Money, Banking, and Financial Institutions

Chapter 32

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Money

• Money: Anything that is generally accepted in payment for goods or services or in the repayment of debt• Important!! Term “money” defined in Economics is different

from commonly used word “money” in everyday conversation!

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Example of Money

So, what can you use for payment at Wal-Mart, McDonald’s, and Exxon gas station?• Currency (cash) including coins and bills

• Cash is an asset. If you have $20 bill, you can spend up to $20 worth of goods and services (e.g. gasoline).

• Check & debit card (electronic version of check)• A check is a means of payment, but it is worthless piece of paper

unless you write a payment and sign it.• Can you write $23,770 check at Toyota dealer to purchase Prius? Yes,

only if you have that amount at your bank.• You can write a check up to an amount in your checking account

without bouncing your check.• Your checking account balance is money, not check itself.

• Credit card? Not really.

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Money by Definit ion

Not every means of payment is money. Money by definition must be• An asset (for repayment of debt)

• A credit card is not money because the credit card is a means of borrowing (not payment, but deferred payment).

• Once charged, you are expected to pay your credit card bill by check or cash (a.k.a. money).

• Generally accepted • If you can use only one or few places, then it is not

money.• Ex. Disney dollar is not money because it can be used

only at Disney store or Disney World.

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Three Functions of Money

Money has three primary functions in any economy.• Medium of Exchange

• Anything used to pay for goods and services

• Unit of Account

• Anything used to measure value in economy

• Store of Value

• A repository of purchasing power over time

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Money as Medium of Exchange

• Every modern economy needs money for efficient exchange of goods and services among people.

• Monetary exchange: Exchange of goods through moneyEx. You have fish and want a loaf of bread.

(You) Fish Money (???) Bread (???)

• Since money comes between two goods in exchange, it is a medium of exchange.

• Even though this involves two exchanges, actually it will take less time for exchanges.

• Money increases efficiency in economy: people can spend more time for production of goods and services rather than exchange.

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Examples of Medium of Exchange

Many commodities have been used as money in various civilizations in history. Some form of money is better medium of exchange than others.• Yap stone money• American Indian wampum• Cigarette in U.S. prisons • Cowries seashell in the South Pacific and Africa• Which is better medium of exchange, Yap stone or

metal coin?

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U.S. Dollar Bil ls

• In modern U.S. economy we use dollar bills and coins as medium of exchange.

• Dollar bills are called “Federal Reserve Note” because they are IOU (note payable) issued by the Federal Reserve Banks. They are assets for holders (households, firms, governments, and foreigners) of IOUs, but liabilities for issuers (the Federal Reserves) of IOUs.

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Money and Generally Accepted

• Money must be generally accepted by definition.• In modern U.S. economy we use worthless paper

money rather than valuable commodity.• We accept worthless paper money because we

expect they are accepted by others.• If no one accepts money, money will seize its primary

function in an economy.• The government guarantees its general acceptance

by making it “legal tender”.

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Money as Unit of Account

• In the U.S. a value (price) of every good and service is quoted in dollars and cents.• By using “dollar and cent” as a standard unit of

value, we can easily compare value of one good with others.

• Ex. How much is a Big Mac? Around $2.19. How much is a cheeseburger? About 99¢. So, you know which is more valuable.

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Money As Store of Value

• Money can keep its purchasing power over time.

• When you receive your paycheck, you do not need to spend every dollar right at that moment. You can keep it in bank account or cash on hand, and spend it later.

• Money is not unique in this function. There are many assets (financial assets and commodity) which can serve as store of value.

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Money As Store of Value

Any assets can serve as store of value. One may serve as a better store of value than another.

− Ex. Any physical and financial assets such as Yugioh-card, Saving account, bonds, stocks, gold, house

• Liquidity: the relative ease and speed with which an asset can be converted into medium of exchange−Money is the most liquid store of value.

• Purchasing Power: Amount of goods and services money can purchase.

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Value of Money

• Prices affect purchasing power of money• Hyperinflation renders money unacceptable• Zimbabwe experienced 80 billion percent inflation

rate in 2008• When there are too many money in public, prices

of goods increase and a purchasing power of money falls.

• Federal Reserve is responsible for controlling quantity of money and maintaining a value of money

LO3

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Evolution of Payment System

• Money is mainly used for making payments.• Over time, methods of payment evolve as the

technology and economy change.• Changes in payment system reduces

transactions cost (less time and effort to exchange) and create even better medium of exchange.

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Tradit ional Methods of Payments

• Commodity Money• Money made up of precious metals or other

valuable commodity• Physical goods that have a value as a

commodity equal to its value as a medium of exchange

• Fiat money• Paper currency decreed by government as legal

tender• Money which does not have a value as a

commodity equal to its value as a medium of exchange

• Checks

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Electronic Payment

You can also make payments electronically.• Debit cards• Electronic check (conversion)• Payment by cell phone (Google Wallet, Apple Pay)• Electronic Funds Transfer (EFT)• Electronic Bill Presentment and Payment (EBPP)• Stored-value card (Prepaid card & Smart card)• Electronic cash (e-cash):

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Measuring Money Supply

• Money supply (Money aggregate): Amount of money in economy

• Why measuring money supply?• How people spend is an important factor affecting the

whole economy. How much people spend depends partly on how much money they have for purchasing (medium of exchange). Through the monetary policy the Federal Reserve affects people’s spending by changing the amount of money in the U.S. economy.

