1.Barter 2.What is money? 3.The functions of money 4.Commodity, representative, and fiat money 5.Financial intermediaries 6.The Federal Reserve System 7.Structure of the U.S. banking system

Money is anything that is generally acceptable in exchange for goods, services, economic resources, or for the settlement of debts

Eliminates the coincidence of wants problem. Facilitates economic specialization

1.Medium of exchange 2.Unit of account 3.Store of value (or wealth)

Goods exchange for other goods Barter exchange is not possible without a “double coincidence of wants.”

Liquidity refers to two properties of assets or stores of value, namely: The ready convertibility of the asset to generalized purchasing power (or money) The comparative safety of the asset. Money is the most liquid asset available under normal circumstances

Least liquid Most liquid Currency, checkable deposits Savings and time deposits Treasury bills, commercial paper Government and corporate bonds, equities Specialized equipment Ceramics, art, rugs, rare coins Farmland, commercial real estate Home equity

8 Purchasing power of $1 measured in constant dollars An increase in the price level over time reduces what $1.00 buys. The price level has risen every year since 1960, so the purchasing power of $1.00 (measured in constant dollars) has fallen from $3.38 in 1960 to $0.48 in 2007

Anything that serves both as money and as a commodity; money that has intrinsic worth.

Bank notes that exchange for a specific commodity, such as gold Examples 1.Tobacco warehouse receipts 2.The Goldsmith bankers

This Note Is Legal Tender For All Debts, Public and Private Fiat Money: Anything which serves as a means of payment by government declaration You are willing to accept money not because it is “backed” by precious metals; but rather because you know it is generally acceptable in exchange

12 Six properties of ideal money QualityRationaleGood examplesBad examples 1. Durable 2. Portable 3. Divisible 4. Uniform quality 5. Low opportunity cost 6. Stable value Money should not wear out quickly Money should be easy to carry, even relatively large sums Market exchange is easier if denominations support a range of possible prices If money is not of uniform quality, people will hoard the best and spend the rest, reducing its quality The fewer resources tied up in creating money, the more available for other uses People are more willing to accept and hold money if they believe it will keep its value over time Coins; sea shells Diamonds; paper money Honey; paper money and coins Salt bricks; paper money; coins Iron coins; paper money Anything whose supply can be controlled by issuing authorities, such as paper money Strawberries; seafood Lead bars; potatoes Cattle; diamonds Diamonds Gold; diamonds Farm crops

These are measures of the money supply. We add together all assets that are liquid enough to be classified as money

The narrow measure of the money supply; includes only the most liquid assets M1 equals Currency and coin in circulation Plus: Checkable deposits Plus: Travelers’ checks

About 60 percent of Federal Reserve notes now circulate abroad

A broader measure of the money supply favored by many economists. M2 equals M1 Plus: Miscellaneous near monies Plus: Small denomination time deposits Plus: Savings deposits Plus: Money market deposit accounts

17 Measures of the money supply (July 2007)

Deposits are Money—But Checks are Not DateItemDebitCreditBalance 1-Jul-03Opening Balance$ Jul-03The Flower Shop$50.00$ (a) Rick’s Account at Delta Bank

DateItemDebitCreditBalance 1-Jul-03Opening Balance$3, Jul-03Rick’s check $50.00$3, (b) The Flower Shop’s Account at Delta Bank

The Monetary System The monetary system consists of the Federal Reserve and the banks and other institutions that accept deposits and provide the services that enable people and businesses to make and receive payments.

Financial Intermediaries These units are interposed between depositors and borrowers 1.Commercial banks 2.Thrift institutions 3.Money market funds: A financial institution that obtains funds by selling shares and uses these funds to purchase assets such as U.S. Treasury bills.

By bringing together both sides of the money market, banks serve as intermediaries or go- betweens. Banks reduce the transactions costs of channeling saving to creditworthy borrowers. Coping with asymmetric information. Reducing risk through diversification.

Banks must maintain a reserve account at the regional Federal Reserve bank Required reserves: The dollar amount of reserves a bank is required to hold as cash in vault or on account at the Fed. Required reserve ratio: The ratio of reserves to deposits that banks by regulation are obligated to hold. Excess reserves: Bank reserves exceeding required reserves

Banks must be ready for customers’ withdrawals, so liquid bank assets are desirable. At the same time, less liquid assets such as commercial and real estate loans are more profitable.

The Fractional Reserve System Reserves: The currency in a bank’s vaults plus the balance on its reserve account at the Federal Reserve Bank. Required reserve ratio: The minimum percentage of deposits that banks and other financial institutions must hold in reserves. Excess reserves: Banks reserves that exceed those needed to meet the required reserve ratio.

Federal Funds Banks that have excess reserves may loan them to banks with reserve deficiencies These loans are made in the interbank loan, or federal funds, market. The interest rate on loans in the interbank market is the federal funds rate.

A Typical Bank Balance Sheet

The Federal Deposit Insurance Corporation (FDIC) Created in 1933 A government agency that insures deposits in commercial banks (up to $100,000 per account). Banks pay premiums to the FDIC Bank failures were often a “self- fulfilling prophesy.”

The history of banking in the U.S. prior to 1913 is messy—featuring widespread panic and runs on banks—for example, in 1893 and The Federal Reserve System was created in 1913.

The Structure of the Federal Reserve System Senate confirms Chair of Board of Governors 12 Federal Reserve District Banks Lend reserves Clear checks Provide currency 3,500 Member Banks Elect 6 directors of each Federal Reserve Bank Appoints 3 directors of each Federal Reserve Bank President appoints Federal Open Market Committee (7 Governors + 5 Reserve Bank Presidents) Conducts open market operations to control the money supply Board of Governors (7 members, including chair) Supervises and regulates member banks Supervises 12 Federal Reserve District Banks Sets reserve requirements and approves discount rate

31 The twelve Federal Reserve Districts The map shows by color the area covered by each of the 12 Federal Reserve districts. Black dots note the locations of the Federal Reserve Bank in each district. Identified with a star is the Board of Governors headquarters in Washington, D.C.

The instruments of monetary policy Reserve requirements The discount rate Open market operations

Legislation: Federal Reserve Act of 1913 DIDMCA of 1982 Depository institutions are required by law to hold a minimum fraction of their liabilities on account at the FED

The discount rate The rate of interest charged on loans made at the FED discount window. The FED is known as the “lender of last resort” to the banking system

Discount Window Borrowings have surged since December, 2007 as the Fed has sought to stabilize the financial system amid a rash of defaults on subprime debt. Billions

Open market operations are the purchase or sale of U.S. government securities on the open market by the Federal Reserve system

The FED Open Market Committee is the unit in charge of open market operations

38 Failures of US savings banks peaked in 1989

39 Failures of US commercial banks peaked in 1988

140 Bank Failures (FDIC-Insured) in 2009

41 Number of commercial banks declined over the last two decades, but the number of branches continue to grow

42 (a) Largest US banks based on total domestic deposits

43 (b) World’s largest banks based on total assets