Money and Banking: Functions, History, and Structure of the Federal Reserve

1. Chapters 14 and 15 Money, Banking and Financial Institutions; Money Creation

3. All About Money Functions of Money Unit of Value -- common unit for measuring how much something is worth (i.e. a 42" HD TV costs $1,000). Medium of Exchange -- willing to accept it in exchange for goods/services 3) Store of Value -- money can be held or stored knowing it can be used to buy future goods/services; holding money is equivalent to holding wealth

4. History of Money Commodity Money -- Goods used as a replacement for money because of its inherent value as a commodity (i.e. furs, metals, spice, etc) Paper Currency (early) -- currency backed by gold or silver -- money would only be issued if the bank received more gold/silver -- people could legitimately go to the bank and trade in their paper currency for gold/silver -- gold conversion was disbanded in 1934 and silver was disbanded in 1963 Fiat Money -- Gov’t declared means of payment -- declaration is printed on each bill -- the term “legal tender” means dollar bills cannot be refused as payment for a debt

5. Money has 4 Characteristics Exists as a unit of account -- provides a common measurement of the relative value of goods and services Eg) If price of a CD is $10.00 and the price of a large Duncan Donuts coffee is $2.00, the value of 1 CD = ___ DD coffees 2) Widely accepted as means of payment 3) Store of Value and is an asset -- money holds value over time -- credit cards are not money because they fail to be a store of value (if you exceed your credit limit or your credit is cancelled, the credit card will not allow you to purchase goods on the next purchase 4) Highly Liquid -- assets that are highly liquid can be easily converted into cash and at little cost -- illiquid assets are assets that can not be converted into cash easily

6. Spectrum of Liquidity More Liquid Less Liquid Cash in Hands of Public Demand Deposits / Other Checkable Deposits/Travelers Checks Savings Type Accounts Money Market Mutual Funds Small Time Deposits Lg Time Deposits Demand Deposits (DD) -- checking accounts of households and firms held at financial institutions

7. Other Checkable Deposits -- quasi-checking accounts such as automatic transfers from savings accounts. These accounts transfer funds from savings accounts into checking accounts when needed Retail Money Market Mutual Funds (MMMF’s) -- deposits made to buy a variety of financial assets. -- Can withdrawal money by writing checks Small and Lg Time Deposits (also known as CD’s) -- requires money to remain in the bank for a specified time period or subject to penalties for early withdrawal -- small time deposits (< $100,000) -- Lg time deposits (>= $100,000)

8. Measures of Money Stock M1 -- standard measure of money supply or money stock, which consists of the four most liquid assets. -- M1 = Cash in hands of public + Demand Deposits + Other Checking Account Deposits + Travelers Checks M2 -- M2 = M1 + Savings Type Accounts + Retail MMMF Balances + Small Denomination Time Deposits

9. Federal Reserve System -- established in 1913, it’s our nation’s central bank (indept agency of the Federal Gov’t) -- 12 Federal Reserve Banks are divided into 12 districts 1) Boston 5) Richmond 9) Minneapolis 2) New York 6) Atlanta 10) Kansas City 3) Philadelphia 7) Chicago 11) Dallas 4) Cleveland 8) St Louis 12) San Francisco Structure of Federal Reserve Chair of Board of Governors (Ben Bernanke) Appoints 3 Directors for each bank 12 Federal Reserve Banks Board Of Governors (7 members, includes chair) Elects 6 Directors for each bank Federal Open Market Committee (7 Governors + 5 Reserve Bank Presidents) 3,500 Member Banks

10. Breakdown of Sectors I] Board of Governors -- appointed by President and approved by Senate for 14 yr terms (nonrenewable) Chairman: -- appointed by President/approved by Senate for 4 yr term (renewable) not to coincide with presidential term of office Specific Duties include: Supervise and regulate member banks Supervise 12 Federal Reserve Banks Set reserve requirements and approve discount rates

11. II] 12 Federal Reserve Banks -- Each is supervised by 9 directors (3 appointed by Bd of Governors and 6 appointed by members banks -- Each bank has a president appointed by the directors -- Specific responsibilities include: Lends reserves Issues currency Clears Checks (clears about 1/3 of all checks) III] Federal Open Market Committee (FOMC) -- 7 Bd of Governors + 5 Reserve Bank Presidents (New York is always represented while 4 other positions rotate among the other banks) -- committee responsible for establishing U.S. monetary policy -- primary function is to conduct open market operations (buying/selling of U.S. bonds) to control money supply -- sets Federal Funds rate target IV] 3.500 Member Banks (not all commercial banks are chartered with the Federal Reserve). -- About 70% of all deposits are in member banks

