Chapter 13 Money and Banking 13-1 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights...

Chapter 13

Money and Banking

13-1Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Objectives

13-2

• The four jobs of money

• What money is

• M1, M2, and M3

• The demand for money

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Objectives

13-3

• The origins of banking

• The creation and destruction of money

• Branch banking and bank chartering

• The FDIC

• The savings and loan debacle


13-4

The Four Jobs of Money

• Medium of exchange

• Standard of value

• Store of value

• Standard of deferred payment


Medium of Exchange

• The most important job of money is to serve as a medium of exchange– When any good or service is purchased, people use

money– Money makes it easier to buy and sell because

money is universally accepted– Money, then, provides us with a shortcut in doing

business

• By acting as a medium of exchange, money performs its most important function


Standard of Value

13-6

• Money is a common denominator in which the relative value of goods and services can be expressed– A job that pays $2 an hour would be nearly

impossible to fill, while one paying $50 an hour would be swamped with applications

– Does money work well as a standard of value? You tell me


Store of Value

13-7

• If you could buy 100 units of goods and services with $100 in 1982, how many units could you buy with $100 in 2000?– Answer: you could have bought just 51 units

– During this period, inflation robbed the dollar of almost half of its purchasing power

• Over the long run, particularly since World War II, money has been a very poor store of value– However, over relatively short periods of time, say,

a few weeks or months, money does not lose much of its value


Standard of Deferred Payment

13-8

• Many contracts promise to pay fixed sums of money well into the future– A couple of examples are 30-year corporate

bonds and a 20-year mortgage



13-9

• When Dave Winfield signed a 10-year, $23 million contract with the New York Yankees in 1980, he really got stuck– Because over the next 10 years the consumer

price index went up by almost 59%– Today when a professional ballplayer,

entertainer, or virtually anyone else signs a long-term contract, she or he is generally protected by an escalator clause, which calls for increased payments to compensate for any future inflation



13-10

• How well does money do its job as a standard of deferred payment?– About as well as it does as a store of value– Usually quite well in the short run, but not

well at all over the long run of, say, three years or more


Money versus Barter• Without money, the only way to do business is

by bartering• For barter to work, I must want what you have

and you must want what I have– This makes it pretty difficult to do business

• “Everything, then, must be assessed in money: for this enables men always to exchange their services, and so makes society possible”– Aristotle, Nicomachean Ethics


Our Money Supply

• Money consist of coins, paper money, demand (or checking) deposits, and checklike deposits (commonly called NOW – or negotiable order of withdrawal – accounts) held by the nonbank public– Coins and paper money together are considered

currency– Six of every ten dollars in our money supply are

demand deposits and other checkable deposits• Virtually all the rest is currency

– Checks are not money but checking deposits are


13-13

Our Money Supply


Federal Reserve Statistical Release, April 5, 2001

13-14

Our Money Supply: M1, M2, M3

Currency

+ Demand deposits

+ Other checkable deposits

+ Traveler’s checks

M1(traditionally our basic money supply)


13-15

Our Money Supply: M1, M2, M3 Currency

+ Demand deposits



M1

+ Savings deposits

+ Small-denomination time deposits (less than $100,00)

+ Money market mutual funds held by individuals

M2


13-16

Our Money Supply: M1, M2, M3 Currency

+ Demand deposits



M1

+ Savings deposits

+ Small-denomination time deposits (less than $100,00)

+ Money market mutual funds held by individuals

M2

+ Large denomination time deposits (more than $100,00)

+ Money market mutual funds held by institutions

+ Other less liquid assets

M3


13-17

Our Money SupplyM1, M2, and M3, January 2001


M1=1,107 M2=5,111 M3=7,361

Currency incirculation

539

Traveler'schecks

8

Demanddeposits

309

Othercheckabledeposits

251

Money market mutual fundsheld by institutions

903

Other lessliquid assets

550

Large-denominationtime deposits

797

M25111

Savingdeposits

1970M11107

Money marketmutual funds

held by individuals985 Small-denomination

time deposits1049

Federal Reserve Bulletin

Our Growing Money Supply


1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000

20

18

16

14

12

10

8

6

4

2

0

Ð2

Ð4

Annual Percentage Change in the Money Supply, M1, 1960-2000

The Demand for Money

• The amount of money people hold is called money balances

• John Maynard Keynes noted that people had three reasons for holding money– People hold money to make transactions– People hold money for precautionary reasons– People hold money to speculate

