Money and the Financial System

1
Money and the Financial System
2
The Evolution of Money

• Barter is a system where people exchange products
  directly
• Barter depends on a double coincidence of wants,
  a situation in which two traders are willing to
  exchange their goods directly
• Under a barter system, not only is a double
  coincidence of wants difficult to obtain, but
  that rate at which the two goods are exchanged
  must be determined
• This points to a need for a commodity that is
  generally accepted in exchange money

3
What is Money?

• Money is any commodity that is generally
  acceptable in exchange for goods and services
• Money fulfills 4 functions
• Money is a medium of exchange
• Money is a unit of account
• Money is a store of value
• Standard of Deferred Payment

4
Money is a Medium of Exchange

• Anything that facilitates trade by being
  generally accepted by all parties in payment for
  goods or services

5
Money is a Unit of Account

• A common unit for measuring the value of every
  good or service

6
Money is a Store of Value

• Anything that roughly retains its purchasing
  power over time

7
Standard of Deferred Payment

• Debt obligations are dominated in terms of money

8
History of Money

• 700-637 BC Lydian King stamped electrum ingots
  with lions head (Western Turkey)

9
Commodity Money

• Commodity money is anything that serves both as
  money and as a commodity
• Historically, corn serves as one example, since
  parties generally believed that there was a ready
  market for this commodity
• Metal commodities have also functioned as money

10
The Problems with Commodity Money

• Deterioration
• Bulkiness
• Indivisibility
• High opportunity cost due to its inherent value
• Subject to supply and demand
• Greshams Law--Bad money drives out good money

11
Coins and Token Money

• Coins evolved as money because metal can be
  debased
• Historically, the power to coin was vested in the
  seignior, or feudal lord
• If the face value of the coin exceeded the cost
  of coinage, the minting of coins became a source
  of revenue (seigniorage)
• Token money is money whose face value exceeds the
  cost of production

12
Paper Money

• Paper money first took the form of bank notes
  which guaranteed delivery of gold or silver upon
  presentation at the issuing bank
• Such notes were easily used as a medium of
  exchange, due to the fact that they were easy to
  carry and backed by precious metals

13
Fiat Money

• Money not redeemable for any commodity
• Its status as money is conferred by the
  government
• Fiat money is declared as legal tender by the
  government

14
History of Money in US

• http//www.ronscurrency.com/rhist.htm
• Franklin The Father of Paper Money
• States issued currency
• Continentals (1777-1781)
• Not worth a continental
• Free Banking ( - 1866)
• States and banks issued their own currency
• Greenbacks (Civil War)
• Nationalization of Gold (1933)
• The Collapse of the Bretton Woods System (1971)

15
Some Facts about the Dollar

• The Dollar
• Ave life of 1 bill is 18 months, 9 years for a
  100
• 490 notes in a lb. So 10 Million in 100s weighs
  204lbs.
• 2 million in 20s would weigh the same.
• ½ of bills printed in a day are 1 denomination
• 80 of Bills abroad are 100 Bills
• 2/3 of all currency in circulation is abroad

16
Monetary AggregatesM1, M2, and M3

• A monetary aggregate is a measure of the
  economys money supply
• M1A measure of the money supply consisting of
  currency and coins held by the nonbank public,
  checkable deposits, and travelers checks
• M2A monetary aggregate consisting of M1 plus
  savings deposits, small time deposits, and money
  market mutual funds
• M3A monetary aggregate consisting of M2 plus
  negotiable certificates of deposit

17
Liquidity

• Liquidity is a measure of the ease with which an
  asset can be converted into money without
  significant loss of its value
• M1, M2, and M3 are progressively less liquid

18
The Early Stage of Modern Banking

• During the middle ages, London goldsmiths kept
  gold, cash, and valuables in reserve for clients
• Since only a small fraction of clients would want
  to retrieve there deposits any point in time,
  this led to cash loans by the goldsmiths to
  others
• A checking account system also evolved whereby
  clients could authorize goldsmiths to relinquish
  gold deposits to another party
• Eventually, goldsmith created money by simply
  creating an account for the borrower
• Beginning of a fractional reserve banking system

19
Fractional Reserve Banking System

• A banking system in which only a portion of
  deposits is backed by reserves

20
Demand Deposits

• Accounts at financial institutions that pay no
  interest and on which depositors can write checks
  to obtain their deposits at any time

