Bell Ringer
• What is the difference between M1, M2 and
M3?
– Don’t know…look it up NOW!

Money, Banking, and
Financial Institutions
Chapter 31

The Functions of Money
• What is money?
– Money is what money does
• There are 3 functions of money
– Medium of exchange—bakery worker doesn’t want to be paid in bagels, a teacher doesn’t want educational services in exchange for teaching student’s and Best Buy doesn’t want to exchange
TVs for fish
• Money gives us something that everyone values equally and thus will trade it in exchange for their goods/services

The Functions of Money
• Other functions of money
– Unit of account—it is how we measure how valuable something is (the more it costs, the more valuable it is)
– Store of value—money allows you to spend your wealth as you need/want, you don’t have to spend it all today because if you put it in a safe or checking account, it will still be there tomorrow

The Supply of Money
• “Money” is different from country to country
– Some people use furs, whale’s teeth, paper, etc.
• There are three types of “money” in the US
– M1 is all currency (“paper” and coin money) and checkable deposits
• Coins only count for 2-3% of all US money
• Money has token value meaning it is worth more than the materials used to make it (except in the case of the penny)
• Paper money (made from cotton) makes up ~50% of M1
• Paper money is a Federal Reserve Note

The Supply of Money
• M1’s checkable deposits
– Checks make it safe to pay large sums of money without fear of losing the money (if lost/stolen)
– The reasons checks count as money is because you can easily turn it into currency and it is widely accepts as “cash”
• These accounts may also be called demand deposits—the consumer can write checks and receive their money anytime they want

The Supply of Money
• A note about M1
– We do not include checkable deposits owned by the federal government in M1
– This allows the Federal Reserve to know how much money consumers have to spend

The Supply of Money
• M2 is a broader definition of money
– It includes M1 + Near Monies (Savings, Money
Market accounts, Small Time Deposits, and
Mutual Funds)
• Savings—Money can be transferred over to a checkable account upon consumer request
• Money Market deposit account—interest bearing account that allows the bank to take the money in your account and invest it into securities—they limit how much you can pull out at a time and require minimum deposits

The Supply of Money
• Time deposits
– Only time deposits under $100K are counted in M2
– These are also known as Certificates of Deposit or CDs and you have to put in a minimum amount and keep it in the account for a specified amount of time—this is an interest bearing account
• Money Market Mutual Funds
– With $500 you can put money in an MMMF which combines your money with other people’s money and purchases securities (shares) in a company and then you earn a portion of the interest/share increase

The Supply of Money
• In short: M1 is money that can be used immediately while M2 has to be converted to spending money
• Note: Credit Cards are not money, they are loans (someone else’s money)

What “Backs” the Money Supply?
• Money in the United States is backed
(guaranteed) by the government’s ability to keep the value of money stable…that’s it!
• Paper money is a debt of the Federal Reserve
Bank and checkable deposits are a debt of the banks
– You cannot exchange your paper money or check for anything other than paper money
• If you go to the bank to exchange your $5 bill, you will only get a different $5 bill
• If you cash a check for $400 you will only get $400 cash, not gold or any other precious material

What “Backs” the Money Supply?
• So why is money valuable?
• What is the difference between the two items below?
• One can purchase items in the real world, the other can’t—but why?

What “Backs” the Money Supply?
• There are three things that make money valuable
– Acceptability—try to get the Dollar General to accept your $1 monopoly money, you’ll probably get kicked out—however, they will happily take your real dollar
– Legal Tender—the government says its valuable, so it is widely accepted as payment (this is called
Fiat money)
• If the government decided chickens were legal form of payment tomorrow, everyone would be using chickens to pay for stuff

What “Backs” the Money Supply?
• Why money is valuable?
– The third reason is because of relative scarcity—like everything else, money’s worth is based on its supply and demand
• The more scarce it is, the more valuable it is (value of the dollar goes up) and if demand goes up, eventually the value will go up

What “Backs” the Money Supply?
• Purchasing Power of money means how much you can get for your money
• The purchase power of the dollar changes as the price level changes
– If the Consumer Price Index or “cost-of-living” goes up, the value of the dollar goes down
(because you can’t purchase as much with it)
– EX: the price level doubles meaning you can only purchase half of what you used to

What “Backs” the Money Supply?
• To find the value of the dollar:
– D = 1/Price Level
– EX: price level is 1.20
• D = 1/1.20 = .833
• If our original price level had been 1, rising to 1.20 would be a 20% increase in the price level which would result in a 16.67% decrease in the value of the dollar

What “Backs” the Money Supply?
• Runaway inflation destroys the value of money
– Best example: the German Mark in 1920 was worth
$87.63 (US = $101.35) worth of gold (used gold standard back then) by 1922 the German Mark was only worth $17.92 (US = $97.66)
• Their government had printed more than 496 quintrillion dollars (496,500,000,000,000,000,000 DM)
• The value of their money fell to one- trillionth of its value between 1914 and 1923
• In other words their money was useless!

