Money, Banking and Financial
Institutions; Money Creation

All About Money
Functions of Money
1) Unit of Value
-- common unit for measuring how much something is worth (i.e. a 42" HD TV costs $1,000).
2) Medium of Exchange
-- willing to accept it in exchange for goods/services
3) Store of Value
-- money can be held or stored knowing it can be used to buy future goods/services; holding money is equivalent to holding wealth

History of Money
1) Commodity Money
-- Goods used as a replacement for money because of its inherent value as a commodity (i.e. furs, metals, spice, etc)
2) Paper Currency (early)
-- currency backed by gold or silver
-- money would only be issued if the bank received more gold/silver
-- people could legitimately go to the bank and trade in their paper currency for gold/silver
-- gold conversion was disbanded in 1934 and silver was disbanded in 1963
3) Fiat Money
-Gov’t declared means of payment
-- declaration is printed on each bill
-the term “legal tender” means dollar bills cannot be refused as payment for a debt

Money has 4 Characteristics
1) Exists as a unit of account
-- provides a common measurement of the relative value of goods and services
Eg) If price of a CD is $10.00 and the price of a large
Duncan Donuts coffee is $2.00, the value of 1 CD = ___ DD coffees
2) Widely accepted as means of payment
3) Store of Value and is an asset
-- money holds value over time
-- credit cards are not money because they fail to be a store of value (if you exceed your credit limit or your credit is cancelled, the credit card will not allow you to purchase goods on the next purchase
4) Highly Liquid
-- assets that are highly liquid can be easily converted into cash and at little cost
-- illiquid assets are assets that can not be converted into cash easily

Spectrum of Liquidity
More Liquid Less Liquid
Cash in
Hands of
Public
Demand
Deposits /
Other
Checkable
Deposits/Tra velers
Checks
Savings
Type
Accounts
Money
Market
Mutual
Funds
Small
Time
Deposits
Lg Time
Deposits
Demand Deposits (DD)
-- checking accounts of households and firms held at financial institutions

Other Checkable Deposits
-- quasi-checking accounts such as automatic transfers from savings accounts. These accounts transfer funds from savings accounts into checking accounts when needed
Retail Money Market Mutual Funds (MMMF’s)
-- deposits made to buy a variety of financial assets.
-- Can withdrawal money by writing checks
Small and Lg Time Deposits (also known as CD’s)
-- requires money to remain in the bank for a specified time period or subject to penalties for early withdrawal
-- small time deposits (< $100,000)
-- Lg time deposits (>= $100,000)

Measures of Money Stock
A) M1
-- standard measure of money supply or money stock, which consists of the four most liquid assets.
-- M1 = Cash in hands of public + Demand
Deposits + Other Checking Account Deposits
+ Travelers Checks
B) M2
-- M2 = M1 + Savings Type Accounts + Retail
MMMF Balances + Small Denomination Time
Deposits

Federal Reserve System
-established in 1913, it’s our nation’s central bank (indept agency of the Federal Gov’t)
-- 12 Federal Reserve Banks are divided into 12 districts
1) Boston 5) Richmond 9) Minneapolis
2) New York 6) Atlanta 10) Kansas City
3) Philadelphia 7) Chicago 11) Dallas
4) Cleveland 8) St Louis
Structure of Federal Reserve
12) San Francisco
Chair of Board of Governors
(Ben Bernanke)
Appoints 3 Directors for each bank
Board Of Governors (7 members, includes chair)
Federal Open Market
Committee (7 Governors +
5 Reserve Bank Presidents)
12 Federal
Reserve Banks
Elects 6 Directors for each bank
3,500 Member
Banks

Breakdown of Sectors
I] Board of Governors
-- appointed by President and approved by Senate for 14 yr terms (nonrenewable)
Chairman:
-- appointed by President/approved by Senate for 4 yr term (renewable) not to coincide with presidential term of office
Specific Duties include:
1) Supervise and regulate member banks
2) Supervise 12 Federal Reserve Banks
3) Set reserve requirements and approve discount rates

