Macroeconomics ECON 2301 Spring 2009 Marilyn Spencer, Ph.D. Professor of Economics Chapter 15

Chapter 15: Money, Banking, and Central Banking

15-3 Learning Objectives 4 Define the fundamental functions of money 4 Identify key properties that any goods that function as money must possess 4 Explain official definitions of the quantity of money in circulation 4 Understand why financial intermediaries such as banks exist 4 Describe the basic structure of the Federal Reserve System 4 Discuss the major functions of the Federal Reserve

15-4 Money 4 Money ÜAny medium that is universally accepted in an economy both by sellers of goods and services and by creditors as payment for debts

15-5 Table 15-1 Types of Money

15-6 The Functions of Money 4 The 4 functions of money 1.Medium of exchange 2.Unit of accounting 3.Store of value (purchasing power) 4.Standard of deferred payment

15-7 The Functions of Money (cont'd) 4 Medium of Exchange ÜAny item that sellers will accept as payment 4 Barter ÜThe direct exchange of goods and services for other goods and services without the use of money

15-8 The Functions of Money (cont'd) 4 Medium of exchange ÜMoney facilitates exchange by reducing transaction costs associated with means-of- payment uncertainty. Permits specialization, facilitates efficiencies 4 Barter ÜSimply a direct exchange Double coincidence of wants

15-9 The Functions of Money (cont'd) 4 Unit of Accounting ÜA measure by which prices are expressed ÜThe common denominator of the price system ÜA central property of money

15-10 The Functions of Money (cont'd) 4 Store of Value ÜThe ability to hold value over time ÜA necessary property of money ÜMoney allows you to transfer value (wealth) into the future.

15-11 The Functions of Money (cont'd) 4 Standard of Deferred Payment ÜA property of an item that makes it desirable for use as a means of settling debts maturing in the future ÜAn essential property of money

15-12 Liquidity 4 Liquidity ÜThe degree to which an asset can be acquired or disposed of without much danger of any intervening loss in nominal value and with small transaction costs ÜMoney is the most liquid asset.

15-13 Figure 15-1 Degrees of Liquidity

15-14 Liquidity (cont'd) 4 Question ÜWhat is the cost of holding money (its opportunity cost)? 4 Answer ÜIt is the alternative interest yield obtainable by holding some other asset.

15-15 Monetary Standards, or What Backs Money 4 Questions ÜWhat backs money? ÜIs it gold, silver, or the federal government? 4 Answer ÜYour confidence

15-16 Monetary Standards, or What Backs Money (cont'd) 4 Transactions Deposits ÜCheckable and debitable account balances in commercial banks and other types of financial institutions, such as credit unions and mutual savings banks ÜAny accounts in financial institutions on which you can easily transmit debit-card and check payments without many restrictions

15-17 Example: E-Gold Backed E- Money 4 The Internet has served as a breeding ground for various forms of e-money. 4 Gold-backed e-money effectively provides measures of the purchasing power, in terms of gold, of several major world currencies.

15-18 Monetary Standards, or What Backs Money (cont'd) 4 Fiduciary Monetary System ÜA system in which currency is issued by the government and its value rests on the public’s confidence that it can be exchanged for goods and services ÜThe Latin fiducia means “trust” or “confidence.”

15-19 Monetary Standards, or What Backs Money (cont'd) 4 Currency and transactions deposits are money because of their ÜAcceptability ÜPredictability of value

15-20 Defining Money 4 Money is important ÜChanges in the rate at which the money supply increases or decreases affect important economic variables (at least in the short run) such as inflation, interest rates, employment, and the level of real GDP. 4 Money Supply ÜThe amount of money in circulation

15-21 Defining Money (cont'd) 4 Economists use two basic approaches to define and measure money. ÜThe transactions approach ÜThe liquidity approach

15-22 Defining Money (cont'd) 4 Transactions Approach ÜA method of measuring the money supply by looking at money as a medium of exchange 4 Liquidity Approach ÜA method of measuring the money supply by looking at money as a temporary store of value

15-23 Defining Money (cont'd) 4 The transactions approach to measuring money: M1 ÜCurrency ÜCheckable (transaction) deposits ÜTraveler’s checks not issued by banks

15-24 Figure 15-2 Composition of the U.S. M1 and M2 Money Supply, 2007, Panel (a)

15-25 Figure 15-2 Composition of the U.S. M1 and M2 Money Supply, 2007, Panel (b)

15-26 Defining Money (cont'd) 4 M1 ÜCurrency Minted coins and paper currency not deposited in financial institutions The bulk of currency “in circulation” actually does not circulate within the U.S. borders.

