Money, Banking and the FED

Federal Reserve, what is money?

What is Money?

Money is a medium of exchange, a unit of account, and a store of value.

As a medium of exchange, money measures value during the exchange of goods and services.

As a unit of account, money is a way to compare the value of goods and services.

As a store of value. Money holds its value even if it is not used though inflation affects money.

What is money?!

The main thing that makes money valuable is the same thing that generates value for other commodities:The demand for money relative to its supply

People demand money because it reduces the cost of exchange

When the supply of money is limited relative to the demand, money will be valuable.

Why is money valuable?

Commodity MoneyLong ago in some

societies, salt was used as money. Salt is an example of commodity money, it can be used as money or eaten.

Commodity money can be used as money but also has value in itself.

Representative Money

Representative money is another type of money.

An example of representative money is a check

The paper that the check is written on can be exchanged for something valuable.

Fiat MoneyFiat money is our money

today.

Our money is money because the government states that it is an acceptable means to pay debts.

In other words, its money because the government says so.

“This note is legal tender for all debts, public and private”

Do we use pigs as money or paper as money? How does a society decide?

There are four physical characteristics of money. Money should be:Portable: small, light and easy to carryDivisible: allows for flexible pricingDurable: strong enough to last through many

transactionsUniform: features and markings that make it recognizable

and difficult to counterfeitThere are three economic characteristics of money:

Accepted: needs to be accepted as a medium of exchangeScarcity: needs to be scarce to maintain valueStability of Value: Purchasing power should be relatively

stable

The Characteristics of Money

Liquidity: how easy it is to convert money into cash.

The breakdown measure the money supply by degree of liquidity.

Currency: all paper money and coinsDemand Deposits: Money in a checking

account is called a demand deposit because it can be converted into currency on demand.

Near Money: Money is a savings account and other time deposits. Called near money because it can be converted into cash with relative ease.

What serves as money in the U.S Today?

The US breaks money down in M1 and M2.

M1:CurrencyDemand depositsTravelers checks

M2M1Savings AccountsCDsMutual Funds near moneyM1 and M2 Explained

M1 and M2

The banking industry includes:Savings and loansCredit UnionsCommercial Banks

Banks are profit-seeking institutionsBanks accept deposits and use part of them to

extend loans and make investments. This is their major source of revenue.

Banks play a central role in the capital marketThey help bring together people who want to save

for the future and those to want to borrow for current investment projects.

The Business of Banking

Banks provide services and pay interest to attract transactions, and encourage the opening of checking, savings and CD accounts

Most of the deposits are invested and loaned out providing interest income for the bank

Banks hold a portion of their assets as reserves to meet their daily obligations toward their depositors.

The Functions of Commercial Banking Institutions

Fractional Reserve BankingThe US banking system is a

fractional reserve system where banks maintain only a fraction of their assets as reserves to meet the requirements of depositors.

Under a fractional reserve system, an increase in reserves will permit banks to extend additional loans and thereby expand the money supply (by creating additional checking deposits)

The lower the percentage of the reserve requirement, the greater the potential expansion in the money supply resulting from the creation of new reserves.

The fractional reserve requirement places a ceiling on potential money creation from new reserves.

The actual deposit multiplier will be less than the potential because:

Some persons will hold currency rather than bank deposits.

Some banks may not use all their excess reserves to extend loans.

How Banks Create Money Extending Loans

History of US BankingA bank is an institution for receiving, keeping

and lending money.Today, the Federal Reserve Bank oversees all

banking in the United States. But there was a time when banks were not regulated by the Federal government. Sometimes bankers made poor decisions that bankrupted their banks.

The History of Banking

At the founding of the nation, Federalists wanted a strong, central bank.Alexander Hamilton believed that a strong central

bank was essential for the new nation. A strong bank would prevent abuses in banking

Anti-Federalists believed that a strong, central bank would only loan to the rich and powerful.Patrick Henry believed that a strong central bank

would have too much power and would favor the rich (exactly why the Americans rebelled in the first place)

Eventually the Federalists won and we now have a strong central bank.

Federalists vs. Anti Federalists

1791 The First Bank of the United States1816-1836 The Second Bank of the United

States1837-1863 Free Banking or “Wildcat Era”Civil War, 1861- Greenbacks

1870’s Gold Standard is established 1 oz Gold Equaled about $20Limited the amount of notes in

circulation

Early Banking

The Panic of 1907: a severe financial panic jolted Wall Street and forced several banks into failure. This panic, however, did not trigger a broad financial collapse. Yet the simultaneous occurrence of general prosperity with a crisis in the nation's financial centers persuaded many Americans that their banking structure was sadly out of date and in need of major reform.

Federal Reserve Act of 1913: The Act provided for a Reserve Bank Organization Committee that would designate no less than eight but no more than twelve cities to be Federal Reserve cities, and would then divide the nation into districts, each district to contain one Federal Reserve City.

Banking in the 20th Century

Glass–Steagall Act 1933: reaction to the great depression. Banks were being too speculative, taking on massive risks and hoping for big rewards. The act was an attempt to curb and control bank spending and investments.

Bank Holding Company Act 1956: further separated financial activities by creating a wall between insurance and banking. Even though banks could, and still can, sell insurance and insurance products, underwriting insurance was forbidden.

