Chapter 13 Money and Banking 13-1 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Objectives 13-2 The three jobs of money What money is M1, M2, and M3 The demand for money Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Objectives 13-3 The origins of banking The creation and destruction of money Branch banking and bank chartering The FDIC The savings and loan debacle Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

13-4 The Three Jobs of Money Medium of exchange Standard of value Store of value Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Medium of Exchange The most important job of money is to serve as a medium of exchange –When any good or service is purchased, people use money –Money makes it easier to buy and sell because money is universally accepted –Money, then, provides us with a shortcut in doing business By acting as a medium of exchange, money performs its most important function 13-5 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Standard of Value 13-6 Money is a common denominator in which the relative value of goods and services can be expressed –A job that pays $2 an hour would be nearly impossible to fill, while one paying $50 an hour would be swamped with applications –Does money work well as a standard of value? You tell me Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Store of Value 13-7 If you could buy 100 units of goods and services with $100 in 1986, how many units could you buy with $100 in 2006? –Answer: you could have bought just 55 units –During this period, inflation robbed the dollar of almost half of its purchasing power Over the long run, particularly since World War II, money has been a very poor store of value –However, over relatively short periods of time, say, a few weeks or months, money does not lose much of its value Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Money versus Barter Without money, the only way to do business is by bartering For barter to work, I must want what you have and you must want what I have –This makes it pretty difficult to do business “Everything, then, must be assessed in money: for this enables men always to exchange their services, and so makes society possible” –Aristotle, Nicomachean Ethics 13-8 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Our Money Supply Money consist of coins, paper money, demand (or checking) deposits, and checklike deposits (commonly called NOW – or negotiable order of withdrawal – accounts) held by the nonbank public –Coins and paper money together are considered currency –Five of every ten dollars in our money supply are demand deposits and other checkable deposits Virtually all the rest is currency not –Checks are not money, demand ( or checking deposits) are money 13-9 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

How Do We Pay Our Bills There are many ways to pay for things –Cash, check, credit cards, debit card, pre-paid or stored- value cards, and electronic fund transfers –Checks are the most important –But we are moving rapidly toward a checkless economy The many different kinds of electronic fund transfers are being used more and more Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

13-11 Our Money Supply M1, M2, and M3 Currency + Demand deposits + Other checkable deposits + Traveler’s checks = M1 (traditionally our basic money supply) Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

13-12 Our Money Supply M1, M2, and M3 Currency + Demand deposits + Other checkable deposits + Traveler’s checks = M1 + Savings deposits + Small-denomination time deposits (less than $100,00) + Money market mutual funds held by individuals = M2 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

13-13 Our Money Supply M1, M2, and M3 Currency + Demand deposits + Other checkable deposits + Traveler’s checks = M1 + Savings deposits + Small-denomination time deposits (less than $100,00) + Money market mutual funds held by individuals = M2 + Large denomination time deposits (more than $100,00) + Money market mutual funds held by institutions + Other less liquid assets = M3 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

13-14 Our Money Supply M1, M2, and M3: February 27, 2006 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. Federal Reserve Statistical Realease

Our Growing Money Supply Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. Annual Percentage Change in the Money Supply, M Economic Report of the President, Federal Reserve Bulletin, March, 2006

The Demand for Money The amount of money people hold is called money balances John Maynard Keynes noted that people had three reasons for holding money –People hold money to make transactions –People hold money for precautionary reasons –People hold money to speculate Economists have since identified four factors that influence the three Keynesian motives for holding money –The price level –Income –The interest rate –Credit availability – Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Keynesian Motives for Holding Money The transaction motive –Individuals have day-to-day purchases for which they pay in cash or by check –Individuals take care of their rent or mortgage payment, car payment, monthly bills, and major purchases by check –Businesses need substantial checking accounts to pay their bills and meet their payrolls Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Keynesian Motives for Holding Money The precautionary motive –People will keep money on hand just in case some unforeseen emergency arises They do not actually expect to spend this money, but they want to be ready if the need arises Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Keynesian Motives for Holding Money The speculative motive –When interest rates are very low you don’t stand to lose much holding your assets in the form of money –Alternatively, by tying up your assets in the form of bonds, you actually stand to lose money should interest rates rise You would be locked into very low rates –This motive is based on the belief that better opportunities for investment will come along and that, in particular, interest rates will rise Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Four Influences on the Demand for Money The price level –As the price level rises, people need to hold higher money balances to carry out day-to-day transactions –As the price level rises, the purchasing power of the dollar declines, so the longer you hold money, the less that money is worth –Even though people tend to cut down on their money balances during periods of inflation, as the price level rises people will hold larger money balances Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Four Influences on the Demand for Money Income –The more you make, the more you spend –The more you spend, the more money you need to hold as cash or in your checking account –Therefore as income rises, so does the demand for money balances Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Four Influences on the Demand for Money Interest rates –The quantity of money demanded (held) goes down as interest rates rise The alternative to holding your assets in the form of money is to hold them in some type of interest- bearing paper As interest rates rise, these assets become more attractive than money balances Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Four Influences on the Demand for Money Credit availability –If you can get credit, you don’t need to hold so much money The last three decades have seen a veritable explosion in consumer credit in the form of credit cards and bank loans Over this period, increasing credit availability has been exerting a downward pressure on the demand for money Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Four Influences on the Demand for Money Four generalizations –As interest rates rise, people tend to hold less money –As the rate of inflation rises, people tend to hold more money –As the level of income rises, people tend to hold more money –As credit availability increases, people tend to hold less money Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Demand Schedule for Money Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. The Three Demands for Money

