Money and Banking
CHAPTER THIRTEEN
MONEY AND BANKING
CHAPTER OVERVIEW
Chapters 13, 14, and 15 form a conventional unit on money and banking. These chapters provide the
foundation for the discussion of modern monetary theory and for the discussion and analysis of the
monetarist and competing theories that follow.
Chapter 13 introduces the student to the U.S. financial system. The chapter first covers the nature and
functions of money and then discusses the Federal Reserve System’s definition of the money supply.
Next, the chapter addresses the question of what “backs” money by looking at the value of money, money
and prices, and the management of the money supply. The demand for money is then covered, and it is
followed by an introduction and discussion of the money market. Finally, there is a rather
comprehensive description of the U.S. financial system, which focuses on the features and functions of
the Federal Reserve System and recent developments in the U.S. financial system.
WHAT’S NEW
The entire chapter has been updated and streamlined with revised discussion of the structure and role of
the Federal Reserve System. There are minor revisions to the End-of-Chapter Questions.
A “Consider This” box titled “Are Credit Cards Money?” has been added. In the previous edition this
appeared in the website’s Analogies, Anecdotes, and Insights section.
The Last Word, “The Global Greenback,” has been updated.
INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to
1. List and explain the three functions of money.
2. Define the money supply, M1 and near-monies, M2, and M3.
3. State three reasons why currency and checkable deposits are money and why they have value.
4. Identify two types of demand for money and the main determinant of each.
5. Describe the relationship between GDP and the interest rate and each type of money demand.
6. Explain what is meant by equilibrium in the money market and the equilibrium rate of interest.
7. Explain the relationship between bond prices and the money market.
8. Describe the structure of the U.S. banking system.
9. Explain why Federal Reserve Banks are central, quasi-public, and bankers’ banks.
10. Describe seven functions of the Federal Reserve System and point out which role is the most
important.
11. Summarize and evaluate the arguments for and against the Federal Reserve System remaining an
independent institution.
12. Describe the conditions that have caused the loss of market share of banks and thrifts to pension
funds, insurance companies, mutual funds, and securities-related firms.
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13. Identify three major changes continuing to occur in the financial services industry.
14. Define and identify terms and concepts listed at the end of the chapter.
COMMENTS AND TEACHING SUGGESTIONS
1. Definitions of the money supply are arbitrary, and this should be stressed. The definition of M1
changes over time as different instruments become acceptable as money.
2. Most students are fascinated by money and will find trivia on the subject interesting. If you would
like to share some of that, consider using the following “Concept Illustration” that appeared on the
website of the previous edition.
Concept Illustration … U.S. paper currency
Trivia can be interesting! Did you know these facts about U.S. currency (Federal Reserve Notes)? 1
 The Bureau of Engraving and Printing, a Division of the United States Treasury, prints Federal
Reserve Notes in denominations of $1, $2, $5, $10, $20, $50, and $100. Since 1946, no $500,
$1,000, $5,000, and $10,000 denominations have been printed.
 Regional Federal Reserve Banks issue the currency and are identified by coding on the face of each
bill: A1 = Boston; B2 = New York; C3 = Philadelphia; D4 = Cleveland; E5 = Richmond; F6 =
Atlanta; G7 = Chicago; H8 = St. Louis; I9 = Minneapolis; J10 = Kansas City; K11 = Dallas; L12 =
San Francisco.
 The newly designed bills have several security features, some of which are readily visible.
Examples: (1) A watermark depicts the same person as the portrait and is visible from both sides
when held up to a light. (2) The same technique reveals a vertical security thread containing “USA”
in the strip. (3) The numeral in the lower right corner looks bright green when examined head on,
but shifts to dark green when the bill is held at an angle.
 The circle on the right side of the back of the $1 bill contains symbolism representing the 13 original
states. The burst of light above the eagle’s head contains 13 stars. The right claws hold an olive
branch with 13 leaves and the left claws hold 13 arrows. (The eagle’s head is turned toward the olive
branch.) The shield has 13 stripes. The ribbon held in the eagle’s beak contains the Latin motto: E
Pluribus Unum, which has 13 letters and means “out of many, one.”
 The unfinished pyramid in the left circle on the back of the $1 bill symbolizes striving toward growth
and perfection. The eye inside the triangle represents the eternal eye of God. The Roman numerals
at the base of the pyramid are “1776,” the founding year of the United States.
