Money

1. ECONOMICS 5e Michael Parkin Money Chapter 31 in Economics

2. Learning Objectives • Define money and describe its functions • Explain the economic functions of banks and other financial institutions • Describe the financial innovations

3. Learning Objectives (cont.) • Explain how banks create money • Explain why the quantity of money is an important economic magnitude • Explain the quantity theory of money

4. Learning Objectives • Define money and describe its functions • Explain the economic functions of banks and other financial institutions • Describe the financial innovations of the 1980s and 1990s

5. What is Money? Money is any commodity or token that is generally acceptable as the means of payment. A means of payment is a method of settling a debt.

6. What is Money? Functions of Money 1) Medium of exchange 2) Unit of account 3) Means of payment 4) Store of value 5) World-wide money

7. What is Money? Medium of Exchange A medium of exchange is an object that is generally accepted in exchange for goods and services. Without money, people would have to exchange goods for goods, or barter.

8. What is Money? Unit of Account A unit of account is an agreed measure for stating the prices of goods and services. This simplifies value comparisons and purchase decision making if all prices are expressed using a uniform measure.

9. The Unit of Account Functions of Money Simplifies Price Comparisons Movie $6.00 each 2 six-packs of soda Soda $3.00 per six-pack 2 ice-cream cones Ice cream $1.50 per cone 3 packs of jelly beans Jelly beans $0.50 per pack 2 cups of coffee Coffee $0.25 per cup 1 local phone call Price in Price in units Good money units of another good

10. What is Money? Store of Value A store of value is any commodity or token that can be held and exchanged later for goods and services.

11. What is Money? • Means of exchange: Based on credit relations: buying on credit or selling on credit

12. What is Money? • World-wide money Gold, silver, platinum, USD, Euro, Swiss Frank, British Pound, Swiss Franc and other “hard currencies”

13. What is Money? Money Today consists of: • Currency • Deposits at banks and other financial institutions

14. What is Money? Money Today (cont.) • Currency is the bills and coins that we use. • Deposits are also money because they can be converted into currency and are used to settle debts.

15. What is Money? Official Measures of Money (cont.) M1 consists of currency and traveler’s checks plus checking deposits. Includes accounts held by individuals and businesses, but does not include currency held by banks, or currency and checking deposits owned by the U.S. government.

16. What is Money? Official Measures of Money (cont.) M2 consists of M1 plus saving deposits and time deposits.

17. What is Money? Official Measures of Money (cont.) M3 consists of M2 plus large-scale time deposits and term deposits

18. What is Money? Are M1 and M2 Really Money? The test of whether an asset is money is whether it serves as a means of payment. • Currency does. • Checking deposits are money because they can be transferred by writing a check. M1 is money

19. What is Money? Are M1 and M2 Really Money? • Some savings deposits are readily accessible and can be used as a means of payment. • Other deposits are less liquid. Liquidity is the property of being instantly convertible into a means of payment with little loss in value. M2 is money

20. What is Money? Other Points Regarding Money 1) Deposits are money but checks are not. 2) Credit cards are not money.

21. Learning Objectives • Define money and describe its functions • Explain the economic functions of banks and other financial institutions • Describe the financial innovations of the 1980s and 1990s

22. Financial Intermediaries Financial intermediaries are firms that take deposits from households and firms and makes loans to other households and firms.

23. Financial Intermediaries Four Types of Financial Intermediaries 1) Commercial banks 2) Savings and loan associations 3) Savings banks and credit unions 4) Money market mutual funds

24. Financial Intermediaries Commercial Banks A commercial bank is a firm, licensed by the Comptroller of the Currency or by a state agency to receive deposits and make loans.

25. Financial Intermediaries Commercial Banks Their balance sheet lists their assets, liabilities, and net worth. • The assets are what the bank owns. • The liabilities are what the bank owes • These include deposits. • Net worth is the difference between assets and liabilities.

26. Financial Intermediaries Commercial Banks Their balance sheet is described by the following formula: Liabilities + Net Worth = Assets

27. Financial Intermediaries Profit and Prudence: A Balancing Act Banks attempt to maximize the net worth of their stockholders: • They earn profit by lending at a higher interest rate than they borrow. • Lending is risky. Banks must be prudent in how they use their deposits.

