Chapter 15 Money, Banking, and Central Banking Introduction Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley have been big names on Wall Street for years. Known as investment banks they were created during the Great Depression and over the years, grew into financial powerhouses. In 2008, however, when values of mortgage loans and securities issued by government-supported Freddie Mac and Fannie Mae plummeted, so did previously rock-solid investment banks. In this chapter you will learn about firms called financial intermediaries. 15-2 Learning Objectives Define the fundamental functions of money Identify key properties that any good that functions as money must possess Explain official definitions of the quantity of money in circulation 15-3
Learning Objectives (cont'd) Understand why financial intermediaries such as banks exist Explain the essential features of federal deposit insurance Describe the basic structure and functions of the Federal Reserve System 15-4 Chapter Outline The Functions of Money Properties of Money Defining Money Financial Intermediation and Banks Federal Deposit Insurance The Federal Reserve System: The U.S. Central Bank 15-5 Did You Know That... It is illegal to carry on your person more than $5 worth on pennies or nickels out of the U.S.? Recent upswings in prices of zinc and copper have pushed the value of these metals used in the coins above the coins face value. By banning the international transport and melting of pennies and nickels, the government is trying to prevent people from profiting from selling coins that are already generating losses to taxpayers. 15-6
Did You Know That (cont d) Coins, paper currency, and bank accounts from which people transmit debit-card and check payments are included in the Federal Reserve s measure of the total amount of money that we can use to purchase goods and services. Money has been important to society for thousands of years and is part of our everyday existence. 15-7 Did You Know That (cont d) Money Any medium that is universally accepted in an economy both by sellers of goods and services and by creditors as payment for debts 15-8 Table 15-1 Types of Money 15-9
The Functions of Money The functions of money Medium of exchange Unit of accounting Store of value (purchasing power) Standard of deferred payment 15-10 The Functions of Money (cont'd) Medium of Exchange Any item that sellers will accept as payment Money facilitates exchange by reducing transaction costs associated with means-ofpayment uncertainty. Permits specialization, facilitates efficiencies 15-11 The Functions of Money (cont'd) Barter The direct exchange of goods and services for other goods and services without the use of money Simply a direct exchange Double coincidence of wants 15-12
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 15-13 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 15-14 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 15-15
Properties of Money 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. 15-16 Figure 15-1 Degrees of Liquidity 15-17 The Properties of Money (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. 15-18
Properties of Money (cont d) Questions What backs money? Is it gold, silver, or the federal government? Answer Your confidence 15-19 Properties of Money (cont d) Transactions Deposits Checkable and debitable account balances in commercial banks and other types of financial institutions, such as credit unions and mutual savings banks Any accounts in financial institutions on which you can easily transmit debit-card and check payments without many restrictions 15-20 Properties of Money (cont d) Fiduciary Monetary System A system in which currency is issued by the government and its value rests on the public s confidence that it can be exchanged for goods and services The Latin fiducia means trust or confidence 15-21
Properties of Money (cont d) Currency and transactions deposits are money because of their Acceptability Predictability of value 15-22 International Example: A Virtual Money Becomes Widely Accepted in China In China, almost 250 million people regularly conduct exchanges using electronic QQ coins. Originally, QQ coins were a company marketing ploy, used to finance purchases of virtual flowers, cellphone ringtones, etc. Recently, people have begun accepting QQ coins in exchange for physical items, such as CDs, movie DVDs, and cosmetics. Is there any particular reason that moneys that people find acceptable in exchange must be issued by a government? 15-23 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 15-24
Economists use two basic approaches to define and measure money. The transactions approach The liquidity approach 15-25 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 15-26 The transactions approach to measuring money: M1 Currency Checkable (transaction) deposits Traveler s checks not issued by banks 15-27
Figure 15-2 Composition of the U.S. M1 and M2 Money Supply, 2009, Panel (a) Sources: Federal Reserve Bulletin; Economic Indicators, various issues; author s estimates. 15-28 Figure 15-2 Composition of the U.S. M1 and M2 Money Supply, 2009, Panel (b) Sources: Federal Reserve Bulletin; Economic Indicators, various issues; author s estimates. 15-29 M1 Currency Minted coins and paper currency not deposited in financial institutions The bulk of currency in circulation actually does not circulate within the U.S. borders. 15-30
M1 Transactions deposits Any deposits in a thrift institution or a commercial bank on which a check may be written or debit card used Thrift Institution Financial institutions that receive most of their funds from the savings of the public 15-31 M1 Traveler s Checks Financial instruments purchased from a bank or a nonbanking organization and signed during purchase that can be used as cash upon a second signature by the purchaser 15-32 The liquidity approach to measuring money: M2 Assets that are almost money Highly liquid Easily converted to cash Time deposits are an example 15-33
