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Money and the F inancial System. Barter What is money? The functions of money Commodity, representative, and fiat money Financial intermediaries The Federal Reserve System Structure of the U.S. banking system. Barter exchange. Goods exchange for other goods.
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Money and the Financial System Barter What is money? The functions of money Commodity, representative, and fiat money Financial intermediaries The Federal Reserve System Structure of the U.S. banking system
Barter exchange Goods exchange for other goods Barter exchange is not possible without a “double coincidence of wants.”
Money is anything that is generally acceptable in exchange for goods, services, economic resources, or for the settlement of debts
Advantages of monetary exchange • Eliminates the coincidence of wants problem. • Facilitates economic specialization
Functions of money Medium of exchange Unit of account Store of value (or wealth)
What is liquidity? • Liquidity refers to two properties of assets or stores of value, namely: • The ready convertibility of the asset to generalized purchasing power (or money) • The comparative safety of the asset. Money is the most liquid asset available under normal circumstances
An increase in the price level over time reduces what $1.00 buys. The price level has risen every year since 1960, so the purchasing power of $1.00 (measured in 1982-1984 constant dollars) has fallen from $3.38 in 1960 to $0.48 in 2007 Purchasing power of $1 measured in 1982-1984 constant dollars
Commodity money Anything that serves both as money and as a commodity; money that has intrinsic worth.
Representative money Bank notes that exchange for a specific commodity, such as gold Examples Tobacco warehouse receipts The Goldsmith bankers
Fiat Money: Anything which serves as a means of payment by government declaration This Note Is Legal Tender For All Debts, Public and Private You are willing to accept money not because it is “backed” by precious metals; but rather because you know it is generally acceptable in exchange
Deposits are Money—But Checks are Not (a) Rick’s Account at Delta Bank
The Monetary System The monetary system consists of the Federal Reserve and the banks and other institutions that accept deposits and provide the services that enable people and businesses to make and receive payments.
Financial Intermediaries • These units are interposed between depositors and borrowers • Commercial banks • Thrift institutions • Money market funds: A financial institution that obtains funds by selling shares and uses these funds to purchase assets such as U.S. Treasury bills.
The Fractional Reserve System • Reserves: The currency in a bank’s vaults plus the balance on its reserve account at the Federal Reserve Bank. • Required reserve ratio: The minimum percentage of deposits that banks and other financial institutions must hold in reserves. • Excess reserves: Banks reserves that exceed those needed to meet the required reserve ratio.
Federal Funds • Banks that have excess reserves may loan them to banks with reserve deficiencies • These loans are made in the interbank loan, or federal funds, market. • The interest rate on loans in the interbank market is the federal funds rate.
The Economic Functions of Monetary Institutions • Create liquidity (money) • Lower costs • Pool risks • Make payments
The Federal Deposit Insurance Corporation (FDIC) • Created in 1933 • A government agency that insures deposits in commercial banks (up to $100,000 per account). • Banks pay premiums to the FDIC Bank failureswere often a “self-fulfilling prophesy.”
Federal Reserve Act of 1913 • The history of banking in the U.S. prior to 1913 is messy—featuring widespread panic and runs on banks—for example, in 1893 and 1907. • The Federal Reserve System was created in 1913.
Chair of Board of Governors Appoints 3 directors of each Federal Reserve Bank President appoints • Board of Governors • (7 members, including chair) • Supervises and regulates member banks • Supervises 12 FederalReserve District Banks • Sets reserve requirements and approves discount rate • 12 Federal Reserve • District Banks • Lend reserves • Clear checks • Provide currency Senate confirms Elect 6 directors of each Federal Reserve Bank • Federal Open Market • Committee • (7 Governors + 5 Reserve • Bank Presidents) • Conducts open market operations to control the money supply 3,500 Member Banks The Structure of the Federal Reserve System
The map shows by color the area covered by each of the 12 Federal Reserve districts. Black dots note the locations of the Federal Reserve Bank in each district. Identified with a star is the Board of Governors headquarters in Washington, D.C. The twelve Federal Reserve Districts
The instruments of monetary policy • Reserve requirements • The discount rate • Open market operations
Depository institutions are required by law to hold a minimum fraction of their liabilities on account at the FED • Legislation: • Federal Reserve Act of 1913 • DIDMCA of 1982
The discount rate The rate of interest charged on loans made at the FED discount window. The FED is known as the “lender of last resort” to the banking system
Billions Discount Window Borrowings have surged since December, 2007 as the Fed has sought to stabilize the financial system amid a rash of defaults on subprime debt.
Open market operationsare the purchase or sale ofU.S. government securitieson the open market by the Federal Reserve system
The FED Open Market Committee is the unit in charge ofopen market operations
Exhibit 7 • Number of commercial banks declined over the last two decades, but the number of branches continue to grow
