Title: Chapter 13 Money, Banking, and the Federal Reserve
1Chapter 13Money, Banking, and the Federal Reserve
ECONOMICS EXPLORE APPLYEnhanced Edition
2Learning Objectives
- Identify the types, functions, and liquidity of
various money measures. - Describe key elements of the banking industry.
- Discuss how banks create money.
- Describe the structure, functions, and policy
tools of the Federal Reserve .
3Learning Objectives
- Work through the process of monetary expansion
using the deposit multiplier. - Explain why the banking crisis of the 1980s
occurred and whether another banking crisis could
happen.
413.1 MONEY
- Money is whatever is commonly used in an economy
to buy and sell things. - Without money, we would have to barter (swap) one
good for another, or produce on our own all of
the goods and services we consume. - Both alternatives are inefficient.
- Important qualities of money are its portability
and divisibility.
5Money
- Historically, gold was used as money.
- Today, gold is no longer used as money rather,
government issued currency and coins are used as
money. - Bank issued checks are the largest part of the
money we own. - Money performs the following functions
- Medium of exchange.
- Store of value.
- Unit of account.
6Money
- Fiat money is money because the law says it is.
- Paper currency and current U.S. coins are
examples of fiat money. - Because the government accepts fiat money, both
individuals and business accept it as legal
tender. - Gold and silver coins, once a commonplace form of
money in the U.S. are examples of commodity
money. - Commodity money is made of precious metals.
- Coins today are made of cheaper metals.
7Money
- Commodity money is subject to Greshams law bad
money drives out good. - The practice of shaving the edges of commodity
money forced people to bite it, weigh it, and
examine it carefully. - Fiat money eliminates this problem, and is
designed so that it is not easily counterfeited. - Governments of virtually all nations hold a
monopoly on the production of fiat money.
8Money Debit or Credit
- The debit card immediately transfers the amount
of the purchase out of your checking account, and
into the stores deposit account. - You cant use your debit card to make a purchase
unless you have the amount of the purchase in
your account. - In contrast, a credit card provides you with a
loan in the amount of the purchase.
9Liquidity M1, M2, and M3
- When paper money and coins are deposited in
banks, money changes form. - Deposits into checking accounts create demand
deposits, also termed checkable deposits. - More money is held in the form of checkable
deposits than in any other form. - These deposits are money because checks orders
to a bank to make payment are generally
accepted by sellers.
10Liquidity M1, M2, and M3
- Liquidity refers to how easily and quickly
something of value can be converted into
spendable form. - Three definitions of money, termed the monetary
aggregates, categorize various types of money
according to how liquid they are. - The monetary aggregates include M1, M2, and M3.
11Liquidity M1, M2, and M3
- The M1measure of the money supply is the most
liquid. - It includes the sum of currency and coins in the
hands of the public, demand deposits, other
checkable deposits, and travelers checks. - M1 totaled 1.3 trillion in 2003.
12Liquidity M1, M2, and M3
- The M2measure of the money supply includes M1
plus the balances in savings deposits, small
time deposits, and balances in money market
mutual funds. - M2 is slightly less liquid than M1, and totaled
6.1 trillion in 2003.
13Liquidity M1, M2, and M3
- The M3 measure of the money supply includes M2
plus large time deposits (at least 100,000),
and several other near monies. M3 is less likely
to be spent than the items in M2, and totaled
8.0 trillion in 2003. - Financial assets, such as stocks and bonds, are
not counted in the money supply figures.
14Liquidity M1, M2, and M3
M2 M1 1,277.3 Savings deposits
3095.3 Small time deposits 843.8 Money
market balances 877.8 Total 6,094.3
M1 Currency 646.2 Travelers checks
8.2 Demand deposits 321.9 Other
checkable deposits 301.0 Total 1,277.3
M3 M1 1,277.3 M2 6094.3 Large denomination
time deposits 902.6 Other M3 items
1,922.7 Total 8,919.5
15Liquidity M1, M2, and M3
1613.2MONEY AND BANKING IN THE U.S.
- Banks are regulated by both state and federal
government. - Bank regulation is designed to protect against
unsound banking practices that could bankrupt
both depositors and government insurance funds. - For example, under the Glass-Steagall Act of 1933
banks were barred from offering insurance and
brokerage services. - The Glass-Steagall Act was abolished in 1999.
