Transcript Ch13andCh14 Notes

Ch. 13: Money and the
Banking System and Ch.
14: The Federal Reserve
and Monetary Policy
Section 13.1: Money
• Functions of Money
– Money is anything that people commonly
accept in exchange for goods and services
• Money was developed to overcome the problems
associated with bartering (exchanging goods and
services w/out using money)
– In the US, money has three functions:
• Serves as a medium of exchange
• Serves as a standard of value
• Serves as store of value
Section 13.1: Money
• Functions of Money continued
– Medium of Exchange
• Any item that sellers accept as payment for goods and
services
– Money assists in the buying & selling of goods and services b/c
buyers know that sellers will accept money in payment for
products
– Standard of Value
• Money provides people w/ a way to measure the relative
value of goods & services by comparing prices
– Store of Value
• Money can be saved (stored for later use)
– For money to be a store of value it must be nonperishable (it
can’t deteriorate while being saved) and keep its value over
time (purchasing power must remain mostly constant)
Section 13.1: Money
• Characteristics of Money
– The five major characteristics of money are:
• Durability
• Portability
• Divisibility
• Stability on value
• Acceptability
– Durability
• Refers to money’s ability to be used over and over
again with little wear and tear
Section 13.1: Money
• Characteristics of Money continued
– Portability
• Money’s usefulness may depend on its portability
or ability to be carried from one place to another
– US paper money is small and lightweight making it very
portable
– Divisibility
• Refers to money’s ability to be divided into smaller
units
– The divisibility of the dollar into cents enables consumers
to compare prices of various products
» Ex: Video game at Meijer costing $59.99 while at
Wal-Mart that same game costs $59.88
Section 13.1: Money
• Characteristics of Money continued
– Stability in Value
• For money to be useful as a store of value it must
be stable in value
– Stability in value encourages savings and maintains
money’s purchasing power
– Acceptability
• Acceptability means that people are willing to
accept money in exchange for their goods and
services
– People accept money b/c they know that they, in turn
can spend it for other products
Section 13.1: Money
• Sources of Money’s Value
– Money must have and retain value
• Economists have identified three sources for the
value of money
– Commodity Money
• An item that has a value of its own (as a
commodity) and that is used as money is called
commodity money
– Precious metals like gold and silver have been used as
money
– Commodity money can be the most convenient
commodity available like tobacco (the lead crop) used as
money in Virginia in the 1600s
Section 13.1: Money
• Sources of Money’s Value continued
– Representative Money
• An item that has value b/c it can be exchanged for
something of value is representative money
– The items only value is the value they represent
– Ex: the Massachusetts Bay Colony gave out bills of credit to
colonists that loaned the colonial government money to fight in
King William’s war
» These bills of credit could be redeemed for money or specie
(gold or silver) at the end of the war
– Fiat Money
• Value is attached to fiat money b/c a government fiat
(decree) says that it has value
– US dollars and coins are fiat money
• The value of fiat money ultimately stems from citizen’s faith
in the US government
• The majority of nations use fiat money called currency
(coins and paper bills) as money
Section 13.1: Money
• Forms of Money
– Coins and Paper Money
• Coins and paper money make up US currency
– Coins are made by the US mint
– Paper bills are printed by the Bureau of Engraving and
Printing
– Although the US gov’t held gold and silver as partial
backing for paper money until 1971, today US currency
is not redeemable for gold or silver
– Demand Deposits
• Checking accounts make up the largest segment
of the US money supply
– B/c checks can be paid “on demand” (at anytime) they
are referred to as demand deposits
Section 13.1: Money
• Forms of Money continued
– Near Money
• Many financial assets are similar to money
– These assets such as savings accounts and time deposits
are referred to as near money and not always counted as
part of the nation’s money supply
» Although such assets are easily accessible, these
accounts can’t be used directly to buy goods or to
pay debts
» B/c funds in these accounts can easily be converted
into cash, they are considered near money
Section 13.3: US Banking Today
• Types of Financial Institutions
– The most common types of financial institutions
have included:
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Commercial banks
Savings and loan associations
Mutual savings banks
Credit unions
– Commercial banks
• The main functions of commercial banks today are to lend
money, accept deposits, and transfer money among
businesses, other banks, & financial institutions, and
individuals
– Commercial banks make up almost 40% of all mortgage loans
and 50% of all other loans
Section 13.3: US Banking Today
• Types of Financial Institutions continued
