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Money and the Financial System

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1 Money and the Financial System

2 The Evolution of Money Barter is a system where people exchange products directly Barter depends on a double coincidence of wants, a situation in which two traders are willing to exchange their goods directly Under 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 determined This 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 services Money fulfills 4 functions Money is a medium of exchange Money is a unit of account Money is a store of value Standard 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 Money BC Lydian King stamped electrum ingots with lions head (Western Turkey)

9 Commodity Money Commodity money is anything that serves both as money and as a commodity Historically, corn serves as one example, since parties generally believed that there was a ready market for this commodity Metal commodities have also functioned as money

10 The Problems with Commodity Money
Deterioration Bulkiness Indivisibility High opportunity cost due to its inherent value Subject to supply and demand Gresham’s Law--“Bad money drives out good money”

11 Coins and Token Money Coins evolved as money because metal can be debased Historically, the power to coin was vested in the seignior, or feudal lord If 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 Money Paper money first took the form of bank notes which guaranteed delivery of gold or silver upon presentation at the issuing bank Such 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 government Fiat 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 currency Continentals ( ) “Not worth a continental” Free Banking ( ) States and banks issued their own currency Greenbacks (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 $100 490 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 denomination 80% of Bills abroad are $100 Bills 2/3 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 supply M1—A measure of the money supply consisting of currency and coins held by the nonbank public, checkable deposits, and travelers checks M2—A monetary aggregate consisting of M1 plus savings deposits, small time deposits, and money market mutual funds M3—A monetary aggregate consisting of M2 plus negotiable certificates of deposit

17 Liquidity Liquidity is a measure of the ease with which an asset can be converted into money without significant loss of its value M1, 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 clients Since 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 others A “checking account” system also evolved whereby clients could authorize goldsmiths to relinquish gold deposits to another party Eventually, goldsmith “created” money by simply creating an account for the borrower Beginning 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 Deposits Accounts 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 deposit A liability is anything that is owed to another individual or institution When a bank makes a loan, it incurs an asset

22 Reserve Funds Funds that banks use to satisfy the cash demands of their customers and the reserve requirements of the Fed Reserves consist of deposits at the Fed plus currency physically held by banks

23 Bank Deposits Deposits in financial institutions against which checks can be written A demand deposit is a checkable deposit which earns no interest A savings deposit earns interest but has no specific maturity date A time deposit earns a fixed rate of interest if held for a specified period

24 Money Creation Banks create money by making loans against excess reserves. Look at the balance sheets of the Banking industry.

25 The Money Multiplier The money multiplier is the multiple by which the money supply increases as a result of an increase in excess reserves in the banking system The 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 reserves Cash drain—increased cash holdings by the public Excess reserves—banks may not lend all excess reserves Each of these has the effect of reducing the money multiplier

27 Financial Institutions in the United States

28 Financial Intermediaries
Institutions that serve as go-betweens, accepting funds from savers and lending them to borrowers Depository institutions Commercial banks and other financial institutions that accept deposits from the public Commercial banks Depository institutions that make short-term loans primarily to businesses Thrift institutions Depository institutions that make long-term loans primarily to households

29 The Banking Industry The banking industry exists due to the fact that mutually benefits “trades” take place between banks an depositors, and between banks and borrowers Depositors lend deposits to banks in exchange for interest payments Banks 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 information Asymmetric information exists when there is unequal information known by each party Bankers must become experts in dealing with asymmetric information Banks can also deal with risk through diversification

31 First Bank of United States 1811

32 Second Bank of United States 1836

33 The Origins and Structure of the Federal Reserve System
The Federal Reserve System (the “Fed”) was established with the Federal Reserve Act of 1914 The Federal Reserve System is the central bank and monetary authority of the U.S. 12 Federal Reserve districts were established around the country The Board of Governors (7 members appointed by the President and confirmed by the Senate) sets and implements the nation’s monetary policy

34 The Federal Reserve System

35 The Organization of the Federal Reserve System
Open Market Committee Advisory President appoints, Senate confirms Board of Governors 12 Federal Reserve Banks

36 The Objectives of the Federal Reserve System
A high level of employment Economic growth Price stability Interest rate stability Stability in financial markets Stability 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 banks The 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 increases The Fed can also change the discount rate When 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 loans Open-market operations are purchases and sales of government securities by the Fed in an effort to influence the money supply These operations are undertaken under the auspices of the Federal Open Market Committee, consisting of the seven governors plus five presidents from the Reserve banks A 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 Depression The Fed failed to act as a lender of last resort when financial markets began to become unstable