28. Financial Intermediaries Reserves and Loans Banks divide their funds into two parts: • Reserves are cash in a bank’s vault plus its deposits at Federal Reserve banks • Loans

29. Financial Intermediaries Three Types of Assets Held by Banks 1) Liquid assets are government Treasury bills and commercial bills. 2) Investment securities are longer-term government bonds and other bonds. 3) Loans are commitments of fixed amounts of money for agreed- upon periods of time.

30. Financial Intermediaries Savings and Loan Associations A savings and loan association is a financial intermediary that receives checking deposits and savings deposits and that makes personal, commercial, and home-purchase loans.

31. Financial Intermediaries Savings Banks and Credit Unions A savings bank (mutual savings bank) is a financial intermediary owned by its depositors that accepts deposits and makes mostly home-purchase loans.

32. Financial Intermediaries Savings Banks and Credit Unions A credit union is a financial intermediary owned by its depositors that accepts savings deposits and makes mostly consumer loans. The key difference between savings banks and credit unions is that credit unions are owned by a social or economic group such as a firm’s employees.

33. Financial Intermediaries Money Market Mutual Funds A money market mutual fund is a financial institution that obtains funds by selling shares and uses these funds to buy highly liquid assets such as Treasury bills

34. Financial Intermediaries The Economic Functions of Financial Intermediaries 1) Creating Liquidity 2) Minimizing the cost of borrowing

35. Financial Intermediaries The Economic Functions of Financial Intermediaries 3) Minimizing the cost of monitoring borrowers 4) Pooling Risk

36. Financial Regulation, Deregulation, and Innovation Financial Regulation Two types of regulation faced by financial intermediaries: • Deposit insurance • Balance sheet rules

37. Financial Regulation, Deregulation, and Innovation Deposit Insurance The deposits of most financial intermediaries are insured by the Federal Deposit Insurance Corporation. • Receives its income from compulsory premiums paid by financial intermediaries • Protects depositors

38. Financial Regulation, Deregulation, and Innovation The balance sheet regulations faced by financial intermediaries include: 1) Capital requirements The minimum amount of an owner’s own financial resources that must be put into an intermediary.

39. Financial Regulation, Deregulation, and Innovation The balance sheet regulations faced by financial intermediaries include: 2) Reserve requirements Rules setting out the minimum percentages of deposits that must be held in currency or other safe, liquid assets.

40. Financial Regulation, Deregulation, and Innovation The balance sheet regulations faced by financial intermediaries include: 3) Deposit rules Restrictions on the different types of deposits that an intermediary can accept.

41. Financial Regulation, Deregulation, and Innovation The balance sheet regulations faced by financial intermediaries include: 4) Lending rules Restrictions on the proportions of different types of loans that an intermediary may make.

42. Financial Regulation, Deregulation, and Innovation Deregulation in the 1980s (USA, UK) The Depository Institutions’ Deregulation and Monetary Control Act (DIDMCA), passed in 1980, removed many of the distinctions between commercial banks and other financial intermediaries.

43. Learning Objectives • Define money and describe its functions • Explain the economic functions of banks and other financial institutions • Describe the financial innovations

44. Financial Regulation, Deregulation, and Innovation Financial Innovation Financial innovation is the development of new ways of borrowing and lending. Primary aim is to increase the profit from financial intermediation.

45. Financial Regulation, Deregulation, and Innovation The three main influences on financial innovation are: 1) Economic environment 2) Technology 3) Regulation

46. Financial Regulation, Deregulation, and Innovation Financial Innovations • Variable interest rate mortgages • Widespread credit card usage • Rise in the importance of the Eurodollar • Paying interest on checkable deposits

47. Learning Objectives • Explain how banks create money • Explain why the quantity of money is an important economic magnitude • Explain the quantity theory of money

48. How Banks Create Money Reserves: Actual and Required • The reserve ratio is the fraction of a bank’s total deposits that are held in reserves. • The required reserve ratio is the ratio of reserves to deposits that banks are required, by regulation, to hold. • Excess reserves are actual reserves minus required reserves.

49. How Banks Create Money Creating Deposits by Making loans in a One-Bank Economy Let’s see an example of how banks create money.

50. Creating Money at theOne-and-Only Bank Balance sheet on January 1 Reserves $100 Deposits $400 Loans $300 Total $400 Total $400 Assets (millions of dollars) Liabilities (millions of dollars)