Chapter 14Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 1 ECON Designed by Amy McGuire, B-books, Ltd. McEachern CHAPTER Money and the Financial System Macro

Chapter 14Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 2 The Evolution of Money LO 1  The earliest money  Good – easily traded later  High degree of acceptability  Functions of money  Medium of exchange  Commodity money  Unit of account  Store of value  Retains purchasing power over time

Chapter 14Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 3 The Evolution of Money LO 1  Properties of the ideal money  Durable  Portable  Divisible  Uniform quality  Low opportunity cost  Relatively stable in value

Chapter 14Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 4 LO 1 Six Properties of Ideal Money Exhibit 1

Chapter 14Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 5 Representative Money and Fiat Money LO 1  Bank notes  IOUs  Paper money  As good as gold  Representative money  Fiat money  From the power of the state  Legal tender

Chapter 14Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 6 The Value of Money LO 1  Purchasing power of money  Rate of exchange for goods and services  Higher price level in economy  Smaller purchasing power  Purchasing power of $ in a year  100 ÷Price index in same year  Evolution over time  Steady decline since 1960

Chapter 14Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 7 LO 1 Purchasing Power of $1 Measured in 1982–1984 Constant Dollars Exhibit 2 An increase in the price level over time reduces what $1.00 buys. The price level has risen every year since 1960, so the purchasing power of $1.00 (measured in constant dollars) has fallen from $3.38 in 1960 to $0.47 in 2009.

Chapter 14Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 8 When Money Performs Poorly LO 1  Hyperinflation in Zimbabwe  Prices grow by the hour  Not reliable store of value  Exchange for stable currency  Barter

Chapter 14Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 9 The Fed LO 3  Before 1863: State banks –Chartered by states  National Banking Act of 1863 –National banks –Issue notes –Regulated  Dual banking system  19 th century –Panic ‘runs’

Chapter 14Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 10 The Fed LO 3  1913 Federal Reserve System –Central bank –Monetary authority –12 Federal Reserve districts  National banks –Had to join the Fed  State banks –Voluntary membership to the Fed

Chapter 14Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 11 The Twelve Federal Reserve Districts The map shows by color the area covered by each of the 12 Federal Reserve districts. Black dots note the locations of the Federal Reserve Bank in each district. Identified with a star is the Board of Governors headquarters in Washington, D.C. LO 3 Exhibit 3

Chapter 14Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 12 The Fed LO 3  Powers of the Fed –Issue bank notes –Buy and sell government securities –Extend loans to member banks –Clear checks in the banking system –Reserve requirement for member banks  Banker’s bank

Chapter 14Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 13 LO 4  Board of Governors –7 members Appointed by the President Confirmed by the Senate 14-year nonrenewable term Insulated from political pressure 1 chair: 4 years –Set and implement monetary policy –Oversees the 12 reserve banks

Chapter 14Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 14 LO 4  Federal Open Market Committee FOMC –Open-market operations The Fed buys, sells government securities –7 board governors –5 presidents of reserve banks –Advise the board

Chapter 14Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 15 Organization Chart of the Federal Reserve System Members of the Board of Governors: appointed by the president, confirmed by the Senate. Seven board members also belong to the 12-member Federal Open Market Committee, which advises the board. The Board of Governors controls the Reserve Banks in each of the 12 districts, which in turn control the US banking system. LO 4 Exhibit 4

Chapter 14Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 16  Regulating the money supply –Open-market operations –Discount rate –Reserve requirements  Deposit insurance –Federal Deposit Insurance Corporation, FDIC $250,000 per depositor per bank 90% banks LO 4

Chapter 14Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 17  Goals –High level of employment in economy –Economic growth –Price stability –Interest rate stability –Financial market stability –Exchange rate stability LO 4

Chapter 14Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 18  Before 1930s: Own corporate stock; bonds  After 1930s –Banking = heavily regulated Loans, government securities Ceiling on interest rates for deposits  1970s: Inflation Increase interest rates Withdrawals  Money market mutual fund Limited check writing LO 4

Chapter 14Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 19  Money market deposit accounts –$8 billion in 1978 –$200 billion in 1982  Deposit insurance  Unregulated interest rates  Wider variety of assets  Moral hazard problem LO 4

Chapter 14Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 20  Savings banks –Wild gambles –Insolvency –Collapse of a growing number of banks –1989 what was then largest financial bailout –3,418 in 1984 –1,220 in 2008  Credit unions –Declined 34% LO 4

Chapter 14Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 21 LO 4 Failures of U.S. Savings Banks Peaked in 1989 Exhibit 5

Chapter 14Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 22  Demise of commercial banks –Risky decisions –Unsound loans –Failures, mergers, acquisitions –14,496 in 1984 –7,085 in 2008 LO 4

Chapter 14Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 23 Failures of U.S. Commercial Banks Peaked in 1988 LO 4 Exhibit 6

Chapter 14Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 24 LO 4  Large number of U.S. banks –Past restrictions on bank branches  Branching restrictions –Inefficiencies –Bank failures (Great Depression)  Bank holding company –Owns several banks –Offers other services  Bank mergers –Expand geographically

Chapter 14Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 25 Largest U.S. Banks Based on Total Domestic Deposits LO 4 Exhibit 8(a)

Chapter 14Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 26 World’s Largest Banks Based on Total Assets LO 4 Exhibit 8(b)