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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.
Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-3
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
2
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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
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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
Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-6
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?
3
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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
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Table 15-1 Types of Money
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The Functions of Money
• The functions of money
Medium of exchange
Unit of accounting
Store of value (purchasing power)
Standard of deferred payment
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The Functions of Money (cont'd)
• Medium of ExchangeAny item that sellers will accept as payment
• BarterThe direct exchange of goods and services for other goods and services without the use of money
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The Functions of Money (cont'd)
• Medium of exchangeMoney facilitates exchange by reducing transaction costs associated with means-of-payment uncertainty.
Permits specialization, facilitates efficiencies
• BarterSimply a direct exchange
Double coincidence of wants
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The Functions of Money (cont'd)
• Unit of Accounting
A measure by which prices are expressed
The common denominator of the price system
A central property of money
5
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The Functions of Money (cont'd)
• 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.
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The Functions of Money (cont'd)
• 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
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Liquidity
• Liquidity
The degree to which an asset can be acquired or disposed of without much danger of any intervening loss in nominalvalue and with small transaction costs
Money is the most liquid asset.
6
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Figure 15-1 Degrees of Liquidity
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Liquidity (cont'd)
• QuestionWhat is the cost of holding money (its opportunity cost)?
• Answer It is the alternative interest yield obtainable by holding some other asset.
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Monetary Standards,or What Backs Money
• QuestionsWhat backs money?
Is it gold, silver, or the federal government?
• AnswerYour confidence
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Monetary Standards,or What Backs Money (cont'd)
• Transactions DepositsCheckable 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
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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.
Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-21
Monetary Standards,or What Backs Money (cont'd)
• 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.”
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Monetary Standards,or What Backs Money (cont'd)
• Currency and transactions deposits are money because of their
Acceptability
Predictability of value
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Defining Money
• Money is importantChanges 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 SupplyThe amount of money in circulation
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Defining Money (cont'd)
• Economists use two basic approaches to define and measure money.
The transactions approach
The liquidity approach
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Defining Money (cont'd)
• Transactions ApproachA method of measuring the money supply by looking at money as a medium of exchange
• Liquidity ApproachA method of measuring the money supply by looking at money as a temporary store of value
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Defining Money (cont'd)
• The transactions approach to measuring money: M1
Currency
Checkable (transaction) deposits
Traveler’s checks not issued by banks
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Figure 15-2 Composition of the U.S. M1 and M2 Money Supply, 2007, Panel (a)
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Figure 15-2 Composition of the U.S. M1 and M2 Money Supply, 2007, Panel (b)
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Defining Money (cont'd)
• 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.
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Figure 15-3 The Value of U.S. Currency in Circulation Outside the United States
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Defining Money (cont'd)
• 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
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Defining Money (cont'd)
• 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
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Defining Money (cont'd)
• The liquidity approach to measuring money: M2
• Near MoneysAssets that are almost money
Highly liquid
Easily converted to cash
Time deposits are an example
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Defining Money (cont'd)
• The liquidity approach: M2 is equal toM1 plus
1. Savings and small denomination time deposits
2. Balances in retail money market mutual funds
3. MMDAs
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Defining Money (cont'd)
• M2
Savings DepositsInterest-earning funds that can be withdrawn at any time without payment of a penalty
Depository InstitutionsAccept deposits from savers and lend those funds out
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Defining Money (cont'd)
• 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
13
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Defining Money (cont'd)
• 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
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Defining Money (cont'd)
• M2
Money Market Mutual FundsFunds obtained from the public that investment companies hold in common
Funds used to acquire short-maturity credit instruments
CD’s, U.S. government securities
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Defining the U.S. Money Supply
• QuestionWhich definition of money correlates best with economic activity?
• AnswerM2, although some businesspeople and policymakers prefer MZM
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Defining Money (cont'd)
• 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.
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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.
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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.
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Financial Intermediation and Banks (cont'd)
• Direct financeIndividuals purchase bonds from a business
• Indirect financeIndividuals hold money in a bank
The bank lends the money to a business
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Financial Intermediation and Banks (cont'd)
• 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
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Figure 15-4 The Process of Financial Intermediation
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Financial Intermediation and Banks (cont'd)
• QuestionWhy might people wish to direct their funds through a bank instead of lending directly to a business?
• AnswersAsymmetric informationAdverse selectionMoral hazardLarger scale and lower management costs
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Financial Intermediation and Banks (cont'd)
• Asymmetric InformationInformation possessed by one party in a financial transaction but not by the other
• Adverse SelectionThe likelihood that borrowers may use their borrowed funds for high-risk projects
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Financial Intermediation and Banks (cont'd)
• Moral HazardThe possibility that a borrower might engage in riskier behavior after a loan has been obtained
• Larger scale and lower management costsPeople can pool funds in an intermediary, reducing costs, risks.
Pension funds and investment companies are examples.
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Financial Intermediation and Banks (cont'd)
• Liabilities
Amounts owed
The sources of funds for financial intermediaries
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Financial Intermediation and Banks (cont'd)
• Assets
Amounts owned
The uses of funds by financial intermediaries
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Table 15-2 Financial Intermediaries and Their Assets and Liabilities
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Financial Intermediation and Banks (cont'd)
• Payment Intermediaries
Institutions that facilitate transfers of funds between depositors who hold transactions deposits with those institutions
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Figure 15-5 How a Debit-Card Transaction Clears
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Financial Intermediation and Banks (cont'd)
• Capital Controls Legal restrictions on the ability of a nation’s residents to hold and trade assets denominated in foreign currencies
• International Financial IntermediationFinancing investment projects in more than one country
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Table 15-3 The World’s Largest Banks
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Financial Intermediation and Banks (cont'd)
• 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
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Banking Structures Throughout the World
• The ways that banks around the world differSize
United States has banks of various sizes Europe and Japan have a few large banks
LegalUniversal bankingLimits on financial services such as insurance and bank stock ownership
Importance in financial systemMajor importancePart of a varied financial system (United States)
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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
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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
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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
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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
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Figure 15-6 Organization of the Federal Reserve System
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Figure 15-7 The Federal Reserve System
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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
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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. Acts as a “lender of last resort”
7. Regulates the money supply
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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?
23
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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.
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Figure 15-8 The Volume and Value of Federal Reserve Check Clearings Since 1985
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Summary Discussion of Learning Objectives
• The key functions of money1. Medium of exchange2. Unit of accounting 3. Store of value4. Standard of deferred payment
• Important properties of goods that serve as money
Acceptability, confidence, and predictable value
24
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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
Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-71
Summary Discussion of Learning Objectives (cont'd)
• Why financial intermediaries such as banks exist
Asymmetric information can lead to adverse selection and moral hazard problemsSavers benefit from the economies of scale
• The basic structure of the Federal Reserve System
12 district banks with 25 branchesGoverned by Board of GovernorsFederal Open Market Committee
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Summary Discussion of Learning Objectives (cont'd)
• Major functions of the Federal ReserveSupply 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
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End of Chapter 15Money, Banking, and Central Banking