21
Liabilities and Assets

• A bank incurs a liability when it accepts a
  deposit
• A liability is anything that is owed to another
  individual or institution
• When a bank makes a loan, it incurs an asset

22
Reserve Funds

• Funds that banks use to satisfy the cash demands
  of their customers and the reserve requirements
  of the Fed
• Reserves consist of deposits at the Fed plus
  currency physically held by banks

23
Bank Deposits

• Deposits in financial institutions against which
  checks can be written
• A demand deposit is a checkable deposit which
  earns no interest
• A savings deposit earns interest but has no
  specific maturity date
• A time deposit earns a fixed rate of interest if
  held for a specified period

24
Money Creation

• Banks create money by making loans against excess
  reserves.
• Look at the balance sheets of the Banking
  industry.

25
The Money Multiplier

• The money multiplier is the multiple by which the
  money supply increases as a result of an increase
  in excess reserves in the banking system
• The simple money multiplier is the reciprocal of
  the required reserve ratio, or 1/r

26
The Actual Money Multiplier

• The simple money multiplier is subject to cash
  drain and excess reserves
• Cash drainincreased cash holdings by the public
• Excess reservesbanks may not lend all excess
  reserves
• Each of these has the effect of reducing the
  money multiplier

27
Financial Institutions in the United States
28
Financial Intermediaries

• Institutions that serve as go-betweens, accepting
  funds from savers and lending them to borrowers
• Depository institutions
• Commercial banks and other financial institutions
  that accept deposits from the public
• Commercial banks
• Depository institutions that make short-term
  loans primarily to businesses
• Thrift institutions
• Depository institutions that make long-term loans
  primarily to households

29
The Banking Industry

• The banking industry exists due to the fact that
  mutually benefits trades take place between
  banks an depositors, and between banks and
  borrowers
• Depositors lend deposits to banks in exchange for
  interest payments
• Banks loan deposits to borrowers in exchange for
  interest on the loan. The borrower gains from
  the service of the loan, but must pay interest
  sufficient to make the bank profitable.

30
Asymmetric Information

• The banker, in dealing with the borrower, faces
  the problem of asymmetric information
• Asymmetric information exists when there is
  unequal information known by each party
• Bankers must become experts in dealing with
  asymmetric information
• Banks can also deal with risk through
  diversification

31
First Bank of United States 1811
32
Second Bank of United States 1836
33
The Origins and Structure of the Federal Reserve
System

• The Federal Reserve System (the Fed) was
  established with the Federal Reserve Act of 1914
• The Federal Reserve System is the central bank
  and monetary authority of the U.S.
• 12 Federal Reserve districts were established
  around the country
• The Board of Governors (7 members appointed by
  the President and confirmed by the Senate) sets
  and implements the nations monetary policy

34
The Federal Reserve System
35
The Organization of the Federal Reserve System
36
The Objectives of the Federal Reserve System

• A high level of employment
• Economic growth
• Price stability
• Interest rate stability
• Stability in financial markets
• Stability in foreign exchange markets

37
The Powers of the Federal Reserve System

• Federal Reserve Act of 1914 authorized to
  exercise general supervision over the 12 Reserve
  banks
• The Fed was also given the power to buy and sell
  government securities, to extend loans to member
  banks, to clear checks, and to require that
  member banks hold reserves equal at least to a
  specified fraction of their deposits

38
The Process of Money Creation Can be Reversed

• The Fed can sell securities to banks or the public

39
Summary of Credit Expansion When Fed Purchases
1,000 Security
40
Other Means of Expanding the Money Supply

• Clearly, when the reserve requirement ratio is
  decreased, the money supply increases
• The Fed can also change the discount rate
• When banks borrow from the Fed, excess reserves
  in the economy increase

41
An Overview of the Tools of the Federal Reserve
System

• The discount rate is the interest rate charged to
  member banks by the Fed for discount loans
• Open-market operations are purchases and sales of
  government securities by the Fed in an effort to
  influence the money supply
• These operations are undertaken under the
  auspices of the Federal Open Market Committee,
  consisting of the seven governors plus five
  presidents from the Reserve banks
• A minimum reserve requirement is imposed on
  member banks

42
Banking During the Great Depression

• Many point to the inaction of the Federal Reserve
  System as a cause for the depth of the Great
  Depression
• The Fed failed to act as a lender of last resort
  when financial markets began to become unstable

