copyright © 2012 pearson addison-wesley. all rights reserved. chapter 15 money, banking, and...

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Chapter 15

Money, Banking, and Central Banking

Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 15-2

Introduction

During the financial meltdown and panic in 2008, Congress raised the limit of the U.S. Federal Deposit Insurance Corporation’s (FDIC) insurance against risk of loss for individual bank deposit accounts from $100,000 to $250,000.

Now some businesses provide savers with access to FDIC-insured deposits up to $50 million.

How do people obtain federal insurance covering bank deposits more than $250,000?

Reading this chapter will help you answer this question.


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

• Understand why financial intermediaries such as banks exist


Learning Objectives (cont'd)

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

• Determine the maximum potential extent that the money supply will change following a Federal Reserve monetary policy action

• Explain the essential features of federal deposit insurance


Chapter Outline

• The Functions of Money

• Properties of Money

• Defining Money

• Financial Intermediation and Banks

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


Chapter Outline (cont’d)

• Fractional Reserve Banking, the Federal Reserve, and the Money Supply

• Federal Deposit Insurance


Did You Know That ...

• In 2009, the U.S. Senate passed a resolution calling for a first-ever thorough government audit of the Federal Reserve System (the Fed) and for a complete list of its recipients of loans?

• That recent resolution that requires closer oversight of the Fed reflects congressional concerns about Fed policymaking.

• The Fed’s primary task has been to conduct monetary policy by regulating the quantity of money in circulation in the U.S. economy.


Did You Know That … (cont’d)

• Money

– Any medium that is universally accepted in an economy both by sellers of goods and services as payment for those 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 requires a double coincidence of wants


Policy Example: The Never-Ending Battle Against Counterfeiters

• If people were to lose faith in the authenticity of currency, it would not circulate as readily as a medium of exchange.

• So, the U.S. government’s Bureau of Engraving and Printing continually seeks to make U.S. currency more difficult to counterfeit, including the use of color-shifting ink, embedding watermarks, and making the composition of the paper bills hard to replicate.



• 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


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


International Policy Example: Venezuela Promotes Private Moneys—with Conditions Attached

• Today the government of Venezuela allows the use of private currencies used in different parts of the nation alongside its national currency, the bolivar.

• However, the government prevents these private currencies from competing with its own currency by not allowing these private currencies to be exchanged for the bolivar, and restricting their use to relatively small organized markets.


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 and coins

– Transactions (checkable) deposits

– Traveler’s checks


Figure 15-2 Composition of the U.S. M1 and M2 Money Supply, 2011, Panel (a)


Figure 15-2 Composition of the U.S. M1 and M2 Money Supply, 2011, 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 deposits

2.Small denomination (<$100,000) time deposits

3.Balances in retail money market mutual funds



• Question– Which definition of money correlates best with economic activity?

• Answer– M2, although some businesspeople and policymakers prefer MZM



• MZM (money-at-zero-maturity)

– Entails adding deposits without set maturities to M1

– 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

– Examples are pension funds, investment companies, and government-sponsored financial institutions such as Federal National Mortgage Association



• Liabilities

– Amounts owed

– The legal clams against a business or household by nonowners

– The sources of funds for financial intermediaries



• Assets

– Amounts owned

– All items to which a business or household holds legal claim

– The uses of funds by financial intermediaries


Table 15-2 Financial Intermediaries and Their Assets and Liabilities


Example: Mobile Payments Are Catching On

• Today nearly 10 percent of U.S. residents have used cell phones to transfer payments to another business or person.

• Almost 20 percent of young people aged 18 to 25 have used this mobile payment method.

• Most observers conclude that mobile payments will proliferate in the coming decade.


Figure 15-4 How a Debit-Card Transaction Clears


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

• 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


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

• 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 15-5 Organization of the Federal Reserve System


Figure 15-6 The Federal Reserve System



• Functions of the Fed

1. 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



• Actual and proposed expansions of the Fed’s functions

– In 2010, President Obama signed into law that added to the Fed’s functions by making it the nation’s primary regulator of systemic risk—the potential for a financial breakdown at a large institution to spread throughout banks and other firms

– Nevertheless, some economists and politicians have expressed concerns about the Fed’s expanded scale of lender-of-last-resort activities and its new role of a systemic risk regulator


Fractional Reserve Banking, the Federal Reserve, and the Money Supply

• Fractional Reserve Banking

– A system in which depository institutions hold reserves that are less than the amount of deposits• Originated when goldsmiths in Greece issued notes that exceeded the value of gold and silver on hand


• Reserves

– In the U.S. Federal Reserve System, deposits held by Federal Reserve district banks for depository institutions, plus depository institutions’ vault cash

Fractional Reserve Banking, the Federal Reserve, and the Money Supply (cont’d)


• Reserve Ratio

– The fraction of transaction deposits that banks hold as reserves

– Its size is determined by:

• Required reserves (reserves required to be held by the Fed)

• Excess reserves (additional reserves that banks voluntarily hold)



• Balance Sheet– Statements of assets (what is owned) and liabilities (what is owed)



• How a single depository institution reacts to an increase in transactions deposits, say $1 million?– We will examine the balance sheet of a single depository institution called Typical Bank



• Assumptions:1.Reserve ratio is 10 percent

2.Zero excess reserves are kept

3.Transactions deposits are the bank’s only liabilities and loans are the bank’s assets

4.Every time a loan is made, the proceeds are put into a deposit account



Reserve Ratio = 10%

Balance Sheet 15-1 Typical Bank


• Open market operations

– The purchase and sale of existing U.S. government securities (such as bonds) in the open private market by the Federal Reserve System

– What is the effect on the money supply if the Fed engages in an open market purchase by buying a $100,000 U.S. government security from a bond dealer?



Transactions deposits in Bank 1 immediately increase by $100,000.

Balance Sheet 15-2 Bank 1


• Following the deposit

– What will Bank 1 do with its additional deposits?• Bank 1 will keep $10,000 as reserves (10%) and allocates the remaining $90,000 of additional deposits to new loans.

• The borrower who receives the $90,000 loan from Bank 1 will spend these funds, which will then be deposited in another bank, say Bank 2.



Bank 2 responds to the additional deposits of $90,000 by adding $9,000 (10%) of these deposits to its reserves and loaning out the remaining $81,000.



If the funds from the $81,000 loan are deposited in an account at Bank 3, this bank will increase its loans by $72,900 after keeping $8,100 (10%) of the deposits as reserves.



• What is the effect on total deposits and the money supply?

– Eventually, total deposits and the money supply will increase by $1 million

• $100,000 original increase in deposits as the Fed paid the bond dealer in exchange for a U.S. government security

• $900,000 generated by deposit-creating bank loans



Table 15-3 Maximum Money Creation with 10 Percent Required Reserves


Figure 15-7 The Multiple Expansion in the Money Supply Due to $100,000 in New Reserves When the Reserve Ratio Is 10 Percent


• Money Multiplier

– A number that, when multiplied by a change in reserves in the banking system, yields the resulting change in the money supply



• Potential money multiplier– The reciprocal of the required reserve ratio, assuming no leakages into currency and no excess reserves

– It is equal to 1 divided by the required reserve ratio



Actual changein the money

supply= Actual money

multiplierChange in

total reserves

Potential money multiplier = 1

Reserve ratio



• Example

– Fed buys $100,000 of government securities

– Reserve ratio = 10%

Potential changein the money

supply= $100,000 = $1,000,000x

1

.10



• The actual money multiplier usually is smaller than the potential money multiplier

– Cash leakage occurs when borrowers want to hold a portion of their loans as currency outside of banks



• Real-world money multipliers

– M1 multiplier: 1.5 to 2.0

– M2 multiplier: 6.5 in the 1960s to over 12 in the mid-2000s; about 5 since then



Why Not … eliminate open market operations?

• In principle, the Federal Reserve could engage in monetary policy by varying the reserve ratio instead of open market operations.

• Since 2008 when Congress granted the Fed authority to pay interest on bank reserves, the Fed has found it difficult to bring about the desired reserve ratio by finding the precise change in the interest rate on reserves.


Federal Deposit Insurance

• Bank Run– Attempt 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

– The result would be the failure of that depository institution


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

– Current maximum of insured deposits is $250,000 per depositor per institution


Federal Deposit Insurance (cont’d)

• As can be seen in Figure 15-8, bank failure rates dropped dramatically after passage of this legislation– Between 1933 and 1984, bank failures were few

– Annual failure rates jumped again in the early and late 2000s


Figure 15-8 Bank Failures


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



• 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


You Are There: A River Currency for Riverwest, Wisconsin

• Like dozens of communities in the United States, the community of Riverwest, Wisconsin, introduces a local currency, called River Currency, in order to encourage people to purchases items from local businesses.

• This and other local currencies circulate as media of exchange as long as people are willing to accept them in trades for goods and services.


Issues & Applications: Entrepreneurs Boost FDIC Coverage—and Moral Hazard

• Because a firm owning more than one bank can offer a “single FDIC-insured account” that actually consists of multiple accounts, some entrepreneurs serve their customers by dividing their large deposits into multiple bank accounts each contains no more than the maximum insured limit of $250,000.

• This raises the moral hazard problem as it removes the incentive for these depositors to pay attention to risky bank activities.


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



• 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



• The maximum potential change in the money supply following a Federal Reserve purchase or sale of U.S. government securities– The money multiplier– The amount of reserves injected (or withdrawn) by the Fed times the potential money multiplier, which is 1 divided by the reserve ratio



• 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

copyright © 2012 pearson addison-wesley. all rights reserved. chapter 15 money, banking, and...

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