Chapter 13
Money and Banking
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
13-1
Chapter Objectives
•
•
•
•
The four jobs of money
What money is
M1, M2, and M3
The demand for money
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
13-2
Chapter Objectives
•
•
•
•
•
The origins of banking
The creation and destruction of money
Branch banking and bank chartering
The FDIC
The savings and loan debacle
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
13-3
The Four Jobs of Money
• Medium of exchange
• Standard of value
• Store of value
• Standard of deferred payment
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13-4
Medium of Exchange
• The most important job of money is to serve as
a medium of exchange
– When any good or service is purchased, people use
money
– Money makes it easier to buy and sell because
money is universally accepted
– Money, then, provides us with a shortcut in doing
business
• By acting as a medium of exchange, money
performs its most important function
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
13-5
Standard of Value
• Money is a common denominator in
which the relative value of goods and
services can be expressed
– A job that pays $2 an hour would be nearly
impossible to fill, while one paying $50 an
hour would be swamped with applications
– Does money work well as a standard of
value? You tell me
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
13-6
Store of Value
• If you could buy 100 units of goods and services
with $100 in 1982, how many units could you
buy with $100 in 2000?
– Answer: you could have bought just 51 units
– During this period, inflation robbed the dollar of
almost half of its purchasing power
• Over the long run, particularly since World
War II, money has been a very poor store of
value
– However, over relatively short periods of time, say, a
few weeks or months, money does not lose much of
its value
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
13-7
Standard of Deferred Payment
• Many contracts promise to pay fixed
sums of money well into the future
– A couple of examples are 30-year corporate
bonds and a 20-year mortgage
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13-8
Standard of Deferred Payment
• When Dave Winfield signed a 10-year,
$23 million contract with the New York
Yankees in 1980, he really got stuck
– Because over the next 10 years the consumer
price index went up by almost 59%
– Today when a professional ballplayer,
entertainer, or virtually anyone else signs a
long-term contract, she or he is generally
protected by an escalator clause, which calls
for increased payments to compensate for
any future inflation
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
13-9
Standard of Deferred Payment
• How well does money do its job as a
standard of deferred payment?
– About as well as it does as a store of value
– Usually quite well in the short run, but not
well at all over the long run of, say, three
years or more
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
13-10
Money versus Barter
• Without money, the only way to do business is
by bartering
• For barter to work, I must want what you have
and you must want what I have
– This makes it pretty difficult to do business
• “Everything, then, must be assessed in money:
for this enables men always to exchange their
services, and so makes society possible”
– Aristotle, Nicomachean Ethics
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
13-11
Our Money Supply
• Money consist of coins, paper money, demand
(or checking) deposits, and checklike deposits
(commonly called NOW – or negotiable order
of withdrawal – accounts) held by the nonbank
public
– Coins and paper money together are considered
currency
– Six of every ten dollars in our money supply are
demand deposits and other checkable deposits
• Virtually all the rest is currency
– Checks are not money but checking deposits are
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
13-12
Our Money Supply
Federal Reserve Statistical Release, April 5, 2001
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
13-13
Our Money Supply: M1, M2, M3
Currency
+ Demand deposits
+ Other checkable deposits
+ Traveler’s checks
M1(traditionally our basic money supply)
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13-14
Our Money Supply: M1, M2, M3
Currency
+ Demand deposits
+ Other checkable deposits
+ Traveler’s checks
M1
+ Savings deposits
+ Small-denomination time deposits (less than $100,00)
+ Money market mutual funds held by individuals
M2
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
13-15
Our Money Supply: M1, M2, M3
Currency
+ Demand deposits
+ Other checkable deposits
+ Traveler’s checks
M1
+ Savings deposits
+ Small-denomination time deposits (less than $100,00)
+ Money market mutual funds held by individuals
M2
+ Large denomination time deposits (more than $100,00)
+ Money market mutual funds held by institutions
+ Other less liquid assets
M3
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
13-16
Our Money Supply
M1, M2, and M3, January 2001
Federal Reserve Bulletin
M 1=1,107
Currency in
circulation
539
M 2=5,111
Traveler's
checks
8
Other
checkable
deposits
251
Demand
deposits
309
M1
1107
M 3=7,361
Money market mutual funds
held by institutions
903
Saving
deposits
1970
Large-denomination
time deposits
797
Other less
liquid assets
550
Money market
mutual funds
held by individuals
985
Small-denomination
time deposits
1049
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
M2
5111
13-17
Our Growing Money Supply
