Money and Banking Chapter 14 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Objectives The functions of money Components of the money supply What “backs” the money supply The Federal Reserve and the U.S. banking system The functions and responsibilities of the Federal Reserve 14-2

Functions of Money Money is a medium of exchange in that it is used to buy and sell goods –Without money, we would be back to bartering It is a unit of account, i.e., it serves as a yardstick by which we can determine the value of all goods, services and resources Money serves as a store of value. If we don’t need it today, we can store wealth as money (checking account) and use in whenever it is needed in the future Money is highly “liquid”; everyone recognizes its value and will accept any willingly 14-3

Money Defined Money consists in several forms and is defined below: M1 is a narrow definition of money and consists of currency (coins and paper money) as well as any deposit upon which a check can be drawn (checkable deposits) –56% of M1 is currency held by the public –Money has only “token” value in that its intrinsic value is less than the actual value (there is less than 10 cents worth of metal in a dime) –All paper currency consists of Federal Reserve Notes issued by the Federal Reserve 14-4

Money Defined Checkable deposits are included in M1, since they can be spent almost as readily as currency, and can be easily changed into currency –Checkable deposits form 44% of M1 Commercial banks are a main source of checkable deposits for households and businesses Thrift institutions such as savings and loans and credit unions also have checkable deposits Qualifications: Currency and checkable deposits held by the federal government, Federal Reserve and other financial institutions are not included –If they were, this would be “double counting” of the money

Money Defined M2 is a broader definition of money It includes not only M1 but also several other “near monies” such as –Savings deposits and money market deposit accounts –Small time deposits (certificates of deposit) less than $100,000 –Money market mutual fund balances which can be redeemed by phone calls, checks, or through the internet

Are Credit Cards Money? Nope, they are not money but are an instantaneous, on the spot, short-term loan between you and the bank whose card you are using Although they are not money, they allow you to hold less currency in your billfold and also less checkable deposits in your bank (until you have to make your monthly payment!!)

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 14-8

Money Supply The astonishing thing about money is that the Federal Government does not “back” it Then the question is - why is money valuable? –It is valuable because the government can keep its “value” stable –It is valuable because it is acceptable to everyone as a medium of exchange –It has not intrinsic value, but only its value in exchange for goods and services –It is “legal tender” and generally must be accepted in repayment of debt (but firms and government may require payment be made by alternative means) –The courts have deemed that pennies are not legal tender –The relative scarcity of money compared to goods and services will allow money to retain its purchasing power 14-9

Money and Prices Prices affect purchasing power of money –Higher prices mean less purchasing power Excessive inflation make may make money essentially worthless –After WWI, consumers in Germany were buying bread with wheelbarrels of marks –The value of the mark decreased to less than 1 billionth of its former value within a four year period –Worthless money leads to use of other currencies that are more stable –Worthless money may lead to barter exchange systems 14-10

Maintaining the Value of Money The government tries to keep the money supply stable with appropriate fiscal (i.e., financial) policy Monetary policy tries to keep money relative scarce to maintain its purchasing power while expanding enough to allow the economy to grow

Federal Reserve System The Federal Reserve System (the “Fed”) was established by Congress in 1913 and is in charge of the money and banking system They were established because of the occurrence of banking crises such as everyone wanting to withdraw the money simultaneously; also the supply of money was largely unregulated The central controlling authority of the system is the Board of Governors which consists of 7 members appointed by the President for staggered 14 year terms (to ensure political freedom) 14-12

The Federal Reserve System The Federal Open Market Committee (FOMC) includes the seven governors plus five regional Federal Reserve Bank presidents whose terms alternate –They set policy on buying and selling of government bonds, the most important type of monetary policy, and meet several times each year

The Federal Reserve System The Federal Reserve System has 12 districts, each with its own district bank and two or three branch banks –The district banks help implement Fed policy and are advisory –Each is quasi-public; it is owned by member banks but controlled by the government’s Federal Reserve Board, and any profits go to the U.S. Treasury –They act as bankers’ banks by accepting reserve deposits and make loans to banks and other financial institutions –In making loans, the Federal Reserve is the lender of last resort should no other options be available

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 14-15

Federal Reserve System The 12 Federal Reserve Banks Source: Federal Reserve Bulletin 14-16

Federal Reserve Functions The Fed issues “Federal Reserve Notes” which is the paper currency used in the U.S. monetary system The Fed sets reserve requirements and holds the reserves of banks and thrifts not held as vault cash The Fed may lend money to banks and thrifts, charging them an interest rate called the discount rate 14-17

Federal Reserve Functions The Fed provides a check collection service for banks by adjusting the reserve deposits of the banks involved The Federal Reserve System acts as the fiscal agent for the Federal government They supervise member banks Monetary policy and control of the money supply is the major function of the Fed

Financial Institutions World’s 12 Largest Financial Institutions, 2007 Barclays (UK) BNP Paribas (France Citigroup (USA) HSBC Group (UK) UBS (Switzerland) Royal Bank of Scotland (UK) ING Group (Netherlands) Mitsubishi UFJ (Japan) Deutsche Bank Group (Ger) Bank of America (US) Allianz Worldwide (Ger) JPMorgan Chase (USA) 0 1,300,000 1,600,000 1,900,000 Source: Organization for Economic Cooperation and Development Assets (Billions of U.S. Dollars) 14-19

The Global Greenback U.S. currency circulating abroad –Russia $80 billion –Argentina $50 billion –$450 billion total –60% of total US currency Black markets and illegal activities Dollar offers stable purchasing power Exchange rate risk 14-20

Key Terms medium of exchange unit of account store of value M1 Federal Reserve Notes token money checkable deposits commercial banks thrift institutions near-monies M2 savings account money market deposit account (MMDA) time deposits money market mutual fund (MMMF) legal tender Federal Reserve System Board of Governors Federal Reserve Banks Federal Open Market Committee (FOMC) financial services industry electronic payments 14-21

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