12“If you think nobody

cares if you’re alive, try missing

a couple of car payments.”

Earl WilsonUS Representative

Money andBanking

Chapter Objectives

The Functions of Money and the Components of the U.S. Money Supply

What “Backs” the Money Supply, Making Us Willing to Accept It?

The Makeup of the Federal Reserve and the U.S. Banking System

The Functions and Responsibilities of the Federal Reserve

2

Money Defined

The Functions of MoneyMedium of Exchange

Means of exchanging goods and services without barter.

Any item sellers generally accept and buyers generally use to pay for goods and services.

Unit of Account Standard unit in which prices can be stated

and the value of goods and services can be compared.

Store of Value An asset set aside for future use.

3

Money Defined

Money Supply ComponentsCurrency

Coins = “token money” Intrinsic value of metal in coin must be less

than face value of coin. Paper = “folding money”

Federal Reserve Notes, issued by Federal Reserve system.

Checkable Deposits “checkbook money”

Checking account balances are easily converted into currency on demand, so checks drawn on these accounts are considered equivalent to currency. 4

Money Defined

Money Supply ComponentsOther liquid savings deposits = “Near-monies” (not medium of exchange, but easily converted)

Savings accounts Money market deposits

Interest-bearing savings, minimum balance and time restrictions

Time deposits Certificates of deposits (CD’s), earns interest,

can’t be withdrawn before time expires without penalty

Money market mutual funds held by individuals Interest-bearing pooled funds offered by

investment firms.5

Money Defined

Measuring the Money SupplyNOTE: Money supply measures do NOT include money in the banks, US Treasury, Federal Reserve or other financial institutions. This would result in double-counting. We only count money held by the public.

M1 Money Supply = Currency + Checkable deposits

M2 Money Supply = M1 + near monies listed on previous slide

6

Money SupplyFebruary 2006

M1 M2

54%

46%M120%

Savings DepositsIncluding Money Market

Deposit Accounts (MMDA)

Small Time Deposits

Money Market MutualFunds Held By Individuals

(MMMF)

CurrencyCheckable Deposits

15%

11%

54%

$1,375Billion

$6,758Billion

Totals

+++

+

+

7

Money Supply

Are Credit Cards Money? NO. Credit cards are a means of postponing payment. The checking account balance used to pay the credit card bill is money. The credit card is not.

What “Backs” the Money Supply?Money supply is backed (guaranteed) by government’s ability to keep the value of money relatively stable.

8

Money Supply

Money as Debt Major components of the money supply are

debts (promises to pay).

Paper currency and checkable deposits have no intrinsic value

Paper money cannot be redeemed for gold or other tangible asset, only for other paper money.

Checkable deposits are only redeemable for paper money.

Monetary authorities attempt to maintain amount of money needed for volume of business activity necessary for full employment.

9

Money Supply

Value of Money Acceptability

Currency is money because people accept it in exchange for goods and services.

Legal Tender

“This note is legal tender for all debts public and private.”

Currency is legal means of payment of debt (but firms are NOT legally required to take cash instead of other forms of payment). 10

Money Supply

Value of MoneyRelative Scarcity

Value of money depends on supply and demand of money. Value is derived from its scarcity, just like

everything else. With relatively constant demand, value

is determined by supply. So what happens to value of money

when money supply increases? What will then happen to prices when

money supply increases?

11

Money Supply

Money and Prices Purchasing power = amount of goods and

services a unit of money will buy, which varies inversely with price level.

Purchasing Power of the Dollar:$V = 1/(Price index/100)

Examples: If CPI = 100, purchasing power of dollar = 1/1.00 =

1 If CPI increases to 135, purchasing power of dollar

falls to 1/1.35 = 0.74 (by what percentage does purchasing power fall for this 35% increase in price?)

12

Federal Reserve System

The Federal Reserve Bank of the United States

aka “the Fed,” central bank of the US

Established with the Federal Reserve Act of 1913

Government’s bank

Bank’s bank

Monetary authority of the US

13

Federal Reserve System

The Federal Reserve Bank of the United States Central authority of US money and banking

system is Fed’s Board of Governors. Seven members, appointed by president,

confirmed by senate (like cabinet members and supreme court justices).

Serve 14 year terms, providing continuity, experience, and independence from political pressures.

One member selected by president to be chairperson (previous chair was Alan Greenspan, served over 18 years. Who is the current chair? The guy in the picture?).

14

Federal Reserve System

The Federal Reserve Bank of the United States Twelve district banks serve collectively as

central bank.

Quasi-public banks, blending private ownership and public control.

Each district bank is owned by private banks in the district.

Federally chartered banks are required to buy stock in the Fed bank in their district.

15

Federal Reserve System

The Federal Reserve Bank of the United States Twelve district banks serve collectively as

central bank.

Policies are established and coordinated by Board of Governors, a government body.

The Fed and its district banks are not profit motivated like private banks.

Their goal is overall economic stability.

If the Fed has an operating profit, it transfers the profit to the US Treasury.

16

Federal Reserve System

The Federal Reserve Bank of the United States

Twelve district banks serve collectively as bank’s bank. They perform the same functions for banks as

banks provide to consumers. Banks have accounts at their district bank and

they can borrow from that banks. Fed banks are “lender of last resort” for local

banks, ensuring they have liquidity to serve our needs (e.g., after 9/11 attacks, when hurricanes hit . . .)

District banks also issue currency to private member banks (district number printed on each bill).

17

Federal Reserve SystemThe 12 Federal Reserve Banks

Source: Federal Reserve Bulletin

18

Federal Reserve System

The Federal Reserve Bank of the United StatesFederal Open Market Committee (FOMC) aids Board of Governors in conducting monetary policy.

FOMC is made up of 12 members, including all 7 of Board of Governors, president of NY district bank, and 4 other presidents who rotate on 1-year terms.

FOMC meets every six weeks to determine direction of monetary policy, conduction open market operations (buy and sell bonds) to control money supply and influence interest rates (more on this later).

19

Framework of the Federal Reserve System and the Relationship to the Public

Commercial BanksThrift Institutions

(Savings and Loan Associations,Mutual Savings Banks,

Credit Unions)

The Public(Households and

Businesses)

12 Federal Reserve Banks

Board of Governors

Federal Open Market Committee

20

Federal Reserve System

Fed Functions and the Money SupplyFederal Reserve Independence

Fed is an independent agency of government to protect it from political pressure so it can effectively control money supply and maintain price stability.

Political pressure would likely result in inflationary pressure, low interest rates, even when economy needs higher rates.

Research shows that nations with independent central banks have lower rates of inflation than countries that don’t.

21

Key Terms

Medium of exchange Unit of account Store of value M1 Token money Federal Reserve

notes Checkable deposits Commercial banks Near-monies M2 Savings account Time deposits

Legal tender Federal Reserve

System Board of Governors Federal Reserve

Banks Federal Open Market

Committee (FOMC)

22

Money and BankingWrap-Up

23

3 Functions of Money

Value of Money

Measures of

Money Supply

Money and Prices

Money The Fed

FOMC

12 District Banks

Bank's Bank

Board of Governors

Politically Independe

nt