1. © 2013, published by Flat World Knowledge

2. Published by: Flat World Knowledge, Inc. One Bridge Street Irvington, NY 10533 © 2013 by Flat World Knowledge, Inc. All rights reserved. Your use of this work is subject to the License Agreement available here http://www.flatworldknowledge.com/legal. No part of this work may be used, modified, or reproduced in any form or by any means except as expressly permitted under the License Agreement.http://www.flatworldknowledge.com/legal

3. © 2013, published by Flat World Knowledge 1. WHAT IS MONEY? Learning Objectives 1.Define money and discuss its three basic functions. 2.Distinguish between commodity money and fiat money, giving examples of each. 3.Define what is meant by the money supply and tell what is included in the Federal Reserve Systems two definitions of it (M1 and M2).

4. © 2013, published by Flat World Knowledge 1.1 The Functions of Money A medium of exchange is anything that is widely accepted as a means of payment. To Barter an individual exchanges goods directly for other goods. A unit of account is a consistent means of measuring the value of things. A store of value is an item that holds value over time. Money is anything that serves as a medium of exchange.

5. © 2013, published by Flat World Knowledge 1.2 Types of Money Commodity money is money that has value apart from its use as money. –E.g. Mackerel in federal prisons, gold, and silver Fiat money is money that some authority, generally a government, has ordered to be accepted as a medium of exchange. –E.g. paper money and coins in the U.S. this note is legal tender for all debts public and private Currency is paper money and coins. Checkable deposits are balances in checking accounts. A check is a written order to a bank to transfer ownership of a checkable deposit.

6. © 2013, published by Flat World Knowledge 1.3 Measuring Money Money supply refers to the total quantity of money in the economy at any one time. Liquidity is the ease with which an asset can be converted into currency. M1 is the narrowest of the Feds money supply definitions that includes currency in circulation, checkable deposits, and travelers checks. M2 is a broader measure of the money supply than M1 that includes M1 and other deposits.

7. © 2013, published by Flat World Knowledge The two Ms: January 2012

8. © 2013, published by Flat World Knowledge 2. THE BANKING SYSTEMS AND MONEY CREATION Learning Objectives 1.Explain what banks are, what their balance sheets look like, and what is meant by a fractional reserve banking system. 2.Describe the process of money creation (destruction), using the concept of the deposit multiplier. 3.Describe how and why banks are regulated and insured.

9. © 2013, published by Flat World Knowledge 2.1 Banks and Other Financial Intermediaries A financial intermediary is an institution that amasses funds from one group and makes them available to another. A bank is a financial intermediary that accepts deposits, makes loans, and offers checking accounts.

10. © 2013, published by Flat World Knowledge 2.2 Bank Finance and a Fractional reserve System A balance sheet is a financial statement showing assets, liabilities, and net worth. Assets are anything of value. Liabilities are obligations to other parties. Net worth refers to assets less liabilities.

11. © 2013, published by Flat World Knowledge 2.2 Bank Finance and a Fractional reserve System Reserves are bank assets held as cash in vaults and in deposits with the Federal Reserve. A fractional reserve banking system is a system in which banks hold reserves whose value is less than the sum of claims outstanding on those reserves.

12. © 2013, published by Flat World Knowledge The Consolidated Balance Sheet for U.S. Commercial Banks, January 2012 AssetsLiabilities and Net Worth Reserves$1,592.9Checkable deposits$8,517.9 Other assets1,316.2Borrowings1,588.1 Loans7,042.0Other liabilities1,049.4 Securities2,546.1 Total assets$12,497.2Total Liabilities$11,155.4 Net worth$1,341.8

13. © 2013, published by Flat World Knowledge 2.3 Money Creation Required reserves are the quantity of reserves banks are required to hold. The required reserve ratio is the ratio of reserves to checkable deposits a bank must maintain. Excess reserves are reserves in excess of the required level. A bank is said to be loaned up when its excess reserves equal zero.

14. 14 Copyright © Houghton Mifflin Company. All rights reserved. Fractional Reserve Banking A system in which banks keep less than 100 percent of the deposits available for withdrawal. – Regulated by Federal Reserve Board

15. 15 Copyright © Houghton Mifflin Company. All rights reserved. How Banks Create Money Reserves: Actual and Required – The reserve ratio is the fraction of a banks 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.

16. 16 How Banks Create Money

17. 17 How Banks Create Money

18. 18 How Banks Create Money

19. 19 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)

20. 20 The Multiple Creation of Bank Deposits

21. 21 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%

22. © 2013, published by Flat World Knowledge A Balance Sheet for ACME Bank ACME Bank AssetsLiabilities Reserves$1,000Deposits$10,000 Loans$9,000

23. © 2013, published by Flat World Knowledge A Balance Sheet for ACME Bank

24. A Balance Sheet for ACME Bank

25. 2.4 The Deposit Multiplier A deposit multiplier is the ratio of the maximum possible change in checkable deposits (ΔD) to the change in reserves (ΔR). EQUATION 2.1 EQUATION 2.2 EQUATION 2.3 EQUATION 2.4 EQUATION 2.5

26. © 2013, published by Flat World Knowledge 2.5 The Regulation of Banks Deposit insurance –In the U.S., if a commercial bank fails, the FDIC guarantees to reimburse depositors up to at least $250,000 per account. Regulation to Prevent Bank Failure –The FDIC audits banks to ensure they are operating safely (i.e. not making investments deemed too risky and maintaining a minimum level of net worth as a fraction of total assets) Regulation in Response to Financial Crises –The Glass-Steagall Act post Great Depression created the FDIC and the separation between commercial banks and investment banks.

