Money and Banking

1. 12 Money and Banking

2. Chapter Objectives • The Functions of Money and the Components of the U.S. Money Supply • What “Backs” the Money Supply, Making Us Willing to Accept It? • The Makeup of the Federal Reserve and the U.S. Banking System • The Functions and Responsibilities of the Federal Reserve

3. The Origin of Money • Money develops from barter due to • lack of coincidence of wants • lack of divisibility • Example: direct exchange vs. indirect exchange Wheat serves as a “medium of exchange.”

4. The Origin of Money cont’d • Media of exchange in history: • cattle in ancient Greece • leather in ancient Rome • animal pelts, whiskey and tobacco leaves in the American colonies • wampum (strings of beads) among American Indians • dried fish in Canadian maritime colonies • maize (corn) in Mexico • salt and iron farming tools in parts of Africa • wives in ancient Egypt; and cigarettes in German POW camps

5. The Origin of Money cont’d Money evolves as more and more people and groups begin to use and accept the same commodity as a medium of exchange; through this self-reinforcing process the more that people use a given good as a medium of exchange the more generally acceptable the good becomes and the more likely it is for other people to turn to this good as a medium of in order to solve the problems of barter.

6. The Function of Money • Money: • is defined as the general medium of exchange accepted by all people in the economy, to buy and sell. • always originates as a useful commodity. All money comes into being as commodity money, historically, gold and silver. • is not the product of a “social contract” or government fiat. Money cannot originate as paper fiat money. • Subsidiary functions of money: • store of value • unit of account (tool of economic calculation)

7. Qualities of a Good Money • Generally acceptable—widely demanded nonmonetary employments • Naturally scarce • Portable—a high value/weight ratio making it easy to carry • Homogeneous—all units are identical to one another • Divisible—it can be divided into small units without loss of value • Durable— does not perish or deteriorate quickly with use • Recognizable—easy to confirm or test its authenticity

8. The Monetary Unit • For a commodity money such as gold the monetary unit is a unit of weight of gold. • For example: • U.S. $: 1834-1933 legally defined as $1:00 ≈ 1/20 oz. gold (23.22 grains of gold) • British £: 1821-1931 legally defined as £1.00 ≈ ¼ oz. gold; French franc as ₣1.00 ≈ 1/100 oz. gold. • So “exchange rate” for 100 years: • $4:86/£ ( ¼ oz. gold ÷ 1/20 oz. gold)

9. Kinds of Money • Commodity Money: money consisting of a tangible good supplied by the market. • Fiat Money: paper money decreed by governments as legal tender, which legally must be accepted as payments for taxes and all private debts.

10. Features of Fiat Money • Fiat money is the logical and historical conclusion of the process of debasement of the currency. • Fiat monetary unit is a pure name which no longer is defined by a specific quantity of a valuable commodity and can be affixed by government to a nearly worthless item. • fiat money can therefore be created practically without cost or limit. • can and has resulted in hyperinflation, a period of inflation during which the value of money rapidly falls toward zero as prices rise toward infinity.

11. The Value of Money • Prices of Goods Purchasing Power of Money $1.00/1 Coke 1 Coke/$ $10.00/1 pizza or 1/10th pizza/$ $100.00/1 IPod or 1/100th iPod/$ $1,000/1 laptop or 1/1,000th laptop/$ • A rise in prices causes a fall in the purchasing power of money $2.00/ 1 Coke ½ Coke/$ $20.00/ 1 pizza or 1/20th pizza/$ $200.00/1 IPod or 1/200th iPod/$ $2,000/1 laptop or 1/2,000th laptop/$ • Inflation therefore leads to a “shrinking” dollar.

12. Measuring the Money Supply • Commodity Money: • the money supply is the total monetary gold in existence in the economy, namely, the total weight of gold coins and bullion available to be used as a medium of exchange. • the money supply (M) can be calculated by summing up the cash balances or individual stocks of money (m) held by all people in the economy. • Thus: M = Σ m.

13. Fed Measures of the U.S. Money Supply • M1: currency, demand deposits, traveler’s checks, and other checkable deposits. • M1 = $2.4 trillion (January 2013) • Institutions offering checkable deposits • Commercial banks • Savings and loan associations • Mutual savings banks • Credit unions

14. Fed Measures of the U.S. Money Supply • M2: everything in M1 plus savings deposits, small time deposits, retail money market mutual funds, and a few minor categories. • M2 = $9.9 trillion (June 2012)

15. Fed Measures of the U.S. Money Supply • MZM: M2 + institutional MMMFs – small time deposits • Money Definition MZM • Money Zero Maturity • Immediately Available • January 2013 M2 was $10,439 Billion and MZM was $11,451 Billion

16. Money Defined M1 M2 January 2013 + Currency 46% M1 + Checkable Deposits 22% 54% + Small Time Deposits 7.6% Money Market Mutual Funds Held By Individuals (MMMF) 15.6% + Savings Deposits Including Money Market Deposit Accounts (MMDA) 62% + Totals $2,459 Billion $10,439 Billion

17. Common Confusions about Money • Money is not wealth. Wealth is the total (estimated) market value of an individual's assets. • Money is not income. Income is a sum of money payments per unit of time. • Money does not “circulate.” At every moment all existing money is always money is always owned by someone—is lying “idle” in someone’s cash balance.