 The average life of the $1 bill is 18 months. The $50 and $100 bills—handled less often—have
average lives of 5 and 8 years, respectively.
 Beginning in 1934 all U.S. paper currency was inscribed with “The United States of America Will
Pay to the Bearer on Demand One [Five, Ten, etc.] Dollar [s] in Lawful Money.” In 1964 the
inscription was replaced with “This Note is Legal Tender for Debts, Public and Private.”
 The Federal Reserve estimates that only 3/100ths of 1 percent of total currency in circulation is
counterfeited. Authorities seize about 75 percent of all counterfeited money before it is circulated.
 If you accept a counterfeit bill, you are stuck with the loss. Don’t try to pass a known counterfeit bill
to someone else, or you can be fined up to $5,000.
 As long as you present what is clearly more than one-half a bill, a bank will accept it for deposit or
replace it. The bank then sends the bill to a Federal Reserve Bank, which destroys it and issues
another bill in its place.
Source: Federal Reserve System, “Fundamental Facts about U. S. Money,” 1998.
3. The Federal Reserve Banks publish a number of excellent low-cost or free educational materials.
A comprehensive guide to these, along with ordering information, is found in Public Information
Materials, available from the Federal Reserve Bank in your district. It could be ordered from any
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district, or from the New York Federal Reserve Bank, 33 Liberty Street, New York, NY 10045.
Address your requests to the Public Information Department of the district bank that you write.
The Federal Reserve Bulletin contains a wealth of financial and economic statistics. Write The
Board of Governors, Federal Reserve System, Washington, D.C. 20551 for subscription
information or check their website given in the first web-based question.
4. As an in-class exercise, have the students collectively identify some or all of the Federal Reserve
districts by finding the bank of issue on bills they have in their possession. On older currency
notes the issuing bank is shown in the circle on the left side of the face of the bill. On the newer
style of notes the name of the issuing Federal Reserve Bank does not appear on the bill, but the
district number and corresponding letter of the alphabet do appear toward the upper left-hand
corner (e.g., L12 denotes the San Francisco district). See if all twelve are represented among the
bills present in your classroom.
5. Students may be curious why the name of the issuing bank no longer appears on the bill; it is one
of the many anticounterfeiting measures appearing on the new style bills. The next generation of
bills, introduced with the $20 bill in late 2002, adds more color variety and additional anticounterfeiting features.
6. There is a lot of ignorance among the general population as to what gives money its value. An
interesting experiment is to have students create their own money and attempt to spend it in the
community. When their currency is refused in transactions, have students ask the vendors why it
is refused and record the responses for later classroom discussion. This would, of course, have to
be monitored closely. It is not illegal to create your own currency so long as you are not
attempting to recreate or pass it off as legal tender. Student currency would have to look
sufficiently different from genuine U.S. currency.
7. Ask students to give examples of each one of the functions of money and point out that in some
contemporary countries, inflation has undermined these functions. In these countries, people often
prefer U.S. dollars instead of their own currencies because their currencies don’t store value or
work for long as a unit of account since prices change rapidly.
8. Discuss the use of barter as an alternative means of exchange in places like Russia and Ukraine.
Ask students to relate examples of barter exchanges they have made. Note the conditions required
for barter. Give students an opportunity to explain why barter exchanges are inconvenient.
9. The Federal Reserve banks, including their branches, offer guided tours of their facilities, and
many of the district banks also have exhibits in their public lobby areas. It is definitely a good
“field trip” if you have the opportunity to take your students. If not, the bank’s public information
department may be willing to schedule a presentation at your institution.
STUDENT STUMBLING BLOCKS
1. It is hard for students to believe that nothing intrinsic backs the money supply. Make sure they
realize that the gold in Fort Knox (or elsewhere) has no function in terms of the value of our
money. Returning to the gold standard continues to be advocated by some. It is a good topic for
debate.
2. Point out to the students that the phrase “central bank” refers to the Federal Reserve System and
the Board of Governors. This system acts as our Central Bank, whereas other countries have a
single institution as their central bank.
