Carlos Andres Rodriguez Herrera 2 1 23 Principles of Macroeconomics ECON 2002 01 Chapter 15 Money Banking and Central Banking Introduction During the early 2000s bank managers in the U S sought to boost total deposits at their institutions In the early 2010s their efforts paid off Total deposits at U S banks had increased by about 10 percent Since then however banks have generally reversed course Most banks have halted their efforts to attract more deposits and a few have begun discouraging increases in funds held on deposit What accounts for this abrupt change In chapter 15 you will learn the answer to this question Learning Objectives Identify key properties that any good that functions as money must possess Explain official definitions of the quantity of money in circulation Define the fundamental functions of money Understand why financial intermediaries such as banks exist Describe the basic structure and functions of the Federal Reserve System Determine the maximum potential extent that the money supply will change following a Federal Reserve monetary policy action Explain the essential features of federal deposit insurance Chapter Outline The Functions of Money Properties of Money Defining Money Financial Intermediation and Banks The Federal Reserve System The U S Central Bank Fractional Reserve Banking the Federal Reserve and the Money Supply Federal Deposit Insurance The Functions of Money The functions of money Medium of exchange Unit of accounting Store of value purchasing power Standard of deferred payment Medium of Exchange Any item that sellers will accept as payment Money facilitates exchange by reducing transaction costs associated with means of payment uncertainty a Permits specialization facilitates efficiencies Barter The Ohio State University 1 The direct exchange of goods and services for other goods and services without the use of money Simply a direct exchange requires a double coincidence of wants Unit of Accounting A measure by which prices are expressed The common denominator of the price system A central property of money 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 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 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 Question Answer What is the cost of holding money it s opportunity cost It is the alternative interest yield obtainable by holding some other asset Transactions Deposits Checkable and debatable 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 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 Currency and transactions deposits are money because of their Acceptability Predictability of value Defining Money Money is important Money supply 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 Carlos Andres Rodriguez Herrera 2 1 23 The amount of money in circulation Economists use two basic approaches to define and measure money The transactions approach The liquidity approach 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 The transactions approach to measuring money M1 Currency and coins Transactions checkable deposits Traveler s checks M1 Transactions deposits a Any deposits in a thrift institution or a commercial bank on which a check may be written or debit card used Thrift Institution a Financial institutions that receive most of their funds from the savings of the public Traveler s Checks a 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 The liquidity approach to measuring money M2 Assets that are almost money Highly liquid Easily converted to cash Time deposits are an example The liquidity approach M2 is equal to M1 plus Savings deposits Small denomination 100 000 time deposits Balances in retail money market mutual funds MZM money at zero maturity Entails adding deposits without set maturities to M1 Includes all money market funds but excludes all deposits with fixed maturities Financial Intermediation and Banks Most nations have a banking system that encompasses two types of institutions One type consists of private banking institutions The other type of institution is a central bank 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 Direct finance Indirect finances Individuals purchase bonds from a business Individuals hold money in a bank The bank lends the money to a business Financial Intermediation The Ohio State University 3 Financial Intermediaries The process by which financial institutions accept savings from businesses households and governments and lend the savings to other businesses households and governments Institutions than transfer funds between ultimate lenders savers and ultimate borrowers Why might people wish to direct their funds through a bank instead of lending directly to a business Questions Answers Asymmetric information Adverse selection Moral hazard Larger scale and lower management costs Asymmetric Information Information possessed by one party in a financial transaction but not by the other The likelihood that borrowers may use their borrowed funds for high risk projects Adverse Selection 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