Chapter 2 Money and the Monetary System © 2011 John Wiley and Sons

2 Chapter Outcomes n Describe the three ways in which money is transferred from savers to businesses n Identify the major components of the monetary system n Describe the functions of money n Give a brief review of the development of money in the U.S.

3 Chapter Outcomes (Continued) n Describe major types of money market securities n Briefly explain the M1, M2, and M3 definitions of the money supply n Explain possible relationships between money supply and economic activity n Comment on developments in the international monetary system

Process of Moving Savings into Investments n Surplus Economic Unit: generates more money than it spends resulting in excess money n Deficit Economic Unit: generates less money than it spends resulting in a need for additional money 4

5 S avings-Investment Process Money Securities Money Securities Firm’s Securities Institution Securities Investment Banking Firm Direct Transfers: Savers Business Firm Indirect Transfers: Savers Business Firm Savers Financial Business Institution Firm

6 Participants in the U.S. Monetary System CENTRAL BANK: n Defines and Regulates Money Supply n Facilitates the Transferring of Money BANKING SYSTEM: n Creates Money n Transfers Money n Provides Financial Intermediation n Processes/Clears Checks

7 The U.S. Monetary System Central Bank Federal Reserve System Board of Governors Federal Reserve Banks Defines and regulates money supply Facilitates transfer of money through check processing/clearing Banking System: 1. Creates money 2. Transfers money 3. Provides financial intermediation 4. Processes/clears checks Other Banks First Bank Last Bank

8 U.S. Central Bank n Federal Reserve System [often referred to as the “Fed”] n Board of Governors n Federal Reserve Banks

9 Central Bank Activities n Defines and regulates money supply n Facilitates the transferring of money through check processing and clearing

Importance and Functions of Money n Real Assets: direct ownership of land, buildings or homes, equipment, inventories, durable goods, and precious metals n Financial Assets: money, debt securities & contracts, and equity securities backed by real assets & earning power of issuers 10

11 Some Basic Definitions n MONEY: anything generally accepted as payment for goods, services, & debts n BARTER: exchange of goods or services without using money n LIQUIDITY: ease and low cost of exchanging an asset for money

12 Functions of Money n MEDIUM OF EXCHANGE: the basic function of money n STORE OF VALUE: money can be held for some period of time, without losing its value, before it is spent n STANDARD OF VALUE: exists when prices and debts are stated in terms of the monetary unit

13 Development of Money in the U.S. Historical Types of U.S. Coins: n FULL-BODIED MONEY: coins that contain the same value in metal as their face value n TOKEN COINS: coins containing metal of less value than their stated value

14 Development of Money in the U.S. Historical Types of Paper Currency: n REPRESENTATIVE FULL-BODIED MONEY: paper money fully backed by a precious metal n FIAT MONEY: legal tender proclaimed to be money by law--not backed by precious metal

15 Deposit Money in the U.S. n CREDIT MONEY: money worth more than what it is made of--backed by the credit- worthiness of issuer n DEPOSIT MONEY: special type of credit money backed by the depository institution that issued the deposit

16 Alternatives to “Paper Checks” n AUTOMATIC TRANSFER SERVICE (ATS) ACCOUNTS: Provide for direct deposits to, and payments from, checkable deposit accounts n DEBIT CARDS: Provide for immediate direct transfer of deposit amounts & can be used to make cash withdrawals from ATMs

Money Market Securities n Money Markets: markets where debt securities with maturities of one year or less are originated (primary markets) or traded (secondary markets) n Money Market Securities: debt securities with maturities of one year or less 17

Money Market Securities n Treasury Bill: short-term debt obligation issued by the U.S. federal government n Negotiable Certificate of Deposit: short-term debt instrument issued by depository institutions that can be traded in the secondary money markets 18

Money Market Securities n Commercial Paper: short-term unsecured note issued by a high credit-quality corporation n Banker’s Acceptance: promise of future payment issued by an importing firm and guaranteed by a bank 19

Money Market Securities n Repurchase Agreement: short-term debt security where the seller agrees to repurchase the security at a specified price and date n Federal Funds: very short-term loans between depository institutions with excess funds and those needing funds 20

Measures of the U.S. Money Supply n M1 Money Supply n M2 Money Supply n M3 Money Supply 21

22 Components of the M1 Definition of the Money Supply n Currency n Traveler’s Checks n Demand Deposits at Banks n Other Checkable Deposits at Depository Institutions

23 Components of the M2 Definition of the Money Supply M1 Money Supply plus: n Savings Accounts n Small-Denomination Time Deposits n Money Market Deposit Accounts (MMDAs) n Retail Money Market Mutual Funds (MMMFs)

24 Components of the M3 Definition of the Money Supply M2 Money Supply plus: n Large-Denomination Time Deposits n Institutional Money Market Mutual Funds n Repurchase Agreements (Overnight and Term) n Eurodollars (Overnight and Term) Held by U.S. Residents

25 Money Supply and Economic Activity n MONETARISTS’ VIEW: amount of money in circulation determines the level of economic activity n KEYNESIANS’ VIEW: change in money supply first causes a change in interest rates which then, in turn, alters the demand for goods and services

26 Monetarists’ View n BASIC EQUATION: MS x VM = GDP n GROSS DOMESTIC PRODUCT (GDP): Measures the output of goods and services in an economy : n MONEY SUPPLY (MS): Usually defined in terms of M1 or M2 n VELOCITY OF MONEY (VM): The rate of circulation of the money supply

27 Another View of GDP n BASIC EQUATION: RO x PL = GDP n GROSS DOMESTIC PRODUCT (GDP): Measures the output of goods and services in an economy n REAL OUTPUT (RO): Units of goods and services n PRICE LEVEL (PL): Average price of goods and services

28 Two Views of GDP Combined n TWO BASIC EQUATIONS: MS x VM = GDP RO x PL = GDP n THE EQUATIONS COMBINED: MS x VM = RO x PL n NOMINAL GDP INCREASES WITH: >An increase in money supply and/or velocity of money >An increase in real output and/or price level

29 International Monetary System n Historically: Tied to the gold standard n Bretton Woods System (1944): Agreement to use fixed or pegged exchange rates tied to the U.S. dollar or gold n Early 1970s: Development of a flexible or floating exchange rate system

30 International Monetary System Terms n CURRENCY EXCHANGE RATE: Value of one currency relative to another n EURO: A single currency that replaced the individual currencies of initially twelve member countries of the European Union

31 Web Links n n n n