Chapter 13 Money _ Banking by jianghongl


									            Project status
• Your Concerns
• Cover the Details
• Interactions and implications

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         Money and Banking

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                            Next topics
• Goals:
      – to develop an understanding of monetary policy
      – Develop the ability to solve problems using both monetary and fiscal
      – 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
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• 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

    •It is portable and readily accepted and thus easily exchanged for goods
    and services. Money is liquid.

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               MONEY SUPPLY
Currency –
  •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),
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     Credit Unions
           MONEY SUPPLY
            =           Plus...
Savings Deposits
• Money Market Deposit Accounts (MMDAs)
  bank products – interest bearing accounts
Smaller Time Deposits < $100,000 “CD’s”

• Money Market Mutual Funds (MMMFs)
  mutual fund products
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                                   Money Defined
                                                         M1        M2
January 2008                              Currency +     56%       M1
                                 Checkable Deposits +    44%      18%
                             Small Time Deposits +                16%
                    Money Market Mutual                           14%
                 Funds Held By Individuals +

                            Savings Deposits,                     52%
                     Including Money Market +
                            Deposit Accounts

                                             Totals     $1,365    $7,499
Source: Federal Reserve System
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                                                        Billion   Billion

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               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

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           Money and Prices

• Prices affect purchasing power of
• Hyperinflation renders money
• Stabilizing money’s purchasing power
  – Intelligent management of the money
    supply – monetary policy
  – Appropriate fiscal policy
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What 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
   •Less Risk relative to bonds or other interest bearing assets

•Disadvantages of holding money as an asset
   •It earns little or no interest
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            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
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                                                  Demand for Money
                                         (a)                         (b)                               Total
                                     Transactions                   Asset                            demand for
                                     demand for                   demand for                         money, Dm
                                      money, Dt                    money, Da                         and supply
Rate of interest, i percent


                                                              +                            =5


                                             Dt                                       Da                                     Dm
                                      50   100    150   200        50   100   150   200         50   100   150   200   250   300

                                     Amount of money               Amount of money                  Amount of money
                                         demanded                      demanded                  demanded and supplied
                                    (billions of dollars)         (billions of dollars)            (billions of dollars)

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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.
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             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

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                                          THE MONEY MARKET
                                                Interaction of bond prices, interest rates,
                                                           And money supply
          Rate of interest, i (percent)

                                          10                                Suppose the money
                                                                            supply is decreased
                                          7.5                               from $200 billion, Sm,
                                                                            to $150 billion Sm1.
                                           5                           ie
                                                                                     Assume that we hold
                                          2.5                                   Dm   both money and bonds
                                                                                     at the same time.
                                                0   50   100   150   200 250 300
                                                    Amount of money demanded
                                                       (billions of dollars)

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          Rate of interest, i (percent)                    Sm1      Sm
                                          10                             A decrease in the supply of
                                                                         money creates a temporary shortage
                                          7.5                            of money, will require the sale of
                                                                         some assets to meet the need.

                                           5                        ie
                                                                            People and institutions try to
                                                                                 gain More money by
                                          2.5                            Dm      selling bonds.
                                                                            The supply of bonds increase,
                                                                                 and the prices of bonds
                                              0 50 100 150 200 250 300           decrease.
                                                                            Interest rates increase.
                                                Amount of money demanded
                                                                            At higher interest rates, people
                                                   (billions of dollars)
                                                                                 reduce the amount of
                                                                                 money they want to hold
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          Rate of interest, i (percent)                                Sm
                                          10                                Suppose the money
                                                                            supply is increased
                                          7.5                               from $200 billion, Sm,
                                                                            to $250 billion Sm2.
                                           5                           ie

                                          2.5                                Dm

                                                0   50   100   150   200 250 300
                                                    Amount of money demanded
                                                       (billions of dollars)

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          Rate of interest, i (percent)                             Sm Sm2
                                          10                                 A temporary surplus
                                                                             of money will require
                                          7.5                                the purchase of some
                                                                             assets to meet the de-
                                           5                        ie       sired level of liquidity.
                                                                         Increased demand for
                                          2.5                         Dm Bonds causes the price of
                                                                         Bonds to rise and interest
                                                                         rates To fall. We re-adjust
                                              0 50 100 150 200 250 300 our holdings of money
                                                                         and bonds to fit our
                                                Amount of money demanded
                                                                         Liquidity preference.
                                                     (billions of dollars)

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       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
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                 Federal Reserve System

                                      Board of Governors

          Federal Open Market Committee

                                   12 Federal Reserve Banks

                                                             Thrift Institutions
                                                       (Savings and Loan Associations,
               Commercial Banks                            Mutual Savings Banks,
                                                               Credit Unions)

                                            The Public
                                          (Households and

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          Federal Reserve System
  The 12 Federal Reserve Banks

                        Source: Federal Reserve Bulletin

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       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
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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
  •Consolidation Among Banks and Thrifts
  •Convergence of Services Provided by
   Financial Institutions
  •Globalization of Financial Markets
  •Electronic transactions
  •Deregulation and creation of new products
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          History of banking regulation

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• 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.

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• 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

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• 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

• 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."

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• 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.

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           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
 13 - 30   securities firm.
medium of exchange      money market mutual fund
unit of account            (MMMF)
store of value          legal tender
M1, M2, M3              transactions demand
token money             asset demand
Federal Reserve Notes   total demand for money
checkable deposits      money market
commercial banks        Federal Reserve System
thrift institutions     Board of Governors
near-monies             Federal Open Market
savings account            Committee (FOMC)
money market deposit    Federal Reserve Banks
   account (MMDA)       financial services industry
time deposits           electronic transactions

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