Macroeconomics
ECON 2301
May 2010
Marilyn Spencer, Ph.D.
Professor of Economics
Chapter 15
Extra Credit Opportunity #7
 Find out who won the Nobel Prize for
Economics – announced Monday, Oct. 12.
 Find out what research strand(s) the prize
is recognizing.
 Send me that info in an email, before class
Wednesday, May 26.
4 points possible
Extra Credit Opportunity #8
 View the film, “Soylent Green.”
 Find out that economy’s solution to its
“social security problem.”
 Send me a summary in an email, before
class Wednesday, May 26.
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
15-5
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
15-6
Table 15-1 Types of Money
15-7
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
15-8
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”
15-9
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
15-10
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.
15-11
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
15-12
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
15-13
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.”
 Currency and transactions deposits are money
because of their
Acceptability
Predictability of value
15-17
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.
15-18
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
15-19
Defining Money (cont'd)
 The transactions approach to measuring
money: M1
Currency
Checkable (transaction) deposits
Traveler’s checks not issued by banks
15-20
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.
15-21
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.
15-22
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
15-23
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.
15-24
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)
15-25
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
15-26
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
15-27
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
15-28
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.
15-29
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
15-30
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
15-31
Figure 15-4 The Process of
Financial Intermediation
15-32
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
15-33
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
15-34
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.
15-35
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
15-36
Table 15-2 Financial Intermediaries and
Their Assets and Liabilities
15-37
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.
15-38
Figure 15-5 How a Debit-Card
Transaction Clears
15-39
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.
In 2008, 25 banks failed. In 2009, 133 banks failed. So far
this year (through May 14), 72 banks have failed.
(http://www.fdic.gov/bank/historical/bank/index.html)
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.
15-46
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
15-48
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
15-49
Figure 15-6 Organization of the
Federal Reserve System
15-50
Figure 15-7: The Federal Reserve System
15-51
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
15-52
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
15-53
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.
15-54
Figure 15-8 The Volume and Value of Federal
Reserve Check Clearings Since 1985
15-55
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 enlarge 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
15-60
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
15-61
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
15-62
Summary of Learning Objectives (cont'd)
6. 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)
7. 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)
8. Major functions of the Federal Reserve
a. Supply the economy with currency
b. Provide systems for transmitting and clearing payments
c. Holding depository institutions’ reserves
d. Acting as the government’s fiscal agent
e. Supervising banks
f. Acting as a “lender of last resort”
g. Regulating the money supply
h. Intervening in foreign exchange markets
15-65