15-27 Figure 15-3 The Value of U.S. Currency in Circulation Outside the United States

15-28 Defining Money (cont'd) 4 M1 ÜTransactions deposits Any deposits in a thrift institution or a commercial bank on which a check may be written or debit card used ÜThrift Institution Financial institutions that receive most of their funds from the savings of the public

15-29 Defining Money (cont'd) 4 M1 ÜTraveler’s Checks Financial instruments purchased from a bank or a nonbanking organization and signed during purchase that can be used as cash upon a second signature by the purchaser

15-30 Defining Money (cont'd) 4 The liquidity approach to measuring money: M2 4 Near Moneys ÜAssets that are almost money ÜHighly liquid ÜEasily converted to cash ÜTime deposits are an example

15-31 Defining Money (cont'd) 4 The liquidity approach: M2 is equal to M1 plus 1.Savings and small denomination time deposits 2.Balances in retail money market mutual funds 3.MMDAs

15-32 Defining Money (cont'd) 4 M2 ÜSavings Deposits Interest-earning funds that can be withdrawn at any time without payment of a penalty ÜDepository Institutions Accept deposits from savers and lend those funds out

15-33 Defining Money (cont'd) 4 M2 ÜMoney Market Deposit Accounts (MMDAs) Accounts issued by banks yielding a market rate of interest with a minimum balance requirement and a limit on transactions They have no minimum maturity

15-34 Defining Money (cont'd) 4 M2 ÜTime Deposit A deposit in a financial institution that requires notice of intent to withdraw or must be left for an agreed period Early withdrawal may result in a penalty ÜCD Time deposit with fixed maturity

15-35 Defining Money (cont'd) 4 M2 ÜMoney Market Mutual Funds Funds obtained from the public that investment companies hold in common Funds used to acquire short-maturity credit instruments –CD’s, U.S. government securities

15-36 Defining the U.S. Money Supply 4 Question ÜWhich definition of money correlates best with economic activity? 4 Answer ÜM2, although some businesspeople and policymakers prefer MZM

15-37 Defining Money (cont'd) 4 MZM (money-at-zero-maturity) 4 MZM entails adding deposits without set maturities to M1. 4 MZM includes all MMFs but excludes all deposits with fixed maturities.

15-38 Financial Intermediation and Banks 4 Most nations have a banking system that encompasses two types of institutions. 1.One type consists of private banking institutions. 2.The other type of institution is a central bank.

15-39 Financial Intermediation and Banks (cont'd) 4 Central Bank ÜA banker’s bank, usually an official institution that also serves as a country’s treasury’s bank ÜCentral banks normally regulate commercial banks.

15-40 Financial Intermediation and Banks (cont'd) 4 Direct finance ÜIndividuals purchase bonds from a business 4 Indirect finance ÜIndividuals hold money in a bank ÜThe bank lends the money to a business

15-41 Financial Intermediation and Banks (cont'd) 4 Financial Intermediation ÜThe process by which financial institutions accept savings from businesses, households, and governments and lend the savings to other businesses, households, and governments

15-42 Figure 15-4 The Process of Financial Intermediation

15-43 Financial Intermediation and Banks (cont'd) 4 Question ÜWhy might people wish to direct their funds through a bank instead of lending directly to a business? 4 Answers ÜAsymmetric information ÜAdverse selection ÜMoral hazard ÜLarger scale and lower management costs

15-44 Financial Intermediation and Banks (cont'd) 4 Asymmetric Information ÜInformation possessed by one party in a financial transaction but not by the other 4 Adverse Selection ÜThe likelihood that borrowers may use their borrowed funds for high-risk projects

15-45 Financial Intermediation and Banks (cont'd) 4 Moral Hazard ÜThe possibility that a borrower might engage in riskier behavior after a loan has been obtained 4 Larger scale and lower management costs ÜPeople can pool funds in an intermediary, reducing costs, risks. ÜPension funds and investment companies are examples.

