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13 - 1
Project status
• Your Concerns
• Cover the Details
• Interactions and implications
13 - 2
Money and Banking
13 - 3
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
13 - 4
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.
13 - 5
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…
13 - 6
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
13 - 7
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
13 - 8
WHAT ABOUT CREDIT CARDS?
13 - 9
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
31-9
13 - 10
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
13 - 11
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
13 - 12
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
13 - 13
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
13 - 14
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.
13 - 15
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
13 - 16
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.
13 - 17
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
13 - 18
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.
13 - 19
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.
13 - 20
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
13 - 21
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
13 - 22
Federal Reserve System
The 12 Federal Reserve Banks
Source: Federal Reserve Bulletin
13 - 23
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
13 - 24
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
13 - 25
History of banking regulation
13 - 26
• 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.
13 - 27
• 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.
13 - 28
• 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."
13 - 29
• 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.
13 - 30
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