Lecture Texas A M University Corpus Christi Faculty Federal Deposit Insurance Corporation

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Lecture Texas A M University Corpus Christi Faculty  Federal Deposit Insurance Corporation Powered By Docstoc
					       ECON2301 - Principles of

           Instructor: Patrick M. Crowley

    Lecture 15 – Money, Banking and Central

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...

   It is illegal to carry on your person more than $5
    worth on pennies or nickels out of the U.S.
   Recent upswings in prices of zinc and copper
    have pushed the value of these metals used in
    the coins above the coins’ face value.
   By banning the international transport and
    melting of pennies and nickels, the government is
    trying to prevent people from profiting from
    selling coins that are already generating losses to
Defn: Money = Any medium that is universally
 accepted in an economy both by sellers of goods
 and services and by creditors as payment for
Many different types of goods have been used as
 money historically.
Defn: Commodity money = Any physical good that
 is used as money
Defn: Fiat money = A physical good or paper money
 that is declared to be money by decree
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 for
        purchase of goods and services
       Money facilitates exchange by reducing transaction
        costs associated with means-of-payment uncertainty.
           Permits specialization, facilitates efficiencies

   Barter
       The direct exchange of goods and services for other
        goods and services without the use of money
       Simply a direct exchange
           Double coincidence of wants
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

   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.                                                8
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

   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
       Money is the most liquid asset.

Liquidity (cont'd)
   Question
       What is the cost of holding money (its opportunity

   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

International Example: A Virtual Money Becomes
Widely Accepted in China

   In China, almost 250 million people regularly conduct
    exchanges using electronic ―QQ coins.‖
   Originally, QQ coins were a company marketing ploy, used
    to finance purchases of virtual flowers, cellphone ringtones,
   Recently, people have begun accepting QQ coins in
    exchange for physical items, such as CDs, movie DVDs, and
   Is there any particular reason that moneys that people find
    acceptable in exchange must be issued by a government?
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

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.‖

Defn: Fiduciary money = money in transaction accounts
 with financial institutions
   Currency and transactions deposits are money because
    of their
       Acceptability
       Predictability of value                                     15
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.

Defn: Money Supply = The amount of money in
   Economists use two basic approaches to define and
    measure money.
       The transactions approach
       The liquidity approach                                       16
Defining Money (cont'd)
   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

Defining Money (cont'd)
   The transactions approach to measuring money:
       Currency
           Minted coins and paper currency not deposited in financial
           The bulk of currency ―in circulation‖ actually does not
            circulate within the U.S. borders.

       Checkable (transaction) deposits
       Traveler’s checks not issued by banks

Figure 15-2 Composition of the U.S. M1
and M2 Money Supply, 2009, Panel (a)

Sources: Federal Reserve Bulletin; Economic Indicators, various issues; author’s
Figure 15-2 Composition of the U.S. M1
and M2 Money Supply, 2009, Panel (b)

Sources: Federal Reserve Bulletin; Economic Indicators, various issues; author’s
Figure 15-3 The Value of U.S. Currency in
Circulation Outside the United States

Defining Money (cont'd)
   M1
       Transactions deposits
            Any deposits in a thrift institution or a commercial bank on
             which a check may be written or debit card used

       Thrift Institution
            Financial institutions that receive most of their funds from
             the savings of the public

Defining Money (cont'd)
   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

    Defining Money (cont'd)
   The liquidity approach: M2 is equal to M1 plus
    1.   Savings and small denomination time deposits
        Savings Deposits = Interest-earning funds that can be
         withdrawn at any time without payment of a penalty
        Time Deposit = A 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

    2,   Balances in retail money market mutual funds
             Funds obtained from the public that investment companies hold in
             Funds used to acquire short-maturity credit instruments       24

             CD’s, U.S. government securities
Defining Money (cont'd)
   M2 (cont)
    3. MMDAs
       Money Market Deposit Accounts (MMDAs)
           Accounts issued by banks yielding a market rate of interest
            with a minimum balance requirement and a limit on
           They have no minimum maturity

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         26
    with fixed maturities.
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
       Usually these are wholly owned by the state
       Central banks normally regulate commercial banks
       They usually are the sole institution responsible for
        monetary policy
       They are responsible for tracking and issuing money
        in the economy

Financial Intermediation
and Banks (cont'd)
   Direct finance
       Individuals purchase bonds from a business

   Indirect finance
       Individuals hold money in a bank
       The bank lends the money to a business
       Indirect finance uses financial intermediation

