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31 13 Money, Banking, and Financial Institutions McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Functions of Money • Medium of exchange • Used to buy/sell goods • Unit of account • Goods are valued in dollars • Store of value • A place to store wealth. LO1 31-2 Money Definition M1 • M1 • Currency • Checkable deposits (demand deposits) • Institutions offering checkable deposits • Commercial banks • Savings and loan associations • Mutual savings banks • Credit unions LO1 31-3 Money Definition M2 • M2 • M1 plus near-monies • Savings deposits including money market deposit accounts (MMDA) • Small-denominated time deposits • Money market mutual funds (MMMF) • What makes these different from M1? LO1 31-4 Money Definitions January 2010 Source: Federal Reserve System LO1 31-5 What “Backs” the Money Supply? • Guaranteed by government’s ability to • • LO2 keep value stable Money as debt Why is money valuable? • Acceptability • Legal tender – “fiat money:” money because the govt. says its money.. • Relative scarcity 31-6 The Demand for Money • Transactions Demand – Dt • Amount of money needed for purchases, etc. • Main determinant is nominal GDP. • Why? • Asset Demand – Da • Amount of wealth people want to hold as money (instead of bonds, stocks, whatever). • It’s main determinant is the interest rate. LO3 31-8 The Demand for Money • Total Demand for Money - Dm • Is the sum of Dt and Da • Change in nominal GDP will shift the total money demand curve. • Change in interest rate will cause a movement along the curve. LO3 31-9 Rate of interest, i percent Demand for Money (a) Transactions demand for money, Dt (b) Asset demand for money, Da 10 Sm 7.5 =5 + 5 2.5 Dt 0 50 100 Da 150 200 Amount of money demanded (billions of dollars) LO1 (c) Total demand for money, Dm and supply 50 100 150 200 Amount of money demanded (billions of dollars) Dm 50 100 150 200 250 300 Amount of money demanded and supplied (billions of dollars) 33-10 Interest Rates • Equilibrium interest rate • Changes with shifts in money supply • LO1 and money demand Interest rates and bond prices • Inversely related • Bond pays fixed annual interest payment • Lower bond price will raise the interest rate 33-11 Federal Reserve - Banking System • Board of Governors • 12 Federal Reserve Banks • Serve as the central bank • Quasi-public banks • Banker’s bank LO3 31-12 Federal Reserve – Banking System The 12 Federal Reserve Banks LO3 31-13 Federal Reserve Functions • Issue currency • Set reserve requirements • Lend money to banks • Collect checks • Act as a fiscal agent for U.S. • • LO4 government Supervise banks Control the money supply 31-15 Federal Reserve Independence • Established by Congress as an • • LO4 independent agency Protects the Fed from political pressures Enables the Fed to take actions to increase interest rates in order to stem inflation as needed 31-16