Announcement 4 We will NOT hold class Tues., April Instead, here is an opportunity for 4 points of extra credit: ÜAttend the Kirkland Lecture in the Performing Arts Center at 9:30 a.m. that morning. ÜBe sure to sign in before entering the auditorium. ÜWrite a summary of the speaker’s remarks, words, and it to me at BEFORE class, April 28.

15-47 Financial Intermediation and Banks (cont'd) 4 Liabilities ÜAmounts owed ÜThe sources of funds for financial intermediaries 4 Assets ÜAmounts owned ÜThe uses of funds by financial intermediaries

15-48 Table 15-2 Financial Intermediaries and Their Assets and Liabilities

15-49 Financial Intermediation and Banks (cont'd) 4 Payment Intermediaries ÜInstitutions that facilitate transfers of funds between depositors who hold transactions deposits with those institutions

15-50 Figure 15-5 How a Debit-Card Transaction Clears

15-51 Financial Intermediation and Banks (cont'd) 4 Capital Controls ÜLegal restrictions on the ability of a nation’s residents to hold and trade assets denominated in foreign currencies 4 International Financial Intermediation ÜFinancing investment projects in more than one country

15-52 Table 15-3 The World’s Largest Banks

15-53 Financial Intermediation and Banks (cont'd) 4 World Index Fund ÜA portfolio of bonds issued in various nations whose individual yields generally move in offsetting directions, thereby reducing the overall risk of losses

15-54 Banking Structures Throughout the World 4 The ways that banks around the world differ ÜSize United States has banks of various sizes Europe and Japan have a few large banks ÜLegal Universal banking Limits on financial services such as insurance and bank stock ownership ÜImportance in financial system Major importance Part of a varied financial system (United States)

15-55 Banking Structures Throughout the World (cont'd) 4 Universal Banking ÜAn environment in which banks face few or no restrictions on their powers to offer a full range of financial services and to own shares of stock in corporations

15-56 Banking Structures Throughout the World (cont'd) 4 Central banks and their roles 1.Perform banking functions for their nations’ governments 2.Provide financial services for private banks 3.Conduct their nations’ monetary policies

15-57 The Federal Reserve System 4 The Fed ÜThe Federal Reserve System; the central bank of the United States ÜThe most important regulatory agency in the U.S. monetary system ÜEstablished in 1913 by the Federal Reserve Act

15-58 The Federal Reserve System (cont'd) 4 Organization of the Fed ÜBoard of Governors 7 members, 14-year terms ÜFederal Reserve Banks (12 Districts) 25 branches ÜFederal Open Market Committee (FOMC) BOG plus 5 presidents of district banks

15-59 Figure 15-6 Organization of the Federal Reserve System

15-60 Figure 15-7 The Federal Reserve System

15-61 The Federal Reserve System (cont'd) 4 Depository institutions Ü7,500 commercial banks Ü1,300 savings and loans Ü11,000 credit unions 4 All may purchase Fed services

15-62 The Federal Reserve System (cont'd) 4 Functions of the Fed 1.Supplies the economy with fiduciary currency 2.Provides a payment-clearing system 3.Holds depository institutions’ reserves 4.Acts as the government’s fiscal agent 5.Supervises depository institutions 6.Acts as a “lender of last resort” 7.Regulates the money supply

15-63 Issues and Applications: Check Clearing—A Rapidly Diminishing Fed Function 4 The volume of checks cleared by the Fed grew rapidly during the 1980s. 4 So why has the Fed’s check clearing speed dropped since the 1990s?

15-64 Issues and Applications: Check Clearing—A Rapidly Diminishing Fed Function (cont'd) 4 The reason is not due to inefficiency; rather, checks are falling out of favor. 4 Government transfers are transmitted electronically—Social Security, Medicare, Medicaid. 4 Electronic payments by households and businesses—debit cards, Internet bill pay, Web based services.

