Chapter 15
Money, Banking,
and Central
Banking
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
Introduction
During the financial meltdown and panic in 2008,
Congress raised the limit of the U.S. Federal Deposit
Insurance Corporation’s (FDIC) insurance against risk
of loss for individual bank deposit accounts from
$100,000 to $250,000.
Now some businesses provide savers with access to
FDIC-insured deposits up to $50 million.
How do people obtain federal insurance covering bank
deposits more than $250,000?
Reading this chapter will help you answer this question.
Learning Objectives
• Define the fundamental functions of money
• Identify key properties that any good that
functions as money must possess
• Explain official definitions of the quantity of
money in circulation
• Understand why financial intermediaries such
as banks exist
Learning Objectives (cont'd)
• Describe the basic structure and functions of
the Federal Reserve System
• Determine the maximum potential extent that
the money supply will change following a
Federal Reserve monetary policy action
• Explain the essential features of federal
deposit insurance
Chapter Outline
• The Functions of Money
• Properties of Money
• Defining Money
• Financial Intermediation and Banks
• The Federal Reserve System: The U.S. Central
Bank
Chapter Outline (cont’d)
• Fractional Reserve Banking, the Federal
Reserve, and the Money Supply
• Federal Deposit Insurance
Did You Know That ...
• In 2009, the U.S. Senate passed a resolution calling for a firstever thorough government audit of the Federal Reserve
System (the Fed) and for a complete list of its recipients of
loans?
• That recent resolution that requires closer oversight of the
Fed reflects congressional concerns about Fed policymaking.
• The Fed’s primary task has been to conduct monetary policy
by regulating the quantity of money in circulation in the U.S.
economy.
Did You Know That … (cont’d)
• Money
– Any medium that is universally accepted in an
economy both by sellers of goods and services as
payment for those goods and services and by
creditors as payment for debts
Table 15-1 Types of Money
The Functions of Money
• The functions of money
– Medium of exchange
– Unit of accounting
– Store of value (purchasing power)
– Standard of deferred payment
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
The Functions of Money (cont'd)
• Barter
– The direct exchange of goods and services for
other goods and services without the use of
money
– Simply a direct exchange requires a double
coincidence of wants
Policy Example: The Never-Ending Battle Against Counterfeiters
• If people were to lose faith in the authenticity of currency, it
would not circulate as readily as a medium of exchange.
• So, the U.S. government’s Bureau of Engraving and Printing
continually seeks to make U.S. currency more difficult to
counterfeit, including the use of color-shifting ink, embedding
watermarks, and making the composition of the paper bills
hard to replicate.
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
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
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
Properties of Money
• 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
Properties of Money (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
Properties of Money (cont’d)
• Questions
– What backs money?
– Is it gold, silver, or the federal government?
• Answer
– Your confidence
Properties of 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
Properties of 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”
Properties of Money (cont’d)
• Currency and transactions deposits are money
because of their
– Acceptability
– Predictability of value
International Policy Example: Venezuela Promotes Private
Moneys—with Conditions Attached
• Today the government of Venezuela allows the use of private
currencies used in different parts of the nation alongside its
national currency, the bolivar.
• However, the government prevents these private currencies
from competing with its own currency by not allowing these
private currencies to be exchanged for the bolivar, and
restricting their use to relatively small organized markets.
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
Defining Money (cont'd)
• Economists use two basic approaches to
define and measure money
– The transactions approach
– The liquidity approach
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
Defining Money (cont'd)
• The transactions approach to measuring
money: M1
– Currency and coins
– Transactions (checkable) deposits
– Traveler’s checks
Figure 15-2 Composition of the U.S. M1 and M2
Money Supply, 2011, Panel (a)
Figure 15-2 Composition of the U.S. M1 and M2
Money Supply, 2011, Panel (b)
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
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
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
Defining Money (cont'd)
• The liquidity approach to measuring money:
M2
• Assets that are almost money
• Highly liquid
• Easily converted to cash
• Time deposits are an example
Defining Money (cont'd)
• The liquidity approach: M2 is equal to M1 plus
1. Savings deposits
2. Small denomination (<$100,000) time deposits
3. Balances in retail money market mutual funds
Defining Money (cont'd)
• Question
– Which definition of money correlates best with
economic activity?