43
Review Terms and Concepts

• M1, or transactions money
• M2, or broad money
• medium of exchange, or means of payment
• money multiplier
• near monies
• Open Market Desk
• open market operations
• required reserve ratio
• reserves
• run on a bank
• store of value
• unit of account

• barter
• commodity monies
• currency debasement
• discount rate
• excess reserves
• Federal Open Market Committee (FOMC)
• Federal Reserve System (the Fed)
• fiat, or token, money
• financial intermediaries
• legal tender
• lender of last resort
• liquidity property of money

44
Additional Slides
45
Recent Problems with Depository Institutions

• Money market mutual funds introduced (1970s)
• A collection of short-term earning assets
  purchased with funds collected from many
  shareholders
• Due to this depository institutions began to
  suffer, since they faced regulations on the
  interest rate offered to depositors
• Deregulation was implemented, while maintaining
  deposit insurance
• This led institutions to undertake risky
  investments, leading to an abundance of thrift
  failures
• Thrift institutions were bailed out by the
  taxpayers

46
The Money Supply andthe Federal Reserve System
47
An Overview of Money

• Money is anything that is generally accepted as a
  medium of exchange.

• Money is not income, and money is not wealth.
  Money is
• a means of payment,
• a store of value, and
• a unit of account.

48
What is Money?

• Barter is the direct exchange of goods and
  services for other goods and services.
• A barter system requires a double coincidence of
  wants for trade to take place. Money eliminates
  this problem.
• As a medium of exchange, or means of payment,
  money is generally accepted by buyers and sellers
  as payment for goods and services.

49
What is Money?

• As a store of value, money serves as an asset
  that can be used to transport purchasing power
  from one time period to another.

50
What is Money?

• As a unit of account, money is a standard that
  provides a consistent way of quoting prices.

51
What is Money?

• Money is easily portable, and easily exchanged
  for goods at all times.
• The liquidity property of money makes money a
  good medium of exchange as well as a store of
  value.

52
Commodity and Fiat Monies

• Commodity monies are items used as money that
  also have intrinsic value in some other use.
  Gold is one form of commodity money.
• Fiat, or token, money is money that is
  intrinsically worthless.

53
Commodity and Fiat Monies

• Legal tender is money that a government has
  required to be accepted in settlement of debts.
• Currency debasement is the decrease in the value
  of money that occurs when its supply is increased
  rapidly.

54
Measuring the Supply ofMoney in the United States

• M1, or transactions money is money that can be
  directly used for transactions.
• M1 ? currency held outside banks demand
  deposits travelers checks other checkable
  deposits
• M1 is a stock measureit is measured at a point
  in timeon a specific day.

55
Measuring the Supply ofMoney in the United States

• M2, or broad money, includes near monies, or
  close substitutes for transactions money.
• M2 / M1 savings accounts money market
  accounts other near monies
• The main advantage of looking at M2 instead of M1
  is that M2 is sometimes more stable.

56
The Private Banking System

• Financial intermediaries are banks and other
  financial institutions that act as a link between
  those who have money to lend and those who want
  to borrow money.

57
How Banks Create Money

• A Historical Perspective Goldsmiths
• Goldsmiths functioned as warehouses where people
  stored gold for safekeeping.
• Upon receiving the gold, a goldsmith would issue
  a receipt to the depositor. After a time, these
  receipts themselves began to be traded for goods,
  and were backed 100 percent by gold.
• Then, Goldsmiths realized that they could lend
  out some of this gold without any fear of running
  out. Now there were more claims than there were
  ounces of gold.

58
How Banks Create Money

• A run on a goldsmith (or a modern-day bank)
  occurs when many people present their claims at
  the same time.

59
The Modern Banking System

• A brief review of accounting
• Assets liabilities / Net Worth, or
• Assets / Liabilities Net Worth
• A banks most important assets are its loans.
  Other assets include cash on hand (or vault cash)
  and deposits with the Fed.
• A banks liabilities are its debtswhat it owes.
  Deposits are debts owed to the banks depositors.

60
The Modern Banking System

• The Federal Reserve System (the Fed) is the
  central bank of the United States.

61
The Modern Banking System

• Reserves are the deposits that a bank has at the
  Federal Reserve bank plus its cash on hand.
• The required reserve ratio is the percentage of
  its total deposits that a bank must keep as
  reserves at the Federal Reserve.

62
T-Account for a Typical Bank

• The balance sheet of a bank must always balance,
  so that the sum of assets (reserves and loans)
  equals the sum of liabilities (deposits and net
  worth).

