1. Chapter 13 Money and Banking 13-1
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Chapter Objectives The four jobs of money What money is M1, M2, and M3
The demand for money
13-2
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

3. Chapter Objectives The origins of banking
The creation and destruction of money
Branch banking and bank chartering
The FDIC
The savings and loan debacle
13-3
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4. Standard of deferred payment
The Four Jobs of Money
Medium of exchange
Standard of value
Store of value
Standard of deferred payment
13-4
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5. Medium of Exchange
The most important job of money is to serve as a medium of exchange
When any good or service is purchased, people use money
Money makes it easier to buy and sell because money is universally accepted
Money, then, provides us with a shortcut in doing business
By acting as a medium of exchange, money performs its most important function
13-5
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6. Standard of Value
Money is a common denominator in which the relative value of goods and services can be expressed
A job that pays $2 an hour would be nearly impossible to fill, while one paying $50 an hour would be swamped with applications
Does money work well as a standard of value? You tell me
13-6
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7. Store of Value
If you could buy 100 units of goods and services with $100 in 1982, how many units could you buy with $100 in 2000?
Answer: you could have bought just 51 units
During this period, inflation robbed the dollar of almost half of its purchasing power
Over the long run, particularly since World War II, money has been a very poor store of value
However, over relatively short periods of time, say, a few weeks or months, money does not lose much of its value
13-7
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8. Standard of Deferred Payment
Many contracts promise to pay fixed sums of money well into the future
A couple of examples are 30-year corporate bonds and a 20-year mortgage
13-8
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9. Standard of Deferred Payment
When Dave Winfield signed a 10-year, $23 million contract with the New York Yankees in 1980, he really got stuck
Because over the next 10 years the consumer price index went up by almost 59%
Today when a professional ballplayer, entertainer, or virtually anyone else signs a long-term contract, she or he is generally protected by an escalator clause, which calls for increased payments to compensate for any future inflation
13-9
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10. Standard of Deferred Payment
How well does money do its job as a standard of deferred payment?
About as well as it does as a store of value
Usually quite well in the short run, but not well at all over the long run of, say, three years or more
13-10
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11. Money versus Barter
Without money, the only way to do business is by bartering
For barter to work, I must want what you have and you must want what I have
This makes it pretty difficult to do business
“Everything, then, must be assessed in money: for this enables men always to exchange their services, and so makes society possible”
Aristotle, Nicomachean Ethics
13-11
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12. Our Money Supply
Money consist of coins, paper money, demand (or checking) deposits, and checklike deposits (commonly called NOW – or negotiable order of withdrawal – accounts) held by the nonbank public
Coins and paper money together are considered currency
Six of every ten dollars in our money supply are demand deposits and other checkable deposits
Virtually all the rest is currency
Checks are not money but checking deposits are
13-12
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13. Federal Reserve Statistical Release, April 5, 2001
Our Money Supply
Federal Reserve Statistical Release, April 5, 2001
13-13
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14. Our Money Supply: M1, M2, M3 Currency + Demand deposits
+ Other checkable deposits
+ Traveler’s checks
M1(traditionally our basic money supply)
13-14
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15. Our Money Supply: M1, M2, M3 + Demand deposits
Currency
+ Demand deposits
+ Other checkable deposits
+ Traveler’s checks M1
+ Savings deposits
+ Small-denomination time deposits (less than $100,00)
+ Money market mutual funds held by individuals M2
13-15
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16. Our Money Supply: M1, M2, M3 13-16 Currency + Demand deposits
+ Other checkable deposits
+ Traveler’s checks M1
+ Savings deposits
+ Small-denomination time deposits (less than $100,00)
+ Money market mutual funds held by individuals M2
+ Large denomination time deposits (more than $100,00)
+ Money market mutual funds held by institutions
+ Other less liquid assets M3
13-16
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17. Federal Reserve Bulletin
Our Money Supply
M1, M2, and M3, January 2001
Federal Reserve Bulletin
13-17
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18. Our Growing Money Supply
Annual Percentage Change in the Money Supply, M1,
13-18