• Economists have since identified four factors that influence the three Keynesian motives for holding money– The price level– Income– The interest rate– Credit availability

– 13-19Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Keynesian Motives for Holding Money

• The transaction motive– Individuals have day-to-day purchases for

which they pay in cash or by check– Individuals take care of their rent or

mortgage payment, car payment, monthly bills and major purchases by check

– Businesses need substantial checking accounts to pay their bills and meet their payrolls



• The precautionary motive– People will keep money on hand just in case

some unforeseen emergency arises• They do not actually expect to spend this money,

but they want to be ready if the need arises



• The speculative motive– When interest rates are very low you don’t

stand to lose much holding your assets in the form of money

– Alternatively, by tying up your assets in the form of bonds, you actually stand to lose money should interest rates rise

• You would be locked into very low rates

– This motive is based on the belief that better opportunities for investment will come along and that, in particular, interest rates will rise


Four Influences on the Demand for Money

• The price level– As the price level rises, people need to hold higher

money balances to carry out day-to-day transactions

– As the price level rises, the purchasing power of the dollar declines, so the longer you hold money, the less that money is worth

– Even though people tend to cut down on their money balances during periods of inflation, as the price level rises people will hold larger money balances



• Income– The more you make, the more you spend– The more you spend, the more money you

need to hold as cash or in your checking account

– Therefore as income rises, so does the demand for money balances



• Interest rates– The quantity of money demanded (held) goes

down as interest rates rise• The alternative to holding your assets in the form

of money is to hold them in some type of interest bearing paper

• As interest rates rise, these assets become more attractive than money balances



• Credit availability– If you can get credit, you don’t need to hold

so much money• The last three decades have seen a veritable

explosion in consumer credit in the form of credit cards and bank loans

• Over this period, increasing credit availability has been exerting a downward pressure on the demand for money



• Four generalizations– As interest rates rise, people tend to hold less

money– As the rate of inflation rises, people tend to

hold more money– As the level of income rises, people tend to

hold more money– As credit availability increases, people tend

to hold less money


The Demand Schedule for Money


Quantity of money (in $ billions)

20

18

16

14

12

10

8

6

4

2

100 200 300 400

Transactionsdemand

A.Transactions demand

20

10

100 200

Precautionarydemand

B. Precautionary demand

20

10

100 200 300 400 500 600 700 800 900 1,000

Speculativedemand

C. Speculative demand

The Three Demands for Money

Total Demand for Money



20

18

16

14

12

10

8

6

4

2

2000 400 600 800 1,000 1,200 1,400 1,600 1,800

Total demandfor money

This is the sum of the transaction demand, precautionary demand, and speculative demand for money shown in the previous slide

Total Demand for Money and the Supply of Money



20

18

16

14

12

10

8

6

4

2

Total demandfor money

M

7.2%

2000 400 600 800 1,000 1,200 1,400 1,600 1,800

The interest rate of 7.2 percent is found at the intersection of the total demand for money and the supply of money (M)

Since at any given time the supply of money (M) is fixed it can be represented as a vertical line

Determination of the Interest Rate


1978

4

20

16

12

8

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

The Prime Rate of Interest Charged by Banks on Short-Term Business Loans, 1978-2001

Although the prime rate is set by the nation’s largest banks, it is strongly influenced by actions of the Federal Reserve Board of Governors

13-32

Who Controls the Interest Rates?

• People who borrow money– players

• Banks– referee

• The FED– coach


13-33

Keeping Track of Interest Rates


1989

10.0%

9.5

9.0

8.5

8.0

7.5

7.0J J A S O N D

Federal funds

3-monthcommercial

paper

3-monthTreasury bills

(a)1989

11%

10

9

8

7

6

AA-ratedutilities

Long-termTreasuries

Municipals

J J A S O N D

(b)

Wall Street Journal, Dec. 11, 1989Wall Street Journal, Dec. 7, 1989

Note how the rates all move up and down virtually in lockstep, while maintaining the same distances from each other.

