Macroeconomics
ECON 2301
Spring 2011
Marilyn Spencer, Ph.D.
Professor of Economics
Chapter 15
Bonus Extra Credit Opportunity
 Dr. Hallet’s talk on fiscal policy in the
European Union
Thursday, April 7, 6 p.m., BH 103
Sign in & attend his talk.
Send me a short summary by the beginning of
class, Apr. 11.
4 points possible
Chapter 15: Money, Banking, and
Central Banking
Learning Objectives
1. Define the fundamental functions of money
2. Identify key properties that any goods that function as
money must possess
3. Explain official definitions of the quantity of money in
circulation
4. Understand why financial intermediaries such as banks
exist
5. Describe the basic structure of the Federal Reserve System
6. Discuss the major functions of the Federal Reserve
15-4
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
15-5
Table 15-1 Types of Money
15-6
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
15-7
The Functions of Money (cont'd)
 Medium of Exchange: Any item that sellers will
accept as payment
Money facilitates exchange by reducing
transaction costs associated with means-ofpayment uncertainty.
• Permits specialization, facilitates efficiencies
 Barter: The direct exchange of goods and services
for other goods and services without the use of
money
• Requires a “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 in a fully
functioning economy
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.
Figure 15-1 Degrees of Liquidity
15-12
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.
15-13
Monetary Standards,
or What Backs Money
 Questions
What backs money?
Is it gold, silver, or the federal government?
 Answer
Your confidence
15-14
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
15-15
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.”
 Currency and transactions deposits are money
because of their
1. Acceptability
2. Predictability of value
15-16
Defining Money
 Money Supply: The amount of money in
circulation
 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.
15-17
Defining Money (cont'd)
 Economists use two basic approaches to
define and measure money:
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
15-18
Defining Money (cont'd)
 The transactions approach to measuring
money: M1
Currency
Checkable (transaction) deposits
Traveler’s checks not issued by banks
15-19
Figure 15-2 , Panel (a)
Composition of the U.S. M1 Money Supply, 2009
Sources: Federal
Reserve Bulletin;
Economic
Indicators, various
issues; author’s
estimates.
15-20
Figure 15-2 , Panel (b)
Composition of the U.S. M2 Money Supply, 2009
Sources:
Federal
Reserve
Bulletin;
Economic
Indicators,
various
issues;
author’s
estimates.
15-21
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.
2. Transactions deposits: Any deposits in a thrift institution
or a commercial bank on which a check may be written or
debit card used
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
15-22
Defining Money (cont'd)
 Thrift Institution: Financial institutions that receive most
of their funds from the savings of the public
 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.
15-23
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)
15-24
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
15-25
M2 (cont’d)
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
15-26
M2 (cont’d)
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
15-27
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-zero-maturity).
15-28
Financial Intermediation & Banks
 Direct finance: Individuals purchase bonds from a
business
 Indirect finance
Individuals hold money in a bank
The bank lends the money to a business
15-29
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
15-30
Figure 15-4 The Process of
Financial Intermediation
15-31
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
1. Asymmetric information
2. Adverse selection
3. Moral hazard
4. Larger scale and lower management costs
15-32
Financial Intermediation & Banks (cont'd)
1. Asymmetric Information: Information
possessed by one party in a financial transaction
but not by the other
2. Adverse Selection: The likelihood that
borrowers may use their borrowed funds for
high-risk projects
15-33
Financial Intermediation & Banks (cont'd)
3. Moral Hazard (in this context): The possibility
that a borrower might engage in riskier behavior
after a loan has been obtained
4. Larger scale and lower management costs
People can pool funds in an intermediary,
reducing costs, risks.
Pension funds and investment companies are
examples.
15-34
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
15-35
Table 15-2 Financial Intermediaries and
Their Assets and Liabilities
15-36
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 banks’ total earnings.
Another 10% of earnings were generated from
processing payments for credit cards, stocks, and
bonds.
15-37
Figure 15-5 How a Debit-Card
Transaction Clears
15-38
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.
FDIC (cont’d)
 As can be seen in Figure 15-5 (next slide), bank
failure rates dropped dramatically after passage of
this legislation.
From WWII to 1984, fewer than 9 banks failed per
year.
From 1985 to the beginning of 1993, however, 1,065
commercial banks failed – averaging 120 bank failures
per year.
In 2008, 25 banks failed. In 2009, 133 banks failed; in
2010, 157 banks failed. So far this year (through
March 25), only 26 banks have failed.
(http://www.fdic.gov/bank/historical/bank/index.html)
Figure 15-5 Bank Failures
Source: Federal Deposit Insurance Corporation.
FDIC (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.
FDIC (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.
FDIC(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.
 We are now in the comment period concerning new rules
that might be put into place. See
http://www.fdic.gov/news/news/press/2011/pr11062.html
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.
15-45
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
 A banker’s bank, usually an official institution that
also serves as a country’s treasury’s bank
3. Conduct their nations’ monetary policies
4. Central banks normally regulate commercial
banks.
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
15-47
The Federal Reserve System (cont'd)
 Organization of the Fed
Board of Governors (BOG)
• 7 members, 14-year terms
Federal Reserve Banks (12 Districts)
• 25 branches
Federal Open Market Committee (FOMC)
• BOG plus 5 presidents of district banks, including
the president of the Bank of New York
15-48
Figure 15-6 Organization of the
Federal Reserve System
15-49
Figure 15-7: The Federal Reserve System
15-50
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.
15-51
The Federal Reserve System (cont'd)
 Functions of the Fed
1. Supplies the economy with fiduciary currency
2. Provides a payment-clearing system (very little of this
now – why?)
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
15-52
Figure 15-8 The Volume and Value of Federal
Reserve Check Clearings Since 1985
15-53
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 gave 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 encrease the “moral
hazard” problem?
Summary of Learning Objectives
1. The key functions of money
a. Medium of exchange
b. Unit of accounting
c. Store of value
d. Standard of deferred payment
2. Important properties of goods that serve
as money
 Acceptability, confidence, and predictable value
15-58
Summary of Learning Objectives (cont'd)
3. 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
15-59
Summary of Learning Objectives (cont'd)
4. 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
5. The basic structure of the Federal Reserve
System
12 district banks with 25 branches
Governed by Board of Governors
Federal Open Market Committee
15-60
Summary of Learning Objectives (cont'd)
a. 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)
b. 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)
c. Major functions of the Federal Reserve
i.
Supply the economy with currency
ii.
Provide systems for transmitting and clearing payments
iii. Holding depository institutions’ reserves
iv. Acting as the government’s fiscal agent
v. Supervising banks
vi. Acting as a “lender of last resort”
vii. Regulating the money supply
viii. Intervening in foreign exchange markets
15-63
Assignment to be completed before
we begin our discussion of Ch. 16:
Pre-read Chapter 16 & these end-of-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.