Money and Banking

1. 12 “If you think nobody cares if you’re alive, try missing a couple of car payments.”Earl Wilson US Representative 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. Money Defined The Functions of Money • Medium of Exchange • Means of exchanging goods and services without barter. • Any item sellers generally accept and buyers generally use to pay for goods and services. • Unit of Account • Standard unit in which prices can be stated and the value of goods and services can be compared. • Store of Value • An asset set aside for future use.

4. Money Defined Components of the Money Supply • Currency • Coins = “token money” • Intrinsic value of metal in coin must be less than face value of coin. • Paper = “folding money” • Federal Reserve Notes, issued by Federal Reserve system. • Checkable Deposits • “checkbook money” • Checking account balances are easily converted into currency on demand, so checks drawn on these accounts are considered equivalent to currency.

5. Money Defined Components of the Money Supply • Other liquid savings deposits = “Near-monies” (not medium of exchange, but easily converted) • Savings accounts • Money market deposits • Interest-bearing savings, minimum balance and time restrictions • Time deposits • Certificates of deposits (CD’s), earns interest, can’t be withdrawn before time expires without penalty • Money market mutual funds held by individuals • Interest-bearing pooled funds offered by investment firms

6. Money Defined Measuring the Money Supply NOTE: Money supply measures do NOT include money at banks, US treasury, federal reserve or other financial institutions. This would result in double-counting. We only count money held by the public. • M1 Money Supply: • Currency + Checkable deposits • M2 Money Supply: • M1 + near monies listed on previous slide

7. Money Defined M1 M2 February 2006 + Currency 54% M1 + Checkable Deposits 20% 46% + Small Time Deposits 15% Money Market Mutual Funds Held By Individuals (MMMF) 11% + Savings Deposits Including Money Market Deposit Accounts (MMDA) 54% + Totals $1,375 Billion $6,758 Billion

8. Money Defined Measuring the Money Supply NOTE: Money supply measures do NOT include money at banks, US treasury, federal reserve or other financial institutions. This would result in double-counting. We only count money held by the public. • M1 Money Supply: • Currency + Checkable deposits • M2 Money Supply: • M1 + near monies listed on previous slide • MZM Money Supply: • Money zero maturity • Includes money balances immediately available at zero cost • MZM = M2 – time deposits + money market mutual funds held by businesses

9. Money Supply Misc Questions: • Are Credit Cards Money? NO. Credit cards are just a means of postponing payment. The checking account balance used to pay the credit card bill is money. The credit card is not. • What “Backs” the Money Supply? Money supply is backed (guaranteed) by government’s ability to keep the value of money relatively stable.

10. Money Supply Money as Debt • Major components of MS are debts (promises to pay). • Paper currency and checkable deposits have no intrinsic value • Paper money cannot be redeemed for gold or other tangible asset, only for other paper money. • Checkable deposits are only redeemable for paper money. • Monetary authorities attempt to maintain amount of money needed for volume of business activity necessary for full employment.

11. Money Supply Value of Money • Acceptability • Currency is money because people accept them in exchange for goods and services. • Legal Tender • “This note is legal tender for all debts public and private.” • Currency is legal means of payment of debt (but firms are NOT legally required to take cash instead of other forms of payment).

12. Money Supply Value of Money • Relative Scarcity • Value of money depends on supply and demand of money - Value is derived from its scarcity, just like everything else. • With relatively constant demand, value is determined by supply. • So what happens to value of money when money supply increases? • What will then happen to prices when money supply increases?

13. Money Supply • Money and Prices • Purchasing power = amount of goods and services a unit of money will buy, which varies inversely with price level. • Purchasing Power of the Dollar: $V = 1/(Price index/100) Examples: • If CPI = 100, purchasing power of dollar = 1/1.00 = 1 • If CPI increases to 135, purchasing power of dollar falls to 1/1.35 = .74(by what percentage does purchasing power fall for this 35% increase in price?)

14. Federal Reserve System The Federal Reserve Bank of the United States • aka “the Fed”, central bank of the US • Established with the Federal Reserve Act of 1913 • Government’s bank • Bank’s bank • Monetary authority of the US

15. Federal Reserve System The Federal Reserve Bank of the United States • Central authority of US money and banking system is Fed’s Board of Governors. • Seven members, appointed by president, confirmed by senate (like cabinet members and supreme court justices). • Serve 14 year terms, providing continuity, experience, and independence from political pressures. • One member selected by president to be chairperson (previous chair was Alan Greenspan, served over 18 years. You should know who the current chair is).

16. Federal Reserve System The Federal Reserve Bank of the United States • Twelve district banks serve collectively ascentral bank. • Policies are coordinated by Bd of Govs. • Quasi-public banks, blending private ownership and public control. Each district bank is owned by private banks in the district (federally chartered banks required to buy stock in fed bank in their district), but policies established by Bd of Govs, which is a government body. • Not profit motivated like private banks. Their goal is overall economic stability.

17. Federal Reserve System The Federal Reserve Bank of the United States • Twelve district banks serve collectively asbank’s bank. • Perform same functions for banks as banks provide for us. • Banks have accounts at and borrow from district banks. • Fed banks are “lender of last resort” for local banks, ensuring they have liquidity to serve our needs (ex, after 9//11 attacks, when hurricanes hit . . .) • District banks also issue currency to private member banks (district number printed on each bill).

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

19. Federal Reserve System The Federal Reserve Bank of the United States • Federal Open Market Committee (FOMC) aids Bd of Govs in conducting monetary policy. • FOMC is made up of 12 members, including all 7 of Bd of Govs, president of NY district bank, and 4 other presidents that rotate on 1-year terms. • FOMC meets every six weeks to determine direction of monetary policy, conduction open market operations (buy and sell bonds) to control money supply and influence interest rates (more on this later).

20. 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)

21. Federal Reserve System Fed Functions and the Money Supply • Federal Reserve Independence • Fed is established as independent agency of govt to protect it from political pressure so it can effectively control money supply and maintain price stability. • Political pressure would likely result in inflationary pressure, low interest rates, even when economy needs higher rates. • Research shows that nations with independent central banks have lower rates of inflation than those that don’t.