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19. The Demand for Money
The amount of money people hold is called money balances
John Maynard Keynes noted that people had three reasons for holding money
People hold money to make transactions
People hold money for precautionary reasons
People hold money to speculate
Economists have since identified four factors that influence the three Keynesian motives for holding money
The price level
Income
The interest rate
Credit availability
13-19
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20. The Keynesian Motives for Holding Money
The transaction motive
Individuals have day-to-day purchases for which they pay in cash or by check
Individuals take care of their rent or mortgage payment, car payment, monthly bills and major purchases by check
Businesses need substantial checking accounts to pay their bills and meet their payrolls
13-20
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21. The Keynesian Motives for Holding Money
The precautionary motive
People will keep money on hand just in case some unforeseen emergency arises
They do not actually expect to spend this money, but they want to be ready if the need arises
13-21
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22. The Keynesian Motives for Holding Money
The speculative motive
When interest rates are very low you don’t stand to lose much holding your assets in the form of money
Alternatively, by tying up your assets in the form of bonds, you actually stand to lose money should interest rates rise
You would be locked into very low rates
This motive is based on the belief that better opportunities for investment will come along and that, in particular, interest rates will rise
13-22
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23. Four Influences on the Demand for Money
The price level
As the price level rises, people need to hold higher money balances to carry out day-to-day transactions
As the price level rises, the purchasing power of the dollar declines, so the longer you hold money, the less that money is worth
Even though people tend to cut down on their money balances during periods of inflation, as the price level rises people will hold larger money balances
13-23
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24. Four Influences on the Demand for Money
Income
The more you make, the more you spend
The more you spend, the more money you need to hold as cash or in your checking account
Therefore as income rises, so does the demand for money balances
13-24
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25. Four Influences on the Demand for Money
Interest rates
The quantity of money demanded (held) goes down as interest rates rise
The alternative to holding your assets in the form of money is to hold them in some type of interest bearing paper
As interest rates rise, these assets become more attractive than money balances
13-25
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26. Four Influences on the Demand for Money
Credit availability
If you can get credit, you don’t need to hold so much money
The last three decades have seen a veritable explosion in consumer credit in the form of credit cards and bank loans
Over this period, increasing credit availability has been exerting a downward pressure on the demand for money
13-26
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27. Four Influences on the Demand for Money
Four generalizations
As interest rates rise, people tend to hold less money
As the rate of inflation rises, people tend to hold more money
As the level of income rises, people tend to hold more money
As credit availability increases, people tend to hold less money
13-27
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28. The Demand Schedule for Money
The Three Demands for Money
13-28
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29. Total Demand for Money 13-29
This is the sum of the transaction demand, precautionary demand, and speculative demand for money shown in the previous slide
13-29
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30. Total Demand for Money and the Supply of Money
The interest rate of 7.2 percent is found at the intersection of the total demand for money and the supply of money (M)
Since at any given time the supply of money (M) is fixed it can be represented as a vertical line
13-30
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31. Determination of the Interest Rate
The Prime Rate of Interest Charged by Banks on Short-Term Business Loans,
Although the prime rate is set by the nation’s largest banks, it is strongly influenced by actions of the Federal Reserve Board of Governors
13-31
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32. Who Controls the Interest Rates?
People who borrow money
players
Banks
referee
The FED
coach
13-32
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33. Keeping Track of Interest Rates
Wall Street Journal, Dec. 7, 1989
Wall Street Journal, Dec. 11, 1989
Note how the rates all move up and down virtually in lockstep, while maintaining the same distances from each other.
All interest rates move up and down together.
13-33
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

34. Banking: A Short History
What is the goldsmith’s reserve ratio when there are 1,000 receipts in circulation and 1,000 coins the safe?
