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 ECON 2301
 Spring 2011

Marilyn Spencer, Ph.D.
Professor of Economics

     Chapter 15
Bonus Extra Credit Opportunity
 Dr. Hallet’s talk on fiscal policy in the
  European Union
  Thursday, April 7, 6 p.m., BH 103
  Sign in & attend his talk.
  Send me a short summary by the beginning of
   class, Apr. 11.

          4 points possible
Chapter 15: Money, Banking, and
               Central Banking
            Learning Objectives
1. Define the fundamental functions of money
2. Identify key properties that any goods that function as
   money must possess
3. Explain official definitions of the quantity of money in
4. Understand why financial intermediaries such as banks
5. Describe the basic structure of the Federal Reserve System
6. Discuss the major functions of the Federal Reserve

 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 4 functions of money
  1. Medium of exchange
  2. Unit of accounting
  3. Store of value (purchasing power)
  4. Standard of deferred payment

     The Functions of Money (cont'd)
 Medium of Exchange: Any item that sellers will
  accept as payment
   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
      • Requires a “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

    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.

    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 in a fully
   functioning economy

 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

 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
 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
   1. Acceptability
   2. Predictability of value
                Defining Money
 Money Supply: The amount of money in
 The size of the Money Supply 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.

        Defining Money (cont'd)

 Economists use two basic approaches to
 define and measure money:
  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: M1
  Checkable (transaction) deposits
  Traveler’s checks not issued by banks

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

                                 Sources: Federal
                                 Reserve Bulletin;
                                 Indicators, various
                                 issues; author’s

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


1. Currency
   • Minted coins and paper currency not deposited in
     financial institutions
   • The bulk of currency “in circulation” actually does not
     circulate within the U.S. borders.
2. Transactions deposits: Any deposits in a thrift institution
   or a commercial bank on which a check may be written or
   debit card used
3. Traveler’s Checks: Financial 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
            Defining Money (cont'd)
 Thrift Institution: Financial institutions that receive most
  of their funds from the savings of the public

 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 = M1 +
  1. Savings and small denomination time deposits
  2. Balances in retail money market mutual funds
  3. Money market deposit accounts (MMDAs)

 1. Savings Deposits: Interest-earning funds that
    can be withdrawn at any time without
    payment of a penalty. Depository Institutions
    accept deposits from savers and lend those
    funds out.
     • 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

M2 (cont’d)
  2. 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
            » CD: Time deposit with fixed maturity

M2 (cont’d)
  3. 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

 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 - money-at-zero-maturity).

    Financial Intermediation & Banks

 Direct finance: Individuals purchase bonds from a

 Indirect finance

   Individuals hold money in a bank
   The bank lends the money to a business

Financial Intermediation & 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

Figure 15-4 The Process of
 Financial Intermediation

Financial Intermediation & Banks (cont'd)

 Question: Why might people wish to direct their funds
  through a bank instead of lending directly to a business?

 Answers
   1. Asymmetric information
   2. Adverse selection
   3. Moral hazard
   4. Larger scale and lower management costs

Financial Intermediation & Banks (cont'd)

1. Asymmetric Information: Information
   possessed by one party in a financial transaction
   but not by the other

2. Adverse Selection: The likelihood that
   borrowers may use their borrowed funds for
   high-risk projects

Financial Intermediation & Banks (cont'd)
3. Moral Hazard (in this context): The possibility
   that a borrower might engage in riskier behavior
   after a loan has been obtained
4. Larger scale and lower management costs
   People can pool funds in an intermediary,
    reducing costs, risks.

   Pension funds and investment companies are
Financial Intermediation & Banks (cont'd)
 Liabilities:

   Amounts owed
   The sources of funds for financial

 Assets:

   Amounts owned
   The uses of funds by financial intermediaries
Table 15-2 Financial Intermediaries and
      Their Assets and Liabilities

Financial Intermediation & Banks (cont'd)
 Payment Intermediaries: Institutions that
  facilitate transfers of funds between depositors
  who hold transactions deposits with those
  Payment Intermediation:
   A recent study revealed that revenues derived from
    debit-card and checking transfer services accounted
    for 28% of the banks’ total earnings.
   Another 10% of earnings were generated from
    processing payments for credit cards, stocks, and
Figure 15-5 How a Debit-Card
      Transaction Clears

      Federal Deposit Insurance
 In 1933, at the height of bank failures, the Federal
  Deposit Insurance Corporation (FDIC) was
  founded to insure the funds of depositors and
  remove the reason for runs on banks.

