1. Part 3 topics Goals: Money and banking -
to develop an understanding of monetary policy
Develop the ability to solve problems using both monetary and fiscal policies
Focus on problem solving
Money and banking -
How banks and thrifts create money -
Monetary policy -
Economic growth –
Deficits, surpluses, and the public debt

2. Please listen to the audio as you work through the slides.
Money and Banking
Please listen to the audio as you work through the slides.

3. Money and Banking Learning Objectives:
Students will be able to thoroughly and completely explain:
M1 and M2 of the Money Supply.
The Demand for Money – transaction demand and asset demand for money.
The impact on interest rates of changes in the demand and supply of money.
The organization of the Federal Reserve System, and the functions of the Federal Reserve

4. The Functions of Money
Medium of Exchange
It’s what sellers generally accept and buyers generally use to pay for goods and services.
Unit of Account
A standard unit that provides a consistent way of quoting prices. It’s how we keep score.
Store of Value
An asset that can be used to transport purchasing power from one time period to another
Liquidity
It is portable and readily accepted and thus easily exchanged for goods and services. Money is liquid.

5. Money Supply Definition… M1 Currency – Coins Federal Reserve Notes
Little Intrinsic Value
Checkable Deposits in:
Commercial Banks
Thrift Institutions - An organization formed as a depository for primarily consumer savings.
Savings and Loan Associations (S&L’s),
Credit Unions

6. = Plus... Money Supply M2 M1 Near-monies Savings Deposits – including:
Money Market Deposit Accounts (MMDAs) bank products – interest bearing accounts
Smaller Time Deposits < $100,000 “CD’s”
Money Market Mutual Funds (MMMFs) Mutual Fund Company products

7. Money Defined + + + + + January 2008 M1 M2 Currency 56% M1
Checkable Deposits
44%
18%
Small Time Deposits +
16%
Money Market Mutual
Funds Held By Individuals
14% +
Savings Deposits,
Including Money Market
Deposit Accounts
52% +
Totals
$1,365
Billion
$7,499
Billion
Source: Federal Reserve System

8. What about credit cards?
Is this money?

9. Money Supply What “backs” the Money Supply? Why is money valuable?
Nothing tangible!
The full faith and credit of the USA
Why is money valuable?
Acceptability – we accept it
Legal tender – Government designated
Relative scarcity – relative to its utility
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10. Money and Prices Prices affect purchasing power of money
Hyperinflation renders money unacceptable
Key goal: Stabilizing money’s purchasing power
Intelligent management of the Money Supply – monetary policy
Appropriate fiscal policy

11. The Demand for Money To make purchases with it
What do we want to do with money?
To make purchases with it
To hold it as an asset or acquire interest bearing assets with it:
corporate bonds – earn interest
Stocks – increase in value “we hope”
private or government bonds – earn interest
or money – earns no interest but is most liquid
Advantage of holding money as and asset
Liquidity
Less Risk relative to bonds, stocks or other interest bearing assets
Disadvantages of holding money as an asset
It earns little or no interest

12. Demand for Money Transactions demand, D1 Asset demand, D2
Determined by nominal GDP
Independent of the interest rate
Asset demand, D2
Money as a store of value
Varies inversely with the interest rate
Downward sloping demand curve
Total money demand, Dm
Bonds are assumed as a typical asset with lower prices associated with higher interest rates

13. Asset Demand for Money Explained:
We have a choice of which assets to hold: money, or bonds.
Money earns no interest while bonds do earn interest.
When interest rates are low we recognize that the opportunity cost of holding bonds is low, so we choose to hold (demand) large amounts of money.
When interest rates are high, the opportunity cost of holding money is high, so we choose to hold (demand) less money (more bonds).
Hence there is an inverse relationship between interest rates and the asset demand for money.

14. Demand for Money + = (c) Total demand for (a) (b) money, Dm
and supply
(a)
Transactions
demand for
money, Dt
(b)
Asset
demand for
money, Da 10
7.5 5
2.5 Sm + =
Rate of interest, i percent 5 Dt Da Dm 50
100
150
200 50
100
150
200 50
100
150
200
250
300
Amount of money
demanded
(billions of dollars)
Amount of money
demanded
(billions of dollars)
Amount of money
demanded and supplied
(billions of dollars)

15. Equilibrium interest rate
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

16. The Money Market ie Sm Dm Suppose the money supply is decreased
Interaction of bond prices, interest rates,
And Money Supply Sm 10
7.5 5
2.5
Suppose the money
supply is decreased
from $200 billion, Sm,
to $150 billion Sm1. ie
Rate of interest, i (percent)
Assume that we hold
both money and bonds
at the same time. Dm
Amount of money demanded
(billions of dollars)

17. Rate of interest, i (percent) Amount of money demanded
The Money Market
Sm1 Sm 10
7.5 5
2.5
A decrease in the supply of
money creates a temporary shortage
of money. We will require the sale of
some assets to meet our need. ie
Rate of interest, i (percent)
People and institutions try to gain More money by selling bonds.
The supply of bonds increase, and the prices of bonds decrease.
Interest rates increase.
At higher interest rates, people reduce the amount of money they want to hold Dm
Amount of money demanded
(billions of dollars)