18. Money Supply • Are Credit Cards Money? • What “Backs” the Money Supply? • NOTHING! • Stable Value of Money • Money as Debt • Acceptability • Legal Tender • Relative Scarcity

19. Money Supply • Money and Prices • Purchasing Power of the Dollar $V = 1/P • Inflation and Acceptability • Stabilizing Money’s Purchasing Power • Intelligent Management of the Money Supply – Monetary Policy • Appropriate Fiscal Policy

20. True Money Supply • TMS = M2 • Minus MMMFs • Minus small time deposits • Plus U.S. government deposits • Plus demand deposits due to foreign commercial banks and official institutions • Plus time and savings deposits due to foreign banks and official institutions

21. Why TMS Aggregate • For an item to be included in the money supply or monetary aggregate it must fulfill the following criteria: • It must be routinely and universally accepted in exchange for goods and services • It must serve as the final means of payment in all transactions, completing discharging the debt owed without creating a new debt • OR • It must be an instantly convertible claim to the general medium of exchange, meaning that it must be interchangeable with the general medium of exchange on demand at par (face value)

22. The Money Supply • The money supply (or money stock): the quantity of money available in the economy • What assets should be considered part of the money supply? Two candidates: • Currency: the paper bills and coins in the hands of the (non-bank) public • Demand deposits: balances in bank accounts that depositors can access on demand by writing a check

23. Money Supply (MS) • In today’s world, MS determined by Federal Reserve, although the banking system and consumers have an influence MS • For now, we assume the Fed precisely controls MS and sets it at some fixed amount.

24. Money Demand (MD) • Refers to how much wealth people want to hold in liquid form. • Depends on P: An increase in P reduces the value of money, so more money is required to buy G & S. • Thus, quantity of money demanded is negatively related to the value of money and positively related to P, other things equal. • (These “other things” include real income, interest rates, availability of ATMs.)

25. The Money Supply-Demand Diagram Value of Money, 1/P Price Level, P 1 As the value of money rises, the price level falls. 1 1.33 3/4 2 1/2 1/4 4 Quantity of Money

26. The Money Supply-Demand Diagram Value of Money, 1/P MS1 Price Level, P 1 1 1.33 3/4 The Fed sets MS at some fixed value, regardless of P. 2 1/2 1/4 4 Quantity of Money $1000

27. The Money Supply-Demand Diagram Value of Money, 1/P A fall in value of money (or increase in P) increases the quantity of money demanded: Price Level, P 1 1 1.33 3/4 2 1/2 1/4 4 MD1 Quantity of Money

28. The Money Supply-Demand Diagram MS1 P adjusts to equate quantity of money demanded with money supply. Price Level, P Value of Money, 1/P 1 1 1.33 3/4 eq’mvalue of money eq’m price level 2 1/2 1/4 4 MD1 Quantity of Money $1000

29. The Effects of a Monetary Injection MS1 MS2 Price Level, P Value of Money, 1/P Then the value of money falls and P rises. 1 1 Suppose the Fed increases the money supply. 1.33 3/4 A 2 1/2 eq’mvalue of money eq’m price level B 1/4 4 MD1 Quantity of Money $2000 $1000

30. A Brief Look at the Adjustment Process Result from graph: Increasing MS causes P to rise. • How does this work? Short version: • At the initial P, an increase in MS causes excess supply of money. • People get rid of their excess money by spending it on G & S or by loaning it to others, who spend it. Result: increased demand for goods. • But supply of goods does not increase, so prices must rise. • (Other things happen in the short run, which we will study in later chapters.)

31. Monetary Adjustment Process • Excess Supply of Money • MS > MD → ↑DG → ↑P → ↓PPM → ↑Qdm → MS = MD • Excess Demand for Money • MS < MD → ↓DG → ↓P → ↑ PPM → ↓Qdm → MS = MD

32. The Proper Supply of Money • For centuries economists debated the question “What is the optimal supply of money?” • Why should economists discuss this question, when they would never ask what the “optimal” supply of pizzas, iPads or automobiles should be? • Most economists agree that the proper supplies of goods and services should be determined by the price system and profit-and-loss test of the market.

33. Difference between Money and Other Goods Capital • Capital goods resources are used up or worn out in the process of producing consumer goods. • Consumer goods are typically destroyed by consumption. • Money is the general medium of exchange and in performing this function it is not used up or destroyed but is transferred from one cash balance to the other.

