Money Banking and Central Banking

Chapter 15
Money,
Banking, and
Central Banking

Copyright © 2008 Pearson Addison
Wesley. All rights reserved. 15-2
Introduction
Why is the Federal Reserve System
clearing fewer checks, and what is its
role in our nations financial system?
In this chapter you will learn the answers,
but first you will learn more generally
about money and banking.

Learning Objectives
• Define the fundamental functions
of money
• Identify key properties that any goods
that function as money must possess
• Explain official definitions of the
quantity of money in circulation

Learning Objectives (cont'd)
• Understand why financial
intermediaries such as banks exist
• Describe the basic structure of the
Federal Reserve System
• Discuss the major functions of the
Federal Reserve

Chapter Outline
• The Functions of Money
• Liquidity
• Monetary Standards, or What Backs Money
• Defining Money
• Financial Intermediation and Banks
• Banking Structures Throughout the World
• The Federal Reserve System

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.

Monetary Standards,
• 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.”

Monetary Standards,
• 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
 Currency
Minted 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 deposits
Any deposits in a thrift institution or a
commercial bank on which a check may be
written or debit card used
 Thrift Institution
Financial institutions that receive most of their
funds from the savings of the public

• M1
 Traveler’s Checks
Financial 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 Institutions
Accept 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 Deposit
A 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
 CD
Time 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.

and Banks (cont'd)
• Direct finance
 Individuals purchase bonds from
a business
• Indirect finance
 Individuals hold money in a bank
 The bank lends the money to a business

and Banks (cont'd)
• 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

and Banks (cont'd)
• 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

and Banks (cont'd)
• 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

and Banks (cont'd)
• 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.

and Banks (cont'd)
• Liabilities
 Amounts owed
 The sources of funds for financial
intermediaries

and Banks (cont'd)
• Assets
 Amounts owned
 The uses of funds by financial
intermediaries

Table 15-2 Financial Intermediaries
and Their Assets and Liabilities

and Banks (cont'd)
• 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

and Banks (cont'd)
• 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

and Banks (cont'd)
• 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 Governors
7 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

Summary Discussion
• 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

Summary Discussion
• 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

End of
Chapter 15
Money,
Banking, and
Central Banking

Money Banking and Central Banking

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