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Money and the Financial System


The Evolution of Money Barter is a system where people exchange products directly Barter depends on a double coincidence of wants, a situation in which two traders ... – PowerPoint PPT presentation

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Title: Money and the Financial System

Money and the Financial System
The Evolution of Money
  • Barter is a system where people exchange products
  • Barter depends on a double coincidence of wants,
    a situation in which two traders are willing to
    exchange their goods directly
  • Under a barter system, not only is a double
    coincidence of wants difficult to obtain, but
    that rate at which the two goods are exchanged
    must be determined
  • This points to a need for a commodity that is
    generally accepted in exchange money

What is Money?
  • Money is any commodity that is generally
    acceptable in exchange for goods and services
  • Money fulfills 4 functions
  • Money is a medium of exchange
  • Money is a unit of account
  • Money is a store of value
  • Standard of Deferred Payment

Money is a Medium of Exchange
  • Anything that facilitates trade by being
    generally accepted by all parties in payment for
    goods or services

Money is a Unit of Account
  • A common unit for measuring the value of every
    good or service

Money is a Store of Value
  • Anything that roughly retains its purchasing
    power over time

Standard of Deferred Payment
  • Debt obligations are dominated in terms of money

History of Money
  • 700-637 BC Lydian King stamped electrum ingots
    with lions head (Western Turkey)

Commodity Money
  • Commodity money is anything that serves both as
    money and as a commodity
  • Historically, corn serves as one example, since
    parties generally believed that there was a ready
    market for this commodity
  • Metal commodities have also functioned as money

The Problems with Commodity Money
  • Deterioration
  • Bulkiness
  • Indivisibility
  • High opportunity cost due to its inherent value
  • Subject to supply and demand
  • Greshams Law--Bad money drives out good money

Coins and Token Money
  • Coins evolved as money because metal can be
  • Historically, the power to coin was vested in the
    seignior, or feudal lord
  • If the face value of the coin exceeded the cost
    of coinage, the minting of coins became a source
    of revenue (seigniorage)
  • Token money is money whose face value exceeds the
    cost of production

Paper Money
  • Paper money first took the form of bank notes
    which guaranteed delivery of gold or silver upon
    presentation at the issuing bank
  • Such notes were easily used as a medium of
    exchange, due to the fact that they were easy to
    carry and backed by precious metals

Fiat Money
  • Money not redeemable for any commodity
  • Its status as money is conferred by the
  • Fiat money is declared as legal tender by the

History of Money in US
  • http//
  • Franklin The Father of Paper Money
  • States issued currency
  • Continentals (1777-1781)
  • Not worth a continental
  • Free Banking ( - 1866)
  • States and banks issued their own currency
  • Greenbacks (Civil War)
  • Nationalization of Gold (1933)
  • The Collapse of the Bretton Woods System (1971)

Some Facts about the Dollar
  • The Dollar
  • Ave life of 1 bill is 18 months, 9 years for a
  • 490 notes in a lb. So 10 Million in 100s weighs
  • 2 million in 20s would weigh the same.
  • ½ of bills printed in a day are 1 denomination
  • 80 of Bills abroad are 100 Bills
  • 2/3 of all currency in circulation is abroad

Monetary AggregatesM1, M2, and M3
  • A monetary aggregate is a measure of the
    economys money supply
  • M1A measure of the money supply consisting of
    currency and coins held by the nonbank public,
    checkable deposits, and travelers checks
  • M2A monetary aggregate consisting of M1 plus
    savings deposits, small time deposits, and money
    market mutual funds
  • M3A monetary aggregate consisting of M2 plus
    negotiable certificates of deposit

  • Liquidity is a measure of the ease with which an
    asset can be converted into money without
    significant loss of its value
  • M1, M2, and M3 are progressively less liquid

The Early Stage of Modern Banking
  • During the middle ages, London goldsmiths kept
    gold, cash, and valuables in reserve for clients
  • Since only a small fraction of clients would want
    to retrieve there deposits any point in time,
    this led to cash loans by the goldsmiths to
  • A checking account system also evolved whereby
    clients could authorize goldsmiths to relinquish
    gold deposits to another party
  • Eventually, goldsmith created money by simply
    creating an account for the borrower
  • Beginning of a fractional reserve banking system