63
The Creation of Money

• Banks usually make loans up to the point where
  they can no longer do so because of the reserve
  requirement restriction (or up to the point where
  their excess reserves are zero).

64
The Creation of Money

• When someone deposits 100 in a bank, and the
  bank deposits the 100 with the central bank, the
  bank has 100 in total reserves.

65
The Creation of Money

• If the required reserve ratio is 20, the bank
  has excess reserves of 80. With 80 of excess
  reserves, the bank can have up to 400 of
  additional deposits. The 100 in reserves plus
  400 in loans equal 500 in deposits.

66
The Creation of Money
67
The Money Multiplier

• The money multiplier is the multiple by which
  deposits can increase for every dollar increase
  in reserves.

• In the example above, the required reserve ratio
  is 20. Each dollar increase in reserves could
  cause an increase in deposits of 5 when there is
  no leakage out of the system. An additional 100
  of reserves result in additional deposits of 500.

68
The Federal Reserve System
69
The Federal Reserve System

• The Federal Open Market Committee (FOMC) sets
  goals regarding the money supply and interest
  rates and directs the operations of the Open
  Market Desk in New York.
• The Open Market Desk is an office in the New York
  Federal Reserve Bank from which government
  securities are bought and sold by the Fed.

70
Functions of the Federal Reserve
The Fed performs important functions for banks
including

• Clearing interbank payments.
• Regulating the banking system.
• Assisting banks in a difficult financial
  position.
• Managing exchange rates and the nations foreign
  exchange reserves.
• Control of mergers between banks.

71
Functions of the Federal Reserve
The Fed performs important functions for banks
including

• Examination of banks to ensure that they are
  financially sound.
• Setting of reserve requirements for all financial
  institutions.
• Lender of last resort The Fed provides funds to
  troubled banks that cannot find any other sources
  of funds.

72
The Federal Reserve Balance Sheet
73
The Federal Reserve Balance Sheet

• Although it is unrelated to the money supply, the
  Feds gold counts as an asset on its balance
  sheet.
• The largest of the Feds assets, by far, consists
  of government securities purchased over the
  years.
• A dollar bill is a liability, or IOU, of the Fed.

74
How the Federal ReserveControls the Money Supply

• Three tools are available to the Fed for changing
  the money supply
• changing the required reserve ratio
• changing the discount rate and
• engaging in open market operations.

75
The Required Reserve Ratio

• The required reserve ratio establishes a link
  between the reserves of the commercial banks and
  the deposits (money) that commercial banks are
  allowed to create.
• If the Fed wants to increase the money supply,
  the Fed can decrease the required reserve ratio,
  which allows the bank to create more deposits by
  making loans.

76
The Required Reserve Ratio
77
The Discount Rate

• The discount rate is the interest rate that banks
  pay to the Fed to borrow from it.
• Bank borrowing from the Fed leads to an increase
  in the money supply. The higher the discount
  rate, the higher the cost of borrowing, and the
  less borrowing banks will want to do.

78
The Discount Rate
79
The Discount Rate

• Moral suasion is the pressure that was exerted in
  the past by the Fed on member banks to discourage
  them from borrowing heavily.
• On January 9, 2003, the Fed announced a new
  procedure that sets the discount rate above the
  rate that banks pay to borrow in the private
  market. It is thus clear that the Fed is not
  using the discount rate as a tool to try to
  change the money supply on a regular basis.

80
Open Market Operations

• Open market operations is the purchase and sale
  by the Fed of government securities in the open
  market a tool used to expand or contract the
  amount of reserves in the system and thus the
  money supply.
• Open market operations is by far the most
  significant tool of the Fed for controlling the
  supply of money.

81
The Mechanics ofOpen Market Operations
82
Open Market Operations

• An open market purchase of securities by the Fed
  results in an increase in reserves and an
  increase in the supply of money by an amount
  equal to the money multiplier times the change in
  reserves.

83
Open Market Operations

• An open market sale of securities by the Fed
  results in a decrease in reserves and a decrease
  in the supply of money by an amount equal to the
  money multiplier times the change in reserves.

84
Open Market Operations

• Open market operations are the Feds preferred
  means of controlling the money supply because
• they can be used with some precision,
• are extremely flexible, and
• are fairly predictable.

85
The Supply Curve for Money

• Through open market operations, the Fed can have
  the money supply be whatever value it wants.