Chapter 13 Money and Our Banking System. Copyright © 2008 Pearson Addison Wesley. All rights...

Chapter 13

Money and Our Banking System

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-2

Did You Know That...

• Money includes not only coins and dollar bills, but also the balance in your checking account?

• Anything widely accepted in exchange for items of value is considered to be money?


Money

• Money

Any medium that is universally accepted in an economy both by sellers of goods and services and by creditors as payment for debts


Table 15-1 Types of Money


The Functions of Money

• The functions of money

Medium of exchange

Unit of accounting

Store of value (purchasing power)

Standard of deferred payment


The Functions of Money (cont'd)

• Medium of Exchange Any item that sellers will accept

as payment

• Barter The direct exchange of goods and services

for other goods and services without the use of money



• Medium of exchange Money facilitates exchange by reducing

transaction costs associated with means-of-payment uncertainty.Permits specialization, facilitates efficiencies

• Barter Simply a direct exchange

Double coincidence of wants



• Unit of Accounting

A measure by which prices are expressed

The common denominator of the price system

A central property of money



• Store of Value

The ability to hold value over time

A necessary property of money

Money allows you to transfer value (wealth) into the future.



• Standard of Deferred Payment

A property of an item that makes it desirable for use as a means of settling debts maturing in the future

An essential property of money


Liquidity

• Liquidity

The degree to which an asset can be acquired or disposed of without much danger of any intervening loss in nominal value and with small transaction costs

Money is the most liquid asset.


Figure 15-1 Degrees of Liquidity


Liquidity (cont'd)

• Question What is the cost of holding money (its

opportunity cost)?

• Answer It is the alternative interest yield obtainable

by holding some other asset.


Monetary Standards,or What Backs Money

• Questions What backs money?

Is it gold, silver, or the federal government?

• Answer Your confidence


Monetary Standards,or What Backs Money (cont'd)

• Transactions Deposits

Checkable and debitable account balances in commercial banks and other types of financial institutions, such as credit unions and mutual savings banks

Any accounts in financial institutions on which you can easily transmit debit-card and check payments without many restrictions


Example: E-Gold Backed E-Money

• The Internet has served as a breeding ground for various forms of e-money.

• Gold-backed e-money effectively provides measures of the purchasing power, in terms of gold, of several major world currencies.



• Fiduciary Monetary System

A system in which currency is issued by the government and its value rests on the public’s confidence that it can be exchanged for goods and services

The Latin fiducia means “trust” or “confidence.”



• Currency and transactions deposits are money because of their

Acceptability

Predictability of value


Defining Money

• Money is important Changes in the rate at which the money supply

increases or decreases affect important economic variables (at least in the short run) such as inflation, interest rates, employment, and the level of real GDP.

• Money Supply The amount of money in circulation


Defining Money (cont'd)

• Economists use two basic approaches to define and measure money.

The transactions approach

The liquidity approach



• Transactions Approach A method of measuring the money

supply by looking at money as a medium of exchange

• Liquidity Approach A method of measuring the money supply

by looking at money as a temporary store of value



• The transactions approach to measuring money: M1

Currency

Checkable (transaction) deposits

Traveler’s checks not issued by banks


Figure 15-2 Composition of the U.S. M1 and M2 Money Supply, 2007, Panel (a)


Figure 15-2 Composition of the U.S. M1 and M2 Money Supply, 2007, Panel (b)



• M1

CurrencyMinted coins and paper currency not deposited

in financial institutions

The bulk of currency “in circulation” actually does not circulate within the U.S. borders.


Figure 15-3 The Value of U.S. Currency in Circulation Outside the United States



• M1

Transactions depositsAny deposits in a thrift institution or a

commercial bank on which a check may be written or debit card used

Thrift InstitutionFinancial institutions that receive most of their

funds from the savings of the public



• M1

Traveler’s ChecksFinancial instruments purchased from a bank

or a nonbanking organization and signed during purchase that can be used as cash upon a second signature by the purchaser



