest, i (percent) Amount of money demanded (billions of dollars) Dt 10 7.5 5 2.5 0 50 100 150 200 250 300 Rate of interest, i (percent) Amount of money demanded (billions of dollars) 10 7.5 5 2.5 Da 0 50 100 150 200 250 300

+ = THE DEMAND FOR MONEY Transactions Demand, Dt Asset Demand, Da Total demand for money, Dm Rate of interest, i (percent) Amount of money demanded (billions of dollars) Dt 10 7.5 5 2.5 0 50 100 150 200 250 300 Rate of interest, i (percent) Amount of money demanded (billions of dollars) 10 7.5 5 2.5 Da Rate of interest, i (percent) Amount of money demanded (billions of dollars) 0 50 100 150 200 250 300 10 7.5 5 2.5 Dm 0 50 100 150 200 250 300

+ = THE DEMAND FOR MONEY ADD THE MONEY SUPPLY TO FIND THE Transactions Demand, Dt Asset Demand, Da Total demand for money, Dm ADD THE MONEY SUPPLY TO FIND THE EQUILIBRIUM RATE OF INTEREST Rate of interest, i (percent) Amount of money demanded (billions of dollars) Dt 10 7.5 5 2.5 0 50 100 150 200 250 300 Rate of interest, i (percent) Amount of money demanded (billions of dollars) 10 7.5 5 2.5 Da Rate of interest, i (percent) Amount of money demanded (billions of dollars) 0 50 100 150 200 250 300 10 7.5 5 2.5 Dm Sm 10 7.5 5 2.5 Rate of interest, i (percent) ie 0 50 100 150 200 250 300 0 50 100 150 200 250 300 Amount of money demanded (billions of dollars) Equilibrium Interest Rate

Rate of interest, i (percent) Amount of money demanded THE MONEY MARKET Sm 10 7.5 5 2.5 Suppose the money supply is decreased from $200 billion, Sm, to $150 billion Sm1. ie Rate of interest, i (percent) Dm 0 50 100 150 200 250 300 Amount of money demanded (billions of dollars)

Rate of interest, i (percent) Amount of money demanded THE MONEY MARKET Sm1 Sm 10 7.5 5 2.5 A temporary shortage of money will require the sale of some assets to meet the need. ie Rate of interest, i (percent) Dm 0 50 100 150 200 250 300 Amount of money demanded (billions of dollars)

Rate of interest, i (percent) Amount of money demanded THE MONEY MARKET Sm 10 7.5 5 2.5 Suppose the money supply is increased from $200 billion, Sm, to $250 billion Sm2. ie Rate of interest, i (percent) Dm 0 50 100 150 200 250 300 Amount of money demanded (billions of dollars)

Rate of interest, i (percent) Amount of money demanded THE MONEY MARKET Sm Sm2 10 7.5 5 2.5 A temporary surplus of money will require the purchase of some assets to meet the de- sired level of liquidity. ie Rate of interest, i (percent) Dm 0 50 100 150 200 250 300 Amount of money demanded (billions of dollars)

THE MONEY MARKET ie Bonds are assumed Sm Sm2 as a typical asset with lower prices associated with higher interest rates Sm Sm2 10 7.5 5 2.5 A temporary surplus of money will require the purchase of some assets to meet the de- sired level of liquidity. ie Rate of interest, i (percent) Dm 0 50 100 150 200 250 300 Amount of money demanded (billions of dollars)

THE FEDERAL RESERVE AND THE BANKING SYSTEM Centralization and Public Control Board of Governors Assistance & Advice Federal Open Market Committee Three Advisory Councils The 12 Federal Reserve Banks Central Bank Role Quasi-Public Banks Banker’s Banks Commercial Banks & Thrifts

THE FEDERAL RESERVE AND THE BANKING SYSTEM Open Market Committee Advisory Councils Board of Governors 12 Federal Reserve Banks Commercial Banks Thrift Institutions (Savings & loan associations, mutual savings banks, credit unions) The Public (Households and businesses)

Setting Reserve Requirements & Holding Reserves FED Functions & the Money Supply Issuing Currency Setting Reserve Requirements & Holding Reserves Lending Money to Banks & Thrifts Providing for Check Collection Acting as Fiscal Agent Supervising Banks Controlling the Money Supply

Federal Reserve Independence Recent Developments FED Functions & the Money Supply Federal Reserve Independence Recent Developments Relative Decline of Banks and Thrifts Financial Services Industry Consolidation Among Banks and Thrifts Globalization of Financial Markets Electronic Transactions

Chapter Conclusions Federal Reserve Independence Recent Developments FED Functions & the Money Supply Federal Reserve Independence Recent Developments Relative Decline of Banks and Thrifts Financial Services Industry Consolidation Among Banks and Thrifts Globalization of Financial Markets Electronic Transactions Chapter Conclusions

KEY TERMS medium of exchange unit of account store of value M1, M2, M3 token money Federal Reserve Notes checkable deposits commercial banks thrift institutions near-monies savings account money market deposit account (MMDA) time deposits money market mutual fund (MMMF) legal tender transactions demand asset demand total demand for money money market Federal Reserve System Board of Governors Federal Open Market Committee (FOMC) Federal Reserve Banks financial services industry electronic transactions Copyright McGraw-Hill/Irwin 2002 BACK END

How Banks and Thrifts Create Money Coming up next... How Banks and Thrifts Create Money Chapter 14