Chapter 13 Money, Banking, and the Federal Reserve

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Chapter 13Money, Banking, and the Federal Reserve
ECONOMICS EXPLORE APPLYEnhanced Edition
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Learning Objectives

1. Identify the types, functions, and liquidity of
   various money measures.
2. Describe key elements of the banking industry.
3. Discuss how banks create money.
4. Describe the structure, functions, and policy
   tools of the Federal Reserve .

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Learning Objectives

1. Work through the process of monetary expansion
   using the deposit multiplier.
2. Explain why the banking crisis of the 1980s
   occurred and whether another banking crisis could
   happen.

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13.1 MONEY

• Money is whatever is commonly used in an economy
  to buy and sell things.
• Without money, we would have to barter (swap) one
  good for another, or produce on our own all of
  the goods and services we consume.
• Both alternatives are inefficient.
• Important qualities of money are its portability
  and divisibility.

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Money

• Historically, gold was used as money.
• Today, gold is no longer used as money rather,
  government issued currency and coins are used as
  money.
• Bank issued checks are the largest part of the
  money we own.
• Money performs the following functions
• Medium of exchange.
• Store of value.
• Unit of account.

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Money

• Fiat money is money because the law says it is.
• Paper currency and current U.S. coins are
  examples of fiat money.
• Because the government accepts fiat money, both
  individuals and business accept it as legal
  tender.
• Gold and silver coins, once a commonplace form of
  money in the U.S. are examples of commodity
  money.
• Commodity money is made of precious metals.
• Coins today are made of cheaper metals.

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Money

• Commodity money is subject to Greshams law bad
  money drives out good.
• The practice of shaving the edges of commodity
  money forced people to bite it, weigh it, and
  examine it carefully.
• Fiat money eliminates this problem, and is
  designed so that it is not easily counterfeited.
• Governments of virtually all nations hold a
  monopoly on the production of fiat money.

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Money Debit or Credit

• The debit card immediately transfers the amount
  of the purchase out of your checking account, and
  into the stores deposit account.
• You cant use your debit card to make a purchase
  unless you have the amount of the purchase in
  your account.
• In contrast, a credit card provides you with a
  loan in the amount of the purchase.

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Liquidity M1, M2, and M3

• When paper money and coins are deposited in
  banks, money changes form.
• Deposits into checking accounts create demand
  deposits, also termed checkable deposits.
• More money is held in the form of checkable
  deposits than in any other form.
• These deposits are money because checks orders
  to a bank to make payment are generally
  accepted by sellers.

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Liquidity M1, M2, and M3

• Liquidity refers to how easily and quickly
  something of value can be converted into
  spendable form.
• Three definitions of money, termed the monetary
  aggregates, categorize various types of money
  according to how liquid they are.
• The monetary aggregates include M1, M2, and M3.

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Liquidity M1, M2, and M3

• The M1measure of the money supply is the most
  liquid.
• It includes the sum of currency and coins in the
  hands of the public, demand deposits, other
  checkable deposits, and travelers checks.
• M1 totaled 1.3 trillion in 2003.

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Liquidity M1, M2, and M3

• The M2measure of the money supply includes M1
  plus the balances in savings deposits, small
  time deposits, and balances in money market
  mutual funds.
• M2 is slightly less liquid than M1, and totaled
  6.1 trillion in 2003.

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Liquidity M1, M2, and M3

• The M3 measure of the money supply includes M2
  plus large time deposits (at least 100,000),
  and several other near monies. M3 is less likely
  to be spent than the items in M2, and totaled
  8.0 trillion in 2003.
• Financial assets, such as stocks and bonds, are
  not counted in the money supply figures.

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Liquidity M1, M2, and M3
M2 M1 1,277.3 Savings deposits
3095.3 Small time deposits 843.8 Money
market balances 877.8 Total 6,094.3
M1 Currency 646.2 Travelers checks
8.2 Demand deposits 321.9 Other
checkable deposits 301.0 Total 1,277.3
M3 M1 1,277.3 M2 6094.3 Large denomination
time deposits 902.6 Other M3 items
1,922.7 Total 8,919.5
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Liquidity M1, M2, and M3
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13.2MONEY AND BANKING IN THE U.S.

• Banks are regulated by both state and federal
  government.
• Bank regulation is designed to protect against
  unsound banking practices that could bankrupt
  both depositors and government insurance funds.
• For example, under the Glass-Steagall Act of 1933
  banks were barred from offering insurance and
  brokerage services.
• The Glass-Steagall Act was abolished in 1999.

