chapter 15 money, banking, and central...

Copyright ©2011 by Pearson Education, Inc.All rights reserved.

Chapter 15

Money, Banking, and Central Banking

15-2Copyright © 2011 Pearson Education, Inc. All rights reserved.

Introduction

In the financial panic of 2008 and other financial panics throughout history, the values of financial assets, such as bonds and bank loans, have decreased and banks and other financial institutionshave collapsed

Since 1933, federal deposit insurance has helped protect the funds of those who hold deposits with banks and helped limit the potential for panics to occur

What is the structure of the U.S. banking system, how are bank deposits insured, and what is the Federal Reserve’s role?

Reading this chapter will help you answer these questions


Learning Objectives

• Define the fundamental functions of money

• Identify key properties that any good that functions as money must possess

• Explain official definitions of the quantity of money in circulation


Learning Objectives (cont'd)

• Understand why financial intermediaries such as banks exist

• Explain the essential features of federal deposit insurance

• Describe the basic structure and functions of the Federal Reserve System


Chapter Outline

• The Functions of Money

• Properties of Money

• Defining Money

• Financial Intermediation and Banks

• Federal Deposit Insurance

• The Federal Reserve System: The U.S. Central Bank


Did You Know That...

• An increasing number of residents of the Solomon Islands in the South Pacific are choosing to use dolphin teeth as a form of money?

• This is happening because:

– Tribal strife has been on an upswing, and a time-honored way to resolve personal disputes is to pay dolphin teeth as a form of compensation

– There has been an upsurge in the population of marriageable young people, and each groom traditionally provides his bride with dolphin teeth as a dowry

– The amount of goods and services that a Solomon Islands dollar can buy has decreased


Did You Know That… (cont’d)

• Coins, paper currency, and bank accounts from which people transmit debit-card and check payments are included in the Federal Reserve’s measure of the total amount of money that we can use to purchase goods and services

• Money has been important to society for thousands of years and is part of our everyday existence


Did You Know That… (cont’d)

• Money

– Any medium that is universally accepted in an economy both by sellers of goods and services and by creditors as payment for debts


Table 15-1 Types of Money


The Functions of Money

• The functions of money

– Medium of exchange

– Unit of accounting

– Store of value (purchasing power)

– Standard of deferred payment


The Functions of Money (cont'd)

• Medium of Exchange– Any item that sellers will accept as payment

– Money facilitates exchange by reducing transaction costs associated with means-of-payment uncertainty• Permits specialization, facilitates efficiencies



• Barter– The direct exchange of goods and services for

other goods and services without the use of money

– Simply a direct exchange• Double coincidence of wants



• Unit of Accounting

– A measure by which prices are expressed

– The common denominator of the price system

– A central property of money



• Store of Value

– The ability to hold value over time

– A necessary property of money

– Money allows you to transfer value (wealth) into the future



• Standard of Deferred Payment

– A property of an item that makes it desirable for use as a means of settling debts maturing in the future

– An essential property of money


Example: Cash-Squeezed Small Businesses Resort to Barter

• In the Great Recession of the late 2000s, so many small businesses in the United States were low on cash that they resorted to bartering goods and services

• In many cases, small businesses allowed customers pinched for cash and behind on paying their bills to provide goods and services instead

• Estimates indicate that during 2008 and 2009, small U.S. companies conducted barter transactions worth nearly $25 billion


International Example: Spooked Savers Choose Precious Metals as Stores of Value over National Moneys

• During the financial panic in 2008, many savers fretted that the U.S. dollar, the British pound, and the European euro might lose much of their future values in terms of goods and services

• A number of these worried savers sought out precious metals such as gold and silver as stand-by stores of value

• One resident of Idaho paid $3,000 to have 100,000 ounces of silver transported from New York by armored truck

• Are precious metals more or less easy to use as media of exchange than national moneys such as dollars, pounds, or euros?


Properties of Money

• Liquidity

– The degree to which an asset can be acquired or disposed of without much danger of any intervening loss in nominal value and with small transaction costs

– Money is the most liquid asset


Figure 15-1 Degrees of Liquidity


Properties of Money (cont’d)

• Question– What is the cost of holding money (its

opportunity cost)?