The liquidity approach: M2 is equal to M1 plus 1. Savings and small denomination time deposits 2. Balances in retail money market mutual funds 3. Money market deposit accounts (MMDAs) 15-34 M2 Savings Deposits Interest-earning funds that can be withdrawn at any time without payment of a penalty Depository Institutions Financial institutions that accept deposits from savers and lend those funds out 15-35 M2 Money Market Deposit Accounts (MMDAs) Accounts issued by banks yielding a market rate of interest with a minimum balance requirement and a limit on transactions They have no minimum maturity 15-36
M2 Time Deposit A deposit in a financial institution that requires notice of intent to withdraw or must be left for an agreed period Early withdrawal may result in a penalty CD Time deposit with fixed maturity 15-37 M2 Money Market Mutual Funds Funds obtained from the public that investment companies hold in common Funds used to acquire short-maturity credit instruments CD s, U.S. government securities 15-38 Question Which definition of money correlates best with economic activity? Answer M2, although some businesspeople and policymakers prefer MZM 15-39
MZM (money-at-zero-maturity) MZM entails adding deposits without set maturities to M1. MZM includes all money market funds but excludes all deposits with fixed maturities. 15-40 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. 15-41 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. 15-42
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 15-43 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 Financial intermediaries Institutions than transfer funds between ultimate lenders (savers) and ultimate borrowers 15-44 Figure 15-3 The Process of Financial Intermediation 15-45
Financial Intermediation and Banks (cont'd) Question Why might people wish to direct their funds through a bank instead of lending directly to a business? Answers Asymmetric information Adverse selection Moral hazard Larger scale and lower management costs 15-46 Financial Intermediation and Banks (cont'd) Asymmetric Information Information possessed by one party in a financial transaction but not by the other Adverse Selection The likelihood that borrowers may use their borrowed funds for high-risk projects 15-47 Financial Intermediation and Banks (cont'd) Moral Hazard The possibility that a borrower might engage in riskier behavior after a loan has been obtained Larger scale and lower management costs People can pool funds in an intermediary, reducing costs, risks. Pension funds and investment companies are examples. 15-48
E-Commerce Example: Watch Out Banks! Here Come Zopa and Circleone At Zopa.com and Circleone.com, lenders and borrowers can engage in transactions without dealing with traditional financial intermediaries. Both Web sites systems rate prospective borrowers according to credit scores and provide estimated loan default rates. Thus, lenders can charge less creditworthy applicants higher interest rates. 15-49 E-Commerce Example: Watch Out Banks! Here Come Zopa and Circleone (cont d) These electronic financial intermediaries profit by charging fees from 1 to 1.5% of the total amount of a borrower s loan. Zopa divides loans into separate shares so that a lender can share the risks of a loan with other lenders. How does this practice potentially help limit each lender s exposure to moral hazard risk? 15-50 Financial Intermediation and Banks (cont'd) Liabilities Amounts owed The sources of funds for financial intermediaries 15-51
Financial Intermediation and Banks (cont'd) Assets Amounts owned The uses of funds by financial intermediaries 15-52 Table 15-2 Financial Intermediaries and Their Assets and Liabilities 15-53 Financial Intermediation and Banks (cont'd) Payment Intermediaries Institutions that facilitate transfers of funds between depositors who hold transactions deposits with those institutions Payment Intermediation A recent study revealed that revenues derived from debitcard and checking transfer services accounted for 28% of the bank s total earnings. Another 10% of earnings were generated from processing payments for credit cards, stocks, and bonds. 15-54
Figure 15-4 How a Debit-Card Transaction Clears 15-55 Federal Deposit Insurance In 1933, at the height of bank failures, the Federal Deposit Insurance Corporation (FDIC) was founded to insure the funds of depositors and remove the reason for runs on banks. The FDIC is a government agency that insures the deposits held in banks and most other depository institutions; all U.S. banks are insured this way. 15-56 Federal Deposit Insurance (cont d) As can be seen in Figure 15-5, bank failure rates dropped dramatically after passage of this legislation. From WWII to 1984, fewer than nine banks failed per year. From 1985 to the beginning of 1993, however, 1,065 commercial banks failed averaging 120 bank failures per year. 15-57
Figure 15-5 Bank Failures Source: Federal Deposit Insurance Corporation. 15-58 Federal Deposit Insurance (cont d) Bank Runs Attempts by many of a bank s depositors to convert transactions and time deposits into currency out of fear that the bank s liabilities may exceed its assets. 15-59 Financial Deposit Insurance (cont d) The FDIC charges premiums to depository institutions based on their total deposits. These premiums go into funds that would reimburse depositors in the event of bank failures. This bolsters depositors trust in the system and gives them incentive to leave their deposits in the bank, even in the face of talk of bank failures. 15-60