Annual Percentage Change in the Money Supply, M1, 1960-2000
20
18
16
14
12
10
8
6
4
2
0
Ð2
Ð4
1960
1964
1968
1972
1976
1980
1984
1988
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1992
1996
2000
13-18
The Demand for Money
• The amount of money people hold is called
money balances
• John Maynard Keynes noted that people had
three reasons for holding money
– People hold money to make transactions
– People hold money for precautionary reasons
– People hold money to speculate
• Economists have since identified four factors
that influence the three Keynesian motives for
holding money
–
–
–
–
The price level
Income
The interest rate
Credit availability
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
13-19
The Keynesian Motives for
Holding Money
• The transaction motive
– Individuals have day-to-day purchases for
which they pay in cash or by check
– Individuals take care of their rent or
mortgage payment, car payment, monthly
bills and major purchases by check
– Businesses need substantial checking
accounts to pay their bills and meet their
payrolls
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
13-20
The Keynesian Motives for
Holding Money
• The precautionary motive
– People will keep money on hand just in case
some unforeseen emergency arises
• They do not actually expect to spend this money,
but they want to be ready if the need arises
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
13-21
The Keynesian Motives for
Holding Money
• The speculative motive
– When interest rates are very low you don’t
stand to lose much holding your assets in the
form of money
– Alternatively, by tying up your assets in the
form of bonds, you actually stand to lose
money should interest rates rise
• You would be locked into very low rates
– This motive is based on the belief that better
opportunities for investment will come along
and that, in particular, interest rates will rise
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
13-22
Four Influences on the Demand
for Money
• The price level
– As the price level rises, people need to hold higher
money balances to carry out day-to-day transactions
– As the price level rises, the purchasing power of the
dollar declines, so the longer you hold money, the
less that money is worth
– Even though people tend to cut down on their
money balances during periods of inflation, as the
price level rises people will hold larger money
balances
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
13-23
Four Influences on the Demand
for Money
• Income
– The more you make, the more you spend
– The more you spend, the more money you
need to hold as cash or in your checking
account
– Therefore as income rises, so does the
demand for money balances
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
13-24
Four Influences on the Demand
for Money
• Interest rates
– The quantity of money demanded (held) goes
down as interest rates rise
• The alternative to holding your assets in the form
of money is to hold them in some type of interest
bearing paper
• As interest rates rise, these assets become more
attractive than money balances
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
13-25
Four Influences on the Demand
for Money
• Credit availability
– If you can get credit, you don’t need to hold
so much money
• The last three decades have seen a veritable
explosion in consumer credit in the form of credit
cards and bank loans
• Over this period, increasing credit availability
has been exerting a downward pressure on the
demand for money
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
13-26
Four Influences on the Demand
for Money
• Four generalizations
– As interest rates rise, people tend to hold less
money
– As the rate of inflation rises, people tend to
hold more money
– As the level of income rises, people tend to
hold more money
– As credit availability increases, people tend
to hold less money
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
13-27
The Demand Schedule for Money
The Three Demands for Money
A.Transactions demand
20
B. Precautionary demand
20
C. Speculative demand
20
18
16
Precautionary
demand
14
Transactions
demand
Speculative
demand
12
10
10
10
8
6
4
2
100
200
300
400
100
200
100 200 300
Quantity of money (in $ billions)
400
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500
600
700
800
900 1,000
13-28
Total Demand for Money
20
18
16
14
12
10
Total demand
for money
8
6
4
2
0
200
400
600
800
1,000
1,200
1,400 1,600 1,800
Quantity of money (in $ billions)
This is the sum of the transaction demand, precautionary demand, and speculative
demand for money shown in the previous slide
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
13-29
Total Demand for Money and the Supply
of Money
The interest rate of 7.2
percent is found at the
intersection of the total
demand for money and
the supply of money (M)
20
18
M
16
14
12
10
7.2%
8
Total demand
for money
6
Since at any given time the
supply of money (M) is fixed
it can be represented as a
vertical line
4
2
0
200
400
600
800
1,000 1,200 1,400 1,600 1,800
Quantity of money (in $ billions)
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13-30
Determination of the Interest Rate
The Prime Rate of Interest Charged by Banks on Short-Term
Business Loans, 1978-2001
20
16
12
8
4
1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
Although the prime rate is set by the nation’s largest banks, it is strongly
influenced by actions of the Federal Reserve Board of Governors
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13-31
Who Controls the Interest
Rates?