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The Banking System
Assets Liabilities
Vault Cash (part 1 of bank reserves) Customer deposits
Deposits held by the Federal reserve (part 2 of bank reserves Federal funds
Loans Discount loans
Securities Paid-in capital
Other
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The Banking System

• Banks hold a fraction of their deposits on
  reserve to meet the cash needs of their
  customers.
• Banks are required by law to meet the reserve
  requirements imposed by the Fed.
• If the reserve requirement is 10, then the banks
  must hold at least 10 in reserves for every 100
  of customer deposits.
• Reserves in excess of the required reserves are
  called excess reserves.

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The Banking System

• Loans are an asset of banks and they represent
  promises by borrowers to repay.
• One interest rate on loans to customers that is
  widely know is the bank prime lending rate.
• Securities, purchased by banks, in the form of
  bonds, are interest paying investments.
• Banks mostly purchase federally issued short-term
  bonds called treasury bills (T-bills)
• The Federal Deposit Insurance Corporation (FDIC)
  insures deposit accounts up to 100,000.

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The Banking System

• Bank deposits are liabilities because they are
  funds owed to depositors.
• Banks also raise funds by borrowing, both from
  each other, and from the Federal Reserve.
• Funds borrowed from other banks are called
  federal funds.
• The interest rate that banks charge on loans to
  other banks is called the federal funds rate.

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The Banking System

• Borrowings by banks from the Fed are called
  discount loans.
• With a discount interest on the loan is paid
  when the loan is made.
• The rate of interest charged to banks when they
  borrow from the Fed is called the discount rate.
• In addition to banks there are other financial
  intermediaries (bank like institutions), that
  accept funds from savers in order to make loans
  or investments.

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Key Interest Rates
Year Prime Rate Federal Funds Rate Discount Rate
1979 12.67 11.20 10.29
1980 15.26 13.35 11.77
1981 18.87 16.39 13.42
1892 14.85 12.24 11.01
1983 10.79 9.09 8.50
1984 12.04 10.23 8.80
1985 9.93 8.10 7.69
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Key Interest Rates (continued)
Year Prime Rate Federal Funds Rate Discount Rate
1986 8.33 6.80 6.32
1987 8.21 6.66 5.66
1988 9.32 7.57 6.20
1989 10.87 9.21 6.93
1990 10.01 8.10 6.98
1991 8.46 5.69 5.45
1992 6.25 3.52 3.25
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Key Interest Rates (continued)
Year Prime Rate Federal Funds Rate Discount Rate
1993 6.00 3.02 3.00
1994 7.15 4.21 3.60
1995 8.83 5.83 5.21
1996 8.27 5.30 5.02
1997 8.44 5.46 5.00
1998 8.35 5.35 4.92
1999 8.00 4.97 4.62
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Key Interest Rates (continued)
Year Prime Rate Federal Funds Rate Discount Rate
2000 9.23 6.24 5.73
2001 6.91 3.88 3.40
2002 4.67 1.67 1.17
2003 4.00 .96 2.00
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How Banks Create Money

• When a bank makes a loan, the quantity of money
  in the economy increases.
• Currency inside of bank vaults is not is not
  counted as a part of the money supply.
• If a loan is received as currency, the amount of
  currency in the hands of the public is greater
  than before the loan.

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How Banks Create Money
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13.3MEET THE FED

• The Federal Reserve performs the central banking
  functions at the heart of the monetary system.
• The U.S. central bank is called the Fed, short
  for Federal Reserve system.
• It was created by the Federal Reserve Act of 1913
  in response to recurring bank failures.
• The act sought to provide a central bank
  contribute to U.S. economic stability.

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Meet the FED

• As our central bank performing its role of
  stabilizing the economy, the Fed does the
  following
• Functions as a bankers bank.
• Functions as a lender of last resort.
• Supervises banks.
• Conducts monetary policy.
• Issues currency.
• Clears checks.

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Meet the FED

• The Fed is an independent, free from political
  pressures, arm of government.
• To further insulate the Fed from political
  pressure, it is divided into three components.
• The Board of Governors, which is responsible for
  the overall direction of the Federal Reserve and
  its policies.
• The Federal Open Market Committee (FOMC), which
  conducts monetary policy.
• The Federal Reserves Banks, which regulate and
  provide a variety of services for banks.