• In order to control money, the Federal Reserve must first know how much money are in an economy.

Fed → Money → Spending → Economy

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Money Definit ion M1

• M1 includes• Currency (bills and coins)• Checkable deposits

• Institutions offering checkable deposits• Commercial banks• Savings and loan associations• Mutual savings banks• Credit unions

LO2

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Money Definit ion M2

• M2 includes

• M1 plus near-monies

• Savings deposits including money market deposit accounts (MMDA)

• Small-denominated time deposits (CDs)

• Money market mutual funds (MMMF)

LO2

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Money Definit ions

LO2

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Functions of Central Bank

• Each country has one central bank which is responsible for• Conducting monetary policy.• Regulating an amount of money supply in economy.• Supervising banks.

• In addition, a central bank may • Regulate financial markets and financial institutions other

than banks.• Control foreign exchanges and foreign reserves.• Act as the government’s bank.• Advising the government on the economic policy.

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Federal Reserve System

• In the United States, the federal reserve system (the Fed) acts as the central bank.

• In most developed countries there is only one central bank. However, in the U.S. the Fed is divided into various organizational components for check and balance.• The federal government have attempted to establish a

single central bank twice, but due to fear of concentration of economic and monetary power, the Congress abolished such institutions.

• In 1931 the Congress established the twelve regional Federal Reserve banks.

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Mission of Federal Reserve System

The Federal Reserve System is the central bank of the United States. It was founded by Congress in 1913 to provide the nation with a safer, more flexible, and more stable monetary and financial system. Over the years, its role in banking and the economy has expanded. Today, the Federal Reserve's duties fall into four general areas:• conducting the nation's monetary policy by influencing the monetary

and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates

• supervising and regulating banking institutions to ensure the safety and soundness of the nation's banking and financial system and to protect the credit rights of consumers

• maintaining the stability of the financial system and containing systemic risk that may arise in financial markets

• providing financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation's payments system

From http://www.federalreserve.gov/aboutthefed/mission.htm

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Functions of Federal Reserve System

Like any other central banks, the Federal Reserve System performs various important functions through its organizational components.• Provide financial services to banks• Clear checks

• Act as government’s bank• Print new currencies and withdraw old ones• Maintain government accounts

• Regulate banking and financial industries• Conduct monetary policy

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Organizational Structure of the Federal Reserve System

Three main organizational components of the Federal Reserve System:• Regional Federal Reserve banks• Board of Governors• Federal Open Market Committee

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Federal Reserve – Banking System

Commercial BanksThrift Institutions

(Savings and Loan Associations,Mutual Savings Banks,

Credit Unions)

The Public(Households and

Businesses)

12 Federal Reserve Banks

Board of Governors

Federal Open Market Committee

LO4

Federal Reserve System

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Regional Federal Reserve Banks

• The U.S. is divided into twelve Federal Reserve districts.• Each district has one Federal Reserve bank.

• Ex. Federal Reserve Bank of Richmond covers states of Maryland, Virginia, North Carolina, and South Carolina.

• By dividing into twelve districts, no one Federal Reserve bank can dominate in the U.S. economy.• Federal Reserve Bank of New York covers only the state

of New York, but holds one-quarter of the assets of the Federal Reserve System.

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Regional Federal Reserve Banks

The 12 Federal Reserve Banks

LO4

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Functions of Regional Federal Reserve Banks

• Regional Federal Reserve banks act like “bankers’ bank”• Clearing checks• Hold deposits of banks as reserves• Setting a discount rate and making discount loans to banks

in their districts• Issuing new currency and withdrawing damaged currency• Examining bank holding companies and state-chartered

member banks• Acting as liaisons between the business community and the

Federal Reserve System• Collecting data on local business conditions• Researching for the conduct of monetary policy

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U.S. Dollar Bil ls

• U.S. dollar bills are issued by the Federal Reserve banks.

Emblem of the Federal Reserve System

“Federal Reserve Note” means IOU (note payable) issued by the Federal Reserve System.

Federal Reserve Bank of San Francisco issued this note.

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Member Banks and Other Depository Institutions

• All national banks are required to be members of the Federal Reserve System.• Currently, about 38% of the commercial banks are

members of the Federal Reserve System.• Member banks are stockholders of the regional Federal

reserve bank.

• Depository Institutions Deregulation and Monetary Control Act of 1980 • Requires all depository institutions (member and

nonmember banks) to hold required reserves.• Makes check-clearing services and the discount window

available for all depository institutions.

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Board of Governors

• The Board of Governors acts like the headquarter of the Federal Reserve System.• Located in Washington, D.C.• Seven members of the Board of Governors are

appointed by the president of the United States and confirmed by the Senate.

