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Chapter 14
Money and
Banking
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Objectives
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The functions of money
Components of the money supply
What “backs” the money supply
The Federal Reserve and the
U.S. banking system
• The functions and responsibilities
of the Federal Reserve
14-2
Functions of Money
• Money is a medium of exchange in that it
is used to buy and sell goods
– Without money, we would be back to bartering
• It is a unit of account, i.e., it serves as a
yardstick by which we can determine the
value of all goods, services and resources
• Money serves as a store of value. If we
don’t need it today, we can store wealth as
money (checking account) and use in
whenever it is needed in the future
• Money is highly “liquid”; everyone
recognizes its value and will accept any
willingly
14-3
Money Defined
• Money consists in several forms and
is defined below:
• M1 is a narrow definition of money
and consists of currency (coins and
paper money) as well as any deposit
upon which a check can be drawn
(checkable deposits)
– 56% of M1 is currency held by the
public
– Money has only “token” value in that its
intrinsic value is less than the actual
value (there is less than 10 cents worth
of metal in a dime)
– All paper currency consists of Federal
Reserve Notes issued by the Federal
Reserve
14-4
Money Defined
• Checkable deposits are included in M1, since they
can be spent almost as readily as currency, and
can be easily changed into currency
– Checkable deposits form 44% of M1
• Commercial banks are a main source of
checkable deposits for households and
businesses
• Thrift institutions such as savings and loans and
credit unions also have checkable deposits
• Qualifications: Currency and checkable deposits
held by the federal government, Federal Reserve
and other financial institutions are not included
– If they were, this would be “double counting” of the
money
Money Defined
• M2 is a broader definition of money
• It includes not only M1 but also several
other “near monies” such as
– Savings deposits and money market deposit
accounts
– Small time deposits (certificates of deposit)
less than $100,000
– Money market mutual fund balances which
can be redeemed by phone calls, checks, or
through the internet
Are Credit Cards Money?
• Nope, they are not money but are an
instantaneous, on the spot, short-term
loan between you and the bank whose
card you are using
• Although they are not money, they allow
you to hold less currency in your billfold
and also less checkable deposits in your
bank (until you have to make your monthly
payment!!)
Money Defined
M1
M2
Currency +
56%
M1
Checkable Deposits +
44%
18%
January 2008
Small Time Deposits +
16%
Money Market Mutual
Funds Held By Individuals +
14%
Savings Deposits,
Including Money Market +
Deposit Accounts
52%
Totals
Source: Federal Reserve System
$1,365
Billion
$7,499
Billion
14-8
Money Supply
• The astonishing thing about money is that the Federal
Government does not “back” it
• Then the question is - why is money valuable?
– It is valuable because the government can keep its
“value” stable
– It is valuable because it is acceptable to everyone as a
medium of exchange
– It has not intrinsic value, but only its value in exchange
for goods and services
– It is “legal tender” and generally must be accepted in
repayment of debt (but firms and government may
require payment be made by alternative means)
– The courts have deemed that pennies are not legal
tender
– The relative scarcity of money compared to goods and
services will allow money to retain its purchasing power
14-9
Money and Prices
• Prices affect purchasing power of money
– Higher prices mean less purchasing power
• Excessive inflation make may make
money essentially worthless
– After WWI, consumers in Germany were
buying bread with wheelbarrels of marks
– The value of the mark decreased to less
than 1 billionth of its former value within a
four year period
– Worthless money leads to use of other
currencies that are more stable
– Worthless money may lead to barter
exchange systems
14-10
Maintaining the Value of Money
• The government tries to keep the
money supply stable with
appropriate fiscal (i.e., financial)
policy
• Monetary policy tries to keep
money relative scarce to maintain
its purchasing power while
expanding enough to allow the
economy to grow
Federal Reserve System
• The Federal Reserve System (the “Fed”) was
established by Congress in 1913 and is in
charge of the money and banking system
• They were established because of the
occurrence of banking crises such as everyone
wanting to withdraw the money simultaneously;
also the supply of money was largely
unregulated
• The central controlling authority of the system is
the Board of Governors which consists of 7
members appointed by the President for
staggered 14 year terms (to ensure political
freedom)
14-12
The Federal Reserve System
• The Federal Open Market Committee
(FOMC) includes the seven governors
plus five regional Federal Reserve Bank
presidents whose terms alternate
– They set policy on buying and selling of
government bonds, the most important type
of monetary policy, and meet several times
each year
The Federal Reserve System
• The Federal Reserve System has 12
districts, each with its own district bank and
two or three branch banks
– The district banks help implement Fed policy and
are advisory
– Each is quasi-public; it is owned by member
banks but controlled by the government’s
Federal Reserve Board, and any profits go to the
U.S. Treasury
– They act as bankers’ banks by accepting reserve
deposits and make loans to banks and other
financial institutions
– In making loans, the Federal Reserve is the
lender of last resort should no other options be
available
Federal Reserve System
Board of Governors
Federal Open Market Committee
12 Federal Reserve Banks
Commercial Banks
Thrift Institutions
(Savings and Loan Associations,
Mutual Savings Banks,
Credit Unions)
The Public
(Households and
Businesses)
14-15
Federal Reserve System
The 12 Federal Reserve Banks
Source: Federal Reserve Bulletin
14-16
Federal Reserve Functions
• The Fed issues “Federal Reserve
Notes” which is the paper currency
used in the U.S. monetary system
• The Fed sets reserve requirements
and holds the reserves of banks and
thrifts not held as vault cash
• The Fed may lend money to banks
and thrifts, charging them an interest
rate called the discount rate
14-17
Federal Reserve Functions
• The Fed provides a check collection
service for banks by adjusting the reserve
deposits of the banks involved
• The Federal Reserve System acts as the
fiscal agent for the Federal government
• They supervise member banks
• Monetary policy and control of the
money supply is the major function of
the Fed
Financial Institutions
World’s 12 Largest Financial Institutions, 2007
0
Assets (Billions of U.S. Dollars)
1,300,000
1,600,000
1,900,000
Barclays (UK)
BNP Paribas (France
Citigroup (USA)
HSBC Group (UK)
UBS (Switzerland)
Royal Bank of Scotland (UK)
ING Group (Netherlands)
Mitsubishi UFJ (Japan)
Deutsche Bank Group (Ger)
Bank of America (US)
Allianz Worldwide (Ger)
JPMorgan Chase (USA)
Source: Organization for Economic Cooperation and Development 14-19
The Global Greenback
• U.S. currency circulating abroad
– Russia $80 billion
– Argentina $50 billion
– $450 billion total
– 60% of total US currency
• Black markets and illegal activities
• Dollar offers stable purchasing power
• Exchange rate risk
14-20
Key Terms
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medium of exchange
unit of account
store of value
M1
Federal Reserve Notes
token money
checkable deposits
commercial banks
thrift institutions
near-monies
M2
savings account
money market deposit
account (MMDA)
• time deposits
• money market mutual
fund (MMMF)
• legal tender
• Federal Reserve
System
• Board of Governors
• Federal Reserve Banks
• Federal Open Market
Committee (FOMC)
• financial services
industry
• electronic payments
14-21
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Money
Creation
14-22