Fractional Reserve Banking System
  • A banking system in which only a portion of
    deposits is backed by reserves

Demand Deposits
  • Accounts at financial institutions that pay no
    interest and on which depositors can write checks
    to obtain their deposits at any time

Liabilities and Assets
  • A bank incurs a liability when it accepts a
  • A liability is anything that is owed to another
    individual or institution
  • When a bank makes a loan, it incurs an asset

Reserve Funds
  • Funds that banks use to satisfy the cash demands
    of their customers and the reserve requirements
    of the Fed
  • Reserves consist of deposits at the Fed plus
    currency physically held by banks

Bank Deposits
  • Deposits in financial institutions against which
    checks can be written
  • A demand deposit is a checkable deposit which
    earns no interest
  • A savings deposit earns interest but has no
    specific maturity date
  • A time deposit earns a fixed rate of interest if
    held for a specified period

Money Creation
  • Banks create money by making loans against excess
  • Look at the balance sheets of the Banking

The Money Multiplier
  • The money multiplier is the multiple by which the
    money supply increases as a result of an increase
    in excess reserves in the banking system
  • The simple money multiplier is the reciprocal of
    the required reserve ratio, or 1/r

The Actual Money Multiplier
  • The simple money multiplier is subject to cash
    drain and excess reserves
  • Cash drainincreased cash holdings by the public
  • Excess reservesbanks may not lend all excess
  • Each of these has the effect of reducing the
    money multiplier

Financial Institutions in the United States
Financial Intermediaries
  • Institutions that serve as go-betweens, accepting
    funds from savers and lending them to borrowers
  • Depository institutions
  • Commercial banks and other financial institutions
    that accept deposits from the public
  • Commercial banks
  • Depository institutions that make short-term
    loans primarily to businesses
  • Thrift institutions
  • Depository institutions that make long-term loans
    primarily to households

The Banking Industry
  • The banking industry exists due to the fact that
    mutually benefits trades take place between
    banks an depositors, and between banks and
  • Depositors lend deposits to banks in exchange for
    interest payments
  • Banks loan deposits to borrowers in exchange for
    interest on the loan. The borrower gains from
    the service of the loan, but must pay interest
    sufficient to make the bank profitable.

Asymmetric Information
  • The banker, in dealing with the borrower, faces
    the problem of asymmetric information
  • Asymmetric information exists when there is
    unequal information known by each party
  • Bankers must become experts in dealing with
    asymmetric information
  • Banks can also deal with risk through

First Bank of United States 1811
Second Bank of United States 1836
The Origins and Structure of the Federal Reserve
  • The Federal Reserve System (the Fed) was
    established with the Federal Reserve Act of 1914
  • The Federal Reserve System is the central bank
    and monetary authority of the U.S.
  • 12 Federal Reserve districts were established
    around the country
  • The Board of Governors (7 members appointed by
    the President and confirmed by the Senate) sets
    and implements the nations monetary policy

The Federal Reserve System
The Organization of the Federal Reserve System
The Objectives of the Federal Reserve System
  • A high level of employment
  • Economic growth
  • Price stability
  • Interest rate stability
  • Stability in financial markets
  • Stability in foreign exchange markets

The Powers of the Federal Reserve System
  • Federal Reserve Act of 1914 authorized to
    exercise general supervision over the 12 Reserve
  • The Fed was also given the power to buy and sell
    government securities, to extend loans to member
    banks, to clear checks, and to require that
    member banks hold reserves equal at least to a
    specified fraction of their deposits

The Process of Money Creation Can be Reversed
  • The Fed can sell securities to banks or the public

Summary of Credit Expansion When Fed Purchases
1,000 Security
Other Means of Expanding the Money Supply
  • Clearly, when the reserve requirement ratio is
    decreased, the money supply increases
  • The Fed can also change the discount rate
  • When banks borrow from the Fed, excess reserves
    in the economy increase