43 Review Terms and Concepts
barter commodity monies currency debasement discount rate excess reserves Federal Open Market Committee (FOMC) Federal Reserve System (the Fed) fiat, or token, money financial intermediaries legal tender lender of last resort liquidity property of money M1, or transactions money M2, or broad money medium of exchange, or means of payment money multiplier near monies Open Market Desk open market operations required reserve ratio reserves run on a bank store of value unit of account

44 Additional Slides

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 shareholders Due to this depository institutions began to suffer, since they faced regulations on the interest rate offered to depositors Deregulation was implemented, while maintaining deposit insurance This led institutions to undertake risky investments, leading to an abundance of thrift failures Thrift institutions were bailed out by the taxpayers

46 The Money Supply and the Federal Reserve System

47 An Overview of Money Money 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, and a 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 deposits M1 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 monies The 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 Money A 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, or Assets / Liabilities + Net Worth A 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) ASSETS LIABILITIES Reserves 20 100 Deposits Loans 90 10 Net worth Total 110

63 The Creation of Money Banks 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 Money When 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 Economy In Panel 2, there is an initial deposit of $100. In Panel 3, the bank has made loans of $400. Panel 1 Panel 2 Panel 3 ASSETS LIABILITIES Reserves 0 0 Deposits Reserves 100 100 Deposits 500 Deposits Loans 400

65 The Creation of Money If 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 Economy In Panel 2, there is an initial deposit of $100. In Panel 3, the bank has made loans of $400. Panel 1 Panel 2 Panel 3 ASSETS LIABILITIES Reserves 0 0 Deposits Reserves 100 100 Deposits 500 Deposits Loans 400

66 The Creation of Money The Creation of Money When There Are Many Banks
Panel 1 Panel 2 Panel 3 ASSETS LIABILITIES Reserves 100 100 Deposits Reserves 100 Loans 80 180 Deposits Reserves 20 Loans 80 Reserves 80 80 Deposits Reserves 80 Loans 64 144 Deposits Reserves 16 Loans 64 Reserves 64 64 Deposits Deposits Reserves 12.80 .00 500 Total . . . .20 51 Bank 4 64 Bank 3 80 Bank 2 100 Bank 1 Deposits Summary:

67 The Money Multiplier .00 500 Total . . . .20 51 Bank 4 64 Bank 3 80 Bank 2 100 Bank 1 Deposits Summary: 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.

68 The Federal Reserve System

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) ASSETS LIABILITIES Gold $ 11,045 $593,031 Federal Reserve notes (outstanding) Loans to banks 36,538 Deposits: U.S. Treasury securities 550,314 20,359 Bank reserves (from depository institutions) 6,219 U.S. Treasury All other assets 46,268 24,556 All other liabilities and net worth Total 644,165 $644,165 Source: 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; and engaging 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 Reserve Commercial Banks Assets Liabilities Government $200 $100 Reserves $500 Deposits securities Currency Loans $400 Note: Money supply (M1) = Currency + Deposits = $600. PANEL 2: REQUIRED RESERVE RATIO = 12.5% $800 Loans (+ $300) $700 (+ $300) Note: Money supply (M1) = Currency + Deposits = $900.

77 The Discount Rate The 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 Rate The 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 FED Federal Reserve Commercial Banks Assets Liabilities Securities $160 $80 Reserves $400 Deposits Currency Loans $320 Note: Money supply (M1) = Currency + Deposits = $480. PANEL 2: COMMERCIAL BANK BORROWING $20 FROM THE FED $100 Reserves (+ $20) $500 Deposits (+ $300) $20 Loans (+ $100) $420 Amount owed to Fed (+ $20) Note: Money supply (M1) = Currency + Deposits = $580.

79 The Discount Rate Moral 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 1 Federal Reserve Commercial Banks Jane Q. Public Assets Liabilities Securities $100 $20 Reserves Deposits $5 $0 Debts $80 Currency Loans Net Worth Note: Money supply (M1) = Currency + Deposits = $180. PANEL 2 Securities (- $5) $95 $15 Reserves (- $5) Deposits (- $5) Securities (+ $5) Note: Money supply (M1) = Currency + Deposits = $175. PANEL 3 $75 Deposits (- $25) Loans (- $20) $60 Note: 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, and are fairly predictable.

85 The Supply Curve for Money
Through open market operations, the Fed can have the money supply be whatever value it wants.


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