15-65 Figure 15-8 The Volume and Value of Federal Reserve Check Clearings Since 1985

15-66 Summary of Learning Objectives 4 The key functions of money 1.Medium of exchange 2.Unit of accounting 3.Store of value 4.Standard of deferred payment 4 Important properties of goods that serve as money ÜAcceptability, confidence, and predictable value

15-67 Summary of Learning Objectives (cont'd) 4 Official definitions of the quantity of money in circulation ÜM1: the narrow definition, focuses on money’s role as a medium of exchange ÜM2: a broader one, stresses money’s role as a temporary store of value

15-68 Summary of Learning Objectives (cont'd) 4 Why financial intermediaries such as banks exist ÜAsymmetric information can lead to adverse selection and moral hazard problems ÜSavers benefit from the economies of scale 4 The basic structure of the Federal Reserve System Ü12 district banks with 25 branches ÜGoverned by Board of Governors ÜFederal Open Market Committee

15-69 Summary of Learning Objectives (cont'd) 4 Major functions of the Federal Reserve ÜSupply the economy with currency ÜProvide systems for transmitting and clearing payments ÜHolding depository institutions’ reserves ÜActing as the government’s fiscal agent ÜSupervising banks ÜActing as a “lender of last resort” ÜRegulating the money supply ÜIntervening in foreign exchange markets

14-70 Learning Objectives: 4 Explain how federal government budget deficits occur 4 Define the public debt and understand alternative measures of the public debt 4 Evaluate circumstances under which the public debt could be a burden to future generations 4 Discuss why the federal budget deficit might be measured incorrectly 4 Analyze the macroeconomic effects of government budget deficits 4 Describe possible ways to reduce the government budget deficit

14-71 Public Deficits and Debts: Flows versus Stocks 4 Government Budget Deficit ÜExists if the government spends more than it receives in taxes during a given period of time ÜIs financed by the selling of government securities (bonds)

14-72 Public Deficits and Debts: Flows versus Stocks (cont'd) 4 The federal deficit is a flow variable, one defined for a specific period of time, usually one year. 4 If spending equals receipts, the budget is balanced. 4 If receipts exceed spending, the government is running a budget surplus.

14-73 Public Deficits and Debts: Flows versus Stocks (cont'd) 4 Balanced Budget ÜA situation in which the government’s spending is exactly equal to the total taxes and revenues it collects during a given period of time 4 Government Budget Surplus ÜAn excess of government revenues over government spending during a given period of time

14-74 Public Deficits and Debts: Flows versus Stocks (cont'd) 4 Public Debt ÜA stock variable ÜThe total value of all outstanding government securities

14-75 Government Finance: Spending More than Tax Collections 4 Since 1940, the U.S. federal government has operated with a budget surplus in 13 years. 4 In all other years, the shortfall of tax revenues below expenditures has been financed with borrowing.

14-76 Figure 14-1 Federal Budget Deficits and Surpluses Since 1940

14-77 Figure 14-2 The Federal Budget Deficit Expressed as a Percentage of GDP

14-78 Policy Example: Explaining a $109 Billion Deficit Projection Turnaround 4 Why was the government’s 2005 deficit projection off by $109 billion? 4 Federal tax revenues turned out to be more than 15% higher in Economic growth caused taxable incomes, hence revenues, to be much higher than anticipated.

14-79 Evaluating the Rising Public Debt 4 Gross Public Debt ÜAll federal government debt irrespective of who owns it 4 Net Public Debt ÜGross public debt minus all government interagency borrowing

14-80 Evaluating the Rising Public Debt (cont'd) 4 Some government bonds are held by government agencies. ÜIn this case, the funds are owed from one branch of the federal government to another. ÜTo arrive at the net public debt, we subtract interagency borrowings from the gross public debt.

14-81 Evaluating the Rising Public Debt (cont'd) 4 Tax revenues tend to be stagnant during times of slow economic growth. 4 Tax revenues grow more quickly when overall growth enhances incomes. 4 As long as spending exceeds revenues, the budget deficit will persist.

14-82 Table 14-1 The Federal Deficit, Our Public Debt, and the Interest We Pay on It

14-83 Figure 14-3 Net U.S. Public Debt as a Percentage of GDP

14-84 Net U.S. Public Debt as a Percentage of GDP 4 During World War II, the net public debt grew dramatically. 4 After the war ÜIt fell until the 1970s ÜStarted rising in the 1980s ÜDeclined once more in the 1990s ÜAnd recently has been increasing again

April 21 Assignment to be completed before class April 21: Read Chapter 16 & also read the end-of-chapter Problems: 16-1, 16-2, 16-4, 16-7, 16-9, & 16-15, on pp