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Project status

• Your Concerns

• Cover the Details

• Interactions and implications

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Money and Banking

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Next topics• Goals:

– to develop an understanding of monetary policy

– Develop the ability to solve problems using both monetary and fiscal policies

– Focus on problem solving

• Money and banking - • How banks and thrifts create money - • Monetary policy - • Extending the analysis of aggregate supply -• Economic growth – • Deficits, surpluses, and the public debt

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FUNCTIONS OF MONEY• Medium of Exchange

•What sellers generally accept and buyers generally use to pay for goods and services.

• Unit of Account•A standard unit that provides a consistent way of quoting prices.

• Store of Value•An asset that can be used to transport purchasing power from one time period to another

•Liquidity •It is portable and readily accepted and thus easily exchanged for goods and services. Money is liquid.

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MONEY SUPPLY

Currency – •Coins•Federal Reserve Notes•Little Intrinsic Value

Checkable Deposits•Commercial Banks•Thrift Institutions - An organization formed as a depository for primarily consumer savings. •Savings and Loan Associations (S&L’s),• Credit Unions

Definition…

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MONEY SUPPLY

= Plus...Near-moniesSavings Deposits• Money Market Deposit Accounts (MMDAs)

bank products – interest bearing accountsSmaller Time Deposits < $100,000 “CD’s”

• Money Market Mutual Funds (MMMFs) mutual fund products

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Money DefinedM1 M2

56%

44%M1

18%

Savings Deposits,Including Money Market

Deposit Accounts

Small Time Deposits

Money Market MutualFunds Held By Individuals

Currency

Checkable Deposits

16%

14%

52%

$1,365Billion

$7,499Billion

January 2008

Totals

++

+

+

+

Source: Federal Reserve System

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WHAT ABOUT CREDIT CARDS?

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Money Supply

• What “backs” the money supply?– Nothing!

• Why is money valuable?– Acceptability – we accept the

– Legal tender – Government designated

– Relative scarcity – relative to its utility

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Money and Prices

• Prices affect purchasing power of money

• Hyperinflation renders money unacceptable

• Stabilizing money’s purchasing power– Intelligent management of the money

supply – monetary policy– Appropriate fiscal policy

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THE DEMAND FOR MONEYWhat do we want to do with money?

•To make purchases with it•To hold it as an asset•corporate bonds – earn interest•Stocks – increase in value “we hope”•private or government bonds – earn interest•or money – earns no interest but is most liquid

•Advantage of holding money as and asset•Liquidity•Less Risk relative to bonds or other interest bearing assets

•Disadvantages of holding money as an asset•It earns little or no interest

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Demand for Money• Transactions demand, D1

– Determined by nominal GDP– Independent of the interest rate

• Asset demand, D2

– Money as a store of value– Varies inversely with the interest rate– Downward sloping demand curve

• Total money demand, Dm• Bonds are assumed as a typical asset with lower prices associated

with higher interest rates

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Demand for MoneyR

ate

of in

tere

st, i

per

cen

t

10

7.5

5

2.5

0 50 100 150 200 50 100 150 200 50 100 150 200 250 300

Amount of moneydemanded

(billions of dollars)

Amount of moneydemanded

(billions of dollars)

Amount of moneydemanded and supplied

(billions of dollars)

=+

(a)Transactionsdemand formoney, Dt

(b)Asset

demand formoney, Da

(c)Total

demand formoney, Dm

and supply

Dt Da Dm

Sm

5

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Asset Demand for Money Explained:• We have a choice of which assets to hold: money, or bonds.

• Money earns no interest while bonds do earn interest.

• When interest rates are low we recognize that the opportunity cost of holding bonds is low, so we choose to hold (demand) large amounts of money.

• When interest rates are high, the opportunity cost of holding money is high, so we choose to hold (demand) less money.

• Hence there is an inverse relationship between interest rates and demand for money.

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Interest Rates• Equilibrium interest rate

– Changes with shifts in money supply and money demand

• Interest rates and bond prices– Inversely related– Bond pays fixed annual interest payment– Lower bond price will raise the interest

rate

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Ra

te o

f in

tere

st,

i (p

erce

nt)

Amount of money demanded(billions of dollars)

0 50 100 150 200 250 300

10

7.5

5

2.5

0

Dm

ie

Sm

THE MONEY MARKETInteraction of bond prices, interest rates,

And money supply

Suppose the moneysupply is decreasedfrom $200 billion, Sm,

to $150 billion Sm1.

Assume that we holdboth money and bondsat the same time.

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Ra

te o

f in

tere

st,

i (p

erce

nt)

Amount of money demanded(billions of dollars)

0 50 100 150 200 250 300

10

7.5

5

2.5

0

Dm

ie

Sm

A decrease in the supply of money creates a temporary shortageof money, will require the sale of some assets to meet the need.

Sm1

THE MONEY MARKET

People and institutions try to gain More money by selling bonds.

The supply of bonds increase, and the prices of bonds decrease.

