1. Chapter 13 Money and Our Banking System

2. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.13-2 Learning Objectives List the functions of money. Explain the difference between the narrowest definition of money, M1, and the next broadest definition, M2. List four of the most important functions of the Federal Reserve System (Fed). Explain how the Fed can increase the money supply.

3. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.13-3 Money Money is whatever people accept as money. Money’s principal functions are to serve as: 1.a medium of exchange, and 2.a unit of accounting.

4. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.13-4 Medium of Exchange To say that money is a medium of exchange simply means that a seller will accept it as a means of payment for a good or service.

5. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.13-5 Barter Without money, people would have to barter—exchange goods and services for other goods and services. Barter requires a double coincidence of wants, that is, each party to a transaction must want exactly what the other person has to offer.

6. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.13-6 Money and Transaction Costs Money facilitates exchange by reducing the transaction costs associated with means-of-payment uncertainty. Individuals no longer have to hold a diverse collection of goods as an exchange inventory for bartering.

7. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.13-7 Money and Specialization As a medium of exchange, money allows individuals to specialize in any area in which they have a competitive advantage, and to receive money payments for their labor.

8. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.13-8 Money as a Unit of Accounting Money is the yardstick that allows people to compare the values of goods and services in relation to one another. By using money prices, people can determine whether one item is a better bargain than another.

9. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.13-9 Liquidity An asset is liquid when it can easily be acquired or disposed of without high transaction costs and with relative certainty as to its value. Money is the most liquid asset.

10. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.13-10 What Backs Money? In a fiduciary monetary system, the value of the payments in the form of currency and checks rests on the public’s confidence that such payments can be exchanged for goods and services.

11. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.13-11 Fiat Money It is any form of money that is not backed by anything other than faith in its universal acceptance in trade. The U.S. dollar is fiat money. It has no intrinsic value.

12. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.13-12 Depository Institutions These are financial institutions that accept money from savers, which is then lent out with interest. In addition to banks, there are thrift institutions–savings and loan associations, savings banks, and credit unions.

13. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.13-13 Defining Money Supply as M1 Money Supply is the amount of money in circulation. M1 includes all currency (bills and coins), all checkable deposits, plus traveler’s checks. M1 is the narrowest definition of money supply.

14. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.13-14 Checkable Deposits These are deposit accounts against which a check can be written out. Checks are a way of transferring the ownership of deposits in financial institutions. They are normally accepted as a medium of exchange.

15. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.13-15 Credit Cards are not part of the Money Supply Using a credit card is borrowing funds from the credit card issuer for a period of several days to a period of several months. The credit car company pays for the borrower’s transaction.

16. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.13-16 M2: A Broader Definition of Money Supply M2 is equal to M1 plus the following near moneys: –Savings deposits and money market deposit accounts, –Small-denomination time deposits, and –Funds held by individuals in money market mutual funds.

17. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.13-17 Savings and Money Market Deposit Accounts Savings deposits are interest-bearing deposit accounts without set maturities. Money market deposit accounts are savings accounts with limited check- writing privileges.

18. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.13-18 Time Deposits Time deposits have set maturities, meaning that the holder must keep the funds on deposit for a fixed length of time to be guaranteed a negotiated interest return. Small-denomination time deposits are accounts with balances under $100,000.

19. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.13-19 Money Market Mutual Funds They are pools of funds from savers that managing firms use to purchase short-term financial assets, such as Treasury bills and large CDs issued by depository financial institutions.

20. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.13-20 The Federal Reserve System The Federal Reserve System, also known as the Fed, is the most important regulatory agency in the United States’ monetary system. The Fed is considered the monetary authority–our central bank.

21. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.13-21 Functions of the Fed Among its many functions, the Fed: –regulates the money supply, –supplies the economy with paper currency and coins, –provides for check collection and clearing, and –holds reserves for the nation’s depository institutions.

22. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.13-22 Fractional Reserve Banking Depository institutions do not keep 100 percent of their deposits on hand. They keep only a fraction of those deposits on hand as reserves.

23. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.13-23 Required Reserves Since its creation in 1913, the Fed has set specific reserve requirements for many banks. Banks must hold a set percentage of their total deposits either as cash in their own vaults or as deposits in their Federal Reserve district bank.

24. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.13-24 Expansion of the Money Supply A large portion of the money supply consists of funds that the Fed and customers deposit in banks. Because banks are not required to keep 100 percent of their deposits in reserve, they can use any new excess reserves to create new money.

25. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.13-25 The Money Multiplier The money multiplier gives the change in the money supply per one dollar change in the banking system’s reserves.

26. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.13-26 Factors that reduce the Money Multiplier The potential money multiplier will not be realized if: –Banks keep excess reserves. –There are currency leakages out of the system. For instance, if a loan is taken out as currency.

27. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.13-27 E-Money One of the most important recent technological innovations in the banking system is the smart card. Each time a cardholder uses a smart card, the amount of a purchase is deducted automatically from the cardholder’s balance and credited to a retailer.

28. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.13-28 Digital Cash Digital cash, also called e-cash, consists of funds contained on computer software stored on microchips and other computer devices. Its use will reduce the nation’s costs of transferring funds because people can store and instantaneously transmit digital cash along preexisting electronic networks.

29. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.13-29 Key Terms and Concepts barter checkable deposits depository institutions digital cash Fed fiduciary monetary system fractional reserve liquidity medium of exchange money market deposit accounts money market mutual funds

30. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.13-30 Key Terms and Concepts (cont.) money multiplier money supply near moneys reserve requirements reserves savings deposits small-denomination time deposits smart cards thrift institutions unit of accounting