   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              28
Figure 15-4 The Process of Financial

Financial Intermediation
and Banks (cont'd)
   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

Financial Intermediation
and Banks (cont'd)
Defn: Asymmetric Information = Information
 possessed by one party in a financial transaction
 but not by the other
Defn: Adverse Selection = The likelihood that
 borrowers may use their borrowed funds for high-
 risk projects
Defn: Moral Hazard = The possibility that a
 borrower might engage in riskier behavior than
 expected after a loan has been obtained

E-Commerce Example: Watch Out Banks! Here
Come Zopa and Circleone

 At and, lenders and
  borrowers can engage in transactions without
  dealing with traditional financial intermediaries.
 Both Web sites’ systems rate prospective
  borrowers according to credit scores and provide
  estimated loan default rates. Thus, lenders can
  charge less creditworthy applicants higher
  interest rates.
E-Commerce Example: Watch Out Banks! Here
Come Zopa and Circleone (cont’d)

 These electronic financial intermediaries profit
  by charging fees from 1 to 1.5% of the total
  amount of a borrower’s loan.
 Zopa divides loans into separate shares so that a
  lender can share the risks of a loan with other
  lenders. How does this practice potentially help
  limit each lender’s exposure to moral hazard
Financial Intermediation
and Banks (cont'd)
   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

Figure 15-5 How a Debit-Card
Transaction Clears

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 Intermediation
       Financing investment projects in more than
        one country

Financial Deposit Insurance (cont’d)
   The Federal Deposit Insurance Reform Act of 2005
     Expanded coverage of the federal deposit insurance and
      potentially increased moral hazard problems.
     Provides the FDIC with improved tools for addressing moral
      hazard risks:
         Deposit Insurance Fund (DIF)
         Altered rule on FDIC deposit insurance premiums
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 (Germany)

          Limits on financial services such as insurance and
           bank stock ownership (USA)
       Importance in financial system
          Major importance (Germany)

          Part of a varied financial system (USA)

Banking Structures
Throughout the World (cont'd)
Defn: 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’
    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
       Partially state owned and partially privately owned
        (by US commercial banks)

The Federal Reserve System (cont'd)
   Organization of the Fed
       Board of Governors
           7 members, 14-year terms

       Federal Reserve Banks (12 Districts)
           25 branches ( - nearest to us is San Antonio)

       Federal Open Market Committee (FOMC)
           BOG plus 5 presidents of district banks
           Effectively the policy making body of the Fed

Figure 15-6 Organization of the
Federal Reserve System

Figure 15-7
The Federal Reserve System

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

The Federal Reserve System (cont'd)
   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
   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?
       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

Issues and Applications: The Crash of 2008 and the
Decline of Investment Banking

   Since the 1990’s, two of the largest financial
    intermediaries in the world have been Fannie Mae and
    Freddie Mac.
   These institutions have specialized in buying hundreds
    of billions of dollars of private mortgage loans from
    banking institutions with funds that they raised by
    issuing mortgage-backed securities purchased by
    private investors.
   Both Fannie Mae and Freddie Mac have been
    government sponsored enterprises.
Issues and Applications: The Crash of 2008 and the
Decline of Investment Banking (cont'd)

    This meant that if either institution became unable to honor its
     obligations, most investors anticipated that the federal government
     would step in to bail them out.
    In the summer and fall of 2008, this is exactly what happened.
    Between 2007 and 2008, average U.S. housing prices declined by more
     than 15%. When people stopped paying on their mortgages, receipts by
     Fannie Mae and Freddie Mac plummeted. Both experienced billions of
     dollars of losses.
    Because investors had known that the government stood behind the
     institutions’ mortgage-backed securities, they were willing to regard
     them as nearly free of risk.
Issues and Applications: The Crash of 2008 and the
Decline of Investment Banking (cont’d)

   This had given Fannie Mae and Freddie Mac an incentive
    to issue too many of these securities and to purchase too
    many low-quality, risky mortgages from banking
   A similar problem also caused ―investment banks‖ to cease
    to exist.
   Why do you suppose that many economists suggest that a
    major U.S. government push for Fannie Mae and Freddie
    Mac to encourage more lending to lower-income households
    in the 2000s helped to enlarge the “moral hazard” problem?
   Defn of money – commodity vs fiat money
   The key functions of money
   Important properties of goods that serve as money
   Official definitions of the quantity of money in circulation
   Why financial intermediaries such as banks exist
   The basic structure of the Federal Reserve System
   Major functions of the Federal Reserve
   The Crash of 2008