• The liquidity approach to measuring money: M2

• Near Moneys Assets that are almost money

Highly liquid

Easily converted to cash

Time deposits are an example



• The liquidity approach: M2 is equal to M1 plus

1. Savings and small denomination time deposits

2. Balances in retail money market mutual funds

3. MMDAs



• M2

Savings Deposits Interest-earning funds that can be withdrawn at

any time without payment of a penalty

Depository InstitutionsAccept deposits from savers and lend those

funds out



• M2

Money Market Deposit Accounts (MMDAs)Accounts issued by banks yielding a market

rate of interest with a minimum balance requirement and a limit on transactions

They have no minimum maturity



• M2

Time DepositA deposit in a financial institution that requires

notice of intent to withdraw or must be left for an agreed period

Early withdrawal may result in a penalty

CDTime deposit with fixed maturity



• M2

Money Market Mutual Funds

Funds obtained from the public that investment companies hold in common

Funds used to acquire short-maturity credit instruments

CD’s, U.S. government securities


Defining the U.S. Money Supply

• Question Which definition of money correlates best

with economic activity?

• Answer M2, although some businesspeople and

policymakers prefer MZM



• MZM (money-at-zero-maturity)

• MZM entails adding deposits without set maturities to M1.

• MZM includes all MMFs but excludes all deposits with fixed maturities.


Financial Intermediation and Banks

• Most nations have a banking system that encompasses two types of institutions.

1. One type consists of private banking institutions.

2. The other type of institution is a central bank.


Financial Intermediation and Banks (cont'd)

• Central Bank

A banker’s bank, usually an official institution that also serves as a country’s treasury’s bank

Central banks normally regulate commercial banks.



• Direct finance Individuals purchase bonds from

a business

• Indirect finance Individuals hold money in a bank

The bank lends the money to a business



• Financial Intermediation

The process by which financial institutions accept savings from businesses, households, and governments and lend the savings to other businesses, households, and governments


Figure 15-4 The Process of Financial Intermediation



• Question Why might people wish to direct their funds

through a bank instead of lending directly to a business?

• Answers Asymmetric information

Adverse selection

Moral hazard

Larger scale and lower management costs



• Asymmetric Information Information possessed by one party in a

financial transaction but not by the other

• Adverse Selection The likelihood that borrowers may use

their borrowed funds for high-risk projects



• Moral Hazard The possibility that a borrower might engage in

riskier behavior after a loan has been obtained

• Larger scale and lower management costs People can pool funds in an intermediary,

reducing costs, risks.

Pension funds and investment companies are examples.



• Liabilities

Amounts owed

The sources of funds for financial intermediaries



• Assets

Amounts owned

The uses of funds by financial intermediaries


Table 15-2 Financial Intermediaries and Their Assets and Liabilities



• Payment Intermediaries

Institutions that facilitate transfers of funds between depositors who hold transactions deposits with those institutions


Figure 15-5 How a Debit-Card Transaction Clears



• Capital Controls Legal restrictions on the ability of a

nation’s residents to hold and trade assets denominated in foreign currencies

• International Financial Intermediation Financing investment projects in more than

one country


Table 15-3 The World’s Largest Banks



• World Index Fund

A portfolio of bonds issued in various nations whose individual yields generally move in offsetting directions, thereby reducing the overall risk of losses


Banking Structures Throughout the World

• The ways that banks around the world differ Size

United States has banks of various sizes Europe and Japan have a few large banks

Legal Universal banking Limits on financial services such as insurance and bank

stock ownership

Importance in financial system Major importance Part of a varied financial system (United States)


Banking Structures Throughout the World (cont'd)

• Universal Banking

An environment in which banks face few or no restrictions on their powers to offer a full range of financial services and to own shares of stock in corporations


Banking Structures Throughout the World (cont'd)

• Central banks and their roles

1. Perform banking functions for their nations’ governments

2. Provide financial services for private banks

3. Conduct their nations’ monetary policies


The Federal Reserve System

• The Fed

The Federal Reserve System; the central bank of the United States

The most important regulatory agency in the U.S. monetary system

Established in 1913 by the Federal Reserve Act


The Federal Reserve System (cont'd)

• Organization of the Fed

Board of Governors7 members, 14-year terms

Federal Reserve Banks (12 Districts)25 branches

Federal Open Market Committee (FOMC)BOG plus 5 presidents of district banks


Figure 15-6 Organization of the Federal Reserve System


Figure 15-7 The Federal Reserve System



• Depository institutions 7,500 commercial banks

1,300 savings and loans

11,000 credit unions

• All may purchase Fed services



• Functions of the Fed

1. Supplies the economy with fiduciary currency

2. Provides a payment-clearing system

3. Holds depository institutions’ reserves

4. Acts as the government’s fiscal agent

5. Supervises depository institutions

6. Acts as a “lender of last resort”

7. Regulates the money supply


Issues and Applications: Check Clearing—A Rapidly Diminishing Fed Function

• The volume of checks cleared by the Fed grew rapidly during the 1980s.

