money banking and central banking

Chapter 15

Money, Banking, and Central Banking

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-2

Introduction

Why is the Federal Reserve System clearing fewer checks, and what is its role in our nations financial system?

In this chapter you will learn the answers, but first you will learn more generally about money and banking.


Learning Objectives

• Define the fundamental functions of money

• Identify key properties that any goods that function 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

• Describe the basic structure of the Federal Reserve System

• Discuss the major functions of the Federal Reserve


Chapter Outline

• The Functions of Money

• Liquidity

• Monetary Standards, or What Backs Money

• Defining Money

• Financial Intermediation and Banks

• Banking Structures Throughout the World

• The Federal Reserve System


Did You Know That...

• Money includes not only coins and dollar bills, but also the balance in your checking account?

• Anything widely accepted in exchange for items of value is considered to be money?


Money

• 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

• Barter The direct exchange of goods and services

for other goods and services without the use of money



• Medium of exchange Money facilitates exchange by reducing

transaction costs associated with means-of-payment uncertainty.Permits specialization, facilitates efficiencies

• Barter 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


Liquidity

• 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


Liquidity (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.


Monetary Standards,or What Backs Money

• Questions

What backs money?

Is it gold, silver, or the federal government?

• Answer

Your confidence


Monetary Standards,or What Backs Money (cont'd)

• 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


Example: E-Gold Backed E-Money

• The Internet has served as a breeding ground for various forms of e-money.

• Gold-backed e-money effectively provides measures of the purchasing power, in terms of gold, of several major world currencies.



• 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, 2007, Panel (a)


Figure 15-2 Composition of the U.S. M1 and M2 Money Supply, 2007, Panel (b)



• M1

CurrencyMinted coins and paper currency not deposited

in financial institutions

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


Figure 15-3 The Value of U.S. Currency in Circulation Outside the United States



• M1

Transactions depositsAny deposits in a thrift institution or a

commercial bank on which a check may be written or debit card used

Thrift InstitutionFinancial institutions that receive most of their

funds from the savings of the public



• M1

Traveler’s ChecksFinancial 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

• Near Moneys

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. MMDAs



• M2

Savings Deposits Interest-earning funds that can be withdrawn at

any time without payment of a penalty

Depository InstitutionsAccept 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 DepositA 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

CDTime 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


Defining the U.S. Money Supply

• 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 MMFs 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


Figure 15-4 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.



• 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


Figure 15-5 How a Debit-Card Transaction Clears



• Capital Controls Legal restrictions on the ability of a

nation’s residents to hold and trade assets denominated in foreign currencies

• International Financial Intermediation Financing investment projects in more than

one country


Table 15-3 The World’s Largest Banks



• World Index Fund

A portfolio of bonds issued in various nations whose individual yields generally move in offsetting directions, thereby reducing the overall risk of losses


Banking Structures Throughout the World

• The ways that banks around the world differ Size

United States has banks of various sizes Europe and Japan have a few large banks

Legal Universal banking Limits on financial services such as insurance and bank

stock ownership

Importance in financial system Major importance Part of a varied financial system (United States)


Banking Structures Throughout the World (cont'd)

• Universal Banking

An environment in which banks face few or no restrictions on their powers to offer a full range of financial services and to own shares of stock in corporations


Banking Structures Throughout the World (cont'd)

• 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 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


The Federal Reserve System (cont'd)

• Organization of the Fed

Board of Governors7 members, 14-year terms

Federal Reserve Banks (12 Districts)25 branches

Federal Open Market Committee (FOMC)BOG plus 5 presidents of district banks


Figure 15-6 Organization of the Federal Reserve System


Figure 15-7 The Federal Reserve System



• Depository institutions

7,500 commercial banks

1,300 savings and loans

11,000 credit unions

• All may purchase Fed services



• 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. Acts as a “lender of last resort”

7. Regulates the money supply


Issues and Applications: Check Clearing—A Rapidly Diminishing Fed Function

• The volume of checks cleared by the Fed grew rapidly during the 1980s.

• So why has the Fed’s check clearing speed dropped since the 1990s?


Issues and Applications:Check Clearing—A Rapidly Diminishing Fed Function (cont'd)

• The reason is not due to inefficiency; rather, checks are falling out of favor.

• Government transfers are transmitted electronically—Social Security, Medicare, Medicaid.

• Electronic payments by households and businesses—debit cards, Internet bill pay, Web based services.


Figure 15-8 The Volume and Value of Federal Reserve Check Clearings Since 1985


Summary Discussion of Learning Objectives

• The key functions of money

1. 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

End of Chapter 15

Money, Banking, and Central Banking

money banking and central banking

Documents

quantity of money

major functions

federal reserve systemdiscuss

federal government

nominal value

accountingstore of value

value wealth

items of value