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Chapter 15

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Chapter 15

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  1. Chapter 15 Money, Banking, and Central Banking

  2. Introduction During the financial meltdown and panic in 2008, Congress raised the limit of the U.S. Federal Deposit Insurance Corporation’s (FDIC) insurance against risk of loss for individual bank deposit accounts from $100,000 to $250,000. Now some businesses provide savers with access to FDIC-insured deposits up to $50 million. How do people obtain federal insurance covering bank deposits more than $250,000? Reading this chapter will help you answer this question.

  3. 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 Understand why financial intermediaries such as banks exist

  4. Learning Objectives (cont'd) 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

  5. Chapter Outline The Functions of Money Properties of Money Defining Money Financial Intermediation and Banks The Federal Reserve System: The U.S. Central Bank

  6. Chapter Outline (cont’d) Fractional Reserve Banking, the Federal Reserve, and the Money Supply Federal Deposit Insurance

  7. Did You Know That ... In 2009, the U.S. Senate passed a resolution calling for a first-ever thorough government audit of the Federal Reserve System (the Fed) and for a complete list of its recipients of loans? That recent resolution that requires closer oversight of the Fed reflects congressional concerns about Fed policymaking. The Fed’s primary task has been to conduct monetary policy by regulating the quantity of money in circulation in the U.S. economy.

  8. Did You Know That … (cont’d) Money Any medium that is universally accepted in an economy both by sellers of goods and services as payment for those goods and services and by creditors as payment for debts

  9. Table 15-1 Types of Money

  10. The Functions of Money The functions of money Medium of exchange Unit of accounting Store of value (purchasing power) Standard of deferred payment

  11. 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-of-payment uncertainty Permits specialization, facilitates efficiencies

  12. 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 requires a double coincidence of wants

  13. Policy Example: The Never-Ending Battle Against Counterfeiters If people were to lose faith in the authenticity of currency, it would not circulate as readily as a medium of exchange. So, the U.S. government’s Bureau of Engraving and Printing continually seeks to make U.S. currency more difficult to counterfeit, including the use of color-shifting ink, embedding watermarks, and making the composition of the paper bills hard to replicate.

  14. 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. 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

  16. 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

  17. 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

  18. Figure 15-1 Degrees of Liquidity

  19. 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

  20. Properties of Money (cont’d) Questions What backs money? Is it gold, silver, or the federal government? Answer Your confidence

  21. 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

  22. 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”

  23. Properties of Money (cont’d) Currency and transactions deposits are money because of their Acceptability Predictability of value

  24. International Policy Example: Venezuela Promotes Private Moneys—with Conditions Attached Today the government of Venezuela allows the use of private currencies used in different parts of the nation alongside its national currency, the bolivar. However, the government prevents these private currencies from competing with its own currency by not allowing these private currencies to be exchanged for the bolivar, and restricting their use to relatively small organized markets.

  25. 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

  26. Defining Money (cont'd) Economists use two basic approaches to define and measure money The transactions approach The liquidity approach

  27. Defining Money (cont'd) 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

  28. Defining Money (cont'd) The transactions approach to measuring money: M1 Currency and coins Transactions (checkable) deposits Traveler’s checks

  29. Figure 15-2 Composition of the U.S. M1 and M2 Money Supply, 2011, Panel (a)

  30. Figure 15-2 Composition of the U.S. M1 and M2 Money Supply, 2011, Panel (b)

  31. Defining Money (cont'd) 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

  32. Defining Money (cont'd) 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

  33. Defining Money (cont'd) 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

  34. Defining Money (cont'd) The liquidity approach to measuring money: M2 Assets that are almost money Highly liquid Easily converted to cash Time deposits are an example

  35. Defining Money (cont'd) The liquidity approach:M2is equal toM1 plus Savings deposits Small denomination (<$100,000) time deposits Balances in retail money market mutual funds

  36. Defining Money (cont'd) Question Which definition of money correlates best with economic activity? Answer M2, although some businesspeople and policymakers prefer MZM

  37. Defining Money (cont'd) 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

  38. 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

  39. 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

  40. 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

  41. 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

  42. Figure 15-3 The Process of Financial Intermediation

  43. 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

  44. 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

  45. 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 Examples are pension funds, investment companies, and government-sponsored financial institutions such as Federal National Mortgage Association

  46. Financial Intermediation and Banks (cont'd) Liabilities Amounts owed The legal clams against a business or household by nonowners The sources of funds for financial intermediaries

  47. Financial Intermediation and Banks (cont'd) Assets Amounts owned All items to which a business or household holds legal claim The uses of funds by financial intermediaries

  48. Table 15-2 Financial Intermediaries and Their Assets and Liabilities

  49. Example: Mobile Payments Are Catching On Today nearly 10 percent of U.S. residents have used cell phones to transfer payments to another business or person. Almost 20 percent of young people aged 18 to 25 have used this mobile payment method. Most observers conclude that mobile payments will proliferate in the coming decade.

  50. Figure 15-4 How a Debit-Card Transaction Clears