PART SIX Money, Banking, and Monetary Policy

Chapter 15: Money and Banking Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

The Functions of Money The three functions of money are: medium of exchange unit of account store of value Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

The Components of the Money Supply Two definitions of the U.S. money supply are M1 and M2. M1 is the narrowest definition of the money supply, whereas M2 is a more broadly defined money supply. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Money Definition: M1 M1 money = currency + checkable deposits Currency includes coins and paper money. All coins in circulation are token money. Paper money, issued by the Federal Reserve Banks, are known as Federal Reserve Notes. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Money Definition: M1 Checkable deposits (checkbook money) are a large component of the stock of money in the U.S.. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

What Backs the Money Supply? The U.S. money supply is guaranteed by governments ability to keep the value of money relatively stable. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Value of Money Money has value because of its acceptability, legal tender designation, and relative scarcity. Government has decreed currency as legal tender; paper money is a valid and legal means of payment of debt. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Money and Prices The purchasing power of money is the amount of goods and services a unit of money will buy. The purchasing power of the dollar varies inversely with the price level. If the price level rises, the purchasing power of the dollar falls, and vice versa. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Money and Prices Inflation may also affect the purchasing power of money and its acceptability. When the government prints too much money, the purchasing power of money declines. Also, runaway inflation may significantly reduce the purchasing power of the dollar and may cause it to cease being used as a medium of exchange. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

The Federal Reserve System and The Banking System A key element of the U.S. banking system is the Federal Reserve System (the Fed). The Fed consists of the Board of Governors of the Federal Reserve and 12 regional Federal Reserve Banks. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

The Federal Reserve System and The Banking System Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

The Federal Reserve System and The Banking System Board of Governors The seven-member group that supervises and controls the money and banking system of the U.S.. The 12 Federal Reserve Banks The 12 banks chartered by the U.S. government to control the money supply and perform other functions. They collectively serve as the nations central bank and also serve as bankers bank. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

The Federal Reserve System and The Banking System Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

The Federal Reserve System and The Banking System Federal Open Market Committee (FOMC) The FOMC is the 12 member Federal Reserve group determines the purchase and sale policies of the Federal Reserve Banks in the market for U.S. securities. The Federal Reserve Bank in New York City conducts most of the Feds open market operations. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

The Federal Reserve System and The Banking System Commercial Banks and Thrifts Of the approximately 7600 commercial banks, three-fourths are state banks, while the remaining one-fourth are national banks, chartered by the Federal government to operate nationally. The 11,400 thrift institutions are regulated by agencies separate and apart from the Board of Governors and the Federal Reserve Banks. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Fed Functions and Responsibilities The Fed performs the following functions. Issues currency Sets reserve requirements and holds reserves Lends money to banks and thrifts Provides the banking system with a means for collecting checks Acts as a fiscal agent for the Federal government Supervises the operation of banks Controls the money supply Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Fed Reserve Independence The Federal Reserve is an independent agency of the government. This protects the Fed from political pressure so that it could effectively control the money supply and interest rates to foster price-level stability. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Depositing Reserves in a Federal Reserve Bank All commercial banks and thrifts that provide checkable deposits must by law keep required reserves. Required reserves are an amount of funds equal to a specified percentage of the banks own deposit liabilities. Required reserves must be kept on deposit with the Federal Reserve Bank or held as cash in the banks vault. Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved.

Depositing Reserves in a Federal Reserve Bank The specified percentage of checkable deposit liabilities that a commercial bank must be keep as reserves is known as the reserve ratio. Reserve banks required reserves ratio banks checkable-deposit liabilities Copyright © 2007 by the McGraw-Hill Companies, Inc. All rights reserved. =