All interest rates move up and down together.

Banking: A Short History


What is the goldsmith’s reserve ratio when there are 1,000 receipts in circulation and 1,000 coins the safe?

Answer: 100 percent



What is the goldsmith’s reserve ratio when there are 1,000 receipts in circulation and 500 coins the safe?

Answer: 50 percent



What is the goldsmith’s reserve ratio when there are 1,000 receipts in circulation and 250 coins the safe?

Answer: 25 percent

Modern Banking

• A bank is a financial institution that accepts deposits, makes loans, and offers checking accounts– Banks keep about 2% of their deposits in the form

of vault cash– All the nation’s commercial banks, credit unions,

savings and loan associations, and mutual savings banks now have to keep up to 10% of their checking deposits on reserve

• This means “on the books”• Remember, checking deposits are bookkeeping entries


Modern Banking

• Commercial Banks– Until the passage of the Depository Institutions

Deregulation and Monetary Control Act of 1980, only commercial banks were allowed to issue checking deposits

• They were the only institutions clearly recognized as banks

– Commercial banks account for the bulk of checkable deposits

– There are slightly more than 9,000 commercial banks in the United States

• They hold nearly all demand deposits and almost half of total savings deposits


Modern Banking

• Mutual Savings Banks– Mostly operated in the northeastern United States,

these institutions were created in the 19th century to encourage savings by the “common people”

– They traditionally made small personal loans, but today, like savings and loan associations, they offer the same range of services as commercial banks

– There are nearly 1,600 mutual savings banks


Modern Banking

• Savings and Loan Associations– Although originally established to finance

home building, these associations also offer most of the services offered by commercial banks

– The nearly 1,100 S&Ls invest more than three quarters of their savings deposits in home mortgages


Modern Banking

• Credit Unions– Although there are nearly 11,000 credit unions in

the United States, they hold less than 5% of total savings deposits

– Credit unions offer a full range of financial services• They specialize in small consumer loans

– Credit unions are cooperatives that generally serve specific employee, union, or community groups


Modern Banking

• The Banking Act of 1980 blurred the distinction between commercial banks and the three other depository institutions– The main distinction – that before 1980 only

commercial banks were legally allowed to issue checking accounts – was swept away in 1980


Bank Lending

• Banks borrow money at low interest rates and lend money out at much higher interest rates– Currently, banks pay either zero or up to maybe 3%

interest on most deposits – and perhaps 1 or 2 points more if you leave your money on deposit for a few years

– Banks charge about 7% for fixed rate mortgages, a bit more for business loans, and about 18% on credit card loans


Financial Intermediaries– Financial intermediaries channel funds from savers

to borrows• Basically, they repackage the flow of deposits, insurance

premiums, pension contributions, and other forms of savings into larger chunks

– $10,000, $1 million, $50 million, or even more• They pay low rates of interest to their lenders and charge

relatively high rates to their borrowers

– Sometime business borrowers dispense with financial middlemen altogether by borrowing directly from savers

• The U.S. Treasury does this every month by issuing new bonds, certificates, notes, and bills

• Large business borrows by issuing relatively short-term commercial paper and long-term bonds


The Home Mortgage Market– In the home mortgage market banks and

other financial intermediaries differentiate between the relatively well off and the less fortunate

• Just over two thirds of all American families own their homes

– Nearly all have outstanding mortgages

• The conventional market provided well off homeowners mortgages at interest rates in the seven-to-eight range in 2000 and 2001

• The subprime market caters to poorer home homeowners and has interest rates that are double what they are in the conventional market


Welfare Banks• “Welfare banks” are check cashing

stores– You will find one in virtually every poor

neighborhood• They usually charge a fee of 1 to 3% of the value

of the check, but some charge as much as 20%• Why don’t poor people go to banks?