Total Demand for Money Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. This is the sum of the transaction demand, precautionary demand, and speculative demand for money shown in the previous slide

Total Demand for Money and the Supply of Money Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. The interest rate of 7.2 percent is found at the intersection of the total demand for money and the supply of money (M) Since at any given time the supply of money (M) is fixed it can be represented as a vertical line

Determination of the Interest Rate Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. The Prime Rate of Interest Charged by Banks on Short-Term Business Loans, Although the prime rate is set by the nation’s largest banks, it is strongly influenced by actions of the Federal Reserve Board of Governors Federal Reserve Bulletin,

13-29 Who Controls the Interest Rates? The people who borrow money –Players Banks –Referees The FED –Coach Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Banking A Short History of Banking Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. What is the goldsmith’s reserve ratio when there are 1,000 receipts in circulation and 1,000 coins the safe? Answer: 100 percent

Banking A Short History of Banking Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. What is the goldsmith’s reserve ratio when there are 1,000 receipts in circulation and 500 coins the safe? Answer: 50 percent

Banking A Short History of Banking Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. What is the goldsmith’s reserve ratio when there are 1,000 receipts in circulation and 250 coins the safe? Answer: 25 percent

Modern Banking A bank is a financial institution that accepts deposits, makes loans, and offers checking accounts –Banks would like to keep about 2 percent of their deposits in the form of vault cash –All the nation’s commercial banks, credit unions, savings and loan associations, and mutual savings banks now have to keep up to 10 percent of their checking deposits on reserve This means “on the books” Remember, checking deposits are bookkeeping entries Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Modern Banking Commercial Banks –Until the passage of the Depository Institutions Deregulation and Monetary Control Act of 1980, only commercial banks were allowed to issue checking deposits They were the only institutions clearly recognized as banks –Commercial banks account for the bulk of checkable deposits –There are 7,500 commercial banks in the United States This is 500 less than two-three years ago Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Modern Banking Mutual Savings Banks –Mostly operated in the northeastern United States, these institutions were created in the 19 th century to encourage savings by the “common people” –They traditionally made small personal loans, but today, like savings and loan associations, they offer the same range of services as commercial banks –There are nearly 1,000 mutual savings banks Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Modern Banking Savings and Loan Associations –Although originally established to finance home building, these associations also offer most of the services offered by commercial banks –The nearly 500 S&Ls invest more than three quarters of their savings deposits in home mortgages Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Modern Banking Credit Unions –Although there are nearly 10,000 credit unions in the United States, they hold less than 5 percent of total savings deposits –Credit unions offer a full range of financial services They specialize in small consumer loans –Credit unions are cooperatives that generally serve specific employee, union, or community groups Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Bank Lending Banks borrow money at low interest rates and lend money out at much higher interest rates –Currently, banks pay either zero or up to maybe 3 percent interest on most deposits – and perhaps 1 or 2 points more if you leave your money on deposit for a few years –Banks charge about 7 percent for fixed rate mortgages, a bit more for business loans, and about 18 percent on credit card loans Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Top Ten American Banks, Ranked by Assets, February Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. The World Almanac, 2006, Forbes.com

13-41 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Financial Intermediaries –Financial intermediaries channel funds from savers to borrows Basically, they repackage the flow of deposits, insurance premiums, pension contributions, and other forms of savings into larger chunks –$10,000, $1 million, $50 million, or even more They pay low rates of interest to their lenders and charge relatively high rates to their borrowers –Sometime business borrowers dispense with financial middlemen altogether by borrowing directly from savers The U.S. Treasury does this every month by issuing new bonds, certificates, notes, and bills Large business borrows by issuing relatively short-term commercial paper and long-term bonds Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Creation and Destruction of Money Banks create money by making loans –This money is created out of nothing –This money is new money in the form of additional demand deposits created with a simple bookkeeping operation Money is destroyed when a loan is repaid –When a loan is repaid, demand deposit accounts go down –This money disappears back into nothing The interest that was paid does not disappear The Federal Reserve controls the bank’s ability to create money by increasing or decreasing the bank’s reserve requirements Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Bank Regulation The Federal Deposit Insurance Corporation (FDIC) –After the massive bank failures of the 1930s, Congress set up the FDIC The whole idea of the FDIC is to avert bank panics by assuring the public that the federal government stands behind the bank, ready to pay off depositors, if it should fail The FDIC would rather pay another bank to take over ailing institutions than pay off its depositors (the FDIC has paid several hundred million dollars to a bank to get it to take over a failing bank) Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Bank Regulation The Federal Deposit Insurance Corporation (FDIC) –Is the FDIC in any danger of running out of money? –Not really –The Congress, the Federal Reserve, the Treasury, and all of the financial resources of the U.S. government are committed to the preservation of the FDIC –More than 99 percent of all banks are members of the FDIC Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.