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Influencing The Money Supply

• The principle method the Fed uses to influence
  the money is called open market operations.
• Open market operations occur when the Fed enters
  the financial marketplace to buy or sell
  government securities, such as treasury bonds.
• When the Fed sells government securities the
  money supply decreases.
• When the Fed buys government securities the money
  supply increases.

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Influencing The Money Supply
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The Money Multiplier

• The money multiplier shows the total effect on
  the money supply of each dollar of open market
  operations.
• Depending upon the size of the reserve
  requirement, changes in the money supply are
  magnified by a multiple amount.
• Banks are able to make loans up to the amount of
  their excess reserves.

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The Money Multiplier
The total of new money created when the money
supply expansion is complete depends on the size
of the money multiplier.
Money supply Money Multiplier x Monetary base
Deposit multiplier 1/Percentage reserve
requirement
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13.4 EXPLORE APPLYHigh Priced Housing Are
Banks at Risk?

• Housing prices in the United States have risen
  nearly 10 for the last decade.
• Is there a housing bubble, as real estate
  prices have gotten so out of hand that they are
  poised to collapse?
• The economist magazine predicts that real estate
  prices will decline 15 to 20 over the next few
  years in the U.S.
• It also predicts declines of 30 or more in other
  countries.

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Why Banks Fail

• As a result of the act, banks began to raise
  interest rates during the 80s in competition for
  depositors.
• Banks were ignoring risk and simply looking at
  interest rates.
• This is an example of moral hazard, which
  occurs when people choose riskier behavior
  because insurance has lowered the price of risk.

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Why Banks Fail

• Two rounds of legislation, 50 years apart set the
  stage for the banking crisis of the 1908s.
• In the 1930s in response to widespread bank
  failures Congress created the Federal Deposit
  Insurance Corporation, and enacted the
  Glass-Steagal Act.
• The Depository Institutions Deregulation and
  Monetary Control Act of 1980 was passed.
• This relaxed restrictions on interest rates and
  bank investments.

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The Banking Crisis of the 1980s

• As a result of the act, banks began to raise
  interest rates during the 80s in competition for
  depositors.
• Banks were ignoring risk and simply looking at
  interest rates.
• The majority of the 80s bank failure revolved
  around bad real estate loans.
• The decline in oil prices in the late 80s
  precipitated a fall in real estate prices in
  Texas and other parts of the country.

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The Banking Crisis of the 1980s

• The government guaranteed deposits above
  100,000.
• They also encouraged the merger of insolvent
  banks with sound banks.
• This is an example of moral hazard, which
  occurs when people choose riskier behavior
  because insurance has lowered the price of risk.
• The 1990s brought a healthier economic climate
  with restored bank profitability and reduced
  numbers of bank failures.

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Terms Along the Way

• money
• barter
• medium of exchange
• store of value
• unit of account
• fiat money
• Greshams law
• demand deposit

• liquidity
• M1
• M2
• M3
• bank reserves
• required reserves
• excess reserves

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Terms Along the Way

• bonds
• federal funds rate
• discount rate
• Federal Reserve System
• open market operations
• monetary base

• money multiplier
• deposit multiplier

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Test Yourself

• Barter is most likely to occur when
• money takes the form of commodity money.
• M1 is the dominant form of money.
• Greshams law requires people to barter.
• there is no money.

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Test Yourself

• 2. The U.S. one dollar coin is an example of
• commodity money.
• fiat money
• money that is neither commodity money nor fiat
  money.
• something that looks like money, but is not since
  it is coined from nearly worthless metals.

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Test Yourself

• 3. Which is NOT a function of money?
• Standard of measurement.
• Unit of account.
• Store of value.
• Medium of exchange.

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Test Yourself

• 4. A banks total reserves equal
• required reserves.
• excess reserves.
• required reserves excess reserves.
• required reserves excess reserves.

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Test Yourself

• 5. If the money supply equals 100 and the money
  multiplier equals 10, then the monetary base must
  equal?
• 1.000.
• 100.
• 10.
• an amount that cannot be determined by the
  information given.

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Test Yourself

• 6. If the reserve requirement were 20 and the
  FED purchased 100 of securities in an open
  market purchase, then the money supply could
  potentially expand by a maximum of
• 5.
• 20.
• 100.
• 500.

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The End! Next Chapter 14 Monetary Policy and
Price Stability