II] 12 Federal Reserve Banks
-- Each is supervised by 9 directors (3 appointed by Bd of Governors and 6 appointed by members banks
-- Each bank has a president appointed by the directors
-- Specific responsibilities include:
1) Lends reserves
2) Issues currency
3) Clears Checks (clears about 1/3 of all checks)
III] Federal Open Market Committee (FOMC)
-- 7 Bd of Governors + 5 Reserve Bank Presidents (New York is always represented while 4 other positions rotate among the other banks)
-- committee responsible for establishing U.S. monetary policy
-- primary function is to conduct open market operations
(buying/selling of U.S. bonds) to control money supply
-- sets Federal Funds rate target
IV] 3.500 Member Banks (not all commercial banks are chartered with the Federal Reserve).
-- About 70% of all deposits are in member banks

Functions of the Federal Reserve (sector responsibility in brackets)
1) Supervising and Regulating Banks [Board of Governors]
-- sets standards for establishing new banks and members banks financial activity
-- establishes reserve requirements for all banks (not just member banks)
2) Acting as a “Bank for Banks” [12 Federal Reserve Banks]
-- Member banks can borrow from the Federal Reserve to meet required reserves
-- Interest rate for borrowed funds is called the discount rate
-- borrowing may be necessary when banks encounter bank runs (many depositors withdrawal money from the bank at one time) and much worse a bank panic (many banks experiencing bank runs at the same time).

3) Issuing Paper Currency
-- puts currency into circulation (does not print it)
-- printing currency is the responsibility of the
Bureau of Engraving
4) Check Clearing
-transferring funds from one bank’s reserves to another
5) Controlling the Money Supply or Open
Market Operations

3 Components of Financial System
1) Banking System
2) Bond Market
3) Stock Market
Banking System
-- Commercial Banks are known as financial intermediaries
 Firms that bridge the relationship between savers
(individuals and businesses) and borrowers
 Uses funds from savers to make loans
4 types of financial intermediaries
1) Commercial Banks
-- largest group
-- obtains funds through checking deposits, savings deposits and time deposits and makes business
(normally small business), mortgage and consumer loans

2) Savings & Loans (S & L’s)
-- obtain funds through checkable deposits, savings deposits, and other time deposits for mainly mortgage loans
-- owned by outside investors
3) Mutual Savings Banks
-- accepts deposits (shares) which are used for mortgage loans
-- owned by shareholders
4) Credit Unions
-- accepts deposits from a specific group and specializes in consumer and mortgage loans
Importance of Financial Intermediaries
-- Financial Intermediaries are necessary because they specialize in evaluating the worthiness of the borrower and have the means for follow-up
 Researching credit history
 Evaluating request for loan  putting it towards productive use
 Monitoring loan and activity of borrower

-- significant amount of time and money would otherwise be spent by savers to gather necessary information to make a informed decision about a potential borrower
-- also aides the borrower by giving them access to credit that might otherwise be time consuming and difficult to find.
Stocks and Bonds
-large corporations’ outlet for generating funds for investment as well as Gov’t (bonds) for financing deficit
A) Bonds
-- a promise to repay a debt, normally involving both a principal amount and interest payments

Key Terms
1) Principal Amount
-- amount originally lent
-- equal to the price of a newly issued bond or when the bond was new
-- amount paid at a specific date in the future or at maturity
2) Coupon Payments
-- regular interest payments made to the owners of the bonds
Coupon Rate: regular interest payments to the owner of the bonds is derived from a coupon rate or the interest rate. The coupon rate is declared at the time bond is issued.
Coupon Payment = Coupon Rate x Principal Amount

Example:
Purchase of a 10 yr bond with principal value of $5,000 and annual coupon payment of $100 has what Coupon Rate?
Coupon Rate = $100/$5,000
= 2.0%
3) Term of Bond
-- length of time until bond reaches maturity
-- can vary from 1 mth to 30 years
-- coupon rates are higher on long term bonds than short term ones
-- borrowers that are high risk or approaching bankruptcy will typically pay higher coupon rates