• So why has the Fed’s check clearing speed dropped since the 1990s?


Issues and Applications:Check Clearing—A Rapidly Diminishing Fed Function (cont'd)

• The reason is not due to inefficiency; rather, checks are falling out of favor.

• Government transfers are transmitted electronically—Social Security, Medicare, Medicaid.

• Electronic payments by households and businesses—debit cards, Internet bill pay, Web based services.


Figure 15-8 The Volume and Value of Federal Reserve Check Clearings Since 1985


Summary Discussion of Learning Objectives

• The key functions of money

1. Medium of exchange

2. Unit of accounting

3. Store of value

4. Standard of deferred payment

• Important properties of goods that serve as money Acceptability, confidence, and predictable value


Summary Discussion of Learning Objectives (cont'd)

• Official definitions of the quantity of money in circulation

M1: the narrow definition, focuses on money’s role as a medium of exchange

M2: a broader one, stresses money’s role as a temporary store of value



• Why financial intermediaries such as banks exist Asymmetric information can lead to adverse

selection and moral hazard problems Savers benefit from the economies of scale

• The basic structure of the Federal Reserve System 12 district banks with 25 branches Governed by Board of Governors Federal Open Market Committee



• Major functions of the Federal Reserve

Supply the economy with currency

Provide systems for transmitting and clearing payments

Holding depository institutions’ reserves

Acting as the government’s fiscal agent

Supervising banks

Acting as a “lender of last resort”

Regulating the money supply

Intervening in foreign exchange markets


Introduction

Smart cards permit people to use digital cash, which consists of funds contained in software programs called digital algorithms.

By the time you finish this chapter, you will understand how the use of digital cash may affect the quantity of money in circulation.


Did You Know That…

• Through actions initiated by a central bank such as the Federal Reserve, depository institutions together create money?

• In this chapter, we shall examine the money multiplier process, which explains how an injection of new money into the banking system leads to an eventual multiple expansion in the total money supply.


Links Between Changes in the Money Supply and Other Economic Variables

• There are links between changes in the money supply and changes in GDP.

• There are links between changes in the money supply and the rate of inflation.


Figure 16-1 Money Supply Growth versus the Inflation Rate


Links Between Changes in the Money Supply and Other Economic Variables (cont'd)

• Fractional Reserve Banking

A system in which depository institutions hold reserves that are less than the amount of depositsOriginated when goldsmiths issued notes that

exceeded the value of gold and silver on hand


Depository Institution Reserves

• What do you think?

Can banks pay off all of their depositors?

How is it possible that they can pay them off eventually but not pay them off simultaneously?


Depository Institution Reserves (cont'd)

• In a fractional reserve banking system, banks do not keep sufficient reserves on hand to cover 100% of their depositors' accounts.

• There are three distinguishable types of reserves: legal, required and excess.



• Reserves

In the U.S. Federal Reserve System, deposits held by Federal Reserve district banks for depository institutions, plus depository institutions’ vault cash



• Legal Reserves

Anything that the law permits banks to claim as reserves—for example, deposits held at Federal Reserve district banks and vault cash



• Required Reserves

The value of reserves that a depository institution must hold in the form of vault cash or deposits with the Fed



• Question Do banks set their own reserve rate?

• Answer No, the Federal Reserve sets the

reserve requirementCurrently it is 10% on most transactions

deposits



• Required Reserve Ratio

The percentage of total transactions deposits that the Fed requires depository institutions to hold in the form of vault cash or deposits with the Fed

Required reserves = Transactions deposits Required reserve ratio



• Excess Reserves

The difference between legal reserves and required reserves

Excess reserves = Legal reserves – Required reserves


The Relationship Between Legal Reserves and Total Deposits

• Balance Sheet Statements of assets (what is owned) and

liabilities (what is owed)

• How a single bank reacts to an increase in reserves We will examine the balance sheet of a

single bank.