• People who borrow money
– players
• Banks
– referee
• The FED
– coach
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
13-32
Keeping Track of Interest
Rates
Wall Street Journal, Dec. 7, 1989
Wall Street Journal, Dec. 11, 1989
10.0%
11%
9.5
10
AA-rated
utilities
Federal funds
9.0
9
Long-term
Treasuries
3-month
commercial
paper
8.5
8
8.0
Municipals
7
3-month
Treasury bills
7.5
7.0
6
J
J
A
S
O
N
D
J
1989
(b)
J
A
S
O
N
D
1989
(a)
Note how the rates all move up and down virtually in lockstep, while maintaining
the same distances from each other.
All interest rates move up and down together.
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13-33
Banking: A Short History
What is the goldsmith’s reserve
ratio when there are 1,000
receipts in circulation and 1,000
coins the safe?
Answer: 100 percent
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13-34
Banking: A Short History
What is the goldsmith’s reserve
ratio when there are 1,000
receipts in circulation and 500
coins the safe?
Answer: 50 percent
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13-35
Banking: A Short History
What is the goldsmith’s reserve
ratio when there are 1,000
receipts in circulation and 250
coins the safe?
Answer: 25 percent
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
13-36
Modern Banking
• A bank is a financial institution that accepts
deposits, makes loans, and offers checking
accounts
– Banks keep about 2% of their deposits in the form
of vault cash
– All the nation’s commercial banks, credit unions,
savings and loan associations, and mutual savings
banks now have to keep up to 10% of their checking
deposits on reserve
• This means “on the books”
• Remember, checking deposits are bookkeeping entries
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13-37
Modern Banking
• Commercial Banks
– Until the passage of the Depository Institutions
Deregulation and Monetary Control Act of 1980,
only commercial banks were allowed to issue
checking deposits
• They were the only institutions clearly recognized as banks
– Commercial banks account for the bulk of
checkable deposits
– There are slightly more than 9,000 commercial
banks in the United States
• They hold nearly all demand deposits and almost half of
total savings deposits
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13-38
Modern Banking
• Mutual Savings Banks
– Mostly operated in the northeastern United States,
these institutions were created in the 19th century to
encourage savings by the “common people”
– They traditionally made small personal loans, but
today, like savings and loan associations, they offer
the same range of services as commercial banks
– There are nearly 1,600 mutual savings banks
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13-39
Modern Banking
• Savings and Loan Associations
– Although originally established to finance
home building, these associations also offer
most of the services offered by commercial
banks
– The nearly 1,100 S&Ls invest more than
three quarters of their savings deposits in
home mortgages
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
13-40
Modern Banking
• Credit Unions
– Although there are nearly 11,000 credit unions in
the United States, they hold less than 5% of total
savings deposits
– Credit unions offer a full range of financial services
• They specialize in small consumer loans
– Credit unions are cooperatives that generally serve
specific employee, union, or community groups
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13-41
Modern Banking
• The Banking Act of 1980 blurred the
distinction between commercial banks
and the three other depository
institutions
– The main distinction – that before 1980 only
commercial banks were legally allowed to
issue checking accounts – was swept away in
1980
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13-42
Bank Lending
• Banks borrow money at low interest rates and
lend money out at much higher interest rates
– Currently, banks pay either zero or up to maybe 3%
interest on most deposits – and perhaps 1 or 2 points
more if you leave your money on deposit for a few
years
– Banks charge about 7% for fixed rate mortgages, a
bit more for business loans, and about 18% on
credit card loans
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13-43
Financial Intermediaries
– Financial intermediaries channel funds from savers
to borrows
• Basically, they repackage the flow of deposits, insurance
premiums, pension contributions, and other forms of
savings into larger chunks
– $10,000, $1 million, $50 million, or even more
• They pay low rates of interest to their lenders and charge
relatively high rates to their borrowers
– Sometime business borrowers dispense with
financial middlemen altogether by borrowing
directly from savers
• The U.S. Treasury does this every month by issuing new
bonds, certificates, notes, and bills
• Large business borrows by issuing relatively short-term
commercial paper and long-term bonds
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13-44
The Home Mortgage Market
– In the home mortgage market banks and
other financial intermediaries differentiate
between the relatively well off and the less
fortunate
• Just over two thirds of all American families own
their homes
– Nearly all have outstanding mortgages
• The conventional market provided well off
homeowners mortgages at interest rates in the
seven-to-eight range in 2000 and 2001
• The subprime market caters to poorer home
homeowners and has interest rates that are
double what they are in the conventional market
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13-45
Welfare Banks
• “Welfare banks” are check cashing stores
– You will find one in virtually every poor
neighborhood
• They usually charge a fee of 1 to 3% of the value
of the check, but some charge as much as 20%
• Why don’t poor people go to banks?