• Each member serves for nonrenewable 14-year term and comes from different districts.• Why 14-year term? To avoid political pressure from the

President and the Congress.• Why from different districts? To prevent one district

over-representing its interest over other districts.

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Chairman of Board of Governors

• The chairman of the Board of Governors is chosen from the seven governors.

– Serves for renewable four-year term.

– Acts like the CEO of the Federal Reserve System.

– Janet Yellen is the current chairman.

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Functions of Board of Governors

• Sets the reserve requirement• Approves the discount rate requested by the Federal Reserve

banks• Advise the president of the United States, testifies in Congress,

and speaks for the Federal Reserve System for the media.• Represents the United States in negotiations with foreign

governments on economic matters• Provides economic analysis for the conduct of monetary policy• Sets margin requirements• Approves bank mergers and applications for new activities and

specifies the permissible activities of bank holding companies• Supervise the activities of foreign banks in the U.S.

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Federal Open Market Committee

• The Federal Open Market Committee• Meets eight times a year• Makes decisions regarding the conduct of open market

operations, including setting a target rate on federal funds• Consists of twelve members: the seven members of the

Board of Governors, the president of the Federal Reserve Bank of New York, and the presidents of four other Federal Reserve banks.

• Directed by the chairman of the Board of Governors

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Monetary Policy and FOMC

• The Federal Open Market Committee (FOMC) is the major body of monetary policy decision-making at the Federal Reserve.• Twelve members of FOMC vote for or against the

proposed monetary policy.• The chairman of the Fed, acting as the chairman of the

FOMC, announces in public about the decision.• “Tightening of monetary policy” (lowering money supply

growth – “hawkish policy”) is accompanied by a rise in the federal funds rate, while “easing of monetary policy” (increasing money supply growth – “dovish policy”) is done by lowering the federal funds rate.

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Banking System

• Commercial banks and thrift institutions• 6,000 commercial banks• 8,500 thrift institutions (Savings & Loans,

Mutual saving banks) and credit unions• Chartered by the Federal government

(National bank) or state governments (State bank)

LO4

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Financial Institutions

LO4

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Institution Description Examples

Commercial Banks

State and national banks that provide checking and savings accounts and make loans

JP Morgan Chase, Bank of America, Citibank, Wells Fargo

Thrifts Savings and loan associations, mutual savings banks, credit unions that offer checking and savings accounts and make loans

Charter One, New York Community Bank

Insurance Companies

Firms that offer policies through which individuals pay premiums to insure against lose

Prudential, New York Life, Northwestern Mutual, Hartford

Mutual Fund Companies

Firms that pool customer deposits to purchase stocks or bonds

Fidelity, Vanguard, Putnam, Janus, T Rowe Price

Pension Funds Institutions that collect savings from workers throughout their working years and then invest the funds to pay retirement benefits

TIAA-CREF, Teamsters’ Union, CalPERs

Securities Firms Firms that offer security advice and buy and sell stocks and bonds for clients

Merrill Lynch, Smith Barney, Charles Schwab

Investment Banks Firms that help corporations and governments raise money by selling stocks and bonds

Goldman Sachs, Morgan Stanley, Deutsche Bank, Nomura Securities

Major Categories of Financial Institutions

LO8

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Federal Reserve Independence

• Established by Congress as an independent agency

• Protects the Fed from political pressures• Enables the Fed to take actions to increase

interest rates in order to stem inflation as needed

LO5

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The Financial Crisis of 2007 and 2008

• Mortgage Default Crisis• Many causes

• Government programs that encouraged home ownership

• Declining real estate values• Bad incentives provided by mortgage-

backed bonds

LO6

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The Financial Crisis of 2007 and 2008

• Securitization- the process of slicing up and bundling groups of loans into new securities (mortgage backed securities)

• As loans defaulted, the system collapsed• “Underwater” homeowners abandoned

homes and mortgages

LO6

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The Financial Crisis of 2007 and 2008

• Failures and near-failures of financial firms• Countrywide: second largest lender• Washington Mutual: largest lender• Wachovia• Lehman Brothers: Investment banks which issued a large

number of mortgage banked securities• Shadow banking: non-bank financial institutions that

provide services similar to commercial banks but outside normal financial regulations

• AIG (American International Group): Insurance company which insured mortgage backed securities by CDSs (Credit default swaps)

LO6

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The Financial Crisis of 2007 and 2008

• Troubled Asset Relief Program (TARP)• Allocated $700 billion to make emergency

loans• Saved several large institutions (e.g. Citi

Group, GM, Fannie Mae) from failure (Too Big to Fail)

LO7

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The Financial Crisis of 2007 and 2008

• The Fed’s lender-of-last-resort activities• Primary Dealer Credit Facility• Term Securities Lending Facility• Asset-Backed Commercial Paper Money Market

Mutual Fund Liquidity Facility• Commercial Paper Funding Facility• Money Market Investor Funding Facility• Term Asset-Backed Securities Loan Facility• Interest Payments on Reserves

LO7

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Post-Crisis U.S. Financial Services

• Wall Street Reform and Consumer Protection Act of 2010• Passed to help prevent many of the

practices that led to the crisis• Critics say it adds heavy regulatory costs

LO8