Answer: 100 percent
13-34
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35. Banking: A Short History
What is the goldsmith’s reserve ratio when there are 1,000 receipts in circulation and 500 coins the safe?
Answer: 50 percent
13-35
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

36. Banking: A Short History
What is the goldsmith’s reserve ratio when there are 1,000 receipts in circulation and 250 coins the safe?
Answer: 25 percent
13-36
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37. Modern Banking
A bank is a financial institution that accepts deposits, makes loans, and offers checking accounts
Banks keep about 2% of their deposits in the form of vault cash
All the nation’s commercial banks, credit unions, savings and loan associations, and mutual savings banks now have to keep up to 10% of their checking deposits on reserve
This means “on the books”
Remember, checking deposits are bookkeeping entries
13-37
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38. Modern Banking Commercial Banks
Until the passage of the Depository Institutions Deregulation and Monetary Control Act of 1980, only commercial banks were allowed to issue checking deposits
They were the only institutions clearly recognized as banks
Commercial banks account for the bulk of checkable deposits
There are slightly more than 9,000 commercial banks in the United States
They hold nearly all demand deposits and almost half of total savings deposits
13-38
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39. Modern Banking Mutual Savings Banks
Mostly operated in the northeastern United States, these institutions were created in the 19th century to encourage savings by the “common people”
They traditionally made small personal loans, but today, like savings and loan associations, they offer the same range of services as commercial banks
There are nearly 1,600 mutual savings banks
13-39
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40. Modern Banking Savings and Loan Associations
Although originally established to finance home building, these associations also offer most of the services offered by commercial banks
The nearly 1,100 S&Ls invest more than three quarters of their savings deposits in home mortgages
13-40
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41. Modern Banking Credit Unions
Although there are nearly 11,000 credit unions in the United States, they hold less than 5% of total savings deposits
Credit unions offer a full range of financial services
They specialize in small consumer loans
Credit unions are cooperatives that generally serve specific employee, union, or community groups
13-41
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42. Modern Banking
The Banking Act of 1980 blurred the distinction between commercial banks and the three other depository institutions
The main distinction – that before 1980 only commercial banks were legally allowed to issue checking accounts – was swept away in 1980
13-42
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43. Bank Lending
Banks borrow money at low interest rates and lend money out at much higher interest rates
Currently, banks pay either zero or up to maybe 3% interest on most deposits – and perhaps 1 or 2 points more if you leave your money on deposit for a few years
Banks charge about 7% for fixed rate mortgages, a bit more for business loans, and about 18% on credit card loans
13-43
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44. Financial Intermediaries
Financial intermediaries channel funds from savers to borrows
Basically, they repackage the flow of deposits, insurance premiums, pension contributions, and other forms of savings into larger chunks
$10,000, $1 million, $50 million, or even more
They pay low rates of interest to their lenders and charge relatively high rates to their borrowers
Sometime business borrowers dispense with financial middlemen altogether by borrowing directly from savers
The U.S. Treasury does this every month by issuing new bonds, certificates, notes, and bills
Large business borrows by issuing relatively short-term commercial paper and long-term bonds
13-44
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45. The Home Mortgage Market
In the home mortgage market banks and other financial intermediaries differentiate between the relatively well off and the less fortunate
Just over two thirds of all American families own their homes
Nearly all have outstanding mortgages
The conventional market provided well off homeowners mortgages at interest rates in the seven-to-eight range in 2000 and 2001
The subprime market caters to poorer home homeowners and has interest rates that are double what they are in the conventional market
13-45
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46. Welfare Banks “Welfare banks” are check cashing stores
You will find one in virtually every poor neighborhood
They usually charge a fee of 1 to 3% of the value of the check, but some charge as much as 20%
Why don’t poor people go to banks?
