Money and Banking Chapter 21

2 Copyright © Houghton Mifflin Company. All rights reserved. “Money is whatever is generally accepted in exchange for goods and services—accepted not as an object to be consumed but as an object that represents a temporary abode of purchasing power to be used for buying still other goods and services.” -- Milton Friedman

3 Copyright © Houghton Mifflin Company. All rights reserved. What is Money? Money is anything that is generally acceptable to sellers in exchange for goods and services. A liquid asset is an asset that can easily (i.e., quickly, cheaply, conveniently) be exchanged for goods and services.

4 Copyright © Houghton Mifflin Company. All rights reserved. What is Money? Functions of Money 1) Medium of exchange 2) Unit of account 3) Store of value 4) Standard of Deferred Payment

5 Copyright © Houghton Mifflin Company. All rights reserved. Medium of Exchange (1) The use of money as a medium of exchange lowers transactions costs. Trade without money, directly exchanging goods for goods, is called barter. – Barter requires a double coincidence of wants—each party to the exchange has to want what the other has to trade. – Finding someone else who wants what you have to trade and who has what you want is time-consuming and costly.

6 Copyright © Houghton Mifflin Company. All rights reserved. Medium of Exchange (2) A medium of exchange must be: – Widely accepted for payment – Portable: easy to transport and transfer to the seller – Divisible: measurable in both small and large units

7 Copyright © Houghton Mifflin Company. All rights reserved. Unit of Account Money acts as a common unit of measurement. This allows us to compare the values of very dissimilar things. It makes accounting possible. As a result of these things, it lowers information costs.

8 Store of Value Money makes it possible to carry buying power forward into the future. Therefore, for money to be a store of value, it must be durable. – Durability is the ability to retain value over time. – Inflation can reduce the effectiveness of money as a store of value. – This can lead to currency substitution—the use of foreign money as a substitute for domestic money when the domestic economy has a high rate of inflation.

9 Standard of Deferred Payment Debt is denominated in money terms. The standard for repayment is money. There is a difference between money and credit: – Money is what you use to pay for goods and services. – Credit is available savings that are lent to borrowers to spend. – Credit is debt, something you owe.

10 M1 Money Supply Money in the United States Today consists of: – Currency is the bills and coins that we use. – Deposits are also money because they can be converted into currency and are used to settle debts.

11 What is Money?—M1 M1 is the narrowest and most liquid measure of the money supply. – It includes financial assets that are immediately available for spending on goods and services. M1 includes: – Currency – Travelers’ Checks – Demand Deposits (checking accounts) – Other Checkable Deposits (interest-bearing checking) Demand Deposits and Checkable Deposits are called transactions accounts—these are checking accounts that can be drawn upon to make payments.

12 U.S. Money Supply: M1

13 About Currency In 2003, currency was 52% of M1. U.S. currency today is not backed by gold or silver. – It is backed only by the confidence and trust of the public. – It is a fiduciary monetary system. (“Fiducia” means “trust” in Latin.) – Also called “fiat money”

14 About Currency Money backed by gold or silver (or something else of value) is called commodity money. – the commodity itself may be used as money Gold, silver, shells, beads, chocolate, cigarettes, diamonds, etc.

15 Problems with Commodity Money At times, the precious metal in gold or silver coins may be worth more than the face value of the coins. – In such situations, the public will begin to hoard the coins. – According to Gresham’s Law, if two coins have the same face value but different intrinsic (commodity) values, the cheaper coin will be used to make transactions and the other coin will be hoarded. “Bad money drives out good.”

16 What is Money?—M2 M2 adds to M1 less liquid assets that can be converted to M1 assets quickly and at low cost. Includes everything in M1 Adds: – Savings deposits – Small denomination time deposits (CDs) – Retail money market mutual funds

17 U.S. Money Supply: M2

The Equation of Exchange M = money stock (M1 or M2) V = velocity of circulation of money (how many times per year each unit of the money stock is used to purchase final goods) P = price level (e.g., consumer price index) Q = real GDP MV = PQ

19 U.S. Money Supply: M3

20 Financial Intermediaries Four Types of Financial Intermediaries 1) Commercial banks 2) Savings and loan associations 3) Savings banks and credit unions 4) Money market mutual funds

21 Financial Intermediaries Commercial Banks – Financial institutions that offer deposits on which checks can be written. They make loans to households and businesses. They are corporations. – Originally only commercial banks could offer (non- interest-bearing) checking accounts. Thrift Institutions – Savings and Loan Associations, Credit Unions, Mutual Savings Banks. – Created to encourage saving, hence “thrift”. – Until 1980, these institutions could offer higher interest rates on savings accounts than banks. – Now “thrifts” can offer many of the same services as commercial banks.

22 Deposit Insurance A bank panic occurs when depositors, fearing a bank’s closing, rush to withdraw their funds. To reduce the likelihood of bank panics, in 1933 the Federal Deposit Insurance Corporation (FDIC) was created. – This is a federal agency that insures bank deposits so that depositors do not lose their deposits if a bank fails.

23 Bank Failures

24 International Banking (1) Eurocurrency market or “offshore banking”: the market for deposits and loans generally denominated in a currency other than the currency of the country in which the transaction occurs. – For example, a U.S. firm may borrow U.S. dollars from a bank in London. – Because foreign banks do not operate under U.S. legal restrictions, they may offer better interest rates on deposits and loans. – On the other hand, foreign banking laws do apply and may cause other problems.

25 International Banking (2) International Banking Facilities (IBFs) were legalized by the Federal Reserve Board in December An IBF is a division of a U.S. bank that is allowed to receive deposits from and make loans to nonresidents of the U.S. without the restrictions that apply to domestic U.S. banks. This allows domestic banks to compete more fairly with offshore banks.

26 Informal Markets in Developing Countries ROSCAs—Rotating Savings and Credit Associations – Operate like savings clubs – Example: 12 members contribute every month, and then every 12 th month each member receives the full amount contributed by everyone.

27 Fractional Reserve Banking A system in which banks keep less than 100 percent of the deposits available for withdrawal. – Regulated by Federal Reserve Board

28 How Banks Create Money Reserves: Actual and Required – The reserve ratio is the fraction of a bank’s total deposits that are held in reserves. – The required reserves ratio is the ratio of reserves to deposits that banks are required, by regulation, to hold. Required reserves are those reserves which must be kept on hand or on deposit with the Federal Reserve in order to comply with the reserve requirements. – Excess reserves are the cash reserves beyond those required, which can be loaned.

29 How Banks Create Money

30 How Banks Create Money

31 How Banks Create Money

32 How Banks Create Money NOTE: Cash leakage or excess reserves held in banks will reduce the multiplier effect Deposit Expansion Multiplier = 1 Reserve Requirement (ratio)

33 The Multiple Creation of Bank Deposits

34 Required Reserve Ratio From the Federal Reserve web site (5/1/07) Liability TypeRRR in % Transaction accounts $8.5 million0% $8.5 to $45.8 million3% $45.8 million +10% Non-personal time deposits0% Eurocurrency liabilities0%

Dolan, Economics Combined Version 4e, Ch. 21 Instruments of Monetary Policy Open market operations are purchases and sales of government securities by the Fed. They are the most frequently used instrument of monetary policy. Changes in interest rates – Discount rate charged by the Fed on reserves it loans to commercial banks – Deposit rate paid by the Fed on reserve deposits of commercial banks Changes in required reserve ratios can also be used to affect the money supply. The Fed does not use this instrument of monetary policy, but it is used by some other central banks around the world. Purchases and sales of foreign assets are used by many central banks as an instrument of monetary policy, but not by the Fed in recent years.