Money, Banking, and Central Banking

Copyright © 2008 Pearson Addison Wesley. All rights reserved Introduction Why is the Federal Reserve System clearing fewer checks, and what is its role in our nations financial system? In this chapter you will learn the answers, but first you will learn more generally about money and banking.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Learning Objectives Define the fundamental functions of money Identify key properties that any goods that function as money must possess Explain official definitions of the quantity of money in circulation

Copyright © 2008 Pearson Addison Wesley. All rights reserved Learning Objectives (cont'd) Understand why financial intermediaries such as banks exist Describe the basic structure of the Federal Reserve System Discuss the major functions of the Federal Reserve

Copyright © 2008 Pearson Addison Wesley. All rights reserved Chapter Outline The Functions of Money Liquidity Monetary Standards, or What Backs Money Defining Money Financial Intermediation and Banks Banking Structures Throughout the World The Federal Reserve System

Copyright © 2008 Pearson Addison Wesley. All rights reserved Did You Know That... Money includes not only coins and dollar bills, but also the balance in your checking account? Anything widely accepted in exchange for items of value is considered to be money?

Copyright © 2008 Pearson Addison Wesley. All rights reserved Money  Any medium that is universally accepted in an economy both by sellers of goods and services and by creditors as payment for debts

Copyright © 2008 Pearson Addison Wesley. All rights reserved Table 15-1 Types of Money

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Functions of Money The functions of money  Medium of exchange  Unit of accounting  Store of value (purchasing power)  Standard of deferred payment

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Functions of Money (cont'd) Medium of Exchange  Any item that sellers will accept as payment Barter  The direct exchange of goods and services for other goods and services without the use of money

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Functions of Money (cont'd) Medium of exchange  Money facilitates exchange by reducing transaction costs associated with means- of-payment uncertainty.  Permits specialization, facilitates efficiencies Barter  Simply a direct exchange  Double coincidence of wants

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Functions of Money (cont'd) Unit of Accounting  A measure by which prices are expressed  The common denominator of the price system  A central property of money

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Functions of Money (cont'd) Store of Value  The ability to hold value over time  A necessary property of money  Money allows you to transfer value (wealth) into the future.

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Functions of Money (cont'd) Standard of Deferred Payment  A property of an item that makes it desirable for use as a means of settling debts maturing in the future  An essential property of money

Copyright © 2008 Pearson Addison Wesley. All rights reserved Liquidity  The degree to which an asset can be acquired or disposed of without much danger of any intervening loss in nominal value and with small transaction costs  Money is the most liquid asset.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 15-1 Degrees of Liquidity

Copyright © 2008 Pearson Addison Wesley. All rights reserved Liquidity (cont'd) Question  What is the cost of holding money (its opportunity cost)? Answer  It is the alternative interest yield obtainable by holding some other asset.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Monetary Standards, or What Backs Money Questions  What backs money?  Is it gold, silver, or the federal government? Answer  Your confidence

Copyright © 2008 Pearson Addison Wesley. All rights reserved Defining Money Money is important  Changes in the rate at which the money supply increases or decreases affect important economic variables (at least in the short run) such as inflation, interest rates, employment, and the level of real GDP. Money Supply  The amount of money in circulation

Copyright © 2008 Pearson Addison Wesley. All rights reserved Defining Money (cont'd) Economists use two basic approaches to define and measure money.  The transactions approach  The liquidity approach

Copyright © 2008 Pearson Addison Wesley. All rights reserved Defining Money (cont'd) Transactions Approach  A method of measuring the money supply by looking at money as a medium of exchange Liquidity Approach  A method of measuring the money supply by looking at money as a temporary store of value

Copyright © 2008 Pearson Addison Wesley. All rights reserved Financial Intermediation and Banks Most nations have a banking system that encompasses two types of institutions. 1. One type consists of private banking institutions. 2. The other type of institution is a central bank.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Financial Intermediation and Banks (cont'd) Central Bank  A banker’s bank, usually an official institution that also serves as a country’s treasury’s bank  Central banks normally regulate commercial banks.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Financial Intermediation and Banks (cont'd) Direct finance  Individuals purchase bonds from a business Indirect finance  Individuals hold money in a bank  The bank lends the money to a business

Copyright © 2008 Pearson Addison Wesley. All rights reserved Financial Intermediation and Banks (cont'd) Financial Intermediation  The process by which financial institutions accept savings from businesses, households, and governments and lend the savings to other businesses, households, and governments

Copyright © 2008 Pearson Addison Wesley. All rights reserved Banking Structures Throughout the World The ways that banks around the world differ  Size  United States has banks of various sizes  Europe and Japan have a few large banks  Legal  Universal banking  Limits on financial services such as insurance and bank stock ownership  Importance in financial system  Major importance  Part of a varied financial system (United States)

Copyright © 2008 Pearson Addison Wesley. All rights reserved Banking Structures Throughout the World (cont'd) Central banks and their roles 1. Perform banking functions for their nations’ governments 2. Provide financial services for private banks 3. Conduct their nations’ monetary policies

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Federal Reserve System The Fed  The Federal Reserve System; the central bank of the United States  The most important regulatory agency in the U.S. monetary system  Established in 1913 by the Federal Reserve Act

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Federal Reserve System (cont'd) Organization of the Fed  Board of Governors  7 members, 14-year terms  Federal Reserve Banks (12 Districts)  25 branches  Federal Open Market Committee (FOMC)  BOG plus 5 presidents of district banks

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 15-7 The Federal Reserve System

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Federal Reserve System (cont'd) Depository institutions  7,500 commercial banks  1,300 savings and loans  11,000 credit unions All may purchase Fed services

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Federal Reserve System (cont'd) Functions of the Fed 1. Supplies the economy with fiduciary currency 2. Provides a payment-clearing system 3. Holds depository institutions’ reserves 4. Acts as the government’s fiscal agent 5. Supervises depository institutions 6. Acts as a “lender of last resort” 7. Regulates the money supply

Copyright © 2008 Pearson Addison Wesley. All rights reserved Summary Discussion of Learning Objectives The key functions of money 1. Medium of exchange 2. Unit of accounting 3. Store of value 4. Standard of deferred payment Important properties of goods that serve as money  Acceptability, confidence, and predictable value

Copyright © 2008 Pearson Addison Wesley. All rights reserved Summary Discussion of Learning Objectives (cont'd) Major functions of the Federal Reserve  Supply the economy with currency  Provide systems for transmitting and clearing payments  Holding depository institutions’ reserves  Acting as the government’s fiscal agent  Supervising banks  Acting as a “lender of last resort”  Regulating the money supply  Intervening in foreign exchange markets