12. Functions of the Federal Reserve (sector responsibility in brackets) Supervising and Regulating Banks [Board of Governors] -- sets standards for establishing new banks and members banks financial activity -- establishes reserve requirements for all banks (not just member banks) Acting as a “Bank for Banks” [12 Federal Reserve Banks] -- Member banks can borrow from the Federal Reserve to meet required reserves -- Interest rate for borrowed funds is called the discount rate -- borrowing may be necessary when banks encounter bank runs (many depositors withdrawal money from the bank at one time) and much worse a bank panic (many banks experiencing bank runs at the same time).

13. 3) Issuing Paper Currency -- puts currency into circulation (does not print it) -- printing currency is the responsibility of the Bureau of Engraving 4) Check Clearing -- transferring funds from one bank’s reserves to another 5) Controlling the Money Supply or Open Market Operations

14. 3 Components of Financial System Banking System Bond Market Stock Market Banking System -- Commercial Banks are known as financial intermediaries Firms that bridge the relationship between savers (individuals and businesses) and borrowers Uses funds from savers to make loans 4 types of financial intermediaries Commercial Banks -- largest group -- obtains funds through checking deposits, savings deposits and time deposits and makes business (normally small business), mortgage and consumer loans

15. 2) Savings & Loans (S & L’s) -- obtain funds through checkable deposits, savings deposits, and other time deposits for mainly mortgage loans -- owned by outside investors 3) Mutual Savings Banks -- accepts deposits (shares) which are used for mortgage loans -- owned by shareholders 4) Credit Unions -- accepts deposits from a specific group and specializes in consumer and mortgage loans Importance of Financial Intermediaries -- Financial Intermediaries are necessary because they specialize in evaluating the worthiness of the borrower and have the means for follow-up Researching credit history Evaluating request for loan  putting it towards productive use Monitoring loan and activity of borrower

16. --significant amount of time and money would otherwise be spent by savers to gather necessary information to make a informed decision about a potential borrower -- also aides the borrower by giving them access to credit that might otherwise be time consuming and difficult to find. Stocks and Bonds -- large corporations’ outlet for generating funds for investment as well as Gov’t (bonds) for financing deficit Bonds -- a promise to repay a debt, normally involving both a principal amount and interest payments

17. Key Terms 1) Principal Amount -- amount originally lent -- equal to the price of a newly issued bond or when the bond was new -- amount paid at a specific date in the future or at maturity 2) Coupon Payments -- regular interest payments made to the owners of the bonds Coupon Rate: regular interest payments to the owner of the bonds is derived from a coupon rate or the interest rate. The coupon rate is declared at the time bond is issued. Coupon Payment = Coupon Rate x Principal Amount

18. Example: Purchase of a 10 yr bond with principal value of $5,000 and annual coupon payment of $100 has what Coupon Rate? Coupon Rate = $100/$5,000 = 2.0% 3) Term of Bond -- length of time until bond reaches maturity -- can vary from 1 mth to 30 years -- coupon rates are higher on long term bonds than short term ones -- borrowers that are high risk or approaching bankruptcy will typically pay higher coupon rates

19. Bonds are bought and sold in the bond market 1) Primary Market For Bonds -- newly issued bonds 2) Secondary Market For Bonds -- buying and selling of bonds issued in previous periods Market Value of Bond = Price of Bond and can be greater than, less than or equal to principal amount of bond -- price is dependent on how the coupon rate compares to the prevailing or current interest rate

20. Bond Prices and Interest Rate -- in general, as interest rates ↑, price bonds ↓ -- inverse relationship between price of bond and interest rate Example Purchase a newly issued 5 yr Gov’t bond with principal amount of $5,000 for $5,000. Bond has an annual coupon rate of 5% Annual Coupon Payment = $5,000 x 5% or $250 At Maturity = $5,000 + $250 or $5,250 If, after 4 yrs, you decide to sell the bond (1 yr left before maturity)