17The Banking System
Assets Liabilities
Vault Cash (part 1 of bank reserves) Customer deposits
Deposits held by the Federal reserve (part 2 of bank reserves Federal funds
Loans Discount loans
Securities Paid-in capital
Other
18The Banking System
- Banks hold a fraction of their deposits on
reserve to meet the cash needs of their
customers. - Banks are required by law to meet the reserve
requirements imposed by the Fed. - If the reserve requirement is 10, then the banks
must hold at least 10 in reserves for every 100
of customer deposits. - Reserves in excess of the required reserves are
called excess reserves.
19The Banking System
- Loans are an asset of banks and they represent
promises by borrowers to repay. - One interest rate on loans to customers that is
widely know is the bank prime lending rate. - Securities, purchased by banks, in the form of
bonds, are interest paying investments. - Banks mostly purchase federally issued short-term
bonds called treasury bills (T-bills) - The Federal Deposit Insurance Corporation (FDIC)
insures deposit accounts up to 100,000.
20The Banking System
- Bank deposits are liabilities because they are
funds owed to depositors. - Banks also raise funds by borrowing, both from
each other, and from the Federal Reserve. - Funds borrowed from other banks are called
federal funds. - The interest rate that banks charge on loans to
other banks is called the federal funds rate.
21The Banking System
- Borrowings by banks from the Fed are called
discount loans. - With a discount interest on the loan is paid
when the loan is made. - The rate of interest charged to banks when they
borrow from the Fed is called the discount rate. - In addition to banks there are other financial
intermediaries (bank like institutions), that
accept funds from savers in order to make loans
or investments.
22Key Interest Rates
Year Prime Rate Federal Funds Rate Discount Rate
1979 12.67 11.20 10.29
1980 15.26 13.35 11.77
1981 18.87 16.39 13.42
1892 14.85 12.24 11.01
1983 10.79 9.09 8.50
1984 12.04 10.23 8.80
1985 9.93 8.10 7.69
23Key Interest Rates (continued)
Year Prime Rate Federal Funds Rate Discount Rate
1986 8.33 6.80 6.32
1987 8.21 6.66 5.66
1988 9.32 7.57 6.20
1989 10.87 9.21 6.93
1990 10.01 8.10 6.98
1991 8.46 5.69 5.45
1992 6.25 3.52 3.25
24Key Interest Rates (continued)
Year Prime Rate Federal Funds Rate Discount Rate
1993 6.00 3.02 3.00
1994 7.15 4.21 3.60
1995 8.83 5.83 5.21
1996 8.27 5.30 5.02
1997 8.44 5.46 5.00
1998 8.35 5.35 4.92
1999 8.00 4.97 4.62
25Key Interest Rates (continued)
Year Prime Rate Federal Funds Rate Discount Rate
2000 9.23 6.24 5.73
2001 6.91 3.88 3.40
2002 4.67 1.67 1.17
2003 4.00 .96 2.00
26How Banks Create Money
- When a bank makes a loan, the quantity of money
in the economy increases. - Currency inside of bank vaults is not is not
counted as a part of the money supply. - If a loan is received as currency, the amount of
currency in the hands of the public is greater
than before the loan.
27How Banks Create Money
2813.3MEET THE FED
- The Federal Reserve performs the central banking
functions at the heart of the monetary system. - The U.S. central bank is called the Fed, short
for Federal Reserve system. - It was created by the Federal Reserve Act of 1913
in response to recurring bank failures. - The act sought to provide a central bank
contribute to U.S. economic stability.
29Meet the FED
- As our central bank performing its role of
stabilizing the economy, the Fed does the
following - Functions as a bankers bank.
- Functions as a lender of last resort.
- Supervises banks.
- Conducts monetary policy.
- Issues currency.
- Clears checks.
30Meet the FED
- The Fed is an independent, free from political
pressures, arm of government. - To further insulate the Fed from political
pressure, it is divided into three components. - The Board of Governors, which is responsible for
the overall direction of the Federal Reserve and
its policies. - The Federal Open Market Committee (FOMC), which
conducts monetary policy. - The Federal Reserves Banks, which regulate and
provide a variety of services for banks.