The Relationship Between Legal Reserves and Total Deposits (cont'd)

• We assume1. Reserve ratio is 10%

2. Transactions deposits are the bank’s only liabilities and loans are the bank’s assets

3. An individual bank can lend as much as legally allowed

4. Every time a loan is made, the proceeds are put into a deposit account (nothing withdrawn)

5. Zero excess reserves are kept

6. Banks have zero net worth



• Net Worth

The difference between assets and liabilities



Description of a Balance Sheet

Assets Liabilities

What is owned Reserves Loans

What is owed Deposits

Net Worth = Assets – Liabilities


Required reserves = .10 $1,100,000 = $110,000

Excess reserves = $200,000 – $110,000 = $90,000


• Following the deposit What are the required reserves of

Typical Bank?

Does Typical Bank have excess reserves?


Balance Sheet 16-2 Typical Bank (cont'd)

Typical Bank has required reserves of $110,000 and excess reserves of $90,000.



• Following the deposit

What will Typical Bank do with its excess reserves?Loan them out

Could Typical Bank safely loan out more than its excess reserves?By law holds a certain amount of

required reserves



• Effect on the money supply

New reserves for the banking system as a whole are not created when debit-card or check payments are transferred from one bank and deposited in another bank.

The Federal Reserve System can however, create new reserves—the subject of our next section.


The Fed’s Direct Effect on the Overall Level of Reserves

• The Federal Open Market Committee (FOMC)

Can instruct the New York Federal Reserve Bank trading desk to buy or sell bonds


The Fed’s Direct Effect on the Overall Level of Reserves (cont'd)

• Open Market Operations

The purchase and sale of existing U.S. government securities (such as bonds) in the open private market by the Federal Reserve System


Money Expansion by the Banking System

• Consider the entire banking system; for practical purposes, we can look at all depository institutions taken as a whole.

• To understand how money is created, we must understand how depository institutions respond to Fed actions that increase reserves in the entire system.


This shows Bank 1’s original position before the Fed’s purchase of a $100,000 U.S. government security.

Balance Sheet 16-6 Bank 1


Fed transfers $100,000 to Bank 1 immediately increasing the money supply by the same amount. Bank 1 has excess reserves of $90,000.



Figure 16-8 shows Bank 1 expands its loans by $90,000.



The borrower deposits $90,000 in Bank 2, and Bank 2 now has money to lend out.

Balance Sheet 16-9 Bank 2 (Changes Only)


Bank 2 makes a loan for $81,000, the amount of its excess reserves.



Money Expansion by the Banking System (cont'd)

• Recall

The Fed bought a bond and deposited it at Bank 1, immediately increasing the money supply by $100,000.

The deposit creation process (in addition to the $100,000) occurs because of the fractional reserve banking system.

Banks will lend out any excess reserves as they can earn interest income on new loans.


Assume the firm borrowing $81,000 from Bank 2 spends these funds, which are deposited in Bank 3.



We assume Bank 3 will want to lend all of those non-interest-earning assets (excess reserves of $72,900).



E-Commerce Example: Remote Capture Speeds the Check Clearing Process

• Traditional check-clearing typically takes one to three days to complete.

• Internet based institutions pioneered a concept called remote capture.

• Remote capture cuts the time to just an hour.



• Question

Looking over our balance sheets, how much do you think the money supply increased after the Fed’s $100,000 purchase of government securities and the three bank loans?



What do you think?• Could Banks 4, 5, 6, etc.

create even more money?• How much can be created?

$100,000 Purchase by the Fed90,000 Loan by Bank 181,000 Loan by Bank 272,900 Loan by Bank 3

$343,900 Total


Table 16-1 Maximum Money Creation with 10 Percent Required Reserves


Figure 16-2 The Multiple Expansion in the Money Supply Due to $100,000 in New Reserves When the Required Reserve Ratio Is 10 Percent



• Only when additional new reserves and deposits are created by the Federal Reserve System does the money supply increase.

• The reverse process occurs when there is a decrease in reserves because the Fed sells $100,000 in government securities.


