Eco 200 – Principles of Macroeconomics

Eco 200 – Principles of Macroeconomics Chapter 13:Money and Banking

Money • Money = any item that is generally accepted as a means of payment for goods and services • Common functions of money: • medium of exchange • unit of account • store of value • standard of deferred payment • Money does not always serve in the last three of these functions.

Evolution of money • Commodity money • Token money • Fiat money (legal tender) • Gresham’s law – “bad money drives out good”

Monetary aggregates: M1 • M1 = those items that serve as a medium of exchange • M1 = currency (including coins) + checkable deposits + traveler’s checks • Note that credit does not serve as money

M2 and M3 • M2 = M1 + savings deposits + small denomination (< $100,000) time deposits + retail money market mutual fund balances • M3 = M2 + repurchase agreements + Eurodollar deposits (no longer reported)

Global money • Sales among industrialized countries usually conducted in the currency of the seller • Sales between industrialized and developing countries are usually conducted in the developed country’s currency • Currencies of industrialized countries dominate international transactions • International reserve currency – used to settle debts between governments (dollar, pound, euro, and yen are most commonly used)

Composite currencies • ECU – introduced in 1979 – value tied to weighted average of national currencies of EU – (replaced by the euro) • Special drawing rights – average of the values of the dollar, euro, yen, and pound – created in 1970 by the IMF

Banking • Commercial banks – traditionally offered only checking accounts • Thrift institutions – traditionally offered only savings accounts • Financial deregulation in the 1980s eliminated the last remaining distinctions between commercial banks and thrift institutions

Financial intermediation • Direct finance – loans made directly from lenders to borrowers • Financial intermediation – banks (and other financial intermediaries) accept deposits and make loans • Financial intermediaries receive profits fr5om the difference in interest rates on loans and deposits • Reasons for financial intermediation: • economies of scale • lowers transaction costs • Savers and borrowers have different time horizons

U.S. Banking • Dual banking system: national and state chartered banks • Multistate branching is a recent phenomenon

Bank failures • High failure rates in the 1930s and 1980s • Federal Deposit Insurance Corporation (FDIC) – created in 1933 – insures deposits up to $100,000

International banking • Eurocurrency markets – deposits held in currencies that differ from the currency of the country in which the bank is located • Eurocurrency deposits are not subject to U.S. banking laws and offer higher interest rates (along with higher risk) • International banking facilities – since 1981- bookkeeping systems that allow U.S. banks to participate in offshore banking activities

Fractional reserve banking system • Banks create money whenever a loan is issued. • Reserve requirement (set by Federal Reserve Board) = fraction of deposits that must be held as reserves • Reserves = vault cash + deposits at Fed • Banks may loan their excess reserves • Required reserves = reserve requirement x deposits • Excess reserves = total reserves – required reserves

T-accounts and deposit multiplier • Initial assumptions: • no currency holdings • no excess reserves

Fed buys a $1000 bond Bank A’s t-account – initial deposit

Loan is created Bank A: Loan is created

Loan check is spent Bank A: Loan check is cashed

Deposit expansion multiplier • Deposit expansion multiplier = 1/reserve requirement • Actual expansion is less due to: • excess reserve holdings • currency holdings

Eco 200 – Principles of Macroeconomics