• Answer
– M2, although some businesspeople and
policymakers prefer MZM
Defining Money (cont'd)
• MZM (money-at-zero-maturity)
– Entails adding deposits without set maturities to
M1
– Includes all money market funds but excludes all
deposits with fixed maturities
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
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
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
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
• Financial intermediaries
– Institutions than transfer funds between ultimate
lenders (savers) and ultimate borrowers
Figure 15-3 The Process of Financial
Intermediation
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
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
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
– Examples are pension funds, investment companies,
and government-sponsored financial institutions such
as Federal National Mortgage Association
Financial Intermediation and Banks
(cont'd)
• Liabilities
– Amounts owed
– The legal clams against a business or household by
nonowners
– The sources of funds for financial intermediaries
Financial Intermediation and Banks
(cont'd)
• Assets
– Amounts owned
– All items to which a business or household holds
legal claim
– The uses of funds by financial intermediaries
Table 15-2 Financial Intermediaries and Their Assets
and Liabilities
Example: Mobile Payments Are Catching On
• Today nearly 10 percent of U.S. residents have used cell
phones to transfer payments to another business or person.
• Almost 20 percent of young people aged 18 to 25 have used
this mobile payment method.
• Most observers conclude that mobile payments will
proliferate in the coming decade.
Figure 15-4 How a Debit-Card
Transaction Clears
The Federal Reserve System: The U.S. Central Bank
• 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;
signed by President Woodrow Wilson
The Federal Reserve System: The U.S. Central Bank
(cont’d)
• Organization of the Fed
– Board of Governors
• 7 members, 14-year terms – Chairman Ben Bernanke
– Federal Reserve Banks (12 Districts)
• 25 branches
– Federal Open Market Committee (FOMC)
• Board of governors plus 5 presidents of district banks
Figure 15-5 Organization of the
Federal Reserve System
Figure 15-6 The Federal Reserve
System
The Federal Reserve System: The U.S. Central Bank
(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. Regulates the money supply
7. Intervenes in foreign currency markets
8. Acts as the “lender of last resort”
The Federal Reserve System: The 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
– When many banks, nonbank financial institutions, and other
companies struggled with serious financial difficulties in the late
2000s, the Fed provided hundreds of billions of dollars in direct
lender-of-last-resort assistance these institutions and companies
The Federal Reserve System: The U.S. Central Bank
(cont’d)
• Actual and proposed expansions of the Fed’s functions
– In 2010, President Obama signed into law that added to the Fed’s
functions by making it the nation’s primary regulator of systemic risk—
the potential for a financial breakdown at a large institution to spread
throughout banks and other firms
– Nevertheless, some economists and politicians have expressed
concerns about the Fed’s expanded scale of lender-of-last-resort
activities and its new role of a systemic risk regulator
Fractional Reserve Banking, the Federal Reserve, and the Money
Supply
• Fractional Reserve Banking
– A system in which depository institutions hold
reserves that are less than the amount of deposits
• Originated when goldsmiths in Greece issued notes
that exceeded the value of gold and silver on hand
Fractional Reserve Banking, the Federal Reserve, and the Money Supply (cont’d)
• Reserves
– In the U.S. Federal Reserve System, deposits held
by Federal Reserve district banks for depository
institutions, plus depository institutions’ vault
cash
Fractional Reserve Banking, the Federal Reserve, and the Money Supply (cont’d)
• Reserve Ratio
– The fraction of transaction deposits that banks
hold as reserves
– Its size is determined by:
• Required reserves (reserves required to be held by the
Fed)
• Excess reserves (additional reserves that banks
voluntarily hold)
Fractional Reserve Banking, the Federal Reserve, and the Money Supply (cont’d)
• Balance Sheet
– Statements of assets (what is owned) and
liabilities (what is owed)
Fractional Reserve Banking, the Federal Reserve, and the Money Supply (cont’d)
• How a single depository institution reacts to
an increase in transactions deposits, say $1
million?
