2 The Evolution of MoneyBarter is a system where people exchange products directlyBarter depends on a double coincidence of wants, a situation in which two traders are willing to exchange their goods directlyUnder a barter system, not only is a double coincidence of wants difficult to obtain, but that rate at which the two goods are exchanged must be determinedThis points to a need for a commodity that is generally accepted in exchange: money
3 What is Money?Money is any commodity that is generally acceptable in exchange for goods and servicesMoney fulfills 4 functionsMoney is a medium of exchangeMoney is a unit of accountMoney is a store of valueStandard of Deferred Payment
4 Money is a Medium of Exchange Anything that facilitates trade by being generally accepted by all parties in payment for goods or services
5 Money is a Unit of Account A common unit for measuring the value of every good or service
6 Money is a Store of Value Anything that roughly retains its purchasing power over time
7 Standard of Deferred Payment Debt obligations are dominated in terms of money
8 History of MoneyBC Lydian King stamped electrum ingots with lions head (Western Turkey)
9 Commodity MoneyCommodity money is anything that serves both as money and as a commodityHistorically, corn serves as one example, since parties generally believed that there was a ready market for this commodityMetal commodities have also functioned as money
10 The Problems with Commodity Money DeteriorationBulkinessIndivisibilityHigh opportunity cost due to its inherent valueSubject to supply and demandGresham’s Law--“Bad money drives out good money”
11 Coins and Token MoneyCoins evolved as money because metal can be debasedHistorically, the power to coin was vested in the seignior, or feudal lordIf the face value of the coin exceeded the cost of coinage, the minting of coins became a source of revenue (seigniorage)Token money is money whose face value exceeds the cost of production
12 Paper MoneyPaper money first took the form of bank notes which guaranteed delivery of gold or silver upon presentation at the issuing bankSuch notes were easily used as a medium of exchange, due to the fact that they were easy to carry and backed by precious metals
13 Fiat Money Money not redeemable for any commodity Its status as money is conferred by the governmentFiat money is declared as “legal tender” by the government
14 History of Money in US http://www.ronscurrency.com/rhist.htm Franklin “The Father of Paper Money”States issued currencyContinentals ( )“Not worth a continental”Free Banking ( )States and banks issued their own currencyGreenbacks (Civil War)Nationalization of Gold (1933)The Collapse of the Bretton Woods System (1971)
15 Some Facts about the Dollar Ave life of $1 bill is 18 months, 9 years for a $100490 notes in a lb. So 10 Million in 100’s weighs 204lbs.2 million in 20’s would weigh the same.½ of bills printed in a day are $1 denomination80% of Bills abroad are $100 Bills2/3 of all currency in circulation is abroad
16 Monetary Aggregates—M1, M2, and M3 A monetary aggregate is a measure of the economy’s money supplyM1—A measure of the money supply consisting of currency and coins held by the nonbank public, checkable deposits, and travelers checksM2—A monetary aggregate consisting of M1 plus savings deposits, small time deposits, and money market mutual fundsM3—A monetary aggregate consisting of M2 plus negotiable certificates of deposit
17 LiquidityLiquidity is a measure of the ease with which an asset can be converted into money without significant loss of its valueM1, M2, and M3 are progressively less liquid
18 The Early Stage of Modern Banking During the middle ages, London goldsmiths kept gold, cash, and valuables in reserve for clientsSince only a small fraction of clients would want to retrieve there deposits any point in time, this led to cash loans by the goldsmiths to othersA “checking account” system also evolved whereby clients could authorize goldsmiths to relinquish gold deposits to another partyEventually, goldsmith “created” money by simply creating an account for the borrowerBeginning of a fractional reserve banking system
19 Fractional Reserve Banking System A banking system in which only a portion of deposits is backed by reserves
20 Demand DepositsAccounts at financial institutions that pay no interest and on which depositors can write checks to obtain their deposits at any time
21 Liabilities and Assets A bank incurs a liability when it accepts a depositA liability is anything that is owed to another individual or institutionWhen a bank makes a loan, it incurs an asset
22 Reserve FundsFunds that banks use to satisfy the cash demands of their customers and the reserve requirements of the FedReserves consist of deposits at the Fed plus currency physically held by banks
23 Bank DepositsDeposits in financial institutions against which checks can be writtenA demand deposit is a checkable deposit which earns no interestA savings deposit earns interest but has no specific maturity dateA time deposit earns a fixed rate of interest if held for a specified period
24 Money CreationBanks create money by making loans against excess reserves.Look at the balance sheets of the Banking industry.