27. © 2013, published by Flat World Knowledge 2.5 The Regulation of Banks Regulation in Response to Financial Crises –In the U.S. in 1999 the Glass-Steagall Act was largely repealed. –The financial crisis of 2008 led to the passage of the Dodd-Frank Act. –Elimination of the separation between the two types of banks by a law passed in 1999.

28. © 2013, published by Flat World Knowledge 2.5 The Regulation of Banks Regulation in Response to Financial Crises –Creation of the Dodd-Frank Wall Street Reform and Consumer Protection Act post financial crisis of 2008. Supervision and regulation of consumer credit markets, such as credit card and bank fees and mortgage contracts.

29. © 2013, published by Flat World Knowledge 3. THE FEDERAL RESERVE SYSTEM Learning Objectives 1.Explain the primary functions of central banks. 2.Describe how the Federal Reserve System is structured and governed. 3.Identify and explain the tools of monetary policy. 4.Describe how the Fed creates and destroys money when it buys and sells federal government bonds. A central bank is a bank that acts as a banker to the central government, acts as a banker to banks, acts as a regulator of banks, conducts monetary policy, and supports the stability of the financial system.

30. 30 Copyright © Houghton Mifflin Company. All rights reserved. The Federal Reserve System The Federal Reserve System (the Fed) serves as the central bank for the United States. A central bank typically has the following functions: – It is the banks bank: it accepts deposits from and makes loans to commercial banks. – It acts as banker for the federal government. – It controls the money supply. – Performs certain regulatory functions for the financial industry.

31. 31 Copyright © Houghton Mifflin Company. All rights reserved. Structure of the Federal Reserve System The primary elements in the Federal Reserve System are: 1.The Board of Governors 2.The Regional Federal Reserve District Banks (FRBs) 3.The Federal Open Market Committee (FOMC)

32. 32 Copyright © Houghton Mifflin Company. All rights reserved. The Federal Reserve Banks 12 District banks Nine directors The directors appoint the district president who is approved by the Board of Governors

33. 33 Copyright © Houghton Mifflin Company. All rights reserved. The Federal Reserve System

34. 34 Copyright © Houghton Mifflin Company. All rights reserved. The Board of Governors Seven members Appointed by the President Confirmed by the Senate Serve 14-year term Terms are staggered so that one comes vacant every two years President appoints a member as Chairman to serve a four-year term – Confirmed by the US Senate

35. 35 Copyright © Houghton Mifflin Company. All rights reserved. Federal Open Market Committee (FOMC) Meets approximately every six weeks to review the economy Made up of the following voting members: – 7 members of the Board of Governors – 5 of the FRB presidents (they rotate yearly) = 12 FOMC members

36. 36 Copyright © Houghton Mifflin Company. All rights reserved. Functions of the Fed (1) Banking Services and Supervision – It supplies currency to banks through its 12 district banks. – It holds the reserves of banks in the district bank of each bank. – It processes and routes checks to banks through its district banks and processing centers. – It makes loans to banksit is the lender of last resort, the bankers bank. – It supervises and regulate banks, ensuring that they operate in a sound and prudent manner. – It is the banker for the U.S. government. It sells government securities for the U.S. Treasury.

37. 37 Copyright © Houghton Mifflin Company. All rights reserved. Functions of the Fed (2) Controlling the Money Supply – The money supply is varied through the course of the year to meet seasonal fluctuations in the demand for money. This helps keep interest rates less volatile. Example: 4 th quarter holiday season creates an increased demand for money to buy gifts. – The Fed also changes the money supply to achieve policy goals set by the FOMC.

38. 38 Copyright © Houghton Mifflin Company. All rights reserved. Policy Goals of the Fed Ultimate Goal: Economic growth with stable prices. This means greater output (GDP) and a low, steady rate of inflation. Intermediate Targets: – The Fed does not control output or the prices directly. It does control the money supply. – The Fed establishes target growth rates for the money supply, which it believes are consistent with its ultimate goals. – The money supply growth rate becomes an intermediate target, an objective used to achieve some ultimate policy goal.

39. © 2013, published by Flat World Knowledge 3.2 Powers of the Fed Reserve requirements The discount window and other credit facilities –The discount rate is the interest rate changed by the Fed when it lends reserves to banks. –The federal funds market is a market in which banks lend reserves to one another. –A federal funds rate is the interest rate charged when one bank lends reserves to another.

40. © 2013, published by Flat World Knowledge 3.2 Powers of the Fed Open market operations –A bond is a promise by the issuer of the bond to pay the owner of the bond a payment or a series of payments on a specific date or dates. –Open market operations are the buying and selling of federal government bonds by the Fed.

41. © 2013, published by Flat World Knowledge 3.2 Powers of the Fed The Fed Banks The Public Reserves Deposits Loans