There are usually no banks in poor neighborhoodsIf you don’t have a required minimum balance, banks also charge pretty stiff feesPeople receiving public assistance are not allowed to have bank accounts


The Creation and Destruction of Money

• Banks create money by making loans– This money is created out of nothing– This money is new money in the form of additional

demand deposits

• Money is destroyed when a loan is repaid– When a loan is repaid, demand deposit accounts go

down– This money disappears back into nothing

• The interest that was paid does not disappear

• The Federal Reserve can affect the bank’s ability to create money by increasing or decreasing the bank’s reserve requirements


Bank Regulation

• Branch Banking– Banking is legally defined as accepting

deposits– Branch banking , therefore, would be the

acceptance of deposits at more than one location


Bank Regulation

• The three types of branch banking– Three types of branch banking have evolved

under various state laws• Unrestricted branch banking under which a

bank may open branches through out the state

• Limited branch banking under which a bank may be allowed to open branches only in contiguous communities

• Unit banking in which state law forbids any branching whatsoever


Bank Regulation

• Automated teller machines (ATMs)– Why shift to ATMs?

• Processing a teller transaction costs more than double what an ATM transaction cost

• By the end of 2000 there were about 250,000 ATMs doing more than 13 billion transaction a year

• This could lead to a decline in branch offices


Bank Regulation

• Automated teller machines (ATMs)– Should banks be allowed to charge fees to

noncustomers?• Virtually all bankers and most economists would

answer “Yes!”• Six out of seven ATM users don’t pay surcharges• Fees only hit users who go to ATMs not owned

by their own bank• Banning ATM surcharges would leave

consumers with fewer choices• We would all have to make do with fewer

machines and longer lines


Bank Regulation

• State and Nationally Chartered Banks– To operate a bank you must get a charter– More than two-thirds of the nation’s banks

have state charters, the rest have national charters

– To get a bank charter you need to demonstrate three things

• That your community needs a bank or an additional bank

• That you have enough capital to start a bank• That you are of good character


Bank Regulation

• State and Nationally Chartered Banks– To summarize

• All nationally chartered banks must join the Federal Reserve System

• All Federal Reserve member banks must join the FDIC

• Only a small percentage of the state-chartered banks are members of the Federal Reserve

• Nearly all banks are members of the FDIC


Bank Regulation

• Interstate Banking• Until 1994 interstate banking was technically

illegal, although banks managed to engage in this practice by buying banks in other states and operating them as separate entities

• The passage of the Riegle-Neal Interstate Banking and Branching Act of 1994 swept away the last barriers to opening branches in different states


Bank Regulation

• The Federal Deposit Insurance Corporation (FDIC)– After the massive bank failures of the 1930s,

Congress set up the FDIC• The whole idea of the FDIC is to avert bank panics by

assuring the public that the federal government stands behind the bank, ready to pay off depositors, if it should fail

• The FDIC would rather pay another bank to take over ailing institutions rather than pay off its depositors (the FDIC has paid several hundred million dollars to a bank to get it to take over a failing bank)


Bank Regulation

• The Federal Deposit Insurance Corporation (FDIC)– Is the FDIC in any danger of running out of money?

– Not really

– The Congress, the Federal Reserve, the Treasury, and all of the financial resources of the U.S. government are committed to the preservation of the FDIC

– More than 99% of all banks are members of the FDIC


Bank Regulation

• The Savings and Loan Debacle– In early 1990, the financial press was calling

the S&L debacle the greatest financial scandal in the history of the United States

– Incompetence, inordinate risk-taking, poor supervision, and outright fraud all played prominent roles in the decline and fall of the savings and loan industry

– The S&L mess will cost hundreds of billions of dollars to clean up

– Guess who gets stuck with the bill?


Bank Regulation

• Will the Commercial Banks Go the Way of the S&Ls?

• From 1987 through 1989 the nation’s commercial were in big trouble

– Nearly 200 banks were going under each year

– Back in the mid-and late 1970s only about 10 a year failed

• More banks will fail, but of the nation’s 8,000 commercial banks, there were less than a dozen bank failures from 1998 to 2000


Date post:	18-Dec-2015
Category:	Documents
Upload:	egbert-harper
View:	220 times
Download:	2 times

Chapter 13 Money and Banking 13-1 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights...

Documents