Chapter 12 Money & Banking ECON 201 Chapter 12 Money & Banking

Learning Objectives 1. Functions of money and the components of the U.S. money supply. 2. What “backs” the money supply, making us willing to accept it as payment. 3. Makeup of the Federal Reserve & the U.S. banking system. 4. Functions and responsibilities of the Federal Reserve.

Functions of Money Medium of exchange: money can be used for buying and selling goods and services. Unit of account: dollars and cents. Store of value: Money allows us to transfer purchasing power from present to future. It is the most liquid (spendable) of all assets, a convenient way to store wealth.

Components of the Money Supply Currency coins + paper money in hands of the public. Checkable Deposits Commercial Banks & thrifts. Other liquid savings Currency and checkable deposits held by the federal government, Federal Reserve, or other financial institutions (not included in M1).

Money defined: M1 & M2 M1= Currency + Checkable Deposits M2 = M1 + Near-Monies Savings Deposits Including Money Market Deposit Accounts (MMDA) Small Time Deposits (less than $100,000) Money Market Mutual Funds (MMMF)

Money defined: MZM MZM – money zero maturity It is basically money that is available right now to consumers and businesses at NO COST Take the money that consumers can get their hands on now w/o penalty (like checking accounts) and add MMMF that businesses can get their hands on now w/o penalty.

Consider This … Are Credit Cards Money? NO Their use involves short‑term loans; their convenience allows you to keep M1 balances low because you need less for daily purchases.

What “backs” the money supply? Government’s ability to keep its value stable provides the backing. Money is debt; paper money is a debt of Federal Reserve Banks and checkable deposits are liabilities of banks and thrifts because depositors own them. Value of money arises not from its intrinsic value, but its value in exchange for goods and services.

The relative scarcity of money compared to goods and services will allow money to retain its purchasing power. Money’s purchasing power determines its value. Higher prices mean less purchasing power. Are pennies legal tender????? If you found a chest full of money from the Civil War era, could you use it?

Excessive inflation may make money worthless and unacceptable Excessive inflation may make money worthless and unacceptable. An extreme example of this was German hyperinflation after World War I, which made the mark worth less than 1 billionth of its former value within a four-year period. Worthless money leads to use of other currencies that are more stable. Worthless money may lead to barter exchange system.

The Federal Reserve and the Banking System Established by Congress in 1913. Holds power over the money and banking system. Board of Governors has seven members appointed by the President for staggered 14‑year terms. Chairman of the board – Ben Bernanke!

The Federal Reserve…cont. Federal Open Market Committee (FOMC) includes the seven governors plus five regional Federal Reserve Bank presidents whose terms alternate. System has twelve districts, each with its own district bank and two or three branch banks.

The Federal Reserve and the Banking System Board of Governors Federal Open Market Committee 12 Federal Reserve Banks Commercial Banks Thrift Institutions (Savings and Loan Associations, Mutual Savings Banks, Credit Unions) The Public (Households and Businesses)

Functions of the Fed Issues Currency Sets Reserve Requirements Lends money to banks and thrifts Provides for check collection Acts as fiscal agent Supervises banks Controls money supply

The 12 Federal Reserve Banks Source: Federal Reserve Bulletin

http://www.federalreserve.gov/

Developments Number of banks & thrifts declining Consolidation of banks & thrifts Convergence of services Credit Unions vs Thrifts (S&Ls) vs Comm. Banks Ins. Companies, pension funds, securities firms Globalization Electronic transactions

Bailout What the heck happened? Interest rates fell, making ‘credit’ easier than ever to get…and lots of people did. Government during the 90s enhanced the CRA and pressured lenders to make loans to people who had no business getting loans, all in the name of ‘fairness’. Banks began to make loans to those who couldn’t honestly afford them, and made ‘creative’ ways to get a loan (100% financing, ARMs, etc)

Bailout…cont. Banks began to ‘sell’ their mortgage loans to larger organizations (Fannie Mae, Freddie Mac) who took the risk of the bad loans. These orgs pooled the loans, then began to sell investments that used these pools as the ‘collateral’. Housing prices kept going up and up, and this fueled people’s desire to get a bigger and bigger house in the hopes of selling it later for a huge profit.

Bailout…cont. As long as housing prices stayed high, everyone was happy. But they didn’t …they crashed. Those who got the loans who couldn’t afford them began to have trouble paying their mortgages. (surprise, surprise!) The value of their house fell and they couldn’t sell it to pay off the loans. So banks foreclosed. Fannie Mae and Freddie Mac investments went in the toilet, so investors pulled out. Fannie Mae and Freddie Mac scream for help from the government to bail them out.

Bailout…cont. What makes this even worse is… Congressional leaders charged with oversight of Fannie and Freddie took large campaign contributions directly from both of them, and looked the other way at what was happening. The managers of Fannie & Freddie, with the help of those congressional leaders, lined their pockets with millions in compensation Large financial firms followed Freddie & Fannie’s lead and got in the same position.

Bailout…cont. Who is to blame? Congressional leaders who are corrupt and disgusting in their arrogance The managers of these companies who skated away from the mess with golden parachutes. Lenders who knew these loans were bad, but made them anyway. (partial blame) People who were dumb and over-extended (partial blame)

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