Financial Deposit Insurance (cont d) Until the 1990s, all insured depository institutions paid the same fee for coverage, regardless of how risky their assets were. Banks then had an incentive to invest in more assets of higher risk (and higher yield). The FDIC and other federal agencies possess regulatory powers to offset the risk-taking temptations. Higher capital requirements were imposed in the early 1990s and adjusted in 2000. 15-61 Financial Deposit Insurance (cont d) Adverse selection deposit insurance shields depositors from the potential adverse effects of risky decisions, so depositors are willing to accept riskier investment strategies by their banks. Moral hazard Insured depositors know they won t suffer losses if their bank fails, so they have little incentive to monitor their bank s activities. Insured banks have incentives to take on more risks than they otherwise would. 15-62 Financial Deposit Insurance (cont d) The results of moral hazard The S&L crisis of the mid-1980s More than 1,500 savings and loan associations failed The estimated taxpayer cost was $200 billion 15-63
Financial Deposit Insurance (cont d) The Federal Deposit Insurance Reform Act of 2005 Expanded coverage of the federal deposit insurance and potentially increased moral hazard problems. Provides the FDIC with improved tools for addressing moral hazard risks: Deposit Insurance Fund (DIF) Altered rule on FDIC deposit insurance premiums 15-64 The Federal Reserve System: The U.S. Central Bank 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 15-65 The Federal Reserve System: The U.S. Central Bank (cont d) 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; signed by President Woodrow Wilson 15-66
The Federal Reserve System: The U.S. Central Bank (cont d) Organization of the Fed Board of Governors 7 members, 14-year terms Chairman Ben Bernanke Federal Reserve Banks (12 Districts) 25 branches Federal Open Market Committee (FOMC) Board of governors plus 5 presidents of district banks 15-67 Figure 15-6 Organization of the Federal Reserve System Source: Board of Governors of the Federal Reserve System, The Federal Reserve System: Purposes and Functions, 7th ed. (Washington, D.C., 1984), p. 5. 15-68 Figure 15-7 The Federal Reserve System Source: Board of Governors of the Federal Reserve System. 15-69
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 15-70 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 8. The Fed intervenes in foreign currency markets 15-71 The Federal Reserve System: The U.S. Central Bank (cont d) Lender of last resort The Federal Reserve s role as an institution that is willing and able to lend a temporary illiquid bank that is otherwise in good financial condition to prevent the bank s illiquid position from leading to a general loss of confidence in that bank or in others. 15-72
Issues and Applications: The Crash of 2008 and the Decline of Investment Banking Since the 1990 s, two of the largest financial intermediaries in the world have been Fannie Mae and Freddie Mac. These institutions have specialized in buying hundreds of billions of dollars of private mortgage loans from banking institutions with funds that they raised by issuing mortgage-backed securities purchased by private investors. Both Fannie Mae and Freddie Mac have been government sponsored enterprises. 15-73 Issues and Applications: The Crash of 2008 and the Decline of Investment Banking (cont'd) This meant that if either institution became unable to honor its obligations, most investors anticipated that the federal government would step in to bail them out. In the summer and fall of 2008, this is exactly what happened. Between 2007 and 2008, average U.S. housing prices declined by more than 15%. When people stopped paying on their mortgages, receipts by Fannie Mae and Freddie Mac plummeted. Both experienced billions of dollars of losses. Because investors had known that the government stood behind the institutions mortgage-backed securities, they were willing to regard them as nearly free of risk. 15-74 Issues and Applications: The Crash of 2008 and the Decline of Investment Banking (cont d) This had given Fannie Mae and Freddie Mac an incentive to issue too many of these securities and to purchase too many low-quality, risky mortgages from banking institutions. A similar problem also caused investment banks to cease to exist. Why do you suppose that many economists suggest that a major U.S. government push for Fannie Mae and Freddie Mac to encourage more lending to lower-income households in the 2000s helped to enlarge the moral hazard problem? 15-75
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 15-76 Summary Discussion of Learning Objectives (cont'd) Official definitions of the quantity of money in circulation M1: the narrow definition, focuses on money s role as a medium of exchange M2: a broader one, stresses money s role as a temporary store of value 15-77 Summary Discussion of Learning Objectives (cont'd) Why financial intermediaries such as banks exist Asymmetric information can lead to adverse selection and moral hazard problems Savers benefit from the economies of scale 15-78
Summary Discussion of Learning Objectives (cont'd) Features of Federal Deposit Insurance Provides deposit insurance by charging some depository institutions premiums based on the value of their deposits. These funds are placed in accounts for use in reimbursing failed banks depositors. This creates adverse selection and moral hazard problems. 15-79 Summary Discussion of Learning Objectives (cont'd) The basic structure of the Federal Reserve System 12 district banks with 25 branches Governed by Board of Governors Federal Open Market Committee 15-80 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 15-81