The Money Multiplier

• Money Multiplier

Gives the maximum potential change in the money supply due to a change in reserves


The Money Multiplier (cont'd)

Actual changein the money

supply= Actual money

multiplierChange in

total reserves

Potential money multiplier = 1

Required reserve ratio



• Example

Fed buys $100,000 of government securities

Reserve ratio = 10%

Potential changein the money

supply= $100,000 = $1,000,000x

1

.10



• Forces that reduce the money multiplier

LeakagesCurrency drains

Excess reserves



• Real-world money multipliers

M1 multiplier = 2.5–3.0

M2 multiplier = 6.5 in the 1960s to over 12 in the 2000s


Ways in Which the Federal Reserve Changes the Money Supply

1. Open market operations

2. Reserve requirement

3. Discount rate


Ways in Which the Federal Reserve Changes the Money Supply (cont'd)

• Discount Rate

The interest rate that the Federal Reserve charges for reserves it lends to depository institutions



• Federal Funds Market A private market in which banks can

borrow reserves from other banks that want to lend them

• Federal Funds Rate The interest rate that depository

institutions pay to borrow reserves in the interbank federal funds market



• Today’s discount rate policy is to set discount rate above the federal funds rate.

• Question Why would the Fed do this?



• Question What if the Fed changes reserve

requirements it imposes?

What if reserve requirements go from 10 to 20%?

• Answer Then the money multiplier changes from

10 to 5.


Table 16-2 Required Reserve Ratios in Selected Nations


Sweep Accounts and the Decreased Relevance of Reserve Requirements

• Many banks offer automatic transfer accounts, in which savings account balances are transferred to demand deposit accounts only when needed.

• This feature allows banks to hold fewer reserves as savings deposits are exempt from reserve requirements.


Sweep Accounts and the Decreased Relevance of Reserve Requirements (cont'd)

• Sweep Account

A depository institution account that entails regular shifts of funds from transactions deposits that are subject to reserve requirements to savings deposits that are exempt from reserve requirements


Figure 16-3 Sweep Accounts and Reserves of U.S. Depository Institutions at Federal Reserve Banks


Sweep Accounts and the Decreased Relevance of Reserve Requirements (cont'd)

• Banks use sweep accounts to shift funds from checking accounts into savings accounts until they are needed to settle check payments.

• Consequently, more of money supply growth has been shifted to M2, and M1 is considered a less reliable indicator of total liquidity.


Federal Deposit Insurance

• When businesses fail, they create hardships for creditors, owners and customers.

• When a depository institution fails even greater hardship results as many individuals and businesses depend on the safety and security of banks.


Source: Federal Deposit Insurance Corporation

Figure 16-4 Bank Failures


Federal Deposit Insurance

• Federal Deposit Insurance Corporation (FDIC) A government agency that insures the deposits

held in banks and most other depository institutions; all U.S. banks are insured this way.

• Bank Runs Attempts by many of a bank’s depositors to

convert transactions and time deposits into currency out of fear that the bank’s liabilities may exceed its assets


Federal Deposit Insurance (cont'd)

• How deposit insurance causes increased risk taking by bank managers

Lack of correlation between risk taking and insurance premiums.



• Deposit insurance, adverse selection, and moral hazard

Adverse selection arises when there is asymmetric information. Information possessed by one side of a

transaction but not the other

The side with more information will be at an advantage.



• Deposit insurance, adverse selection, and moral hazard

Moral hazard arises as a result of information asymmetry after a transaction has occurred.



• The results of moral hazard

The S&L crisis of the mid-1980s

More than 1,500 savings and loan associations failed.

The estimated taxpayer cost was $200 billion.


Issues and Applications: Smart Cards, Digital Cash, and the Money Supply

• The microchips embedded in smart cards give them a technical edge over debit cards.

• At present, about 300 million smart cards are used around the globe.

• In a world in which people widely use digital cash the money multiplier would be larger.


Figure 16-5 The Distribution of the World’s Smart Cards

Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 13-131

Key Terms and Concepts

• barter

• checkable deposits

• depository institutions

• digital cash

• Fed

• fiduciary monetary system

• fractional reserve

• liquidity

• medium of exchange

• money market deposit accounts

• money market mutual funds

Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 13-132

Key Terms and Concepts (cont.)

• money multiplier

• money supply

• near moneys

• reserve requirements

• reserves

• savings deposits

• small-denomination time deposits

• smart cards

• thrift institutions

• unit of accounting

Date post:	05-Jan-2016
Category:	Documents
Upload:	maud-marsh
View:	218 times
Download:	0 times

Chapter 13 Money and Our Banking System. Copyright © 2008 Pearson Addison Wesley. All rights...

Documents