• Answer – It is the alternative interest yield obtainable by

holding some other asset



• Questions– What backs money?

– Is it gold, silver, or the federal government?

• Answer– Your confidence



• Transactions Deposits

– Checkable and debitable account balances in commercial banks and other types of financial institutions, such as credit unions and mutual savings banks

– Any accounts in financial institutions on which you can easily transmit debit-card and check payments without many restrictions



• Fiduciary Monetary System

– A system in which currency is issued by the government and its value rests on the public’s confidence that it can be exchanged for goods and services

– The Latin fiducia means “trust” or “confidence”



• Currency and transactions deposits are money because of their

– Acceptability

– Predictability of value


Defining Money

• Money is important– Changes in the rate at which the money supply increases

or decreases affect important economic variables (at least in the short run) such as inflation, interest rates, employment, and the level of real GDP

• Money Supply– The amount of money in circulation


Defining Money (cont'd)

• Economists use two basic approaches to define and measure money

– The transactions approach

– The liquidity approach



• Transactions Approach– A method of measuring the money supply by

looking at money as a medium of exchange

• Liquidity Approach– A method of measuring the money supply by

looking at money as a temporary store of value



• The transactions approach to measuring money: M1

– Currency

– Checkable (transaction) deposits

– Traveler’s checks not issued by banks


Figure 15-2 Composition of the U.S. M1 and M2 Money Supply, 2009, Panel (a)


Figure 15-2 Composition of the U.S. M1 and M2 Money Supply, 2009, Panel (b)



• M1

– Currency• Minted coins and paper currency not deposited in

financial institutions

• The bulk of currency “in circulation” actually does not circulate within the U.S. borders



• M1

– Transactions deposits• Any deposits in a thrift institution or a commercial bank

on which a check may be written or debit card used

– Thrift Institution• Financial institutions that receive most of their funds

from the savings of the public



• M1

– Traveler’s Checks• Financial instruments purchased from a bank or a

nonbanking organization and signed during purchase that can be used as cash upon a second signature by the purchaser



• The liquidity approach to measuring money: M2

• Assets that are almost money

• Highly liquid

• Easily converted to cash

• Time deposits are an example



• The liquidity approach: M2 is equal to M1 plus

1. Savings and small denomination time deposits

2. Balances in retail money market mutual funds

3. Money market deposit accounts (MMDAs)



• M2

– Savings Deposits• Interest-earning funds that can be withdrawn at any

time without payment of a penalty

– Depository Institutions• Financial institutions that accept deposits from savers

and lend those funds out



• M2

– Money Market Deposit Accounts (MMDAs)• Accounts issued by banks yielding a market rate of

interest with a minimum balance requirement and a limit on transactions

• They have no minimum maturity



• M2

– Time Deposit• A deposit in a financial institution that requires notice of

intent to withdraw or must be left for an agreed period

• Early withdrawal may result in a penalty

– CD• Time deposit with fixed maturity



• M2

– Money Market Mutual Funds

• Funds obtained from the public that investment companies hold in common

• Funds used to acquire short-maturity credit instruments

– CD’s, U.S. government securities



• Question– Which definition of money correlates best with

economic activity?

• Answer– M2, although some businesspeople and

policymakers prefer MZM



• MZM (money-at-zero-maturity)

• MZM entails adding deposits without set maturities to M1

• MZM includes all money market funds but excludes all deposits with fixed maturities


Financial Intermediation and Banks

• Most nations have a banking system that encompasses two types of institutions

1. One type consists of private banking institutions

2. The other type of institution is a central bank


Financial Intermediation and Banks (cont'd)

• Central Bank

– A banker’s bank, usually an official institution that also serves as a country’s treasury’s bank

– Central banks normally regulate commercial banks



• Direct finance– Individuals purchase bonds from a business

• Indirect finance– Individuals hold money in a bank

– The bank lends the money to a business



• Financial Intermediation

– The process by which financial institutions accept savings from businesses, households, and governments and lend the savings to other businesses, households, and governments

• Financial intermediaries

– Institutions than transfer funds between ultimate lenders (savers) and ultimate borrowers


Figure 15-3 The Process of Financial Intermediation



• Question– Why might people wish to direct their funds

through a bank instead of lending directly to a business?