34. The Federal Reserve System • The Federal Reserve Act of 1913 created the Federal Reserve System • To provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes • First United States Bank [1791-1811] • Second United States Bank [1816-1836] • The charters of both were allowed to lapse • The 1907 bank crises caused the public to demand the government do something to keep this from happening again

35. The Federal Reserve System • The Federal Reserve has five main jobs • Conduct monetary policy which is, by far, the most important job • Monetary policy is the control of the rate of growth of the money supply to foster relatively full employment, price stability, and a satisfactory rate of economic growth • Serve as lender of last resort to commercial banks, savings banks, savings and loan associations, and credit unions

36. The Federal Reserve District Banks • Each Federal Reserve District Bank is owned by the several hundred member banks in that district • A commercial bank becomes a member by buying stock in the Federal Reserve District Bank • So, the Fed is a quasi public-private enterprise, not controlled by the president or Congress • Effective control is really exercised by the Federal Reserve Board of Governors in Washington, D.C.

37. The Federal Reserve System • 12 District Banks • Propose discount rates • Hold reserve balances for member institutions • Lends reserves • Furnish currency • Collects & clears checks • Handle U.S. government debt & cash balances • Board of Governors • 7 appointed members • Appointed by President • Confirmed by Senate • Sets reserve requirements • Supervises & regulates member banks • Establishes and administers regulations • Oversees Federal Reserve Banks

38. Federal Reserve System • The Federal Reserve and the Banking System • Historical Background • Board of Governors • Federal Open Market Committee (FOMC) • Open Market Operations

39. Federal Reserve System Framework of the Federal Reserve System and the Relationship to the Public Board of Governors Federal Open Market Committee 12 Federal Reserve Banks Commercial Banks Thrift Institutions (Savings and Loan Associations, Mutual Savings Banks, Credit Unions) The Public (Households and Businesses)

40. Federal Reserve System The 12 Federal Reserve Banks Source: Federal Reserve Bulletin

41. Federal Reserve System The 12 Federal Reserve Banks • Private and Public Control • Central Bank • Quasi-Public Banks • Banker’s Banks • Commercial Banks and Thrifts

42. Federal Reserve System Fed Functions and the Money Supply • Issuing Currency • Setting Reserve Requirements and Holding Reserves • Lending Money to Banks and Thrifts • Discount Rate • Check Collection • Fiscal Agent for U.S. • Supervising Banks • Controlling the Money Supply

43. Federal Reserve System Fed Functions and the Money Supply • Federal Reserve Independence • Recent Developments • Relative Decline of Banks and Thrifts • Consolidation Among Banks and Thrifts • Convergence of Services Provided by Financial Institutions • Globalization of Financial Markets • Electronic Payments

44. GLOBAL PERSPECTIVE Financial Institutions • Barclays (U.K.) • UBS (Switzerland) • Citigroup (U.S.) • ING Group (Netherland) • Mizuho Financial (Japan) • Allianz Worldwide (Germany) • Bank of America (U.S.) • HSBC Group (U.K.) • BNP Paribus (France) • JPMorgan Chase (U.S.) • Deutsche Bank Group (Germany) • Royal Bank of Scotland (U.K.) World’s Largest Financial Institutions 2005 Assets (Millions of U.S. Dollars) $1,587,061 1,519,399 1,494,037 1,369,546 1,325,227 1,300,648 1,291,795 1,274,219 1,227,951 1,198,942 1,134,826 1,119,901 Source: Forbes Global 2000

45. GLOBAL PERSPECTIVE Financial Institutions • Deutsche Bank Group (Germany) $2,804,332 • BNP Paribus (France) $2,546,693 • Industrial & Commercial Bank of China Limited (China) $2,458,597 • Barclays (U.K.) $2,426,889 • Japan Post Bank (Japan) $2,362,977 • Crédit Agricole SA (France) $2,233,521 • Royal Bank of Scotland (U.K.) $2,224,124 • China Construction Bank Corporation (China) $1,951,046 • Bank of Tokyo (Japan) $1,948,128 • Bank of China Limited (China) $1,879,280 World’s Largest Financial Institutions 2013 Assets (Millions of U.S. Dollars) Source: Forbes Global 2000

46. Which state boasts two Federal Reserve Banks? • Solution:  Missouri, with FRBs in St. Louis and Kansas City.  • (Champ Clark of Missouri was Speaker of the House of Representatives in 1913, when the Federal Reserve System was established.)

47. Financial Institutions Major U.S. Financial Institutions • Commercial Banks (7,300) • Thrifts (11,000) • Insurance Companies • Mutual Fund Companies • Pension Funds • Securities Firms

48. 13 Money Creation

49. Chapter Objectives • Why the U.S. Banking System is Called a “Fractional Reserve” System • Distinction Between a Bank’s Actual Reserves and Its Required Reserves • How a Bank Can Create Money Through Granting Loans • The Multiple Expansion of Loans and Money by the Entire Banking System • The Monetary Multiplier and How to Calculate it

50. Bank Reserves • In a fractional reserve banking system, banks keep a fraction of deposits as reservesand use the rest to make loans. • The Fed establishes reserve requirements, regulations on the minimum amount of reserves that banks must hold against deposits. • Banks may hold more than this minimum amount if they choose. • The reserve ratio, R • fraction of deposits that banks hold as reserves • total reserves as a percentage of total deposits