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Money and the Financial System
1. Barter2. What is money?3. The functions of money4. Commodity, representative, and fiat
money5. Financial intermediaries6. The Federal Reserve System7. Structure of the U.S. banking system
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Barter exchangeGoods exchange for other goods
Barter exchange is not possible without
a “double coincidence of
wants.”
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Money is anything that is generally acceptable in
exchange for goods, services, economic
resources, or for the settlement of debts
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Advantages of monetary exchange
•Eliminates the coincidence of wants problem.•Facilitates economic specialization
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Functions of money1. Medium of exchange2. Unit of account3. Store of value (or wealth)
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Liquidity refers to two properties of assets or stores of value, namely:•The ready convertibility of the asset to generalized purchasing power (or money)•The comparative safety of the asset. Money is the most
liquid asset available under normal circumstances
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Purchasing power of $1 measured in 1982-1984 constant dollars
An increase in the price level over time reduces what $1.00 buys. The price level has risen every year since 1960, so the purchasing power of $1.00 (measured in 1982-1984 constant dollars) has fallen from $3.38 in 1960 to $0.48 in 2007
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Commodity money
Anything that serves both as money and as a commodity; money that has intrinsic worth.
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Representative money
Bank notes that exchange for a specific commodity, such as gold
Examples
1. Tobacco warehouse receipts2. The Goldsmith bankers
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This Note Is Legal Tender For All Debts, Public and Private
Fiat Money: Anything which serves as a means of payment by government declaration
You are willing to accept money not because it is
“backed” by precious metals; but rather because you know it is generally acceptable in
exchange
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Six properties of ideal moneyQuality Rationale Good examples Bad examples
1. Durable
2. Portable
3. Divisible
4. Uniform quality
5. Low opportunity cost
6. Stable value
Money should not wear out quickly
Money should be easy to carry, even relatively large sums
Market exchange is easier if denominations support a range of possible prices
If money is not of uniform quality, people will hoard the best and spend the rest, reducing its quality
The fewer resources tied up in creating money, the more available for other uses
People are more willing to accept and hold money if they believe it will keep its value over time
Coins; sea shells
Diamonds; paper money
Honey; paper money and coins
Salt bricks; paper money; coins
Iron coins; paper money
Anything whose supply can be controlled by issuing authorities, such as paper money
Strawberries; seafoodLead bars; potatoes
Cattle; diamonds
Diamonds
Gold; diamonds
Farm crops
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Deposits are Money—But Checks are Not
Date Item Debit Credit Balance
1-Jul-03 Opening Balance $500.00
11-Jul-03 The Flower Shop $50.00 $450.00
(a) Rick’s Account at Delta Bank
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Date Item Debit Credit Balance
1-Jul-03 Opening Balance $3,000.00
11-Jul-03 Rick’s check $50.00 $3,050.00
(b) The Flower Shop’s Account at Delta Bank
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The Monetary System
The monetary system consists of the Federal Reserve and the
banks and other institutions that accept deposits and provide the services that
enable people and businesses to make and receive payments.
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Financial IntermediariesThese units are interposed between
depositors and borrowers1. Commercial banks2. Thrift institutions3. Money market funds: A financial
institution that obtains funds by selling shares and uses these funds to purchase assets such as U.S. Treasury bills.
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The Fractional Reserve System
•Reserves: The currency in a bank’s vaults plus the balance on its reserve account at the Federal Reserve Bank.•Required reserve ratio: The minimum percentage of deposits that banks and other financial institutions must hold in reserves.•Excess reserves: Banks reserves that exceed those needed to meet the required reserve ratio.
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Federal Funds
•Banks that have excess reserves may loan them to banks with reserve deficiencies•These loans are made in the interbank loan, or federal funds, market.•The interest rate on loans in the interbank market is the federal funds rate.
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Assets Liabilities Cash in vault Demand(checkable)
deposits Reserves on account
Savings deposits
Federal funds sold
Time deposits
Government securities
Federal funds bought
Loans
A Typical Bank Balance Sheet
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The Economic Functions of Monetary Institutions
• Create liquidity (money)• Lower costs• Pool risks• Make payments
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The Federal Deposit Insurance Corporation (FDIC)
•Created in 1933•A government agency that insures deposits in commercial banks (up to $100,000 per account).•Banks pay premiums to the FDIC
Bank failureswere often a
“self-fulfilling
prophesy.”
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Federal Reserve Act of 1913
•The history of banking in the U.S. prior to 1913 is messy—featuring widespread panic and runs on banks—for example, in 1893 and 1907.•The Federal Reserve System was created in 1913.
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The Structure of the Federal Reserve System
Senate confirms
Chair of Board of Governors
12 Federal ReserveDistrict Banks
• Lend reserves • Clear checks
• Provide currency
3,500 Member Banks
Elect 6 directorsof each
Federal ReserveBank
Appoints 3 directors of each Federal Reserve BankPresident
appoints
Federal Open MarketCommittee
(7 Governors + 5 Reserve Bank Presidents)
• Conducts open market operations to control the money supply
Board of Governors(7 members, including chair)
• Supervises and regulates member banks
• Supervises 12 Federal Reserve District Banks
• Sets reserve requirements and approves discount rate
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The twelve Federal Reserve Districts
The map shows by color the area covered by each of the 12 Federal Reserve districts. Black dots note the locations of the Federal Reserve Bank in each district. Identified with a star is the Board of Governors headquarters in Washington, D.C.
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The instruments of monetary policy
• Reserve requirements• The discount rate• Open market
operations
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Legislation:•Federal Reserve Act of 1913•DIDMCA of 1982
Depository institutionsare required by law to
hold a minimum fractionof their liabilities on account at the FED
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The discount rate The rate of interest charged on loans made at the FED discount window.
The FED is known as the “lender of last resort” to the
banking system
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Discount Window Borrowings have surged since December, 2007 as the Fed has sought to stabilize the financial system amid a rash of defaults on subprime debt.
Billi
ons
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Open market operationsare the purchase or sale ofU.S. government securitieson the open market by the
Federal Reserve system
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The FED Open Market Committee is the unit in
charge ofopen market operations
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Failures of US savings banks peaked in 1989
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Failures of US commercial banks peaked in 1988
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Exhibit 7
• Number of commercial banks declined over the last two decades, but the number of branches continue to grow
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• (a) Largest US banks based on total domestic deposits
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• (b) World’s largest banks based on total assets