21. -- The price at which you can sell the bond depends on the current interest rate where the current interest rate is the interest rate on newly issued bonds. If current Interest Rate on 1 yr bond = 6% At maturity, newly issued bond will pay: $5,000 + 6% or $5,300 -- No one would pay $5,000 for the used bond since 5% coupon rate is below current interest or would result in $50 less revenue than new bond -- In order to sell the bond, the price of the bond will have to be set to a level that will allow a 6% return: Price Bond x (1+ current interest rate) = $5,250 Price Bond x (1.06) = $5,250 Price Bond = $5,250 / 1.06 = $4,952.83 (below original price or principal amount)

22. If the prevailing interest rate were 3%: Price Bond x (1+ current interest rate) = $5,250 Price Bond x (1.03) = $5,250 Price Bond = $5,250 / 1.03 = $5,097.09 (above original price or principal amount) If the prevailing interest rate were 5% Price Bond x (1+ current interest rate) = $5,250 Price Bond x (1.05) = $5,250 Price Bond = $5,250 / 1.05 = $5,000 (equal to original price or principal amount)

23. B) Stocks -- partial ownership in a firm -- # of stocks equates to % of ownership in a firm (# shares / # of shares outstanding) -- Stocks provide a return on investment in one of two ways: 1) Dividends Periodic payment to owners of shares of stock Amount is determined by company and is usually tied to profits 2) Capital Gains Increase in value of stock

24. Determination of Stock Price Stock Price with no concern over risk -- riskiness of stock is not a concern -- considers your anticipated or expected level of return when purchasing a stock. Expected level of return is based on comparison against alternative financial investments (such as Gov’t bonds) Example -- If a 1 yr Gov’t Bond is earning 3% interest and the stock price of a Company A one year from now is expected to be $50.00 and paying a $4.00 dividend Stock Price x 1.03 = $54.00 Stock Price = $54.00/1.03 = $52.43

25. -- As expected dividends ↑, ↑ in the value of the stock price or what investors would be willing to pay -- As interest rates ↑, ↓ in the value of stock price as stocks compete against the financial benefits of buying bonds Certain financial assets carry more risk than others (Gov’t bonds tend to be one of the least risky) and therefore the level of risk needs to be considered in the investment. Riskier assets is said to carry a risk premium Risk Premium Rate of Return for -- Rate of Return on Risky Assets On Low Risk Ones

26. Joe’s Bank Balance Sheet

27. Terms Securities: Banks hold securities such as Gov’t and corporate bond and treasury bills Loans: Borrowed funds by households & non-corporate businesses Demand Deposits: A liability for the bank because the banks owes this money on the spot if withdrawn Net Worth or Stockholders equity: Total Assets – Total Liabilities -- the value of the firm if it closed Reserves: Vault Cash: money stored in a vault Accounts with Federal Reserve -- banks have accounts with the Federal Reserve Banks Purpose of Reserves i) Must have enough available cash for withdrawals ii) Law requires a specific amount of reserves called required reserves -- the larger the amount of deposit liabilities (i.e. demand deposits), the larger the required reserves

28. Required Reserve Ratio (RR): the minimum fraction of demand deposits balances that banks must hold as reserves -- set by Federal Reserve -- current RR is 10% Example: Using Joe’s Banks Balance Sheet, since demand deposits are $100 million, the bank is required to hold $____________ in reserves. Since the sum of reserves or vault cash + Accts w the Federal Reserve equals $___________, the bank meets the minimum reserve requirement.

29. Fed and control of the Money Supply -- Changes in the money supply are accomplished through Open Market Operations (buying / selling of Gov’t bonds) 2 Assumptions Households and businesses are satisfied with cash at hand. Additional funds are deposited in checking accounts/Decrease in funds are transferred from checking account Banks never hold any more than required reserves and RR = 10%

30. I] Increase in the Money Supply -- Fed buys Gov’t bonds, called an open market purchase Example: Fed buys $1,000 bond from Bond Dealer who has a checking account with National City Bank Changes in National City’s Balance Sheet Check is deposited in Bonds Dealers account (increasing demand deposits) and at the same time reserves increase by $1,000. This Gov’t transaction increases the money supply by $1,000

31. -- Since the RR = 10%, required reserves have increased by $______. Since reserves have gone up by $1,000, there is excess reserves of $_____________ Excess Reserves = Reserves - Required Reserves -- National City will now try to lend out excess reserves of $__________. Ironically, Bob walks into National City and needs a $_______ loan for a boat. After examining his credit history and financials, he is awarded a loan and money is deposited in his checking account with the bank (increase in demand deposits). Bob is buying the boat from Jack who has a checking account with Corporate America Bank where the funds will be deposited (increase in demand deposits).