There are usually no banks in poor
neighborhoods
If you don’t have a required minimum balance,
banks also charge pretty stiff fees
People receiving public assistance are not allowed
to have bank accounts
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
13-46
The Creation and Destruction
of Money
• Banks create money by making loans
– This money is created out of nothing
– This money is new money in the form of additional
demand deposits
• Money is destroyed when a loan is repaid
– When a loan is repaid, demand deposit accounts go
down
– This money disappears back into nothing
• The interest that was paid does not disappear
• The Federal Reserve can affect the bank’s
ability to create money by increasing or
decreasing the bank’s reserve requirements
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13-47
Bank Regulation
• Branch Banking
– Banking is legally defined as accepting
deposits
– Branch banking , therefore, would be the
acceptance of deposits at more than one
location
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13-48
Bank Regulation
• The three types of branch banking
– Three types of branch banking have evolved
under various state laws
• Unrestricted branch banking under which a
bank may open branches through out the state
• Limited branch banking under which a bank
may be allowed to open branches only in
contiguous communities
• Unit banking in which state law forbids any
branching whatsoever
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13-49
Bank Regulation
• Automated teller machines (ATMs)
– Why shift to ATMs?
• Processing a teller transaction costs more than
double what an ATM transaction cost
• By the end of 2000 there were about 250,000
ATMs doing more than 13 billion transaction a
year
• This could lead to a decline in branch offices
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13-50
Bank Regulation
• Automated teller machines (ATMs)
– Should banks be allowed to charge fees to
noncustomers?
• Virtually all bankers and most economists would
answer “Yes!”
• Six out of seven ATM users don’t pay surcharges
• Fees only hit users who go to ATMs not owned by
their own bank
• Banning ATM surcharges would leave consumers
with fewer choices
• We would all have to make do with fewer
machines and longer lines
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13-51
Bank Regulation
• State and Nationally Chartered Banks
– To operate a bank you must get a charter
– More than two-thirds of the nation’s banks
have state charters, the rest have national
charters
– To get a bank charter you need to
demonstrate three things
• That your community needs a bank or an
additional bank
• That you have enough capital to start a bank
• That you are of good character
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13-52
Bank Regulation
• State and Nationally Chartered Banks
– To summarize
• All nationally chartered banks must join the
Federal Reserve System
• All Federal Reserve member banks must join the
FDIC
• Only a small percentage of the state-chartered
banks are members of the Federal Reserve
• Nearly all banks are members of the FDIC
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13-53
Bank Regulation
• Interstate Banking
• Until 1994 interstate banking was technically
illegal, although banks managed to engage in this
practice by buying banks in other states and
operating them as separate entities
• The passage of the Riegle-Neal Interstate
Banking and Branching Act of 1994 swept away
the last barriers to opening branches in different
states
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13-54
Bank Regulation
• The Federal Deposit Insurance Corporation
(FDIC)
– After the massive bank failures of the 1930s,
Congress set up the FDIC
• The whole idea of the FDIC is to avert bank panics by
assuring the public that the federal government stands
behind the bank, ready to pay off depositors, if it should
fail
• The FDIC would rather pay another bank to take over
ailing institutions rather than pay off its depositors (the
FDIC has paid several hundred million dollars to a bank to
get it to take over a failing bank)
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13-55
Bank Regulation
• The Federal Deposit Insurance Corporation
(FDIC)
– Is the FDIC in any danger of running out of money?
– Not really
– The Congress, the Federal Reserve, the Treasury,
and all of the financial resources of the U.S.
government are committed to the preservation of
the FDIC
– More than 99% of all banks are members of the
FDIC
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13-56
Bank Regulation
• The Savings and Loan Debacle
– In early 1990, the financial press was calling
the S&L debacle the greatest financial
scandal in the history of the United States
– Incompetence, inordinate risk-taking, poor
supervision, and outright fraud all played
prominent roles in the decline and fall of the
savings and loan industry
– The S&L mess will cost hundreds of billions
of dollars to clean up
– Guess who gets stuck with the bill?
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13-57
Bank Regulation
• Will the Commercial Banks Go the Way
of the S&Ls?
• From 1987 through 1989 the nation’s commercial
were in big trouble
– Nearly 200 banks were going under each year
– Back in the mid-and late 1970s only about 10 a year
failed
• More banks will fail, but of the nation’s 8,000
commercial banks, there were less than a dozen
bank failures from 1998 to 2000
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13-58