Money, Banking, and the Federal Reserve

People have used money for thousands of years as an exchange for

goods and/or services (from bills, coins, checks to shells, gold, and

other goods)

Money• For something to be considered money, it must have

three functions:– Medium of exchange – seller accepts in

exchange for goods or services• Money can be used to buy whatever you want or

need• Without money, barter (trading of goods and

services) would dominate–Double coincidence (buyers and sellers must

have exchangeable desires) necessary for barter to occur

Money– Unit of accounting – “yardstick” of measuring

value of goods and services (determines values in amounts)• U.S. – Dollar Japan – Yen• Allows for accurate record keeping

– Store of value – can store purchasing power for later use• save money for larger purchases• ex. - waiting for paycheck on payday, not

everyday

Characteristics of Money• Durable – must be able to last over a period

of time• Portable– easily carried• Divisible– divided into smaller parts for

purchases at any price• Stable value– value cannot change quickly

or usefulness will fall (store of value)• Scarce– gives value to money• Accepted– must be taken in exchange for

goods or services

Types of Money• Commodity money – medium of exchange as

a good and money– Ex.- sheep, diamonds

• Representative money – backed by valuable items (gold or silver)

– U.S. – gold or silver certificates – banknotes (promise to convert into coin on demand) for bullion

• Fiat money– value from government order as acceptable payment

• Legal tender – money by law that must be accepted

Basic History of American Money• England forbade the colonies from using printed money or

coins• Still some gold and silver was used in bartering

– Spanish dolár – common coin, later called dollar by colonists

• Bartering for goods prevailed• To help pay for Revolutionary War debts, Continental

Congress issued continentals (bills of credit), but printed too many, became worthless and were unaccepted

• U.S. looked for more reliable means of exchange; Constitution gives Congress the ability to print money, backed by gold and silver values.

• But private banks could still issue banknotes

Banking Services• Wide variety

– Checking accounts– Automatic deposits and payment– Storage of values – safety deposit boxes– Money transfers – moving money from person to person– Overdraft checking – allows for checks to be written for more than person has

in their account, but must be repaid with interest or fee• Banks usually offer similar commodities but with a variety of services and charges• Electronic banking – computer age

– EFT – electronic funds transfer – banking functions on computers rather than on paper

– ATM – automated teller machine– Bank from home – online– Concerns: tampering, lack of privacy, “float” time

• EFT Act (1978) protects against fraud

How To Write a Check

• Can you label these parts to a check?

Types of money in the U.S.

• Money and near moneys– Currency – coins and bills (notes from Federal

Reserve)– Checks – checking accounts and checkable deposits

(demand deposits)– Credit cards – not really money, but represents future

payments• Loan by issuer of card

– Debit cards – automatically withdraw money from accounts

– Closer to being electronic checks– Near moneys – assets that can be quickly turned into

money without risk of loss of value (savings account)

Money Supply• Two most basic definitions of money

supply:–M1: narrowest definition – currency,

checkable deposits, and traveler’s checks–M2: broader definition – all of M1 and

savings, certificates, money market deposits, mutual funds, and other specialized account balances

The Federal Reserve

• Created in 1913 as central banking operation in the United States to settle financial “panics” of the late 1800’s and early 1900’s–Also known as the Fed

Organization• Board of Governors:

– Direct operations of the Fed and supervise the Federal Reserve banks and activities

– 7 members, appointed by the President with Senate approval

– serve for 14 years (one opening every two years)– cannot be reappointed, but do not have to have approval

of President or Congress in decisions• Federal Advisory Council (FAC):

– Assists Board of Governors by reporting on the nation’s business conditions

– 12 members (each elected by the director of each Federal Reserve district bank)

• Federal Open Market Council (FOMC):– Decide how to control money supply– Raise or lower interest rates (big effect on economy)

Organization• Federal Reserve Banks:

– Nation divided into 12 districts (each with Federal Reserve district bank – set up as a corporation owned by member banks, who have bought stock in district banks)

– 9 member boards supervise each district– 25 Federal Reserve branch banks – acting as

offices and aid each district in operations and duties

• Member Banks:– All national banks must join– State charted banks have option to join– Regulated by Federal Reserve district banks

Functions of Federal Reserve • Clear checks – Figure 15.3 p.403 (complex process)• Acts as federal government’s bank– tracking deposits and checks,

advising government spending• Supervising member banks– regulating member banks and operations

– Federal Deposit Insurance Corporation (FDIC) – guarantees deposits of member banks for up to $250,000 per depositor

• Holding reserves and setting reserve requirements–– Certain percentage of deposits must be kept in reserve (on hand)– Change in reserve requirements controls money supply

• Supply paper currency– – All printed in D.C. but with mark of which district bank issues the

federal reserve note– Most new money is for replacing old money (worn out)

• Regulate money supply (monetary policy)- determine amount of money in circulation

– Consumer protection– truth-in-lending• make known interest rates and monthly payments

Monetary Policy• Monetary policy: changing rate of growth of the money supply

to affect costs and credit• Cost of credit = interest

• If interest ↑, credit demanded ↓, and vice versa• Two types:

– Loose money policy (expansionary) – make credit easier to get and abundant – encourages economic growth

• more people borrow, more spending, expanding of business, more employment

• may lead to inflation– Tight money policy (contractionary) – makes

credit expensive• to slow economy (control inflation)• less borrowing, less spending, less production

Fractional Reserve Banking

• Fractional reserve banking – only percentage of deposits required to be in reserve (on hand)–Rest of the money can be lent

• Reserve requirements: certain percentage that must be kept (about 10% now)– in case of large withdrawals

Money Expansion

• Most money is in deposits (by Fed and customers)–Because reserve requirements are not

100%, excess can be used to create “new money” – to be borrowed

–after time and time again – multiple expansion of money

Changing Reserve Requirements

• Lower requirements = more money to lend (and vice versa)

• If raises, banks can call loans, sell investments, or borrow to meet reserve requirements

• This has an extreme effect on economy, not changed much because of this.

Changing Discount Rate• Discount rate – interest rate Fed charges

banks on borrowed money• Prime rate – interest rate charged to

customers by banks– if DR ↑, PR ↑ - discourages borrowing– if DR ↓, PR ↓ - banks borrow more to lend

more• Federal funds rate – interest rate banks charge

each other on short term loans (usually overnight – to ensure meeting reserve requirements)

– if FFR ↑ - less borrowing– if FFR ↓ - more borrowing

Open-Market Operations• Open-marketing operations: buying and

selling United States securities to affect money supply (major tool of the Fed)– Securities– government IOUs- treasury notes,

bills, and bonds

• By buying securities, can increase bank’s money supply, therefore increasing their lending ability (and vice versa)

Difficulties of Monetary Policy

• Hard to gather and interpret information on the money supply–Too much money and activity to track

• Critics say Fed should stay out of regulating money supply

• Government influences with taxes and spending have affect on the economy and monetary policy actions