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Money Banking and Central Banking
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Introduction
Why is the Federal Reserve System
clearing fewer checks, and what is its
role in our nations financial system?
In this chapter you will learn the answers,
but first you will learn more generally
about money and banking.
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Learning Objectives
• Define the fundamental functions
of money
• Identify key properties that any goods
that function as money must possess
• Explain official definitions of the
quantity of money in circulation
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Learning Objectives (cont'd)
• Understand why financial
intermediaries such as banks exist
• Describe the basic structure of the
Federal Reserve System
• Discuss the major functions of the
Federal Reserve
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Chapter Outline
• The Functions of Money
• Liquidity
• Monetary Standards, or What Backs Money
• Defining Money
• Financial Intermediation and Banks
• Banking Structures Throughout the World
• The Federal Reserve System
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Did You Know That...
• Money includes not only coins and
dollar bills, but also the balance in your
checking account?
• Anything widely accepted in exchange
for items of value is considered to
be money?
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Money
• Money
Any medium that is universally accepted
in an economy both by sellers of goods
and services and by creditors as payment
for debts
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Table 15-1 Types of Money
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The Functions of Money
• The functions of money
Medium of exchange
Unit of accounting
Store of value (purchasing power)
Standard of deferred payment
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The Functions of Money (cont'd)
• Medium of Exchange
Any item that sellers will accept
as payment
• Barter
The direct exchange of goods and services
for other goods and services without the
use of money
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The Functions of Money (cont'd)
• Medium of exchange
Money facilitates exchange by reducing
transaction costs associated with means-
of-payment uncertainty.
Permits specialization, facilitates efficiencies
• Barter
Simply a direct exchange
Double coincidence of wants
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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
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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.
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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
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Liquidity
• 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.
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Figure 15-1 Degrees of Liquidity
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Liquidity (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.
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Monetary Standards,
or What Backs Money
• Questions
What backs money?
Is it gold, silver, or the federal
government?
• Answer
Your confidence
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Monetary Standards,
or What Backs 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
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Example: E-Gold Backed E-Money
• The Internet has served as a breeding
ground for various forms of e-money.
• Gold-backed e-money effectively
provides measures of the purchasing
power, in terms of gold, of several
major world currencies.
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Monetary Standards,
or What Backs 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.”
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Monetary Standards,
or What Backs Money (cont'd)
• Currency and transactions deposits are
money because of their
Acceptability
Predictability of value
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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
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Defining Money (cont'd)
• Economists use two basic approaches
to define and measure money.
The transactions approach
The liquidity approach
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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
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Defining Money (cont'd)
• The transactions approach to
measuring money: M1
Currency
Checkable (transaction) deposits
Traveler’s checks not issued by banks
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Figure 15-2 Composition of the U.S. M1
and M2 Money Supply, 2007, Panel (a)
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Figure 15-2 Composition of the U.S. M1
and M2 Money Supply, 2007, Panel (b)
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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.
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Figure 15-3 The Value of U.S. Currency
in Circulation Outside the United States
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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
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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
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Defining Money (cont'd)
• The liquidity approach to measuring
money: M2
• Near Moneys
Assets that are almost money
Highly liquid
Easily converted to cash
Time deposits are an example
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Defining Money (cont'd)
• The liquidity approach: M2 is equal to
M1 plus
1. Savings and small denomination
time deposits
2. Balances in retail money market
mutual funds
3. MMDAs
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Defining Money (cont'd)
• M2
Savings Deposits
Interest-earning funds that can be withdrawn at
any time without payment of a penalty
Depository Institutions
Accept deposits from savers and lend those
funds out
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Defining Money (cont'd)
• M2
Money Market Deposit Accounts (MMDAs)
Accounts issued by banks yielding a market
rate of interest with a minimum balance
requirement and a limit on transactions
They have no minimum maturity
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Defining Money (cont'd)
• M2
Time Deposit
A deposit in a financial institution that requires
notice of intent to withdraw or must be left for
an agreed period
Early withdrawal may result in a penalty
CD
Time deposit with fixed maturity
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Defining Money (cont'd)
• M2
Money Market Mutual Funds
Funds obtained from the public that investment
companies hold in common
Funds used to acquire short-maturity
credit instruments
CD’s, U.S. government securities
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Defining the U.S. Money Supply
• Question
Which definition of money correlates best
with economic activity?