– Savings and Loan Associations (S&Ls)
• Were established to lend money & accept deposits
– Members of S&Ls deposit money into a large general
fund and take turns borrowing from that fund and paying
it back
– With time and new federal laws and regulations, S&Ls
began to offer many of the same services as commercial
banks
– Mutual Savings Banks
• Created to serve people who wished to make
small deposits that large commercial banks did
not want to handle
– Offer slightly lower interest rates than commercial banks
Section 13.3: US Banking Today
• Types of Financial Institutions continued
– Credit Unions
• Employees of large businesses and institutions
and members of large labor unions often belong
to credit unions
– When credit union members deposit money they
purchase shares that pay interest
» Credit unions use this savings pool to supply low-cost
loans to their members
– Credit unions usually offer higher interest rates on
savings and lower interest rates on loans
» Personal, automobile, and home improvement loans
are the majority of credit union loan activity
Section 13.3: US Banking Today
• Automation
– The reliance on computers to handle transactions
• Also called electronic funds transfer (EFT), automated
banking increased banks’ efficiency by allowing them to
execute banking transactions electronically by computer
– This process allows transactions to affect accounts immediately
and saves banks money by decreasing the numbers of workers
needed
– The four main types of automated banking are:
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•
•
•
Automated teller machines (ATMs)
Automatic clearing house services
Point-of-sale terminals
Home banking
Section 13.3: US Banking Today
• Automation continued
– Automated Teller Machines (ATMs)
• Machines that allow people to deposit or withdraw money
from their bank account w/out needing to see a bank teller
using an ATM card
– Automatic Clearing House Services
• A system that transfer money from a customer’s account to
those of his creditors (those he owes money to)
– Point-of-Sale Transactions
• Involves the direct transfer of money from a buyer’s bank
account to a seller’s bank account
– Ex: Using a debit card
– Home Banking
• Home banking services link personal computers in homes w/
the bank’s computers allowing people to monitor their
accounts, transfer funds, and pay bills
Section 13.3: US Banking Today
• Deregulation
– Prior to the 2008 Financial Collapse, the trend of
deregulation (reducing government restrictions on
banks was used to increase competition between
banks) was a popular policy with the Federal
Government
• Financial Troubles in Banking
– Loan defaults
• When a borrower is unable to repay the funds they had
borrowed
– This failure to make a payment on your loan is called default
– Bank Failures
• Bank banks go out of business due to bad investments
and/or depletion of customers
Section 14.1: The Federal Reserve System
• Panic of 1907
– Two causes:
• Cause 1: The nation’s monetary system at the
time has no mechanism for expanding the amount
of money in circulation
– This meant that business expansion was restricted b/c
consumers & businesses competed for a fixed supply of
loanable funds
» As individuals & businesses found themselves unable
to borrow money, they began to withdraw their
savings (bank run) causing banks to fail and a giant
financial panic taking hold
Section 14.1: The Federal Reserve System
• The Panic of 1907 continued
– Two causes:
• Cause 2: The system of pyramided reserves
failed
– In a pyramided reserves system, virtually all smaller,
local banks deposit some of their reserves at larger city
banks
» Those city banks than deposit some of their reserves
in the super-banks in cities like New York and
Chicago
– During recessions, financial panic runs require smaller
banks to withdraw their deposits from larger banks
» As happened in the Panic of 1907, the reserves of the
larger banks could not cover the sudden demand for
cash b/c they had loaned out too much of the
deposits
» Thus, many businesses went bankrupt and many
depositors lost their savings
Section 14.1: The Federal Reserve System
• The Panic of 1907 continued
– Response to the panic
• 1908: the newly created National Monetary Commission
recommends a new central bank
• 1913: Congress passes the Federal Reserve Act, which
created a central bank called the Federal Reserve (The Fed)
• Role of the Fed
– The Fed’s stated goals were “to furnish an elastic
currency and…to establish a more effective
supervision of banking in the US
• The Fed achieves this goal through their main purposes
– Supervising member banks
– Holds cash reserves representing funds available for short-term
borrowing by commercial banks or by the government
» The cash reserves guarantees that money is available in
the economy when needed
– The Fed moves money into and out of circulation to stabilize
the banking system
Section 14.1: The Federal Reserve System
• Characteristics of the Fed
– The Fed is not the only central bank in the world, but has
several features that makes it distinct from other countries
central banks
– These features include:
• A lack of a single central bank
