1. Money and the BankingSystem F ERNANDO Q UIJANO, Y VONN Q UIJANO, K YLE T HIEL & A PARNA S UBRAMANIAN PREPARED BY: © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez

2. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 2 of 24 1 What fraction of the stock of U.S. currency is held abroad? More Than Half of U.S. Currency Is Held Overseas 2 Who were the two men who served as chairman of the Federal Reserve from 1979 to 2006 and what were their principal accomplishments? Two Recent Major Leaders of the Federal Reserve Board 3 How did the Fed successfully respond to the major stock market crash in 1987? Coping with a Stock Market Crash: Black Monday, 1987 4 How did the Fed manage to keep the financial system in operation immediately following the attacks on September 11, 2001? The Financial System Under Stress: September 11, 2001

3. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 3 of 24 money Any items that are regularly used in economic transactions or exchanges and accepted by buyers and sellers. medium of exchange Any item that buyers give to sellers when they purchase goods and services. WHAT IS MONEY? 13.1 Three Properties of Money MONEY SERVES AS A MEDIUM OF EXCHANGE barter The exchange of one good or service for another. double coincidence of wants The problem in a system of barter that one person may not have what the other desires.

4. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 4 of 24 WHAT IS MONEY? 13.1 Three Properties of Money MONEY SERVES AS A MEDIUM OF EXCHANGE unit of account A standard unit in which prices can be stated and the value of goods and services can be compared. MONEY SERVES AS A UNIT OF ACCOUNT

5. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 5 of 24 WHAT IS MONEY? 13.1 Three Properties of Money store of value The property of money that it preserves value until it is used in an exchange. MONEY SERVES AS A STORE OF VALUE

6. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 6 of 24 commodity money A monetary system in which the actual money is a commodity, such as gold or silver. WHAT IS MONEY? 13.1 Different Types of Monetary Systems gold standard A monetary system in which gold backs up paper money. fiat money A monetary system in which money has no intrinsic value but is backed by the government.

7. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 7 of 24 M1 The sum of currency in the hands of the public, demand deposits, other checkable deposits, and travelers’ checks. WHAT IS MONEY? 13.1 Measuring Money in the U.S. Economy  FIGURE 13.1 Components of M1 for the United States

8. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 8 of 24 M2 M1 plus other assets, including deposits in savings and loans accounts and money market mutual funds. WHAT IS MONEY? 13.1 Measuring Money in the U.S. Economy  FIGURE 13.2 Components of M2 in the United States

9. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 9 of 24 MORE THAN HALF OF U.S. CURRENCY IS HELD OVERSEAS APPLYING THE CONCEPTS #1: What fraction of the stock of U.S. currency is held abroad? According to a report from the U.S. Treasury, between 55 and 60 percent of U.S. currency outstanding is held abroad. About 25 percent of the currency held abroad is located in Latin America, 20 percent in Africa and the Middle East, and about 15 percent in Asia. The remaining 40 percent is held in Europe and countries of the former Soviet Union and their trading partners. Why do foreigners want to hold U.S. dollars? They provide a safe store of value. They also provide anonymity to the holder of the currency and are accepted widely throughout the world. As long as the U.S. economy remains strong, there will always be a worldwide demand for dollars.

10. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 10 of 24 balance sheet An account statement for a bank that shows the sources of its funds (liabilities) as well as the uses of its funds (assets). HOW BANKS CREATE MONEY 13.2 A Bank’s Balance Sheet: Where the Money Comes From and Where It Goes liabilities The sources of funds for a bank, including deposits and owners’ equity. assets The uses of the funds of a bank, including loans and reserves. owners’ equity The funds provided to a bank by its owners.

11. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 11 of 24 HOW BANKS CREATE MONEY 13.2 A Bank’s Balance Sheet: Where the Money Comes From and Where It Goes reserves The portion of banks’ deposits set aside in either vault cash or as deposits at the Federal Reserve. required reserves The specific fraction of their deposits that banks are required by law to hold as reserves. excess reserves Any additional reserves that a bank holds above required reserves.  FIGURE 13.3 A Balance Sheet for a Bank

12. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 12 of 24 reserve ratio The ratio of reserves to deposits. HOW BANKS CREATE MONEY 13.2 How Banks Create Money  FIGURE 13.4 Process of Deposit Creation: Changes in Balance Sheets

13. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 13 of 24 money multiplier The ratio of the increase in total checking account deposits to an initial cash deposit. HOW BANKS CREATE MONEY 13.2 How the Money Multiplier Works How the Money Multiplier Works in Reverse

14. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 14 of 24 central bank A banker’s bank: an official bank that controls the supply of money in a country. A BANKER’S BANK: THE FEDERAL RESERVE 13.3 lender of last resort A central bank is the lender of last resort, the last place, all others having failed, from which banks in emergency situations can obtain loans.

15. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 15 of 24 A BANKER’S BANK: THE FEDERAL RESERVE 13.3 monetary policy The range of actions taken by the Federal Reserve to influence the level of GDP or inflation. THE FED SUPPLIES CURRENCY TO THE ECONOMY THE FED PROVIDES A SYSTEM OF CHECK COLLECTION AND CLEARING THE FED HOLDS RESERVES FROM BANKS AND OTHER DEPOSITORY INSTITUTIONS AND REGULATES BANKS THE FED CONDUCTS MONETARY POLICY

16. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 16 of 24 A BANKER’S BANK: THE FEDERAL RESERVE 13.3 Federal Reserve Bank One of 12 regional banks that are an official part of the Federal Reserve System. The Structure of the Federal Reserve  FIGURE 13.5 Locations of the 12 Federal Reserve Banks

17. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 17 of 24 A BANKER’S BANK: THE FEDERAL RESERVE 13.3 Board of Governors of the Federal Reserve The seven-person governing body of the Federal Reserve System in Washington, D.C. The Structure of the Federal Reserve  FIGURE 13.6 The Structure of the Federal Reserve System Federal Open Market Committee (FOMC) The group that decides on monetary policy: It consists of the seven members of the Board of Governors plus five of 12 regional bank presidents on a rotating basis. The Independence of the Federal Reserve

18. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 18 of 24 TWO RECENT MAJOR LEADERS OF THE FEDERAL RESERVE BOARD APPLYING THE CONCEPTS #2: Who were the two men who served as chairman of the Federal Reserve between 1979 to 2006 and what were their principal accomplishments? The two chairmen before the current chairman, Benjamin Bernanke, were Paul Volcker, who served from 1979 to 1987, and Alan Greenspan, who served from 1987 to 2006. In their day, each was the country’s major figure in monetary policy. Paul Volcker was appointed by President Jimmy Carter, who sought an established banker to help combat inflation. In 1987, President Ronald Reagan appointed Alan Greenspan. Greenspan was first tested by the 1987 stock market crash and steered the economy away from a recession. Over the following years, he successfully guided monetary policy. In 1999 and 2000, the Federal Reserve may have tightened monetary policy prematurely. Nonetheless, Greenspan’s performance has earned near universal praise, and one author deemed him the “maestro.’’

19. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 19 of 24 WHAT THE FEDERAL RESERVE DOES DURING A FINANCIAL CRISIS 13.4 COPING WITH A STOCK MARKET CRASH: BLACK MONDAY, 1987 APPLYING THE CONCEPTS #3: How did the Fed successfully respond to the major stock market crash in 1987? On October 19, 1987, known as “Black Monday,” the Dow Jones index of the stock market fell a dramatic 22.6 percent in one day. Similar declines were felt in other indexes and stock markets around the world. These declines shocked both businesses and investors. A sharp drop in available credit could plunge the economy into a deep recession. Alan Greenspan had just become chairman of the Federal Reserve that year. He quickly issued a public statement in which he said that the Federal Reserve stood ready to provide liquidity to the economy and the financial system. The Fed provided liquidity to such an extent that interest rates even fell. Result: “Black Monday” did not cause a recession in the United States.

20. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 20 of 24 BANKING TECHNOLOGY IS ALL ABOUT SPEED There are currently 30,000 retail establishments from McDonald’s to local cafes where these contactless cards can be used. According to the experts “flashing instead of swiping the card reduces transaction time by 25 percent.” While still in the pilot phase, there are millions of users already. However, many small merchants are reluctant to incur the cost of the receivers until customers demand them. In addition to cost concerns there are also some security concerns. Since the cards use radio frequency identification there is some fear that the signal may broadcast too far. Banks are testing no-envelope ATMs which are expected to increase consumer confidence and allow them quicker access to deposits. Technology in the financial system has progressed to the point where ATMs and magnetic strip card readers may soon be an artifact of the past. New technologies in contactless credit cards and no-envelope ATMs are being introduced by major banks as the newest time saving techniques. Extra Application 6

21. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 21 of 24 THE FINANCIAL SYSTEM UNDER STRESS: SEPTEMBER 11, 2001 APPLYING THE CONCEPTS #4: How did the Fed manage to keep the financial system in operation immediately following the attacks on September 11, 2001? The Fed was tested again on September 11, 2001, following the terrorist attacks against the United States. The first tool that the Federal Reserve used was to allow banks to borrow more. The difference between the credits and the debits extended by the Federal Reserve is called the “Federal Reserve float.” Immediately following September 11, the Federal Reserve allowed this float to increase sharply from $2.9 billion to $22.9 billion. The Federal Reserve also purchased government securities in the marketplace. Result: Taken together, all these actions increased the credit extended by the Federal Reserve by over $90 billion. This massive response by the Federal Reserve prevented a financial panic that could have had devastating effects on the world economy.

22. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 22 of 24 HOUSING COOLING, ECONOMY OK Poole agrees that rising home inventories do indeed signal a housing slowdown, but also believes that consumer spending in the recent past has not all been fueled by homeowners drawing down home equity. He maintains that income growth and better employment opportunities have a much greater impact on consumption. Mr. Poole also indicated that he believed, as do many other economists, that a housing “bubble” does not exist in most regions. In addition, slowing growth in one housing market does not necessarily translate to a slowdown in other housing markets. The housing market appears to have slowed in some regions but not enough to worry the St. Louis Federal Reserve president, William Poole. Poole believes that housing will maintain a healthy stable level for the remainder of 2006. He based his forecast on his belief that the Federal Open Market Committee (FOMC) will keep a tight rein on inflation and that real household income will recover from the spike in energy prices. Extra Application 5

23. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 23 of 24 assets balance sheet barter Board of Governors of the Federal Reserve central bank commodity money double coincidence of wants excess reserves Federal Open Market Committee (FOMC) Federal Reserve Bank fiat money gold standard lender of last resort liabilities M1 M2 medium of exchange monetary policy money money multiplier owners’ equity required reserves reserve ratio reserves store of value unit of account

24. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 24 of 24 Formula for Deposit Creation