– We will examine the balance sheet of a single
depository institution called Typical Bank
Fractional Reserve Banking, the Federal Reserve, and the Money Supply (cont’d)
• Assumptions:
1. Reserve ratio is 10 percent
2. Zero excess reserves are kept
3. Transactions deposits are the bank’s only
liabilities and loans are the bank’s assets
4. Every time a loan is made, the proceeds are put
into a deposit account
Balance Sheet 15-1 Typical Bank
Reserve Ratio = 10%
Fractional Reserve Banking, the Federal Reserve, and the Money Supply (cont’d)
• Open market operations
– The purchase and sale of existing U.S. government
securities (such as bonds) in the open private
market by the Federal Reserve System
– What is the effect on the money supply if the Fed
engages in an open market purchase by buying a
$100,000 U.S. government security from a bond
dealer?
Balance Sheet 15-2 Bank 1
Transactions deposits in Bank 1 immediately increase
by $100,000.
Fractional Reserve Banking, the Federal Reserve, and the Money Supply (cont’d)
• Following the deposit
– What will Bank 1 do with its additional deposits?
• Bank 1 will keep $10,000 as reserves (10%) and
allocates the remaining $90,000 of additional deposits
to new loans.
• The borrower who receives the $90,000 loan from Bank
1 will spend these funds, which will then be deposited
in another bank, say Bank 2.
Balance Sheet 15-3 Bank 2
Bank 2 responds to the additional deposits of $90,000 by
adding $9,000 (10%) of these deposits to its reserves and
loaning out the remaining $81,000.
Balance Sheet 15-4 Bank 3
If the funds from the $81,000 loan are deposited in an
account at Bank 3, this bank will increase its loans by
$72,900 after keeping $8,100 (10%) of the deposits as
reserves.
Fractional Reserve Banking, the Federal Reserve, and the Money Supply (cont’d)
• What is the effect on total deposits and the
money supply?
– Eventually, total deposits and the money supply
will increase by $1 million
• $100,000 original increase in deposits as the Fed paid
the bond dealer in exchange for a U.S. government
security
• $900,000 generated by deposit-creating bank loans
Table 15-3 Maximum Money Creation with 10 Percent
Required Reserves
Figure 15-7 The Multiple Expansion in the Money Supply Due to $100,000 in
New Reserves When the Reserve Ratio Is 10 Percent
Fractional Reserve Banking, the Federal Reserve, and the Money Supply (cont’d)
• Money Multiplier
– A number that, when multiplied by a change in
reserves in the banking system, yields the
resulting change in the money supply
Fractional Reserve Banking, the Federal Reserve, and the Money
Supply (cont’d)
• Potential money multiplier
– The reciprocal of the required reserve ratio,
assuming no leakages into currency and no excess
reserves
– It is equal to 1 divided by the required reserve
ratio
Fractional Reserve Banking, the Federal Reserve, and the Money Supply (cont’d)
1
Potential money multiplier =
Reserve ratio
Actual change
in the money
supply
=
Actual money
multiplier

Change in
total reserves
Fractional Reserve Banking, the Federal Reserve, and the Money Supply (cont’d)
• Example
– Fed buys $100,000 of government securities
– Reserve ratio = 10%
Potential change
1
in the money = $100,000
= $1,000,000
x
.10
supply
Fractional Reserve Banking, the Federal Reserve, and the Money Supply (cont’d)
• The actual money multiplier usually is smaller
than the potential money multiplier
– Cash leakage occurs when borrowers want to hold
a portion of their loans as currency outside of
banks
Fractional Reserve Banking, the Federal Reserve, and the Money Supply (cont’d)
• Real-world money multipliers
– M1 multiplier: 1.5 to 2.0
– M2 multiplier: 6.5 in the 1960s to over 12 in the
mid-2000s; about 5 since then
Why Not … eliminate open market operations?