– The Federal Reserve System relies on district banks to carry out the
banking policies developed at the national level
• Ownership & control by member banks
– The US government does not own stock in the Fed
» Instead, member banks own stock in the Fed banks in their
respective districts
» Thus, the Fed operates w/ a high degree of independence from
political authorities although it ultimately answers to Congress
– Optional membership in the Fed for some banks
» All nationally charted banks are required to join the Fed, but statecharted banks have the option not to join the Federal Reserve
System
» Only 40% of commercial banks are part of the system
Section 14.1: The Federal Reserve System
• Organization of the Fed
– To prevent a single central bank from holding too much power
over the economy, the Fed is organized on two level: national &
district
– National Level
• The Fed makes its key decisions at the national level
– The main decision-making bodies are the Board of Governors & the
Federal Open Market Committee (FOMC)
• The Board of Governors is the highest policy making body that
supervises the Fed’s banking services & issues polices designed to
regulate the supply of money in the economy
– The president appoints and the Senate confirms the 7 members of the
board
– Each governor is appointed to a 14-year term
– The board’s chairperson serves a four-year term
• The seven members of the Board of Governors and the president of
the New York Federal Reserve Bank are permanent members of
FOMC
– The remaining four members are district Federal Reserve bank
presidents who serve one-year terms on a rotating basis
Section 14.1: The Federal Reserve System
• Organization of the Fed continued
– District Level
• There are 12 district and separate Federal Reserve
banks
– Each of these banks serve a designated geographic
region
» In addition 25 branch offices are located throughout
the nation
» All commercial banks charted by the federal
government are members of the Fed
• The member banks in each Federal Reserve
district elect six of the nine directors of their
Federal Reserve bank
– No more than three of the six directors can be bankers
– The Board of Governors selects the remaining three
directors of each bank
Section 14.2: The Federal Reserve at Work
• The Fed serves consumers like us
indirectly by providing services to
commercial banks and to the federal
government
• Services to Banks
– One of the Fed’s main roles is to supervise
and provide services to commercial banks
through the 12 Federal Reserve district banks
• The Fed oversees the flow of money between
members banks and its district banks
– It does so though clearing checks and lending reserves
to commercial banks
Section 14.2: The Federal Reserve at Work
• Services to Banks continued
– Clearing Checks
• The Fed keeps track of the billions of checks
written each year through the service of check
clearing
– Check clearing is the method of crediting and debiting
banks’ reserve accounts and in turn checking accounts
Section 14.2: The Federal Reserve at Work
• Services to Banks continued
– Loans to banks
• When a bank or other depository institution needs
a loan, it contacts its district Federal Reserve bank
– These loans are needed when a private bank needs a
short term resupply of cash due to a large unexpected
withdrawal
• Most Federal Reserve loans are sought for
seasonal factors (withdrawals by many banks
clients to purchase Christmas gifts), natural
disasters, and financial emergencies (recession or
depression)
Section 14.2: The Federal Reserve at Work
• Services to Government
– The Fed and US Treasury Department work
together to manage the $1.5 trillion the
federal government raises each year
• The Treasury Department pays out all the bills
owed by the federal government, collects taxes
through the IRS (under the Authority of the
Treasury Department), prints money and produces
coins
• The Federal Reserve:
– Serves as the government’s bank
– Supervisees the Fed member banks
– Regulates the national money supply
Section 14.2: The Federal Reserve at Work
• Services to Government continued
– Serving as the government’s bank
• The Fed’s banking services to government are
similar to those that banks provide to individuals
– The Fed serves as the depository for federal revenues
» Gov’t funds are deposited in the Federal Reserve
banks by the Treasury Department
– The Fed holds a Treasury checking account on which the
Treasury writes checks to cover tax refunds, social
security checks, and any other government payments
– The Fed records the deposits and withdrawals of federal
funds and conducts the purchase and sale of government
securities like US Treasury bills
– The Fed advises the legislative and executive branches
on developing economic policy
Section 14.2: The Federal Reserve at Work
• Services to Government continued
– Supervising Member Banks
• The Fed functions as the banking system's “watchdog”
– Each of the 12 Federal Reserve banks has a staff of bank
examiners that supervises the financial activities of member
banks
» These examiners monitor loans & investments & conduct
reviews of bank records
– Regulating the Money Supply
• The Fed regulates the nation’s money supply (amount of