Bonds are bought and sold in the bond market
1) Primary Market For Bonds
-- newly issued bonds
2) Secondary Market For Bonds
-- buying and selling of bonds issued in previous periods
Market Value of Bond = Price of Bond and can be greater than, less than or equal to principal amount of bond
-- price is dependent on how the coupon rate compares to the prevailing or current interest rate

Bond Prices and Interest Rate
-in general, as interest rates ↑, price bonds ↓
-- inverse relationship between price of bond and interest rate
Example
Purchase a newly issued 5 yr Gov’t bond with principal amount of $5,000 for $5,000. Bond has an annual coupon rate of 5%
Annual Coupon Payment = $5,000 x 5% or $250
At Maturity = $5,000 + $250 or $5,250
If, after 4 yrs, you decide to sell the bond (1 yr left before maturity)

-- The price at which you can sell the bond depends on the current interest rate where the current interest rate is the interest rate on newly issued bonds.
If current Interest Rate on 1 yr bond = 6%
At maturity, newly issued bond will pay: $5,000 + 6% or
$5,300
-- No one would pay $5,000 for the used bond since 5% coupon rate is below current interest or would result in $50 less revenue than new bond
-- In order to sell the bond, the price of the bond will have to be set to a level that will allow a 6% return:
Price Bond x (1+ current interest rate) = $5,250
Price Bond x (1.06) = $5,250
Price Bond = $5,250 / 1.06
= $4,952.83
(below original price or principal amount)

If the prevailing interest rate were 3%:
Price Bond x (1+ current interest rate) = $5,250
Price Bond x (1.03) = $5,250
Price Bond = $5,250 / 1.03
= $5,097.09
(above original price or principal amount)
If the prevailing interest rate were 5%
Price Bond x (1+ current interest rate) = $5,250
Price Bond x (1.05) = $5,250
Price Bond = $5,250 / 1.05
= $5,000
(equal to original price or principal amount)

B) Stocks
-- partial ownership in a firm
-- # of stocks equates to % of ownership in a firm (# shares / # of shares outstanding)
-- Stocks provide a return on investment in one of two ways:
1) Dividends
•
Periodic payment to owners of shares of stock
• Amount is determined by company and is usually tied to profits
2) Capital Gains
• Increase in value of stock

Determination of Stock Price
1) Stock Price with no concern over risk
-- riskiness of stock is not a concern
-- considers your anticipated or expected level of return when purchasing a stock. Expected level of return is based on comparison against alternative financial investments
(such as Gov’t bonds)
Example
-- If a 1 yr Gov’t Bond is earning 3% interest and the stock price of a Company A one year from now is expected to be
$50.00 and paying a $4.00 dividend
Stock Price x 1.03 = $54.00
Stock Price = $54.00/1.03
= $52.43

-As expected dividends ↑, ↑ in the value of the stock price or what investors would be willing to pay
-As interest rates ↑, ↓ in the value of stock price as stocks compete against the financial benefits of buying bonds
Certain financial assets carry more risk than others (Gov’t bonds tend to be one of the least risky) and therefore the level of risk needs to be considered in the investment. Riskier assets is said to carry a risk premium
Risk Premium
Rate of Return for -Rate of Return on
Risky Assets On Low Risk Ones

Joe’s Bank Balance Sheet
Assets (in millions)
Property & Bldgs
Securities
Loans
Liabilities (in millions)
$20 Demand Deposits (DD)
25
65 Net Worth or Stockholders
Equity
Reserves (Cash in
Vaults + on deposit w
Federal reserve)
Total Assets
10
120 Total Liabilities + Net Worth
$100
20
120