31Influencing The Money Supply
- The principle method the Fed uses to influence
the money is called open market operations. - Open market operations occur when the Fed enters
the financial marketplace to buy or sell
government securities, such as treasury bonds. - When the Fed sells government securities the
money supply decreases. - When the Fed buys government securities the money
supply increases.
32Influencing The Money Supply
33The Money Multiplier
- The money multiplier shows the total effect on
the money supply of each dollar of open market
operations. - Depending upon the size of the reserve
requirement, changes in the money supply are
magnified by a multiple amount. - Banks are able to make loans up to the amount of
their excess reserves.
34The Money Multiplier
The total of new money created when the money
supply expansion is complete depends on the size
of the money multiplier.
Money supply Money Multiplier x Monetary base
Deposit multiplier 1/Percentage reserve
requirement
3513.4 EXPLORE APPLYHigh Priced Housing Are
Banks at Risk?
- Housing prices in the United States have risen
nearly 10 for the last decade. - Is there a housing bubble, as real estate
prices have gotten so out of hand that they are
poised to collapse? - The economist magazine predicts that real estate
prices will decline 15 to 20 over the next few
years in the U.S. - It also predicts declines of 30 or more in other
countries.
36Why Banks Fail
- As a result of the act, banks began to raise
interest rates during the 80s in competition for
depositors. - Banks were ignoring risk and simply looking at
interest rates. - This is an example of moral hazard, which
occurs when people choose riskier behavior
because insurance has lowered the price of risk.
37Why Banks Fail
- Two rounds of legislation, 50 years apart set the
stage for the banking crisis of the 1908s. - In the 1930s in response to widespread bank
failures Congress created the Federal Deposit
Insurance Corporation, and enacted the
Glass-Steagal Act. - The Depository Institutions Deregulation and
Monetary Control Act of 1980 was passed. - This relaxed restrictions on interest rates and
bank investments.
38The Banking Crisis of the 1980s
- As a result of the act, banks began to raise
interest rates during the 80s in competition for
depositors. - Banks were ignoring risk and simply looking at
interest rates. - The majority of the 80s bank failure revolved
around bad real estate loans. - The decline in oil prices in the late 80s
precipitated a fall in real estate prices in
Texas and other parts of the country.
39The Banking Crisis of the 1980s
- The government guaranteed deposits above
100,000. - They also encouraged the merger of insolvent
banks with sound banks. - This is an example of moral hazard, which
occurs when people choose riskier behavior
because insurance has lowered the price of risk. - The 1990s brought a healthier economic climate
with restored bank profitability and reduced
numbers of bank failures.
40Terms Along the Way
- money
- barter
- medium of exchange
- store of value
- unit of account
- fiat money
- Greshams law
- demand deposit
- liquidity
- M1
- M2
- M3
- bank reserves
- required reserves
- excess reserves
41Terms Along the Way
- bonds
- federal funds rate
- discount rate
- Federal Reserve System
- open market operations
- monetary base
- money multiplier
- deposit multiplier
42Test Yourself
- Barter is most likely to occur when
- money takes the form of commodity money.
- M1 is the dominant form of money.
- Greshams law requires people to barter.
- there is no money.
-
43Test Yourself
- 2. The U.S. one dollar coin is an example of
- commodity money.
- fiat money
- money that is neither commodity money nor fiat
money. - something that looks like money, but is not since
it is coined from nearly worthless metals.
44Test Yourself
- 3. Which is NOT a function of money?
- Standard of measurement.
- Unit of account.
- Store of value.
- Medium of exchange.
45Test Yourself
- 4. A banks total reserves equal
- required reserves.
- excess reserves.
- required reserves excess reserves.
- required reserves excess reserves.
46Test Yourself
- 5. If the money supply equals 100 and the money
multiplier equals 10, then the monetary base must
equal? - 1.000.
- 100.
- 10.
- an amount that cannot be determined by the
information given.
47Test Yourself
- 6. If the reserve requirement were 20 and the
FED purchased 100 of securities in an open
market purchase, then the money supply could
potentially expand by a maximum of - 5.
- 20.
- 100.
- 500.
48The End! Next Chapter 14 Monetary Policy and
Price Stability