31 Money, Banking, and Financial Institutions McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 13

Functions of Money Medium of exchange Used to buy/sell goods Unit of account Goods are valued in dollars Store of value A place to store wealth. LO1 31-2

Money Definition M1 M1 Currency Checkable deposits (demand deposits) Institutions offering checkable deposits Commercial banks Savings and loan associations Mutual savings banks Credit unions LO1 31-3

Money Definition M2 M2 M1 plus near-monies Savings deposits including money market deposit accounts (MMDA) Small-denominated time deposits Money market mutual funds (MMMF) What makes these different from M1? LO1 31-4

Money Definitions January 2010 Source: Federal Reserve System LO1 31-5

What “Backs” the Money Supply? Guaranteed by government’s ability to keep value stable Money as debt Why is money valuable? Acceptability Legal tender – “fiat money:” money because the govt. says its money.. Relative scarcity LO2 31-6

What “Backs” the Money Supply? Prices affect purchasing power of money Hyperinflation renders money unacceptable Stabilizing money’s purchasing power Intelligent management of the money supply – monetary policy Appropriate fiscal policy LO2 31-7

The Demand for Money Transactions Demand – D t Amount of money needed for purchases, etc. Main determinant is nominal GDP. Why? Asset Demand – D a Amount of wealth people want to hold as money (instead of bonds, stocks, whatever). It’s main determinant is the interest rate. LO3 31-8

The Demand for Money Total Demand for Money - D m Is the sum of D t and D a Change in nominal GDP will shift the total money demand curve. Change in interest rate will cause a movement along the curve. LO3 31-9

Demand for Money Rate of interest, i percent Amount of money demanded (billions of dollars) Amount of money demanded (billions of dollars) Amount of money demanded and supplied (billions of dollars) = + (a) Transactions demand for money, D t (b) Asset demand for money, D a (c) Total demand for money, D m and supply DtDt DaDa DmDm SmSm 5 LO

Interest Rates Equilibrium interest rate Changes with shifts in money supply and money demand Interest rates and bond prices Inversely related Bond pays fixed annual interest payment Lower bond price will raise the interest rate LO

Federal Reserve - Banking System Board of Governors 12 Federal Reserve Banks Serve as the central bank Quasi-public banks Banker’s bank LO

Federal Reserve – Banking System LO3 The 12 Federal Reserve Banks 31-13

Federal Reserve – Banking System Federal Open Market Committee Aids Board of Governors in setting monetary policy Conducts open market operations Commercial banks and thrifts 6,800 commercial banks 8,700 thrifts LO

Federal Reserve Functions Issue currency Set reserve requirements Lend money to banks Collect checks Act as a fiscal agent for U.S. government Supervise banks Control the money supply LO

Federal Reserve Independence Established by Congress as an independent agency Protects the Fed from political pressures Enables the Fed to take actions to increase interest rates in order to stem inflation as needed LO

Financial Institutions World’s 12 Largest Financial Institutions, 2009 Royal Bank of Scotland (UK) Barclays (UK) Deutsche Bank (Germany) BNP Paribas (France) HSBC Holdings (UK) JPMorgan Chase (US) Credit Agricole (France) Citigroup (US) Mitsubishi UFJ (Japan) UBS (Switzerland) ING Group (Netherlands) Bank of America (US) Source: Forbes Global 2000, Assets (Trillions of U.S. Dollars) LO

The Financial Crisis of 2007 and 2008 Mortgage Default Crisis Many causes Government programs that encouraged home ownership Declining real estate values Bad incentives provided by mortgage-backed bonds LO

The Financial Crisis of 2007 and 2008 Securitization- the process of slicing up and bundling groups of loans into new securities As loans defaulted, the system collapsed “Underwater” homeowners abandoned homes and mortgages LO

The Financial Crisis of 2007 and 2008 Failures and near-failures of financial firms Countrywide: second largest lender Washington Mutual: largest lender Wachovia Other firms came close LO

The Financial Crisis of 2007 and 2008 Troubled Asset Relief Program (TARP) Allocated $700 billion to make emergency loans Saved several institutions from failure LO

The Financial Crisis of 2007 and 2008 The Fed’s lender-of-last-resort activities Primary Dealer Credit Facility Term Securities Lending Facility Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility Commercial Paper Funding Facility LO

The Financial Crisis of 2007 and 2008 Money Market Investor Funding Facility Term Asset-Backed Securities Loan Facility Interest Payments on Reserves LO

Post-Crisis U.S. Financial Services Major Categories of Financial Institutions Commercial Banks Thrifts Insurance Companies Mutual Fund Companies Pension Funds Securities Firms Investment Banks LO

InstitutionDescriptionExamples Commercial Banks State and national banks that provide checking and savings accounts and make loans JP Morgan Chase, Bank of America, Citibank, Wells Fargo Thrifts Savings and loan associations, mutual savings banks, credit unions that offer checking and savings accounts and make loans Charter One, New York Community Bank Insurance Companies Firms that offer policies through which individuals pay premiums to insure against lose Prudential, New York Life, Northwestern Mutual, Hartford Mutual Fund Companies Firms that pool customer deposits to purchase stocks or bonds Fidelity, Vanguard, Putnam, Janus, T Rowe Price Pension Funds Institutions that collect savings from workers throughout their working years and then invest the funds to pay retirement benefits TIAA-CREF, Teamsters’ Union, CalPERs Securities Firms Firms that offer security advice and buy and sell stocks and bonds for clients Merrill Lynch, Smith Barney, Charles Schwab Investment Banks Firms that help corporations and governments raise money by selling stocks and bonds Goldman Sachs, Morgan Stanley, Deutsche Bank, Nomura Securities Major Categories of Financial Institutions LO

Post-Crisis U.S. Financial Services Wall Street Reform and Consumer Protection Act Passed to help prevent many of the practices that led to the crisis Critics say it adds heavy regulatory costs LO

Electronic Banking Electronic-based payment systems have pushed aside currency and checks Credit/debit cards Fedwire transfers ACH transactions Electronic money Stored-value cards 31-27