• In principle, the Federal Reserve could engage in monetary
policy by varying the reserve ratio instead of open market
operations.
• Since 2008 when Congress granted the Fed authority to pay
interest on bank reserves, the Fed has found it difficult to
bring about the desired reserve ratio by finding the precise
change in the interest rate on reserves.
Federal Deposit Insurance
• Bank Run
– Attempt 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
– The result would be the failure of that depository
institution
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
– The FDIC is a government agency that insures the
deposits held in banks and most other depository
institutions; all U.S. banks are insured this way
– Current maximum of insured deposits is $250,000
per depositor per institution
Federal Deposit Insurance (cont’d)
• As can be seen in Figure 15-8, bank failure rates dropped
dramatically after passage of this legislation
– Between 1933 and 1984, bank failures were few
– Annual failure rates jumped again in the early and
late 2000s
Figure 15-8 Bank Failures
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 Deposit Insurance (cont’d)
• Adverse selection
– Deposit insurance shields depositors from the
potential adverse effects of risky decisions, so
depositors are willing to accept riskier investment
strategies by their banks
• Moral hazard
– Insured depositors know they won’t suffer losses if
their bank fails, so they have little incentive to
monitor their bank’s activities. Insured banks have
incentives to take on more risks than they otherwise
would
Financial Deposit Insurance (cont’d)
• The results of moral hazard
– The S&L crisis of the late-1980s
• More than 1,500 savings and loan associations failed
• The estimated taxpayer cost was $200 billion
– In the late-2000s
• Dozens of banks failed and hundreds more banks
received bailouts
• The estimated taxpayer cost was >$1 trillion
Financial Deposit Insurance (cont’d)
• Federal Deposit Insurance Reform Act of 2005
– Expanded coverage of the federal deposit
insurance and potentially increased moral hazard
problems
– Provides the FDIC with improved tools for
addressing moral hazard risks:
• Deposit Insurance Fund (DIF)
• Altered rule on FDIC deposit insurance premiums
Financial Deposit Insurance (cont’d)
• During the banking troubles of the late
2000s:
– Congress sought to increase the public’s
confidence in depository institutions by
temporarily extending federal deposit insurance
to cover virtually all of the deposits in the
banking system
– But, it also expanded the moral hazard risks of
deposit insurance
You Are There: A River Currency for Riverwest, Wisconsin
• Like dozens of communities in the United States, the
community of Riverwest, Wisconsin, introduces a local
currency, called River Currency, in order to encourage people
to purchases items from local businesses.
• This and other local currencies circulate as media of exchange
as long as people are willing to accept them in trades for goods
and services.
Issues & Applications: Entrepreneurs Boost FDIC Coverage—and
Moral Hazard
• Because a firm owning more than one bank can offer a “single
FDIC-insured account” that actually consists of multiple
accounts, some entrepreneurs serve their customers by dividing
their large deposits into multiple bank accounts each contains
no more than the maximum insured limit of $250,000.
• This raises the moral hazard problem as it removes the
incentive for these depositors to pay attention to risky bank
activities.
Summary Discussion 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
Summary Discussion 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
Summary Discussion 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
Summary Discussion 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 Discussion 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
Summary Discussion of Learning Objectives (cont'd)
• The maximum potential change in the money
supply following a Federal Reserve purchase
or sale of U.S. government securities
– The money multiplier
– The amount of reserves injected (or withdrawn)
by the Fed times the potential money multiplier,
which is 1 divided by the reserve ratio
Summary Discussion 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