3. Another common error that students make is to equate money with income. Focus on the
distinction between the amount of money in one’s possession and one’s income. This helps
students to understand that money and income are not synonyms. For example, you could ask
them to estimate how much M1 money they have at the moment in currency and checking. If they
are typical, this will be much less than their annual income. In other words, the student’s average
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money supply is less than the student’s income. The concept of velocity is introduced later, but it
could be mentioned at this point as a way of helping students to contrast the money supply with
income concepts.
4. If you want students to understand why interest rates on bonds vary as described in Money Market
section, you must explain carefully. If bond price : rate relationship is not important for you, focus
only on money : rate relationships. See question 9 at end of chapter for practice on relating bond
prices to interest rates.
LECTURE NOTES
I.
Functions of Money
A. Medium of exchange: Money can be used for buying and selling goods and services.
B. Unit of account: Prices are quoted in dollars and cents.
C. Store of value: Money allows us to transfer purchasing power from present to future. It is
the most liquid (spendable) of all assets, a convenient way to store wealth.
II.
Supply of Money
A. Narrow definition of money: M1 includes currency and checkable deposits (see Table 13-1).
1. Currency (coins + paper money) held by public.
a. Is “token” money, which means its intrinsic value is less than actual value. The
metal in a dime is worth less than 10¢.
b. All paper currency consists of Federal Reserve Notes issued by the Federal Reserve.
2. Checkable deposits are included in M1, since they can be spent almost as readily as
currency and can easily be changed into currency.
a. Commercial banks are a main source of checkable deposits for households and
businesses.
b. Thrift institutions (savings and loans, credit unions, mutual savings banks) also have
checkable deposits.
3. Qualification: Currency and checkable deposits held by the federal government, Federal
Reserve, or other financial institutions are not included in M1.
B. Money Definition: M2 = M1 + some near-monies which include (See Table 13-1)
1. Savings deposits and money market deposit accounts.
2. Certificates of deposit (time accounts) less than $100,000.
3. Money market mutual fund balances, which can be redeemed by phone calls, checks, or
through the Internet.
C. Money Definition: M3 = M2 + large certificates of deposit (time accounts) of $100,000 or
more (See Table 13-1)
D. Which definitions are used? M1 will be used in this text, but M2 is watched closely by the
Federal Reserve in determining monetary policy.
1. M2 and M3 are important because they can easily be changed into M1 types of money
and influence people’s spending of income.
2. The ease of shifting between M1, M2, and M3 complicates the task of controlling the
spendable money supply.
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3. The definition becomes important when authorities attempt to measure and control the
money supply.
E. CONSIDER THIS … Are Credit Cards Money?
Credit cards are not money, but their use involves short-term loans; their convenience allows
you to keep M1 balances low because you need less for daily purchases.
III.
What “backs” the money supply?
A. The government’s ability to keep its value stable provides the backing.
B. Money is debt; paper money is a debt of Federal Reserve Banks and checkable deposits are
liabilities of banks and thrifts because depositors own them.
C. The value of money arises not from anything intrinsic, but its value in exchange for goods
and services.
1. It is acceptable as a medium of exchange.
2. Currency is legal tender or fiat money. In general, it must be accepted in repayment of
debt, but that doesn’t mean that private firms and government are mandated to accept
cash; alternative means of payment may be required. (Note that checks are not legal
tender but, in fact, are generally acceptable in exchange for goods, services, and
resources. Legal cases have essentially determined that pennies are not legal tender.)
3. The relative scarcity of money compared to goods and services will allow money to
retain its purchasing power.
D. Money’s purchasing power determines its value. Higher prices mean less purchasing power.
(Key Question #6)
E. Excessive inflation may make money worthless and unacceptable. An extreme example of
this was German hyperinflation after World War I, which made the mark worth less than 1
billionth of its former value within a four-year period.
1. Worthless money leads to the use of other currencies that are more stable.
2. Worthless money may lead to barter exchange system.
F. Maintaining the value of money
1. The government tries to keep supply stable with appropriate fiscal policy.
2. Monetary policy tries to keep money relatively scarce to maintain its purchasing power,
while expanding enough to allow the economy to grow.
IV.
The Demand for Money: Two Components
A. Transactions demand, Dt, is money kept for purchases and will vary directly with GDP
(Figure 13-1a).
B. Asset demand, Da, is money kept as a store of value for later use. Asset demand varies
inversely with the interest rate, since that is the price of holding idle money (Figure 13-1b).