Terms
Securities : Banks hold securities such as Gov’t and corporate bond and treasury bills
Loans: Borrowed funds by households & non-corporate businesses
Demand Deposits: A liability for the bank because the banks owes this money on the spot if withdrawn
Net Worth or Stockholders equity: Total Assets – Total Liabilities
-- the value of the firm if it closed
Reserves:
1) Vault Cash: money stored in a vault
2) Accounts with Federal Reserve
-- banks have accounts with the Federal Reserve Banks
Purpose of Reserves i) Must have enough available cash for withdrawals ii) Law requires a specific amount of reserves called required reserves
-- the larger the amount of deposit liabilities (i.e. demand deposits), the larger the required reserves

-- set by Federal Reserve
-- current RR is 10%
Example: Using Joe’s Banks Balance Sheet, since demand deposits are $100 million, the bank is required to hold $____________ in reserves. Since the sum of reserves or vault cash + Accts w the Federal Reserve equals $___________, the bank meets the minimum reserve requirement.

Fed and control of the Money Supply
-- Changes in the money supply are accomplished through Open Market Operations (buying / selling of Gov’t bonds)
2 Assumptions
1) Households and businesses are satisfied with cash at hand. Additional funds are deposited in checking accounts/Decrease in funds are transferred from checking account
2) Banks never hold any more than required reserves and
RR = 10%

I] Increase in the Money Supply
-Fed buys Gov’t bonds, called an open market purchase
Example: Fed buys $1,000 bond from Bond Dealer who has a checking account with National City Bank
Changes in National City’s Balance Sheet
Assets Liabilities
Reserves + $1,000 Demand
Deposits
+$1,000
Check is deposited in Bonds Dealers account (increasing demand deposits) and at the same time reserves increase by $1,000. This Gov’t transaction increases the money supply by $1,000

-- Since the RR = 10%, required reserves have increased by $______. Since reserves have gone up by $1,000, there is excess reserves of
$_____________
Excess Reserves = Reserves - Required Reserves
-- National City will now try to lend out excess reserves of $__________. Ironically, Bob walks into National
City and needs a $_______ loan for a boat. After examining his credit history and financials, he is awarded a loan and money is deposited in his checking account with the bank (increase in demand deposits). Bob is buying the boat from Jack who has a checking account with Corporate America Bank where the funds will be deposited (increase in demand deposits).

Changes in National City’s Balance Sheet
Assets Liabilities
Reserves
Loans
+ $1,000 Demand
Deposits
+ 900 Demand
Deposits
+ $1,000
+ 900
With this loan, the money supply increases by $900 ( ↑ in
DD). Once the check clears, the balance sheets become the following:

Changes in National City’s Balance Sheet (check clears)
Reserves
Loans
Reserves
Assets Liabilities
+ $1,000 Demand Deposits + $1,000
+ 900 Demand Deposits
-900 Demand Deposits
+ 900
-900
Note: check clears @ Nat’l City (Bob’s bank) causing both demand deposits and reserves to decrease. Notice that reserves are now
$100 or equal to the amount of required reserves. Since National
City has no excess reserves, they are “loaned up”
Changes in Corporate America Bank’s Balance Sheet
Reserves
Assets Liabilities
+ $900 Demand Deposits + $900
Note: At Corp America Bank (Jack’s bank), demand deposits increase and reserves increase when check is deposited.

Changes in Corporate America Bank’s Balance Sheet
Reserves
Assets Liabilities
+ $900 Demand Deposits + $900
Since Demand Deposits increased by $900, required reserves increase by $90. Excess reserves are now
$810. Corporate America Bank will now try to loan out
$810 or amount of excess reserves.
Say Susie walks into Corporate America Bank (where she also has a checking account) and asks for a loan of
$810 to buy an antique lamp from Monica (has a checking account at Fifth Avenue Bank). This transaction has the following effect:

I
Changes in Corporate America Bank’s Balance Sheet
Assets Liabilities
Reserves
Loans
+ $900 Demand
Deposits
+ 810 Demand
Deposits
+ $900
+ 810
With this loan, the money supply increases by $810.
Once the check clears, the balance sheets become the following:

Changes in Corporate America Bank’s Balance Sheet (check clears)
Reserves
Assets Liabilities
+ $900 Demand Deposits + $900
Loans + 810 Demand Deposits + 810
Reserves - 810 Demand Deposits - 810
Note: Check clears @ Corporate America Bank (Susie’s bank) causing both demand deposits and reserves to decrease. Notice that reserves are now $90 or equal to the amount of required reserves. Since
Corporate America has no excess reserves, they are “loaned up”
Changes in Fifth Avenue Bank’s Balance Sheet
Reserves
Assets Liabilities
+ $810 Demand Deposits + $810
Note: At Fifth Avenue Bank (Monica’s bank), demand deposits increase and reserves increase when check is deposited.

Results
-- Demand Deposits increase each time a bank lends money out from its excess reserves or money supply increases
-- Demand deposits increase by 90% when each loan is made
Bank Addt’l Demand Deposits Cumulative Demand
(DD) per bank Deposits (DD) all banks
Nat’l City $1,000 $1,000
Corp America
Fifth Ave
$ 900
$ 810
.
.
$1,900
$2,710
.
.
.
$2,826
.
$10,000
Derivation
∆DD (all banks) = Demand Deposit Multiplier x initial ∆ reserves
Demand Deposit Multiplier = 1/RR or 1/.10
∆DD (all banks) = 1/.10 x 1000
= 10 x 1,000 or $10,000
∆Money Supply = ∆DD + ∆currency held by the public
∆Money Supply = $10,000 + $0

II] Decrease in the Money Supply
-Fed sells Gov’t bonds, called an open market sale
Example: Fed sells a $1,000 bond to local investment firm who has a checking account with National City Bank
Changes in National City’s Balance Sheet
Assets
Reserves - $1,000
Liabilities
Demand
Deposits
- $1,000
Money is withdrawn from investment firms’ account
(decreasing demand deposits) and at the same time reserves decrease by $1,000 (money supply decreases by $1,000

-- Since the RR = 10%, required reserves have decreased by $______. Since reserves have decreased by $1,000, there is now deficient reserves of $_____________
-- In order to gain these reserves, National City will now try to call-in loans or ask for repayment equal to amount of deficient reserves or $__________. Say a loan equal to amount of deficient reserves is paid from a client holding a checking account with
Corporate America Bank.

Changes in National City’s Balance Sheet (check clears)
Assets
Reserves
Reserves
Loans
Liabilities
- $1,000 Demand Deposits - $1,000
+ 900
- 900
Note: check clears and reserves increase by $900 and loans decrease by $900. Notice that change in reserves is now -$100 or equal to the reduction allowable given the RR.
Changes in Corporate America Bank’s Balance Sheet
Reserves
Assets Liabilities
- $900 Demand Deposits - $900
Note: At Corp America Bank, demand deposits decrease and reserves decrease when check clears and loan payment is made to
National City

-- Since the RR = 10%, required reserves have decreased by $90. Since reserves however have decreased by $900, there is now deficient reserves of $810.
-- In order to gain these reserves,
Corporate America Bank will now try to call-in loans or ask for repayment equal to amount of deficient reserves or $810.

Results
-- Demand Deposits decrease each time a bank calls-in loans or the money supply decreases
-- Demand deposits decrease by 90% with each loan called-in
Bank ↓ in Demand Deposits Cumulative ↓ in Demand
(DD) per bank Deposits (DD) all banks
Nat’l City $1,000 $1,000
Corp America $ 900 $1,900
.
.
.
.
.
$2,826
.
$10,000
Derivation
∆DD (all banks) = Demand Deposit Multiplier x initial ∆ reserves
Demand Deposit Multiplier = 1/RR or 1/.10
∆DD (all banks) = 10 x -1,000 or -$10,000
∆Money Supply = ∆DD + ∆currency held by the public
= -10,000 + 0
= -10,000