Macroeconomics
ECON 2301
Spring 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
Example: E-Gold Backed EMoney
 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.
15-17
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.”
15-18
Monetary Standards,
or What Backs Money (cont'd)
 Currency and transactions deposits are
money because of their
Acceptability
Predictability of value
15-19
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
15-20
Defining Money (cont'd)
 Economists use two basic approaches to
define and measure money.
The transactions approach
The liquidity approach
15-21
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
15-22
Defining Money (cont'd)
 The transactions approach to measuring
money: M1
Currency
Checkable (transaction) deposits
Traveler’s checks not issued by banks
15-23
Figure 15-2 Composition of the U.S. M1 and
M2 Money Supply, 2007, Panel (a)
15-24
Figure 15-2 Composition of the U.S. M1 and
M2 Money Supply, 2007, Panel (b)
15-25
Defining Money (cont'd)
 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.
15-26
Figure 15-3 The Value of U.S. Currency in
Circulation Outside the United States
15-27
Defining Money (cont'd)
 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
15-28
Defining Money (cont'd)
 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
15-29
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
15-30
Defining Money (cont'd)
 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
15-31
Defining Money (cont'd)
 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
15-32
Defining Money (cont'd)
 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
15-33
Defining Money (cont'd)
 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
15-34
Defining Money (cont'd)
 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
15-35
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
15-36
Defining Money (cont'd)
 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.
15-37
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.
15-38
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.
15-39
Financial Intermediation
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
15-40
Financial Intermediation
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
15-41
Figure 15-4 The Process of
Financial Intermediation
15-42
Financial Intermediation
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
15-43
Financial Intermediation
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
15-44
Financial Intermediation
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.
15-45
Announcement
 We will NOT hold class Tues., April 21.
 Instead, here is an opportunity for 4 points of extra
credit:
Attend the Kirkland Lecture in the Performing Arts
Center at 9:30 a.m. that morning.
Be sure to sign in before entering the auditorium.
Write a summary of the speaker’s remarks, 50-100
words, and email it to me at
marilyn.spencer@tamucc.edu BEFORE class, April 28.
Financial Intermediation
and Banks (cont'd)
 Liabilities
Amounts owed
The sources of funds for financial
intermediaries
 Assets
Amounts owned
The uses of funds by financial intermediaries
15-47
Table 15-2 Financial Intermediaries and
Their Assets and Liabilities
15-48
Financial Intermediation
and Banks (cont'd)
 Payment Intermediaries
Institutions that facilitate transfers of funds
between depositors who hold transactions
deposits with those institutions
15-49
Figure 15-5 How a Debit-Card
Transaction Clears
15-50
Financial Intermediation
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
15-51
Table 15-3
The World’s Largest Banks
15-52
Financial Intermediation
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
15-53
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)
15-54
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
15-55
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
15-56
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
15-57
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
15-58
Figure 15-6 Organization of the
Federal Reserve System
15-59
Figure 15-7
The Federal Reserve System
15-60
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
15-61
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
15-62
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?
15-63
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.
15-64
Figure 15-8 The Volume and Value
of Federal Reserve Check Clearings Since
1985
15-65
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
15-66
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
15-67
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
15-68
Summary
of Learning Objectives (cont'd)
 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
15-69
Learning Objectives:
 Explain how federal government budget deficits occur
 Define the public debt and understand alternative measures
of the public debt
 Evaluate circumstances under which the public debt could
be a burden to future generations
 Discuss why the federal budget deficit might be measured
incorrectly
 Analyze the macroeconomic effects of government budget
deficits
 Describe possible ways to reduce the government budget
deficit
14-70
Public Deficits and Debts:
Flows versus Stocks
 Government Budget Deficit
Exists if the government spends more
than it receives in taxes during a given period
of time
Is financed by the selling of government
securities (bonds)
14-71
Public Deficits and Debts:
Flows versus Stocks (cont'd)
 The federal deficit is a flow variable, one
defined for a specific period of time, usually
one year.
 If spending equals receipts, the budget is
balanced.
 If receipts exceed spending, the government
is running a budget surplus.
14-72
Public Deficits and Debts:
Flows versus Stocks (cont'd)
 Balanced Budget
A situation in which the government’s
spending is exactly equal to the total taxes and
revenues it collects during a given period of
time
 Government Budget Surplus
An excess of government revenues over
government spending during a given period of
time
14-73
Public Deficits and Debts:
Flows versus Stocks (cont'd)
 Public Debt
A stock variable
The total value of all outstanding government
securities
14-74
Government Finance: Spending
More than Tax Collections
 Since 1940, the U.S. federal government
has operated with a budget surplus in 13
years.
 In all other years, the shortfall of tax
revenues below expenditures has been
financed with borrowing.
14-75
Figure 14-1 Federal Budget Deficits
and Surpluses Since 1940
14-76
Figure 14-2 The Federal Budget Deficit
Expressed as a Percentage of GDP
14-77
Policy Example: Explaining a $109
Billion Deficit Projection Turnaround
 Why was the government’s 2005 deficit projection
off by $109 billion?
 Federal tax revenues turned out to be more than
15% higher in 2005.
 Economic growth caused taxable incomes, hence
revenues, to be much higher than anticipated.
14-78
Evaluating the Rising Public Debt
 Gross Public Debt
All federal government debt irrespective of
who owns it
 Net Public Debt
Gross public debt minus all government
interagency borrowing
14-79
Evaluating the Rising Public Debt (cont'd)
 Some government bonds are held by government
agencies.
In this case, the funds are owed from one
branch of the federal government to another.
To arrive at the net public debt, we subtract
interagency borrowings from the gross public
debt.
14-80
Evaluating the Rising Public Debt (cont'd)
 Tax revenues tend to be stagnant during times of
slow economic growth.
 Tax revenues grow more quickly when overall
growth enhances incomes.
 As long as spending exceeds revenues, the budget
deficit will persist.
14-81
Table 14-1 The Federal Deficit, Our Public
Debt, and the Interest We Pay on It
14-82
Figure 14-3 Net U.S. Public Debt
as a Percentage of GDP
14-83
Net U.S. Public Debt as a Percentage of GDP
 During World War II, the net public debt grew
dramatically.
 After the war
It fell until the 1970s
Started rising in the 1980s
Declined once more in the 1990s
And recently has been increasing again
14-84
Assignment to be completed
before class April 21:
Read Chapter 16 & also read the
end-of-chapter Problems: 16-1,
16-2, 16-4, 16-7, 16-9, 16-12 &
16-15, on pp. 420-421.