   FDIC: a government agency that insures the
    deposits held in banks and most other
    depository institutions; all U.S. banks are
    insured this way.
                     FDIC (cont’d)
 As can be seen in Figure 15-5 (next slide), bank
  failure rates dropped dramatically after passage of
  this legislation.
   From WWII to 1984, fewer than 9 banks failed per
   From 1985 to the beginning of 1993, however, 1,065
    commercial banks failed – averaging 120 bank failures
    per year.
   In 2008, 25 banks failed. In 2009, 133 banks failed; in
    2010, 157 banks failed. So far this year (through
    March 25), only 26 banks have failed.
Figure 15-5 Bank Failures

 Source: Federal Deposit Insurance Corporation.
                  FDIC (cont’d)
 Bank Runs: Attempts by many of a bank’s
  depositors to convert transactions and time
  deposits into currency out of fear that the bank’s
  liabilities may exceed its assets.
                     FDIC (cont’d)
 The FDIC charges premiums to depository institutions
  based on their total deposits.

 These premiums go into funds that would reimburse
  depositors in the event of bank failures.

 This bolsters depositors’ trust in the system and gives them
  incentive to leave their deposits in the bank, even in the
  face of talk of bank failures.
 Until the 1990s, all insured depository institutions paid
  the same fee for coverage, regardless of how risky their
  assets were.
 Banks then had an incentive to invest in more assets of
  higher risk (and higher yield).
 The FDIC and other federal agencies possess regulatory
  powers to offset the risk-taking temptations.
 Higher capital requirements were imposed in the early
  1990s and adjusted in 2000.
 We are now in the comment period concerning new rules
  that might be put into place. See
Financial Intermediation and Banks
 Most nations have a banking system that
  includes two types of institutions:
   1. One type consists of private banking

   2. The other type of institution is a central bank.

   The Federal Reserve System:
     The U.S. Central Bank
 Central banks and their roles
  1. Perform banking functions for their nations’
  2. Provide financial services for private banks
      A banker’s bank, usually an official institution that
       also serves as a country’s treasury’s bank
  3. Conduct their nations’ monetary policies
  4. Central banks normally regulate commercial
   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

   The Federal Reserve System (cont'd)
 Organization of the Fed
  Board of Governors (BOG)
     • 7 members, 14-year terms

  Federal Reserve Banks (12 Districts)
     • 25 branches

  Federal Open Market Committee (FOMC)
     • BOG plus 5 presidents of district banks, including
       the president of the Bank of New York
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 (very little of this
      now – why?)
   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
   8. Intervenes in foreign currency markets
Figure 15-8 The Volume and Value of Federal
     Reserve Check Clearings Since 1985

The Federal Reserve System: U.S. Central Bank (cont’d)

  Lender of last resort: The Federal Reserve’s
   role as an institution that is willing and able to
   lend a temporary illiquid bank that is otherwise
   in good financial condition to prevent the bank’s
   illiquid position from leading to a general loss
   of confidence in that bank or in others.
  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

 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
 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 gave 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 institutions.

 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 encrease the “moral
  hazard” problem?
Summary of Learning Objectives
1. The key functions of money
   a. Medium of exchange
   b. Unit of accounting
   c. Store of value
   d. Standard of deferred payment

2. Important properties of goods that serve
   as money
    Acceptability, confidence, and predictable value

Summary of Learning Objectives (cont'd)
3. Official definitions of the quantity of money in
   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

Summary of Learning Objectives (cont'd)
4. 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

5. The basic structure of the Federal Reserve
   12 district banks with 25 branches
   Governed by Board of Governors
   Federal Open Market Committee

Summary of Learning Objectives (cont'd)
 a. Features of Federal Deposit Insurance
    • Provides deposit insurance by charging some
      depository institutions premiums based on the
      value of their deposits.

    • These funds are placed in accounts for use in
      reimbursing failed banks’ depositors.

    • This creates adverse selection and moral hazard
Summary of Learning Objectives (cont'd)
 b. The basic structure of the Federal Reserve
    • 12 district banks with 25 branches

    • Governed by Board of Governors

    • Federal Open Market Committee
Summary of Learning Objectives (cont'd)
  c. Major functions of the Federal Reserve
     i.    Supply the economy with currency
     ii.   Provide systems for transmitting and clearing payments
     iii. Holding depository institutions’ reserves
     iv. Acting as the government’s fiscal agent
     v. Supervising banks
     vi. Acting as a “lender of last resort”
     vii. Regulating the money supply
     viii. Intervening in foreign exchange markets

Assignment to be completed before
we begin our discussion of Ch. 16:
Pre-read Chapter 16 & these end-of-chapter
   14th ed: 16-1, 16-2, 16-4, 16-7, 16-9, 16-12 & 16-15 on
     pp. 420-421;

   15th ed: 16-1, 16-2, 16-4, 16-7, 16-9, 16-10 & 16-13 on
     pp. 420-421.

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