• Answer
M2, although some businesspeople and
policymakers prefer MZM
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Defining Money (cont'd)
• MZM (money-at-zero-maturity)
• MZM entails adding deposits without
set maturities to M1.
• MZM includes all MMFs but excludes
all deposits with fixed maturities.
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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.
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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.
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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
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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
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Figure 15-4 The Process of
Financial Intermediation
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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
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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
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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.
Pension funds and investment companies are
examples.
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Financial Intermediation
and Banks (cont'd)
• Liabilities
Amounts owed
The sources of funds for financial
intermediaries
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Financial Intermediation
and Banks (cont'd)
• Assets
Amounts owned
The uses of funds by financial
intermediaries
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Table 15-2 Financial Intermediaries
and Their Assets and Liabilities
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Financial Intermediation
and Banks (cont'd)
• Payment Intermediaries
Institutions that facilitate transfers of funds
between depositors who hold transactions
deposits with those institutions
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Figure 15-5 How a Debit-Card
Transaction Clears
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Financial Intermediation
and Banks (cont'd)
• Capital Controls
Legal restrictions on the ability of a
nation’s residents to hold and trade assets
denominated in foreign currencies
• International Financial Intermediation
Financing investment projects in more than
one country
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Table 15-3
The World’s Largest Banks
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Financial Intermediation
and Banks (cont'd)
• World Index Fund
A portfolio of bonds issued in various
nations whose individual yields generally
move in offsetting directions, thereby
reducing the overall risk of losses
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Banking Structures
Throughout the World
• The ways that banks around the world differ
Size
United States has banks of various sizes
Europe and Japan have a few large banks
Legal
Universal banking
Limits on financial services such as insurance and bank
stock ownership
Importance in financial system
Major importance
Part of a varied financial system (United States)
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Banking Structures
Throughout the World (cont'd)
• Universal Banking
An environment in which banks face few or
no restrictions on their powers to offer a
full range of financial services and to own
shares of stock in corporations
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Banking Structures
Throughout the World (cont'd)
• Central banks and their roles
1. Perform banking functions for their
nations’ governments
2. Provide financial services for
private banks
3. Conduct their nations’ monetary policies
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The Federal Reserve System
• 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
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The Federal Reserve System (cont'd)
• Organization of the Fed
Board of Governors
7 members, 14-year terms
Federal Reserve Banks (12 Districts)
25 branches
Federal Open Market Committee (FOMC)
BOG plus 5 presidents of district banks
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Figure 15-6 Organization of the
Federal Reserve System
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Figure 15-7
The Federal Reserve System
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The Federal Reserve System (cont'd)
• Depository institutions
7,500 commercial banks
1,300 savings and loans
11,000 credit unions
• All may purchase Fed services
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The Federal Reserve System (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. Acts as a “lender of last resort”
7. Regulates the money supply
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Issues and Applications:
Check Clearing—A Rapidly Diminishing
Fed Function
• The volume of checks cleared by the
Fed grew rapidly during the 1980s.
• So why has the Fed’s check clearing
speed dropped since the 1990s?
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Issues and Applications:
Check Clearing—A Rapidly Diminishing
Fed Function (cont'd)
• The reason is not due to inefficiency; rather,
checks are falling out of favor.
• Government transfers are transmitted
electronically—Social Security, Medicare,
Medicaid.
• Electronic payments by households and
businesses—debit cards, Internet bill pay,
Web based services.
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Figure 15-8 The Volume and Value
of Federal Reserve Check Clearings
Since 1985
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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
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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
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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
• The basic structure of the Federal
Reserve System
12 district banks with 25 branches
Governed by Board of Governors
Federal Open Market Committee
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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