Interest rates increase.At higher interest rates,

people reduce the amount of money they want to hold

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Ra

te o

f in

tere

st,

i (p

erce

nt)

Amount of money demanded(billions of dollars)

0 50 100 150 200 250 300

10

7.5

5

2.5

0

Dm

ie

Sm

THE MONEY MARKET

Suppose the moneysupply is increasedfrom $200 billion, Sm,

to $250 billion Sm2.

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Ra

te o

f in

tere

st,

i (p

erce

nt)

Amount of money demanded(billions of dollars)

0 50 100 150 200 250 300

10

7.5

5

2.5

0

Dm

ie

Sm Sm2

THE MONEY MARKET

A temporary surplusof money will requirethe purchase of someassets to meet the de-sired level of liquidity.

Increased demand for Bonds causes the price of Bonds to rise and interest rates To fall. We re-adjust our holdings of money and bonds to fit our Liquidity preference.

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Centralization and Public Control• Board of Governors – 7 members• Assistance & Advice

• Federal Open Market Committee (FOMC) – 12 people buying & selling bonds

• The 12 Federal Reserve Banks• Central Bank Role• Quasi-Public Banks• Banker’s Banks• Supervise Commercial Banks & Thrifts

THE FEDERAL RESERVE AND THE BANKING SYSTEM

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Federal Reserve System

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

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Federal Reserve System

The 12 Federal Reserve Banks

Source: Federal Reserve Bulletin

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FED Functions & the Money Supply • Issuing Currency• Setting Reserve Requirements &

Holding Reserves• Lending Money to Banks & Thrifts

•Discount Rate• Providing for Check Collection• Acting as Fiscal Agent for the Govt• Supervising Banks• Controlling the Money Supply

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Some recent developments in the financial services sector.

•Relative Decline of Banks and Thrifts – decline in their % of assets held

•Financial Services Industry – changes in composition

•Consolidation Among Banks and Thrifts•Convergence of Services Provided by Financial Institutions

•Globalization of Financial Markets•Electronic transactions•Deregulation and creation of new products

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History of banking regulation

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• 1913: Federal Reserve Act creates national banking system.

• 1914: Federal Trade Commission Act prohibits unfair or deceptive business practices.

• 1933: With memories of 1929 stock crash still fresh, Glass-Steagall Act separates "commercial banks" focusing on consumer activities (checking, savings) from "investment banks," which deal with speculative trading and mergers.

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• Sept 1987: Drexel Burnham Lambert, home to "junk-bond king" Michael Milken, creates "collateralized debt obligations" (CDOS)—securities made up of myriad loans and bonds with different risk levels.

• April 1998: Citicorp and Travelers announce biggest-ever corporate merger ($70 billion); transaction technically illegal under Glass-Steagall; CEO Sandy Weill launches $12 million campaign to repeal law.

• June 1998: Conseco purchases mobile home lender turned subprime powerhouse Green Tree in $6 billion deal.

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• Nov 1999: Gramm-Leach-Bliley Act guts Glass-Steagall, setting off wave of megamergers among banks and insurance and securities companies. Driving force is Sen. Phil Gramm (R-Texas), who has received $4.6 million from FIRE sector over previous decade.

• Dec 14: As Congress heads for Christmas recess, Sen. Gramm attaches 262-page amendment to an omnibus appropriations bill. Commodity Futures Modernization Act will deregulate derivatives trading, give rise to Enron debacle, and open door to an explosion in new, unregulated securities

• April 6 2001: Fed chair Alan Greenspan signals concern with "abusive lending practices that target vulnerable segments of the population and can result in unaffordable payments, equity stripping, and foreclosure."

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• Oct 7 2002: Swiss investment bank UBS announces that Sen. Gramm is joining it to "advise clients on corporate finance issues and strategy"; he will also lobby Congress, Treasury, and Fed on banking and mortgage issues as industry pushes to eliminate predatory-lending rules.

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Major US financial institutions • Commercial banks • Bank of America, • Wells Fargo• JPMorgan Chase Bank

• Thrifts – S&L’s, mutual saving banks, credit unions• Insurance companies – • Prudential, • New York Life,

• Mutual fund companies – Fidelity, Putnam, and many more• Pension funds • TIAA-CREF, Teachers Insurance and Annuity Association,

College Retirement Equities Fund (TIAA-CREF), • Teamsters union• CalPERS – California Public Employees

• Securities firms • Merrill Lynch (part of Bank of America), • Charles Schwab, • Bear Stearns, Goldman Sachs – global investment banking and

securities firm.

medium of exchangeunit of accountstore of valueM1, M2, M3token moneyFederal Reserve Notescheckable depositscommercial banksthrift institutionsnear-moniessavings accountmoney market deposit account (MMDA)time deposits

money market mutual fund (MMMF)

legal tendertransactions demandasset demandtotal demand for moneymoney marketFederal Reserve SystemBoard of GovernorsFederal Open Market

Committee (FOMC)Federal Reserve Banksfinancial services industryelectronic transactions