18. Rate of interest, i (percent) Amount of money demanded
The Money Market Sm 10
7.5 5
2.5
Suppose the money
supply is increased
from $200 billion, Sm,
to $250 billion Sm2. ie
Rate of interest, i (percent) Dm
Amount of money demanded
(billions of dollars)

19. Rate of interest, i (percent) Amount of money demanded
The Money Market Sm
Sm2
A temporary surplus
of money will require:
1. the purchase of some
assets to meet the de-
sired level of liquidity. 10
7.5 5
2.5 ie
Rate of interest, i (percent)
2. Increased demand for
Bonds causes the price of Bonds to rise and interest rates To fall.
3. We re-adjust our holdings of money and bonds to fit our Liquidity preference. Dm
Amount of money demanded
(billions of dollars)

20. The Federal Reserve and the Banking System
Centralization and Public Control
Board of Governors – 7 members, appointed by president & confirmed by Senate, 14 year terms.
Assistance & Advice
Federal Open Market Committee (FOMC) – 12 people advise on the buying & selling bonds
Meet every 6 weeks
The 12 Federal Reserve Banks
Central Bank Role
Quasi-Public Banks
Banker’s Banks
Supervise Commercial Banks & Thrifts

21. Federal Reserve System
Board of Governors
Federal Open Market Committee
12 Federal Reserve Banks
Commercial Banks
Thrift Institutions
(Savings and Loan Associations,
Mutual Savings Banks,
Credit Unions)
The Public
(Households and
Businesses)

22. Federal Reserve System
The 12 Federal Reserve Banks
Source: Federal Reserve Bulletin

23. Issuing Currency (not manufacturing it)
FED Functions & the Money Supply
Issuing Currency (not manufacturing it)
Setting Reserve Requirements & Holding Reserves
Lending Money to Banks & Thrifts
Discount Rate
Providing for Check Collection
Acting as Fiscal Agent for the Government
Supervising Banks
Controlling the Money Supply

24. Some recent developments in the financial services sector.
Relative Decline of Banks and Thrifts – decline in their % of assets held
Financial Services Industry – changes in composition
Consolidation Among Banks and Thrifts
Convergence of Services Provided by Financial Institutions
Globalization of Financial Markets
Electronic transactions
Deregulation and creation of new products

25. Major US financial institutions
Commercial banks
Bank of America,
Wells Fargo
JPMorgan Chase Bank
Thrifts – S&L’s, mutual saving banks, credit unions
Insurance companies –
Prudential,
New York Life,
Mutual fund companies – Fidelity, Putnam, and many more
Pension funds
TIAA-CREF, Teachers Insurance and Annuity Association, College Retirement Equities Fund (TIAA-CREF),
Teamsters union
CalPERS – California Public Employees
Securities firms
Merrill Lynch (part of Bank of America),
Charles Schwab,
Bear Stearns, Goldman Sachs – global investment banking and securities firm.

26. History of banking regulation

27. 1913: Federal Reserve Act creates national banking system.
1914: Federal Trade Commission Act prohibits unfair or deceptive business practices.
1933: With memories of 1929 stock crash still fresh, Glass-Steagall Act separates "commercial banks" focusing on consumer activities (checking, savings) from "investment banks," which deal with speculative trading and mergers.

28. Sept 1987: Drexel Burnham Lambert, home to "junk-bond king" Michael Milken, creates "collateralized debt obligations" (CDOS)—securities made up of myriad loans and bonds with different risk levels.
April 1998: Citicorp and Travelers announce biggest-ever corporate merger ($70 billion); transaction technically illegal under Glass-Steagall; CEO Sandy Weill launches $12 million campaign to repeal law.
June 1998: Conseco purchases mobile home lender turned subprime powerhouse Green Tree in $6 billion deal.

29. Nov 1999: Gramm-Leach-Bliley Act guts Glass-Steagall, setting off wave of megamergers among banks and insurance and securities companies. Driving force is Sen. Phil Gramm (R-Texas), who has received $4.6 million from FIRE sector over previous decade.
Dec 14: As Congress heads for Christmas recess, Sen. Gramm attaches 262-page amendment to an omnibus appropriations bill. Commodity Futures Modernization Act will deregulate derivatives trading, give rise to Enron debacle, and open door to an explosion in new, unregulated securities
April : Fed chair Alan Greenspan signals concern with "abusive lending practices that target vulnerable segments of the population and can result in unaffordable payments, equity stripping, and foreclosure."

30. Oct 7 2002: Swiss investment bank UBS announces that Sen
Oct : Swiss investment bank UBS announces that Sen. Gramm is joining it to "advise clients on corporate finance issues and strategy"; he will also lobby Congress, Treasury, and Fed on banking and mortgage issues as industry pushes to eliminate predatory-lending rules.

31. The Recent Financial Crisis
Topics
Causes
Impacts
Government responses