Macroeconomics
ECON 2301
Fall 2009
Marilyn Spencer, Ph.D.
Professor of Economics
Chapter 15
Chapter 15: Money, Banking, and
Central 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
 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
15-3
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
15-4
Table 15-1 Types of Money
15-5
The Functions of Money
 The 4 functions of money
1. Medium of exchange
2. Unit of accounting
3. Store of value (purchasing power)
4. Standard of deferred payment
15-6
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
15-7
The Functions of Money (cont'd)
 Medium of exchange
Money facilitates exchange by reducing
transaction costs associated with means-ofpayment uncertainty.
• Permits specialization, facilitates efficiencies
 Barter
Simply a direct exchange
• Double coincidence of wants
15-8
The Functions of Money (cont'd)
 Unit of Accounting
A measure by which prices are expressed
The common denominator of the
price system
A central property of money
15-9
The Functions of Money (cont'd)
 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.
15-10
The Functions of Money (cont'd)
 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
15-11
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.
15-12
Figure 15-1 Degrees of Liquidity
15-13
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.
15-14
Monetary Standards,
or What Backs Money
 Questions
What backs money?
Is it gold, silver, or the federal government?
 Answer
Your confidence
15-15
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
15-16
Monetary Standards, or What Backs
Money (cont'd)
 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.”
15-17
Monetary Standards, or What Backs
Money (cont'd)
 Currency and transactions deposits are
money because of their
Acceptability
Predictability of value
15-18
Defining Money
 The size of the Money Supply 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
15-19
Defining Money (cont'd)
 Economists use two basic approaches to
define and measure money.
The transactions approach
The liquidity approach
15-20
Defining Money (cont'd)
 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
15-21
Defining Money (cont'd)
 The transactions approach to measuring
money: M1
Currency
Checkable (transaction) deposits
Traveler’s checks not issued by banks
15-22
Figure 15-2 Composition of the U.S. M1 and
M2 Money Supply, 2009, Panel (a)
Sources: Federal
Reserve Bulletin;
Economic
Indicators, various
issues; author’s
estimates.
15-23
Figure 15-2 Composition of the U.S. M1 and
M2 Money Supply, 2009, Panel (b)
Sources:
Federal
Reserve
Bulletin;
Economic
Indicators,
various
issues;
author’s
estimates.
15-24
Defining Money (cont'd)
 M1
1. 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.
15-25
Defining Money (cont'd)
 M1
2. 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
15-26
Defining Money (cont'd)
 M1
3. 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
15-27
Defining Money (cont'd)
 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.
15-28
Defining Money (cont'd)
 The liquidity approach: M2 = M1 +
1. Savings and small denomination
time deposits
2. Balances in retail money market mutual funds
3. Money market deposit accounts (MMDAs)
15-29
Defining Money (cont'd)
 M2
1. 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.
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
15-30
Defining Money (cont'd)
 M2
2. 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
» CD: Time deposit with fixed maturity
15-31
Defining Money (cont'd)
 M2
3. 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
15-32
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 (money-at-zeromaturity) which includes all MMFs but excludes
all deposits with fixed maturities.
• MZM entails adding deposits without set maturities to
M1.
15-33
Financial Intermediation & 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
15-34
Financial Intermediation & 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
15-35
Figure 15-4 The Process of
Financial Intermediation
15-36
Financial Intermediation & 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
15-37
Financial Intermediation & 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
15-38
Financial Intermediation & Banks (cont'd)
 Moral Hazard (in this context): 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.
15-39
Financial Intermediation & Banks (cont'd)
 Liabilities:
Amounts owed
The sources of funds for financial
intermediaries
 Assets:
Amounts owned
The uses of funds by financial intermediaries
15-40
Table 15-2 Financial Intermediaries and
Their Assets and Liabilities
15-41
Financial Intermediation & Banks (cont'd)
 Payment Intermediaries: Institutions that
facilitate transfers of funds between
depositors who hold transactions deposits
with those institutions
Payment Intermediation:
A recent study revealed that revenues derived from
debit-card and checking transfer services accounted for
28% of the bank’s total earnings.
Another 10% of earnings were generated from
processing payments for credit cards, stocks, and bonds.
15-42
Figure 15-5 How a Debit-Card
Transaction Clears
15-43
Federal Deposit Insurance
 In 1933, at the height of bank failures, the Federal
Deposit Insurance Corporation (FDIC) was
founded to insure the funds of depositors and
remove the reason for runs on banks.
FDIC: a government agency that insures
the deposits held in banks and most other
depository institutions; all U.S. banks are
insured this way.
Federal Deposit Insurance (cont’d)
 As can be seen in Figure 15-5, bank failure rates
dropped dramatically after passage of this
legislation.
From WWII to 1984, fewer than nine banks
failed per year.
From 1985 to the beginning of 1993, however,
1,065 commercial banks failed – averaging 120
bank failures per year.
More than 150 banks have failed within this
past year.
Figure 15-5 Bank Failures
Source: Federal Deposit Insurance Corporation.