25 The Money MultiplierThe money multiplier is the multiple by which the money supply increases as a result of an increase in excess reserves in the banking systemThe simple money multiplier is the reciprocal of the required reserve ratio, or 1/r
26 The Actual Money Multiplier The simple money multiplier is subject to cash drain and excess reservesCash drain—increased cash holdings by the publicExcess reserves—banks may not lend all excess reservesEach of these has the effect of reducing the money multiplier
28 Financial Intermediaries Institutions that serve as go-betweens, accepting funds from savers and lending them to borrowersDepository institutionsCommercial banks and other financial institutions that accept deposits from the publicCommercial banksDepository institutions that make short-term loans primarily to businessesThrift institutionsDepository institutions that make long-term loans primarily to households
29 The Banking IndustryThe banking industry exists due to the fact that mutually benefits “trades” take place between banks an depositors, and between banks and borrowersDepositors lend deposits to banks in exchange for interest paymentsBanks loan deposits to borrowers in exchange for interest on the loan. The borrower gains from the service of the loan, but must pay interest sufficient to make the bank profitable.
30 Asymmetric Information The banker, in dealing with the borrower, faces the problem of asymmetric informationAsymmetric information exists when there is unequal information known by each partyBankers must become experts in dealing with asymmetric informationBanks can also deal with risk through diversification
33 The Origins and Structure of the Federal Reserve System The Federal Reserve System (the “Fed”) was established with the Federal Reserve Act of 1914The Federal Reserve System is the central bank and monetary authority of the U.S.12 Federal Reserve districts were established around the countryThe Board of Governors (7 members appointed by the President and confirmed by the Senate) sets and implements the nation’s monetary policy
35 The Organization of the Federal Reserve System Open MarketCommitteeAdvisoryPresident appoints, Senate confirmsBoard of Governors12 Federal Reserve Banks
36 The Objectives of the Federal Reserve System A high level of employmentEconomic growthPrice stabilityInterest rate stabilityStability in financial marketsStability in foreign exchange markets
37 The Powers of the Federal Reserve System Federal Reserve Act of 1914 authorized “to exercise general supervision” over the 12 Reserve banksThe Fed was also given the power to buy and sell government securities, to extend loans to member banks, to clear checks, and to require that member banks hold reserves equal at least to a specified fraction of their deposits
38 The Process of Money Creation Can be Reversed The Fed can sell securities to banks or the public
39 Summary of Credit Expansion When Fed Purchases $1,000 Security
40 Other Means of Expanding the Money Supply Clearly, when the reserve requirement ratio is decreased, the money supply increasesThe Fed can also change the discount rateWhen banks borrow from the Fed, excess reserves in the economy increase
41 An Overview of the Tools of the Federal Reserve System The discount rate is the interest rate charged to member banks by the Fed for discount loansOpen-market operations are purchases and sales of government securities by the Fed in an effort to influence the money supplyThese operations are undertaken under the auspices of the Federal Open Market Committee, consisting of the seven governors plus five presidents from the Reserve banksA minimum reserve requirement is imposed on member banks
42 Banking During the Great Depression Many point to the inaction of the Federal Reserve System as a cause for the depth of the Great DepressionThe Fed failed to act as a lender of last resort when financial markets began to become unstable
43 Review Terms and Concepts bartercommodity moniescurrency debasementdiscount rateexcess reservesFederal Open Market Committee (FOMC)Federal Reserve System (the Fed)fiat, or token, moneyfinancial intermediarieslegal tenderlender of last resortliquidity property of moneyM1, or transactions moneyM2, or broad moneymedium of exchange, or means of paymentmoney multipliernear moniesOpen Market Deskopen market operationsrequired reserve ratioreservesrun on a bankstore of valueunit of account
45 Recent Problems with Depository Institutions Money market mutual funds introduced (1970s)A collection of short-term earning assets purchased with funds collected from many shareholdersDue to this depository institutions began to suffer, since they faced regulations on the interest rate offered to depositorsDeregulation was implemented, while maintaining deposit insuranceThis led institutions to undertake risky investments, leading to an abundance of thrift failuresThrift institutions were bailed out by the taxpayers
46 The Money Supply and the Federal Reserve System
47 An Overview of MoneyMoney is anything that is generally accepted as a medium of exchange.Money is not income, and money is not wealth. Money is:a means of payment,a store of value, anda unit of account.