32. Changes in National City’s Balance Sheet With this loan, the money supply increases by $900 (↑ in DD). Once the check clears, the balance sheets become the following:

33. Changes in National City’s Balance Sheet (check clears) Note: check clears @ Nat’l City (Bob’s bank) causing both demand deposits and reserves to decrease. Notice that reserves are now $100 or equal to the amount of required reserves. Since National City has no excess reserves, they are “loaned up” Changes in Corporate America Bank’s Balance Sheet Note: At Corp America Bank (Jack’s bank), demand deposits increase and reserves increase when check is deposited.

34. Changes in Corporate America Bank’s Balance Sheet Since Demand Deposits increased by $900, required reserves increase by $90. Excess reserves are now $810. Corporate America Bank will now try to loan out $810 or amount of excess reserves. Say Susie walks into Corporate America Bank (where she also has a checking account) and asks for a loan of $810 to buy an antique lamp from Monica (has a checking account at Fifth Avenue Bank). This transaction has the following effect:

35. IChanges in Corporate America Bank’s Balance Sheet With this loan, the money supply increases by $810. Once the check clears, the balance sheets become the following:

36. Changes in Corporate America Bank’s Balance Sheet (check clears) Note: Check clears @ Corporate America Bank (Susie’s bank) causing both demand deposits and reserves to decrease. Notice that reserves are now $90 or equal to the amount of required reserves. Since Corporate America has no excess reserves, they are “loaned up” Changes in Fifth Avenue Bank’s Balance Sheet Note: At Fifth Avenue Bank (Monica’s bank), demand deposits increase and reserves increase when check is deposited.

37. Results -- Demand Deposits increase each time a bank lends money out from its excess reserves or money supply increases -- Demand deposits increase by 90% when each loan is made Bank Addt’l Demand Deposits Cumulative Demand (DD) per bank Deposits (DD) all banks Nat’l City $1,000 $1,000 Corp America $ 900 $1,900 Fifth Ave $ 810 $2,710 . . . . . . $2,826 $10,000 Derivation ∆DD (all banks) = Demand Deposit Multiplier x initial ∆ reserves Demand Deposit Multiplier = 1/RR or 1/.10 ∆DD (all banks) = 1/.10 x 1000 = 10 x 1,000 or $10,000 ∆Money Supply = ∆DD + ∆currency held by the public ∆Money Supply = $10,000 + $0

38. II] Decrease in the Money Supply -- Fed sells Gov’t bonds, called an open market sale Example: Fed sells a $1,000 bond to local investment firm who has a checking account with National City Bank Changes in National City’s Balance Sheet Money is withdrawn from investment firms’ account (decreasing demand deposits) and at the same time reserves decrease by $1,000 (money supply decreases by $1,000

39. -- Since the RR = 10%, required reserves have decreased by $______. Since reserves have decreased by $1,000, there is now deficient reserves of $_____________ -- In order to gain these reserves, National City will now try to call-in loans or ask for repayment equal to amount of deficient reserves or $__________. Say a loan equal to amount of deficient reserves is paid from a client holding a checking account with Corporate America Bank.

40. Changes in National City’s Balance Sheet (check clears) Note: check clears and reserves increase by $900 and loans decrease by $900. Notice that change in reserves is now -$100 or equal to the reduction allowable given the RR. Changes in Corporate America Bank’s Balance Sheet Note: At Corp America Bank, demand deposits decrease and reserves decrease when check clears and loan payment is made to National City

41. -- Since the RR = 10%, required reserves have decreased by $90. Since reserves however have decreased by $900, there is now deficient reserves of $810. -- In order to gain these reserves, Corporate America Bank will now try to call-in loans or ask for repayment equal to amount of deficient reserves or $810.

42. Results -- Demand Deposits decrease each time a bank calls-in loans or the money supply decreases -- Demand deposits decrease by 90% with each loan called-in Bank ↓ in Demand Deposits Cumulative ↓ in Demand (DD) per bank Deposits (DD) all banks Nat’l City $1,000 $1,000 Corp America $ 900 $1,900 . . . . . . $2,826 $10,000 Derivation ∆DD (all banks) = Demand Deposit Multiplier x initial ∆ reserves Demand Deposit Multiplier = 1/RR or 1/.10 ∆DD (all banks) = 10 x -1,000 or -$10,000 ∆Money Supply = ∆DD + ∆currency held by the public = -10,000 + 0 = -10,000