Federal Deposit Insurance (cont’d)
 Bank Runs: Attempts by many of a bank’s
depositors to convert transactions and time
deposits into currency out of fear that the
bank’s liabilities may exceed its assets.
Financial Deposit Insurance (cont’d)
 The FDIC charges premiums to depository
institutions based on their total deposits.
 These premiums go into funds that would
reimburse depositors in the event of bank failures.
 This bolsters depositors’ trust in the system and
gives them incentive to leave their deposits in the
bank, even in the face of talk of bank failures.
Financial Deposit Insurance (cont’d)
 Until the 1990s, all insured depository institutions
paid the same fee for coverage, regardless of how
risky their assets were.
 Banks then had an incentive to invest in more
assets of higher risk (and higher yield).
 The FDIC and other federal agencies possess
regulatory powers to offset the risk-taking
temptations.
 Higher capital requirements were imposed in the
early 1990s and adjusted in 2000.
Financial Intermediation and Banks
 Most nations have a banking system that
includes two types of institutions:
1. One type consists of private banking
institutions.
2. The other type of institution is a central bank.
15-50
The Federal Reserve System:
The U.S. Central Bank
 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
Financial Intermediation & 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.
15-52
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
15-53
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
15-54
Figure 15-6 Organization of the
Federal Reserve System
15-55
Figure 15-7
The Federal Reserve System
15-56
The Federal Reserve System (cont'd)
 Depository institutions
7,500 commercial banks
1,300 savings and loans
11,000 credit unions
 All may purchase Fed services
15-57
The Federal Reserve System (cont'd)
 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
8. Intervenes in foreign currency markets
15-58
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?
 The reason is not due to inefficiency; rather,
checks are falling out of favor. Electronic
payments by households and businesses—debit
cards, Internet bill pay, Web based services.
 Government transfers are transmitted electronically
-Social Security, Medicare, Medicaid, military pay.
15-59
Figure 15-8 The Volume and Value of Federal
Reserve Check Clearings Since 1985
15-60
The Federal Reserve System: U.S. Central Bank
(cont’d)
 Lender of last resort: The Federal
Reserve’s role as an institution that is
willing and able to lend a temporary illiquid
bank that is otherwise in good financial
condition to prevent the bank’s illiquid
position from leading to a general loss of
confidence in that bank or in others.
Issues and Applications: The Crash of 2008 and
the Decline of Investment Banking
 Since the 1990’s, two of the largest financial
intermediaries in the world have been Fannie Mae
and Freddie Mac.
 These institutions have specialized in buying
hundreds of billions of dollars of private mortgage
loans from banking institutions with funds that they
raised by issuing mortgage-backed securities
purchased by private investors.
 Both Fannie Mae and Freddie Mac have been
government sponsored enterprises.
Issues and Applications: The Crash of 2008 and
the Decline of Investment Banking (cont'd)
 This meant that if either institution became unable to honor
its obligations, most investors anticipated that the federal
government would step in to bail them out. In the summer
and fall of 2008, this is exactly what happened.
 Between 2007 and 2008, average U.S. housing prices
declined by more than 15%. When people stopped paying
on their mortgages, receipts by Fannie Mae and Freddie
Mac plummeted. Both experienced billions of dollars of
losses.
 Because investors had known that the government stood
behind the institutions’ mortgage-backed securities, they
were willing to regard them as nearly free of risk.
Issues and Applications: The Crash of 2008 and
the Decline of Investment Banking (cont’d)
 This had given Fannie Mae and Freddie Mac an incentive
to issue too many of these securities and to purchase too
many low-quality, risky mortgages from banking
institutions.
 A similar problem also caused “investment banks” to
cease to exist.
 Why do you suppose that many economists suggest that a
major U.S. government push for Fannie Mae and Freddie
Mac to encourage more lending to lower-income
households in the 2000s helped to enlarge the “moral
hazard” problem?
Summary 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
15-65
Summary 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
15-66
Summary of Learning Objectives (cont'd)
 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
15-67
Summary of Learning Objectives (cont'd)
 Features of Federal Deposit Insurance
Provides deposit insurance by charging some
depository institutions premiums based on the
value of their deposits.
These funds are placed in accounts for use in
reimbursing failed banks’ depositors.
This creates adverse selection and moral hazard
problems.
Summary of Learning Objectives (cont'd)
 The basic structure of the Federal Reserve
System
12 district banks with 25 branches
Governed by Board of Governors
Federal Open Market Committee
Summary of Learning Objectives (cont'd)
 Major functions of the Federal Reserve
1. Supply the economy with currency
2. Provide systems for transmitting and clearing payments
3. Holding depository institutions’ reserves
4. Acting as the government’s fiscal agent
5. Supervising banks
6. Acting as a “lender of last resort”
7. Regulating the money supply
8. Intervening in foreign exchange markets
15-70
Assignment to be completed
before class November 16:
Read Chapter 16 & also read these endof-chapter Problems:
14th ed:16-1, 16-2, 16-4, 16-7, 16-9, 16-12 &
16-15, on pp. 420-421.
15th ed:16-1, 16-2, 16-4, 16-7, 16-9, 16-10 &
16-13, on pp. 420-421.