• Answers– Asymmetric information

– Adverse selection

– Moral hazard

– Larger scale and lower management costs



• Asymmetric Information– Information possessed by one party in a financial

transaction but not by the other

• Adverse Selection– The likelihood that borrowers may use their

borrowed funds for high-risk projects



• Moral Hazard– The possibility that a borrower might engage in

riskier behavior after a loan has been obtained

• Larger scale and lower management costs– People can pool funds in an intermediary,

reducing costs, risks

– Pension funds and investment companies are examples


E-Commerce Example: “Loan Funds”Move Online

• Some online financial firms have started “loan funds,” which pool together the funds of small savers and use the funds to make loans to individual borrowers

• One Web-based loan fund is Pertuity, which extends loans to individual borrowers and then bundles the loans together into groups based on their relative degrees of risk of borrower default



• Liabilities

– Amounts owed

– The sources of funds for financial intermediaries



• Assets

– Amounts owned

– The uses of funds by financial intermediaries


Table 15-2 Financial Intermediaries and Their Assets and Liabilities



• Payment Intermediaries– Institutions that facilitate transfers of funds between

depositors who hold transactions deposits with those institutions

• Payment Intermediation

– A recent study revealed that revenues derived from debit-card and checking transfer services accounted for 28% of the bank’s total earnings

– Another 10% of earnings were generated from processing payments for credit cards, stocks, and bonds


Figure 15-4 How a Debit-Card Transaction Clears


Federal Deposit Insurance

• In 1933, at the height of bank failures, the Federal Deposit Insurance Corporation (FDIC) was founded to insure the funds of depositors and remove the reason for runs on banks–The FDIC is a government agency that

insures the deposits held in banks and most other depository institutions; all U.S. banks are insured this way


Federal Deposit Insurance (cont’d)

• As can be seen in Figure 15-5, bank failure rates dropped dramatically after passage of this legislation– From WWII to 1984, fewer than nine banks failed

per year – From 1985 to the beginning of 1993, however,

1,065 commercial banks failed – averaging 120 bank failures per year


Figure 15-5 Bank Failures


Federal Deposit Insurance (cont’d)

• Bank Runs– Attempts by many of a bank’s depositors to

convert transactions and time deposits into currency out of fear that the bank’s liabilities may exceed its assets


Financial Deposit Insurance (cont’d)

• The FDIC charges premiums to depository institutions based on their total deposits

• These premiums go into funds that would reimburse depositors in the event of bank failures

• This bolsters depositors’ trust in the system and gives them incentive to leave their deposits in the bank, even in the face of talk of bank failures



• Until the 1990s, all insured depository institutions paid the same fee for coverage, regardless of how risky their assets were

• Banks then had an incentive to invest in more assets of higher risk (and higher yield)

• The FDIC and other federal agencies possess regulatory powers to offset the risk-taking temptations

• Higher capital requirements were imposed in the early 1990s and adjusted in 2000



• Adverse selection – deposit insurance shields depositors from the potential adverse effects of risky decisions, so depositors are willing to accept riskier investment strategies by their banks

• Moral hazard – Insured depositors know they won’t suffer losses if their bank fails, so they have little incentive to monitor their bank’s activities. Insured banks have incentives to take on more risks than they otherwise would



• The results of moral hazard

– The S&L crisis of the late-1980s

• More than 1,500 savings and loan associations failed

• The estimated taxpayer cost was $200 billion

– In the late-2000s

• Dozens of banks failed and hundreds more banks received bailouts

• The estimated taxpayer cost was >$1 trillion



• The Federal Deposit Insurance Reform Act of 2005– Expanded coverage of the federal deposit

insurance and potentially increased moral hazard problems

– Provides the FDIC with improved tools for addressing moral hazard risks: • Deposit Insurance Fund (DIF)• Altered rule on FDIC deposit insurance premiums



• During the banking troubles of the late 2000s:

– Congress sought to increase the public’s confidence in depository institutions by temporarily extending federal deposit insurance to cover virtually all of the deposits in the banking system

– But, it also expanded the moral hazard risks of deposit insurance


The Federal Reserve System: The U.S. Central Bank

• Central banks and their roles

1. Perform banking functions for their nations’governments

2. Provide financial services for private banks

3. Conduct their nations’ monetary policies


The Federal Reserve System: The U.S. Central Bank (cont’d)

• The Fed

– The Federal Reserve System; the central bank of the United States

– The most important regulatory agency in the U.S. monetary system

– Established in 1913 by the Federal Reserve Act; signed by President Woodrow Wilson



• Organization of the Fed– Board of Governors

• 7 members, 14-year terms – Chairman Ben Bernanke

– Federal Reserve Banks (12 Districts)

• 25 branches

– Federal Open Market Committee (FOMC)

• Board of governors plus 5 presidents of district banks


Figure 15-6 Organization of the Federal Reserve System


Figure 15-7 The Federal Reserve System


The Federal Reserve System (cont'd)

• Depository institutions – 7,500 commercial banks

– 1,300 savings and loans

– 11,000 credit unions

• All may purchase Fed services


The Federal Reserve System (cont'd)

• Functions of the Fed1. Supplies the economy with fiduciary currency

2. Provides a payment-clearing system

3. Holds depository institutions’ reserves

4. Acts as the government’s fiscal agent

5. Supervises depository institutions

6. Regulates the money supply

7. Intervenes in foreign currency markets

8. Acts as the “lender of last resort”



• Lender of last resort

– The Federal Reserve’s role as an institution that is willing and able to lend a temporary illiquid bank that is otherwise in good financial condition to prevent the bank’s illiquid position from leading to a general loss of confidence in that bank or in others

– When many banks, nonbank financial institutions, and other companies struggled with serious financial difficulties in the late 2000s, the Fed provided hundreds of billions of dollars in direct lender-of-last-resort assistance these institutions and companies

– Some observers and some members of Congress are questioning the magnitude of the Fed’s last-resort lending


Policy Example: Is the Fed Facing a Future Restructuring?

• Since 2002, annual expenses incurred by the Federal Reserve System as a whole have increased even as the volume of services has declined

• As a consequence, the U.S. Senate voted 96-2 in favor of a resolution calling for “an evaluation of the appropriate number and the associated costs of Federal Reserve banks”


Issues and Applications: The Federal Reserve’s Role in the Panic of 2008

• During the financial panic of 2008, the Fed expanded its role by:

– Responding to a “liquidity crunch” by developing a new auction program, in which institutions could bid for funds by offering interest rates at which they were willing to borrow

– Broadening its special funds auction program to include investment banks

– Buying debts of other kinds of firms, such as the auto credit provider GMAC and the insurance giant AIG


Summary Discussion of Learning Objectives

• The key functions of money1. Medium of exchange

2. Unit of accounting

3. Store of value

4. Standard of deferred payment

• Important properties of goods that serve as money– Acceptability, confidence, and predictable value


Summary Discussion of Learning Objectives (cont'd)

• Official definitions of the quantity of money in circulation

– M1: the narrow definition, focuses on money’s role as a medium of exchange

– M2: a broader one, stresses money’s role as a temporary store of value



• Why financial intermediaries such as banks exist– Asymmetric information can lead to

adverse selection and moral hazard problems

– Savers benefit from the economies of scale



• Features of Federal Deposit Insurance– Provides deposit insurance by charging some

depository institutions premiums based on the value of their deposits

– These funds are placed in accounts for use in reimbursing failed banks’ depositors.

– This creates adverse selection and moral hazard problems



• The basic structure of the Federal Reserve System– 12 district banks with 25 branches– Governed by Board of Governors– Federal Open Market Committee



• Major functions of the Federal Reserve

– Supply the economy with currency

– Provide systems for transmitting and clearing payments

– Holding depository institutions’ reserves

– Acting as the government’s fiscal agent

– Supervising banks

– Acting as a “lender of last resort”

– Regulating the money supply

– Intervening in foreign exchange markets

chapter 15 money, banking, and central...

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