C. Total demand will equal quantities of money demanded for assets plus that for transactions
(Figure 13-1c).
V.
The Money Market: Interaction of Money Supply and Demand
A. Key Graph 13-1c illustrates the money market. It combines demand with supply of money.
B. Figure 13-2 illustrates how equilibrium changes with a shift in the supply of money.
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C. If the quantity demanded exceeds the quantity supplied, people sell assets like bonds to get
money. This causes bond supply to rise, bond prices to fall, and a higher market rate of
interest.
D. If the quantity supplied exceeds the quantity demanded, people reduce money holdings by
buying other assets, like bonds. Bond prices rise, and lower market rates of interest result
(see example in text).
E. Monetary authorities can shift supply to affect interest rates, which in turn affect investment
and consumption and aggregate demand and, ultimately, output, employment, and prices.
(Key Question #7)
F. Try Quick Quiz 13-2.
VI.
The Federal Reserve and the Banking System
A. The Federal Reserve System (the “Fed”) was established by Congress in 1913 and holds
power over the money and banking system.
1. Figure 13-3 gives the framework of the Fed and its relationship to the public.
2. The central controlling authority for the system is the Board of Governors, which has
seven members appointed by the President for staggered 14-year terms. Its power means
the system operates like a central bank.
3. The Federal Open Market Committee (FOMC) includes the seven governors plus five
regional Federal Reserve Bank presidents whose terms alternate. They set policy on
buying and selling of government bonds, the most important type of monetary policy,
and meet several times each year.
4. The system has twelve districts, each with its own district bank and two or three branch
banks. They help implement Fed policy and are advisory. (See Figure 13-4)
a. Each is quasi-public: It is owned by member banks but controlled by the
government’s Federal Reserve Board, and any profits go to the U.S. Treasury.
b. They act as bankers’ banks by accepting reserve deposits and making loans to banks
and other financial institutions. In making loans, the Federal Reserve is the “lender
of last resort,” meaning that the Fed is available to lend money should other avenues
(e.g., other commercial banks) not be available.
3. About 7,800 commercial banks existed in 2003. They are privately owned and consist of
state banks (three-fourths of the total) and large national banks (chartered by the Federal
government).
4. Thrift institutions consist of savings and loan associations, credit unions, and mutual
savings banks. They are regulated by the Treasury Dept. Office of Thrift Supervision,
but they may use services of the Fed and keep reserves on deposit at the Fed. See Figure
13-4. Of the approximately 11,800 thrift institutions, 10,300 are credit unions.
5. Global Perspective 13-1 gives the world’s twelve largest financial institutions.
B. Functions of the Fed and money supply.
1. The Fed issues “Federal Reserve Notes,” the paper currency used in the U.S. monetary
system.
2. The Fed sets reserve requirements and holds the reserves of banks and thrifts not held as
vault cash.
3. The Fed may lend money to banks and thrifts, charging them an interest rate called the
discount rate.
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4. The Fed provides a check collection service for banks (checks are also cleared locally or
by private clearing firms).
5. The Fed acts as the fiscal agent for the Federal government.
6. The Fed supervises member banks.
7. Monetary policy and control of the money supply is the “major function” of the Fed.
C. Federal Reserve independence is important but is also controversial from time to time.
Advocates of independence fear that more political ties would cause the Fed to follow
expansionary policies and create too much inflation, leading to an unstable currency such as
exists in some other countries (see Last Word for this chapter).
VII.
Recent Developments in Money and Banking
A. Relative decline of banks and thrifts: Several other types of firms offer financial services.
B. Consolidation among banks and thrifts: Because of failures and mergers, there are fewer
banks and thrifts today. Since 1990, there has been a decline of 5000 banks.
C. Convergence of services provided has made financial institutions more similar: See text on
new laws of 1996 and 1999 that made many changes possible.
D. Globalization of financial markets: Significant integration of world financial markets is
occurring and recent advances in computer and communications technology suggest the trend
is likely to accelerate.
E. Electronic transactions: Internet buying and selling, electronic cash, and “smart cards” are
examples.
1. In the future, nearly all payments could be made with a personal computer or “smart
card.”
2. Unlike currency, E-cash is “issued” by private firms rather than by government. To
control the money supply the Fed will need to find ways to control the total amount of
E-cash, including that created through Internet loans.
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