48 What is Money?Barter is the direct exchange of goods and services for other goods and services.A barter system requires a double coincidence of wants for trade to take place. Money eliminates this problem.As a medium of exchange, or means of payment, money is generally accepted by buyers and sellers as payment for goods and services.
49 What is Money?As a store of value, money serves as an asset that can be used to transport purchasing power from one time period to another.
50 What is Money?As a unit of account, money is a standard that provides a consistent way of quoting prices.
51 What is Money?Money is easily portable, and easily exchanged for goods at all times.The liquidity property of money makes money a good medium of exchange as well as a store of value.
52 Commodity and Fiat Monies Commodity monies are items used as money that also have intrinsic value in some other use. Gold is one form of commodity money.Fiat, or token, money is money that is intrinsically worthless.
53 Commodity and Fiat Monies Legal tender is money that a government has required to be accepted in settlement of debts.Currency debasement is the decrease in the value of money that occurs when its supply is increased rapidly.
54 Measuring the Supply of Money in the United States M1, or transactions money is money that can be directly used for transactions.M1 currency held outside banks + demand deposits + traveler’s checks + other checkable depositsM1 is a stock measure—it is measured at a point in time—on a specific day.
55 Measuring the Supply of Money in the United States M2, or broad money, includes near monies, or close substitutes for transactions money.M2 / M1 + savings accounts + money market accounts + other near moniesThe main advantage of looking at M2 instead of M1 is that M2 is sometimes more stable.
56 The Private Banking System Financial intermediaries are banks and other financial institutions that act as a link between those who have money to lend and those who want to borrow money.
57 How Banks Create Money A Historical Perspective: Goldsmiths Goldsmiths functioned as warehouses where people stored gold for safekeeping.Upon receiving the gold, a goldsmith would issue a receipt to the depositor. After a time, these receipts themselves began to be traded for goods, and were backed 100 percent by gold.Then, Goldsmiths realized that they could lend out some of this gold without any fear of running out. Now there were more claims than there were ounces of gold.
58 How Banks Create MoneyA run on a goldsmith (or a modern-day bank) occurs when many people present their claims at the same time.
59 The Modern Banking System A brief review of accounting:Assets – liabilities / Net Worth, orAssets / Liabilities + Net WorthA bank’s most important assets are its loans. Other assets include cash on hand (or vault cash) and deposits with the Fed.A bank’s liabilities are its debts—what it owes. Deposits are debts owed to the bank’s depositors.
60 The Modern Banking System The Federal Reserve System (the Fed) is the central bank of the United States.
61 The Modern Banking System Reserves are the deposits that a bank has at the Federal Reserve bank plus its cash on hand.The required reserve ratio is the percentage of its total deposits that a bank must keep as reserves at the Federal Reserve.
