1. Chapter 2 Money and the Monetary System © 2003 John Wiley and Sons

2. 2 Chapter Outcomes n Describe the roles of major components of the financial system n Describe the three ways in which money is transferred from savers and investors n Explain why depository institutions are an important part of the monetary system n Describe the functions of money

3. 3 Chapter Outcomes (Continued) n Describe the functions of money n Give a brief review of the development of money in the U.S. n Briefly define the M1, M2, and M3 definitions of the money supply n Explain possible relationships between money supply and economic activity n Comment on developments in the international monetary system

4. 4 Review of the Financial System nPnPolicy Makers President, Congress & U.S. Treasury Federal Reserve Board Role: Pass laws & set fiscal & monetary policies nMnMonetary System Federal Reserve Central Bank Commercial Banking System Role: Create & transfer money

5. 5 nFnFinancial Institutions Depository Institutions, Contractual Savings organizations, Securities Firms, and Finance Firms Role: Accumulate & lend/invest savings nFnFinancial Markets Securities Markets, Mortgage Markets, Derivatives Markets, and Currency Exchange Markets Role: Market & facilitate transfer of financial assets

6. 6 S avings-Investment Process Money Securities Money Securities Firm’s Securities Intermed’s Securities Investment Banking Firm Direct Transfers: Savers Business Firm Indirect Transfers: Savers Business Firm Savers Financial Business Intermediary Firm

7. 7 Participants in the U.S. Monetary System CENTRAL BANK: Defines and Regulates Money Supply Facilitates the Transferring of Money BANKING SYSTEM: Creates Money Transfers Money Provides Financial Intermediation Processes/Clears Checks

8. 8 The U.S. Monetary System Central Bank Federal Reserve System Board of Governors Federal Reserve Banks Defines and regulates money supply Facilitates transfer of money through check processing/clearing Banking System: 1. Creates money 2. Transfers money 3. Provides financial intermediation 4. Processes/clears checks Other Banks First Bank Last Bank

9. 9 U.S. Central Bank n Federal Reserve System [often referred to as the “Fed”] n Board of Governors n Federal Reserve Banks

10. 10 Central Bank Activities n Defines and regulates money supply n Facilitates the transferring of money through check processing and clearing

11. 11 Some Basic Definitions n MONEY: Anything that is generally accepted as payment n BARTER: Exchange of goods or services without using money n LIQUIDITY: How easily an asset can be exchanged for money

12. 12 Functions of Money n MEDIUM OF EXCHANGE: The basic function of money n STORE OF VALUE: Money can be held for some period of time, without losing its value, before it is spent n STANDARD OF VALUE: Exists when prices and debts are stated in terms of the monetary unit

13. 13 Historical Types of U.S. Coins n FULL-BODIED MONEY: Coins that contain the same value in metal as their face value n TOKEN COINS: Coins containing metal of less value than their stated value

14. 14 Historical Types of U.S. Paper Currency n REPRESENTATIVE FULL-BODIED MONEY: Paper money fully backed by a precious metal n FIAT MONEY: Legal tender proclaimed to be money by law (i.e., not backed by a precious metal)

15. 15 Deposit Money in the U.S. n CREDIT MONEY: n CREDIT MONEY: Money worth more than what it is made of. It is backed by the “credit- worthiness” of the issuer n DEPOSIT MONEY: n DEPOSIT MONEY: A special type of credit money backed by the depository institution that issued the deposit

16. 16 Alternatives to “Paper Checks” n AUTOMATIC TRANSFER SERVICE (ATS) ACCOUNTS: n AUTOMATIC TRANSFER SERVICE (ATS) ACCOUNTS: Provide for direct deposits to, and payments from, checkable deposit accounts n DEBIT CARDS: n DEBIT CARDS: Provide for immediate direct transfer of deposit amounts

17. 17 Components of the M1 Definition of the Money Supply n Currency n Traveler’s Checks n Demand Deposits at Banks n Other Checkable Deposits at Depository Institutions

18. 18 Components of the M2 Definition of the Money Supply n M1 Money Supply n Savings Accounts at Depository Institutions n Small-Denomination Time Deposits n Retail Money Market Mutual Funds

19. 19 Components of the M3 Definition of the Money Supply n M2 Money Supply n Large-Denomination Time Deposits n Institutional Money Market Mutual Funds n Repurchase Agreements (Overnight and Term) n Eurodollars (Overnight and Term) Held by U.S. Residents

20. 20 Money Supply and Economic Activity Relationships n MONETARISTS’ VIEW: n MONETARISTS’ VIEW: The amount of money in circulation determines the level of economic activity n KEYNESIANS’ VIEW: n KEYNESIANS’ VIEW: Change in the money supply first causes a change in interest rates which, in turn, alters the demand for goods and services

21. 21 Monetarists’ View n BASIC EQUATION: n BASIC EQUATION: MS x VM = GDP n GROSS DOMESTIC PRODUCT (GDP): n GROSS DOMESTIC PRODUCT (GDP): Measures the output of goods and services in an economy n MONEY SUPPLY (MS): n MONEY SUPPLY (MS): Usually defined in terms of M1 or M2 n VELOCITY OF MONEY (VM): n VELOCITY OF MONEY (VM): The rate of circulation of the money supply

22. 22 Another View of GDP n BASIC EQUATION: n BASIC EQUATION: RO x PL = GDP n GROSS DOMESTIC PRODUCT (GDP): n GROSS DOMESTIC PRODUCT (GDP): Measures the output of goods and services in an economy n REAL OUTPUT (RO): n REAL OUTPUT (RO): Units of goods and services n PRICE LEVEL (PL): n PRICE LEVEL (PL): Average price of goods and services

23. 23 Two Views of GDP Combined n TWO BASIC EQUATIONS: MS x VM = GDP RO x PL = GDP n THE EQUATIONS COMBINED: n THE EQUATIONS COMBINED: MS x VM = RO x PL n NOMINAL GDP INCREASES WITH: >An increase in money supply and/or velocity of money >An increase in real output and/or price level

24. 24 International Monetary System n Historically: Tied to the gold standard n Bretton Woods System (1944): Agreement to use fixed or pegged exchange rates tied to the U.S. dollar or gold n Early 1970s: Development of a flexible or floating exchange rate system