money circulating in the US economy)
• The Fed distributes the coins and bills that make up our
currency
– New currency is put into circulation for two reasons: to replace
old and worn out notes & to increase the amount of money in
circulation, thus expanding the pool of cash the Fed banks can
loan out
» The Fed increases or decreases the money supply by
selling and buying US government securities
Section 14.2: The Federal Reserve at Work
• Money Supply
– The Fed must determine how much money is
circulating in the economy
– M1
• The narrowest simplest measure of the money
supply
– M1 economists believe that the money supply should
consist only of funds that are easily accessible and in
actual circulation
» M1 counts only money in circulation, the value of
Traveler’s Checks, all checking account deposits, etc…
Section 14.2: The Federal Reserve at Work
• Money Supply continued
– M2
• A broader measure of the money supply
– In addition to all the money counted in M1, M2 includes
money market accounts, money market mutual fund
shares, and other savings deposits (like CODs) in
amounts under $100,000
– M3
• An even broader measure than M2
– M3 includes the money in M2 as well as large time
deposits (like CODs) with a value over $100,000,
repurchase agreements, and US dollars deposited into
US banks by Americans oversee (Eurodollars)
Section 14.3: Monetary Policy Strategies
• Monetary Policy and Aggregate Demand
– Monetary Policy is the plan to expand or contract the
money supply in order to influence the cost and
availability of credit
• By regulating the money supply and the interest rates
charged for credit, the Fed influences aggregate demand
(the total demand for all products in the economy)
– Easy-Money Policy
• Designed to expand the money supply, increase aggregate
demand, create jobs, and thus reduce unemployment &
promote economic growth
– Achieved by reducing the interest rate the Fed charges banks
to borrow money thus allowing those banks to charge lower
interest rates for individuals
– Tight-Money Policy
• Designed to slow business activity and help stabilize prices
to decrease inflation rates
– Achieved when the Fed reduces the money supply and
increases the interest rate they charge banks to borrow money
Section 14.3: Monetary Policy Strategies
• Components of Monetary Policy
– Open-Market Operations
• The buying and selling of government securities
– When the Fed sells securities, bank reserves shrink and
demand decreases resulting in a contracted money supply
– When the Fed buys securities, bank reserves increase and
demand increases resulting in an expanded money supply
– Discount Rate
• The interest rate that the Fed charges member banks for the
use of its reserves
– When the Fed lowers the discount rate, banks are encouraged
to borrow from the Fed, which increases bank reserves and
expands the money supply
– When the Fed increases the discount rate, banks are
discouraged from borrowing from the Fed which decreases
bank reserves and contracts the money supply
Section 14.3: Monetary Policy Strategies
• Components of Monetary Policy continued
– Reserve Requirement
• The money that must be held by banks either in their own
vaults or in their accounts at district Federal reserve Banks
– When the Fed lowers the reserve requirement, banks hold
fewer reserves and extend more loans, interest rates fall,
demand increases, and the money supply expands
– When the Fed increases the reserve requirement, banks hold
more reserves and extend fewer loans, interest rates rise,
demand decreases, and the money supply contracts
– Margin Requirements
• The percentage of cash investors must have to buy stocks,
options, and other investments
– Ex: The Fed requires investors to have 60% of the cost of
buying stock on hand and only use credit for the other 40%
Section 14.3: Monetary Policy Strategies
• Components of Monetary Policy continued
– Credit Regulation
• The Fed has the power to regulate consumer
credit in times of national emergency
– The Fed had this power revoked in 1952
– Moral Suasion
• The unofficial pressures that Federal Reserve
Policy makers exert on the banking system such
as direct appeals to banks or testimonies before
Congress
Section 14.3: Monetary Policy Strategies
• Policy Limitations
– The main challenges of the Fed:
• Economic Forecasting
– To develop monetary policy, the Fed must make a prediction (forecast)
of future business activity and consumer spending
» Incorrect forecasts can lead to inappropriate policy
• Time Lags
– Once an economic forecast is developed, time passes before policies go
into effect
» Demand and production activity rarely react instantly to Fed
actions
• Lack of Coordination
– The lack of coordination between the Fed and other government
agencies concerning economic priorities can hinder economic activity
and send mixed signals to the markets
• Priorities and Trade Offs
– Monetary policy is designed to fight inflation or a recession, fighting
one may cause the other
• Conflicting Opinions
– The disagreement over the goals off US monetary policy among
politicians and government officials leaves the Fed in the middle trying
to please both sides and do their job in an effective way