62 T-Account for a Typical Bank The balance sheet of a bank must always balance, so that the sum of assets (reserves and loans) equals the sum of liabilities (deposits and net worth).T-Account for a Typical Bank (millions of dollars)ASSETSLIABILITIESReserves20100DepositsLoans9010Net worthTotal110
63 The Creation of MoneyBanks usually make loans up to the point where they can no longer do so because of the reserve requirement restriction (or up to the point where their excess reserves are zero).
64 The Creation of MoneyWhen someone deposits $100 in a bank, and the bank deposits the $100 with the central bank, the bank has $100 in total reserves.Balance Sheets of a Bank in a Single-Bank EconomyIn Panel 2, there is an initial deposit of $100. In Panel 3, the bank has made loans of $400.Panel 1Panel 2Panel 3ASSETSLIABILITIESReserves 00 DepositsReserves 100100 Deposits500 DepositsLoans 400
65 The Creation of MoneyIf the required reserve ratio is 20%, the bank has excess reserves of $80. With $80 of excess reserves, the bank can have up to $400 of additional deposits. The $100 in reserves plus $400 in loans equal $500 in deposits.Balance Sheets of a Bank in a Single-Bank EconomyIn Panel 2, there is an initial deposit of $100. In Panel 3, the bank has made loans of $400.Panel 1Panel 2Panel 3ASSETSLIABILITIESReserves 00 DepositsReserves 100100 Deposits500 DepositsLoans 400
66 The Creation of Money The Creation of Money When There Are Many Banks Panel 1Panel 2Panel 3ASSETSLIABILITIESReserves 100100 DepositsReserves 100 Loans 80180 DepositsReserves 20 Loans 80Reserves 8080 DepositsReserves 80 Loans 64144 DepositsReserves 16 Loans 64Reserves 6464 DepositsDepositsReserves 12.80.00500Total. . ..2051Bank 464Bank 380Bank 2100Bank 1DepositsSummary:
67 The Money Multiplier.00500Total. . ..2051Bank 464Bank 380Bank 2100Bank 1DepositsSummary:The money multiplier is the multiple by which deposits can increase for every dollar increase in reserves.In the example above, the required reserve ratio is 20%. Each dollar increase in reserves could cause an increase in deposits of $5 when there is no leakage out of the system. An additional $100 of reserves result in additional deposits of $500.
69 The Federal Reserve System The Federal Open Market Committee (FOMC) sets goals regarding the money supply and interest rates and directs the operations of the Open Market Desk in New York.The Open Market Desk is an office in the New York Federal Reserve Bank from which government securities are bought and sold by the Fed.
70 Functions of the Federal Reserve The Fed performs important functions for banks including:Clearing interbank payments.Regulating the banking system.Assisting banks in a difficult financial position.Managing exchange rates and the nation’s foreign exchange reserves.Control of mergers between banks.
71 Functions of the Federal Reserve The Fed performs important functions for banks including:Examination of banks to ensure that they are financially sound.Setting of reserve requirements for all financial institutions.Lender of last resort: The Fed provides funds to troubled banks that cannot find any other sources of funds.
72 The Federal Reserve Balance Sheet Assets and Liabilities of the Federal Reserve System, June 30, 2003 (millions of dollars)ASSETSLIABILITIESGold$11,045$593,031Federal Reserve notes (outstanding)Loans to banks36,538Deposits:U.S. Treasury securities550,31420,359Bank reserves (from depository institutions)6,219U.S. TreasuryAll other assets46,26824,556All other liabilities and net worthTotal644,165$644,165Source: Federal Reserve Bulletin, August 2003, Table 1.18.
73 The Federal Reserve Balance Sheet Although it is unrelated to the money supply, the Fed’s gold counts as an asset on its balance sheet.The largest of the Fed’s assets, by far, consists of government securities purchased over the years.A dollar bill is a liability, or IOU, of the Fed.