What “Backs” the Money Supply?
• If rapid inflation occurs, people may stop accepting the currency as a medium of exchange
– When this happens the economy will return to the barter system
• Foreign countries with rapid inflation will adopt other countries currencies as legal tender sometimes
– Ecuador did this in 2000adopted the dollar

What “Backs” the Money Supply?
• If the money doesn’t stay stable it can no longer be used as a store of value or as a unit of account because you will not have a clear understanding of what the money is worth
– The US stabilizes money through fiscal policy and monetary policy (explained in upcoming chapters)
• They use a legislation, government policy, and social practice as stabilization methods

The Demand for Money
• Why do people keep some their wealth?
– To make future transactions (buy stuff) and to hold as an asset
• Households hold money to make transactions like paying bills, buying food, etc.—Businesses hold money to pay wages, buy inputs, etc.
– These uses are called transaction demand for money

The Demand for Money
• Transaction demand for money correlates to nominal GDP
– If the price level goes up, demand for money will go up
– Because you have to pay your bills, it doesn’t matter what the interest rate is, you are still going to have the same transaction demand
Interest
10
7.5
5
2.5
D t
50 100 150 200
(transaction demand in billions)

The Demand for Money
• Asset Demand for money is saving money in cash form
• When interest rates are low, you are going to want to keep your money as cash, when interest rates are high, you are going to want to put them into bonds, etc.
Interest
10
7.5
5
2.5
D a
50 100 150 200
(transaction demand in billions)

The Demand for Money
• When you add up all demand for money
(asset and transaction) you get total demand for money (D m
) which tells you how much money people want to hold at each interest rate
– Note: Supply stays the same because the amount of money in the economy at a given point is fixed
Interest
10
7.5
i e
S m
2.5
D m
50 100 150 200
(transaction demand in billions)

The Money Market
Interest
10
7.5
S m1
S m
S m2 i e
2.5
50 100 150 200 250
(transaction demand in billions)
D m
1. What happens if you move from S m to
S m1 but you stay at the same interest rate?
2. From S m to
S m2 at the same interest rate?
1. You will have a shortage of money
(too much demand)
2. You will have a surplus of money

The Federal Reserve and the
Banking System
• The Federal Reserve (the Fed) is the organization that sets our monetary/fiscal policies
– When you hear that the government raised interest rates, it was the Fed who created that

The Federal Reserve and the
Banking System
• The Board of Governors is made up of 7 people who were selected by the President and approved by the Senate
– They serve 14 years
– The President chooses the Chairperson and
Vice-Chairperson and those two serve in that position for 4 years

The Federal Reserve and the
Banking System
Ben Bernanke
Chairperson
Donald Kohn
Vice Chairperson

The Federal Reserve and the
Banking System
• The Federal Open Market Committee (FOMC) aids the Board of Governors in making monetary policy
– Includes the 7 Board members
– The President of the New York Federal Reserve
Bank
– 4 of the remaining presidents of the Federal
Reserve Banks (1 year rotating cycle)
– This group meets regularly to decided on issues of government bills, notes, bonds, and whether to change interest rates

The Federal Reserve and the
Banking System
Federal Open Market
Committee
Board of Governors
12 Federal Reserve Banks
Commercial Banks
Thrift Institutions
(Savings and loan, credit unions, etc.)
The Public
(households and businesses)

The Federal Reserve and the
Banking System
• The 12 Federal Reserve Banks are the US’s
“central banks”
– Other countries (Japan, Britain, etc.) have a national bank—like the US did until Jackson destroyed it
– Today, these 12 F.R.B.s collectively assist in the control of the flow of money

The Federal Reserve and the
Banking System

The Federal Reserve and the
Banking System
• The Reserve Banks are “owned” by the commercial banks in their district—those banks have to purchase stock in the Fed.
Reserve Bank
– Even though the Fed. Reserve Bank is a private institution, it runs like a public (non-profit) organization
– It doesn’t compete with commercial banks
– These banks are not used by consumes, they are the banks your bank uses and the government

The Federal Reserve and the
Banking System
• The Fed. Reserve Banks are “bankers banks” meaning when your bank needs a loan, they request it from the Fed. Reserve
Bank
– These loans account for about $150M per day
• The F.R.B. also acts as a normal bank for your bank
• They issue currency when the Fed tells them to

The Federal Reserve and the
Banking System
• There are ~7800 commercial banks in the
US, most are state authorized (Riverside
Bank, Orange Bank)
– Only ¼ of the banks are national banks
(Citigroup, J.P. Morgan, etc.)
• Thrift institutions exist and are subject to control by the Fed.
– These are savings and loans, credit unions, etc.

The Federal Reserve and the
Banking System
• The Fed has 7 functions
– Issue currency
– Sets reserve requirements—tells the commercial banks how much they have to keep on hand
– Lending money to banks and thrifts—when they do this, they charge an interest rate called the discount rate
– Provide for check collection

The Federal Reserve and the
Banking System
1. Jack (MI) write $200 check
(Detroit) to Kate
Bank of Detroit withdrawals
$200 from Jack’s
Account
Kate (OR) deposits check in her account
(Portland)
FRB Chicago debits Bank of
Detroit and sends the check to Detroit
FRB credits
Portland and sends check to
FRB Chicago
Bank of Portland credits Kate’s acct. and sends check to
Fed Bank in San
Francisco

The Federal Reserve and the
Banking System
• Other functions of the Fed
– Acting as fiscal agent for the federal government—they put their money in these banks as well as sell/redeem bonds
– Supervising banks
– Controlling the money supply—through interest rates and printing (more to come on this)

The Federal Reserve and the
Banking System
• The Fed is an independent government agency so that it doesn’t have to deal typical political pressures
– Avoids issues with lobbying groups, etc.
• Countries that have independent central banks tend to have lower inflation rates, etc.

Recent Development in Money and
Banking
• Decline of Banks and Thrifts
• Consolidation among Banks and Thrifts
(Wells Fargo and Wachovia)
• Banks combining with other financial services (insurance, pension funds, securities)
• Globalization of banking
• Electronic Transactions