There are usually no banks in poor neighborhoods
If you don’t have a required minimum balance, banks also charge pretty stiff fees
People receiving public assistance are not allowed to have bank accounts
13-46
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47. The Creation and Destruction of Money
Banks create money by making loans
This money is created out of nothing
This money is new money in the form of additional demand deposits
Money is destroyed when a loan is repaid
When a loan is repaid, demand deposit accounts go down
This money disappears back into nothing
The interest that was paid does not disappear
The Federal Reserve can affect the bank’s ability to create money by increasing or decreasing the bank’s reserve requirements
13-47
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48. Bank Regulation Branch Banking
Banking is legally defined as accepting deposits
Branch banking , therefore, would be the acceptance of deposits at more than one location
13-48
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49. Bank Regulation The three types of branch banking
Three types of branch banking have evolved under various state laws
Unrestricted branch banking under which a bank may open branches through out the state
Limited branch banking under which a bank may be allowed to open branches only in contiguous communities
Unit banking in which state law forbids any branching whatsoever
13-49
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50. Bank Regulation Automated teller machines (ATMs) Why shift to ATMs?
Processing a teller transaction costs more than double what an ATM transaction cost
By the end of 2000 there were about 250,000 ATMs doing more than 13 billion transaction a year
This could lead to a decline in branch offices
13-50
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51. Bank Regulation Automated teller machines (ATMs)
Should banks be allowed to charge fees to noncustomers?
Virtually all bankers and most economists would answer “Yes!”
Six out of seven ATM users don’t pay surcharges
Fees only hit users who go to ATMs not owned by their own bank
Banning ATM surcharges would leave consumers with fewer choices
We would all have to make do with fewer machines and longer lines
13-51
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52. Bank Regulation State and Nationally Chartered Banks
To operate a bank you must get a charter
More than two-thirds of the nation’s banks have state charters, the rest have national charters
To get a bank charter you need to demonstrate three things
That your community needs a bank or an additional bank
That you have enough capital to start a bank
That you are of good character
13-52
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53. Bank Regulation State and Nationally Chartered Banks To summarize
All nationally chartered banks must join the Federal Reserve System
All Federal Reserve member banks must join the FDIC
Only a small percentage of the state-chartered banks are members of the Federal Reserve
Nearly all banks are members of the FDIC
13-53
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54. Bank Regulation Interstate Banking
Until 1994 interstate banking was technically illegal, although banks managed to engage in this practice by buying banks in other states and operating them as separate entities
The passage of the Riegle-Neal Interstate Banking and Branching Act of 1994 swept away the last barriers to opening branches in different states
13-54
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55. Bank Regulation The Federal Deposit Insurance Corporation (FDIC)
After the massive bank failures of the 1930s, Congress set up the FDIC
The whole idea of the FDIC is to avert bank panics by assuring the public that the federal government stands behind the bank, ready to pay off depositors, if it should fail
The FDIC would rather pay another bank to take over ailing institutions rather than pay off its depositors (the FDIC has paid several hundred million dollars to a bank to get it to take over a failing bank)
13-55
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56. Bank Regulation The Federal Deposit Insurance Corporation (FDIC)
Is the FDIC in any danger of running out of money?
Not really
The Congress, the Federal Reserve, the Treasury, and all of the financial resources of the U.S. government are committed to the preservation of the FDIC
More than 99% of all banks are members of the FDIC
13-56
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57. Bank Regulation The Savings and Loan Debacle
In early 1990, the financial press was calling the S&L debacle the greatest financial scandal in the history of the United States
Incompetence, inordinate risk-taking, poor supervision, and outright fraud all played prominent roles in the decline and fall of the savings and loan industry
The S&L mess will cost hundreds of billions of dollars to clean up
Guess who gets stuck with the bill?
13-57
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58. Bank Regulation Will the Commercial Banks Go the Way of the S&Ls?
From 1987 through 1989 the nation’s commercial were in big trouble
Nearly 200 banks were going under each year
Back in the mid-and late 1970s only about 10 a year failed
More banks will fail, but of the nation’s 8,000 commercial banks, there were less than a dozen bank failures from 1998 to 2000
13-58
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