74 How the Federal Reserve Controls the Money Supply Three tools are available to the Fed for changing the money supply:changing the required reserve ratio;changing the discount rate; andengaging in open market operations.
75 The Required Reserve Ratio The required reserve ratio establishes a link between the reserves of the commercial banks and the deposits (money) that commercial banks are allowed to create.If the Fed wants to increase the money supply, the Fed can decrease the required reserve ratio, which allows the bank to create more deposits by making loans.
76 The Required Reserve Ratio A Decrease in the Required Reserve Ratio From 20 Percent to 12.5 Percent Increases the Supply of Money (All Figures in Billions of Dollars)PANEL 1: REQUIRED RESERVE RATIO = 20%Federal ReserveCommercial BanksAssetsLiabilitiesGovernment$200$100Reserves$500DepositssecuritiesCurrencyLoans$400Note: Money supply (M1) = Currency + Deposits = $600.PANEL 2: REQUIRED RESERVE RATIO = 12.5%$800Loans (+ $300)$700(+ $300)Note: Money supply (M1) = Currency + Deposits = $900.
77 The Discount RateThe discount rate is the interest rate that banks pay to the Fed to borrow from it.Bank borrowing from the Fed leads to an increase in the money supply. The higher the discount rate, the higher the cost of borrowing, and the less borrowing banks will want to do.
78 The Discount RateThe Effect On the Money Supply of Commercial Bank Borrowing from the Fed (All Figures in Billions of Dollars)PANEL 1: NO COMMERCIAL BANK BORROWING FROM THE FEDFederal ReserveCommercial BanksAssetsLiabilitiesSecurities$160$80Reserves$400DepositsCurrencyLoans$320Note: Money supply (M1) = Currency + Deposits = $480.PANEL 2: COMMERCIAL BANK BORROWING $20 FROM THE FED$100Reserves (+ $20)$500Deposits (+ $300)$20Loans (+ $100)$420Amount owed to Fed (+ $20)Note: Money supply (M1) = Currency + Deposits = $580.
79 The Discount RateMoral suasion is the pressure that was exerted in the past by the Fed on member banks to discourage them from borrowing heavily.On January 9, 2003, the Fed announced a new procedure that sets the discount rate above the rate that banks pay to borrow in the private market. It is thus clear that the Fed is not using the discount rate as a tool to try to change the money supply on a regular basis.
80 Open Market Operations Open market operations is the purchase and sale by the Fed of government securities in the open market; a tool used to expand or contract the amount of reserves in the system and thus the money supply.Open market operations is by far the most significant tool of the Fed for controlling the supply of money.
81 The Mechanics of Open Market Operations Open Market Operations (The Numbers in Parentheses in Panels 2 and 3 Show the Differences Between Those Panels and Panel 1. All Figures in Billions of Dollars)PANEL 1Federal ReserveCommercial BanksJane Q. PublicAssetsLiabilitiesSecurities$100$20ReservesDeposits$5$0Debts$80CurrencyLoansNet WorthNote: Money supply (M1) = Currency + Deposits = $180.PANEL 2Securities (- $5)$95$15Reserves (- $5)Deposits (- $5)Securities (+ $5)Note: Money supply (M1) = Currency + Deposits = $175.PANEL 3$75Deposits (- $25)Loans (- $20)$60Note: Money supply (M1) = Currency + Deposits = $155.
82 Open Market Operations An open market purchase of securities by the Fed results in an increase in reserves and an increase in the supply of money by an amount equal to the money multiplier times the change in reserves.
83 Open Market Operations An open market sale of securities by the Fed results in a decrease in reserves and a decrease in the supply of money by an amount equal to the money multiplier times the change in reserves.
84 Open Market Operations Open market operations are the Fed’s preferred means of controlling the money supply because:they can be used with some precision,are extremely flexible, andare fairly predictable.
85 The Supply Curve for Money Through open market operations, the Fed can have the money supply be whatever value it wants.