Gramm-Leach-Bliley Act: repealed part of the Glass-Steagall Act. Commercial banks, investment banks, securities firms, and insurance companies were allowed to consolidate.

Banking Regulation and Deregulation

The deregulation of the banking industry in the 1980’s ended major restrictions on banks and brought major changes to how they operateBank Mergers: There have been several of

them. Larger banks with more branches make banking more available to people

Expansion of Services: Banks have become like financial supermarkets. You can get loans, insurance, stocks, bonds, and more from just one bank.

Banking Deregulation

history of the FEDCreated by the Federal Reserve Act of 1913: Created a

central bank for the United States which is our nation’s main monetary authority. Our central Bank is called the Federal Reserve System, aka THE FED!

The Duties of the FedRegulation and Oversight: make sure that banks are

following sound practices and are not defrauding customers

The Banker’s Bank: lends $ and provides other banking services for private banks and the national government

Times of Emergency: Financed involvement in WWI and lent $45 billion after 9/11 to minimize the disruption to the banking system

Distributes Currency: Issues currency and regulates the supply of money.

The FED

The Structure of the FED

The Board of Governors of the Federal Reserve is at the center of the banking system in the U.S. The board sets all the rates and regulations for all depository institutions. 7 members, appointed to 14-year terms. Appointed by President and

approved by senate. Serve only 1 term. Every 4 years the president chooses a chairman from the board. (Janet

Yellen)The FOMC is a 12-member board that establishes Fed policy

regarding the buying and selling of government securities. The 12 members are the seven members of the Board of Governors; the president of the Federal Reserve Bank of New York; and four of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis.

FOMC meets 8 times a year to review economic & financial conditions, make recommendations on changes in monetary policy and monitor growth.

Advisory Councils: The Fed has several advisory councils that advise the FED on the specific needs of various segments of financial institutions.

The Fed Structure Explained

The map indicates the 12 Federal Reserve districts and the cities in which the district banks are located.Each district bank monitors the commercial banks in their region and assists them with the clearing of checks.The Board of Governors of the Federal Reserve System is located in Washington D.C.

The Federal Reserve controls the three tools of monetary policy: open market operations, the discount rate, and reserve requirements. The board of Governors is responsible for the discount rate and the reserve requirements and the FOMC is responsible for open market operations.

How the Fed uses Monetary Policy

Reserve requirements:The minimum percentage of deposits that banks must keep on reserve to back up checking type accounts

When the Fed lowers the required reserve ratio, it creates excess reserves for commercial banks allowing them to extend additional loans, expanding the money supply.

Raising the reserve requirements means banks have less money to lend and the money supply decreases.

The tools of the Fed

Open Market Operations: the buying and selling of U.S. securities (in the form of bonds) by the Fed.

This is the primary tool used by the Fed. Fed buys bonds – the money supply expands:

bond buyers acquire moneybank reserves increase, placing banks in a position to

expand the money supply through the extension of additional loans.

Fed sells bonds – the money supply contracts:bond buyers give up money for securitiesbank reserves decline, causing them to extend fewer

loans.

The Tools of the Fed

Discount Rate:the interest rate the Fed charges banking institutions for borrowed funds (loans). Banks whose reserves dip below the reserve requirement set by the Federal Reserve's board of governors use that money to correct their shortage. The board of directors of each reserve bank sets the discount rate every 14 days.

An increase in the discount rate decreases the money supply (restrictive) because it discourages banks from borrowing from the Federal Reserve to extend new loans.

A reduction in the discount rate increases the money supply (expansionary) because it makes borrowing from the Federal Reserve less costly.

The tools of the Fed

Cash on Hand: Holiday season, natural disasters, etc. During these times the Fed will increase the amount of cash at banks

Interest rates: When rates are high, people will place more cash in savings instruments and the demand for money is low because there is less incentive to spend and more incentive to save and earn interest. Opposite when rates are low.

Cost of Consumer Goods and Services: as the cost of goods and services increases, buyers may wish to have more money available to them

Level of Income: As income increases people have a tendency to hold more cash.

Factors Affecting Demand for Money

Difference between the Fed and the U.S. Treasury

The Federal Reserve:

Is concerned with the monetary climate for the economy.

Does not issue bonds.

Determines the money supply — primarily through its buying and selling of bonds issued by the U.S. Treasury.

The U.S. Treasury:Is concerned with

the finance of the federal government.

Issues bonds to the general public to finance the budget deficits of the federal government.

Does not determine the money supply.

Monetary PolicyExpansionary

Monetary Policy (easy-money policy)When the FED tries

to increase the amount of money in circulation

Contractionary Monetary Policy (Tight-money policy)When the Fed tries

to reduce the amount of money in circulation

Short Term Effects: immediate increases or decreases on interest rates, lending, and money supply

Policy Lags: It may be hard to identify the economic problem when it is time to implement the policy

Timing Issues: Policies need to be implemented in the right time during the business cycle.Monetarism: theory that rapid changes in money supply

actually cause economic instability. They prefer slow, steady growth and dislike when the FED tinkers with rates to get the $ supply up quickly.

Other Issues: The fed is independent of president and congress and they may not all always agree on monetary policy.

Impacts and Limitations of Monetary Policy