An Overview of the Tools of the Federal Reserve
  • The discount rate is the interest rate charged to
    member banks by the Fed for discount loans
  • Open-market operations are purchases and sales of
    government securities by the Fed in an effort to
    influence the money supply
  • These operations are undertaken under the
    auspices of the Federal Open Market Committee,
    consisting of the seven governors plus five
    presidents from the Reserve banks
  • A minimum reserve requirement is imposed on
    member banks

Banking During the Great Depression
  • Many point to the inaction of the Federal Reserve
    System as a cause for the depth of the Great
  • The Fed failed to act as a lender of last resort
    when financial markets began to become unstable

Review Terms and Concepts
  • M1, or transactions money
  • M2, or broad money
  • medium of exchange, or means of payment
  • money multiplier
  • near monies
  • Open Market Desk
  • open market operations
  • required reserve ratio
  • reserves
  • run on a bank
  • store of value
  • unit of account
  • barter
  • commodity monies
  • currency debasement
  • discount rate
  • excess reserves
  • Federal Open Market Committee (FOMC)
  • Federal Reserve System (the Fed)
  • fiat, or token, money
  • financial intermediaries
  • legal tender
  • lender of last resort
  • liquidity property of money

Additional Slides
Recent Problems with Depository Institutions
  • Money market mutual funds introduced (1970s)
  • A collection of short-term earning assets
    purchased with funds collected from many
  • Due to this depository institutions began to
    suffer, since they faced regulations on the
    interest rate offered to depositors
  • Deregulation was implemented, while maintaining
    deposit insurance
  • This led institutions to undertake risky
    investments, leading to an abundance of thrift
  • Thrift institutions were bailed out by the

The Money Supply andthe Federal Reserve System
An Overview of Money
  • Money is anything that is generally accepted as a
    medium of exchange.
  • Money is not income, and money is not wealth.
    Money is
  • a means of payment,
  • a store of value, and
  • a unit of account.

What is Money?
  • Barter is the direct exchange of goods and
    services for other goods and services.
  • A barter system requires a double coincidence of
    wants for trade to take place. Money eliminates
    this problem.
  • As a medium of exchange, or means of payment,
    money is generally accepted by buyers and sellers
    as payment for goods and services.

What is Money?
  • As a store of value, money serves as an asset
    that can be used to transport purchasing power
    from one time period to another.

What is Money?
  • As a unit of account, money is a standard that
    provides a consistent way of quoting prices.

What is Money?
  • Money is easily portable, and easily exchanged
    for goods at all times.
  • The liquidity property of money makes money a
    good medium of exchange as well as a store of

Commodity and Fiat Monies
  • Commodity monies are items used as money that
    also have intrinsic value in some other use.
    Gold is one form of commodity money.
  • Fiat, or token, money is money that is
    intrinsically worthless.

Commodity and Fiat Monies
  • Legal tender is money that a government has
    required to be accepted in settlement of debts.
  • Currency debasement is the decrease in the value
    of money that occurs when its supply is increased

Measuring the Supply ofMoney in the United States
  • M1, or transactions money is money that can be
    directly used for transactions.
  • M1 ? currency held outside banks demand
    deposits travelers checks other checkable
  • M1 is a stock measureit is measured at a point
    in timeon a specific day.

Measuring the Supply ofMoney in the United States
  • M2, or broad money, includes near monies, or
    close substitutes for transactions money.
  • M2 / M1 savings accounts money market
    accounts other near monies
  • The main advantage of looking at M2 instead of M1
    is that M2 is sometimes more stable.

The Private Banking System
  • Financial intermediaries are banks and other
    financial institutions that act as a link between
    those who have money to lend and those who want
    to borrow money.

How Banks Create Money
  • A Historical Perspective Goldsmiths
  • Goldsmiths functioned as warehouses where people
    stored gold for safekeeping.
  • Upon receiving the gold, a goldsmith would issue
    a receipt to the depositor. After a time, these
    receipts themselves began to be traded for goods,
    and were backed 100 percent by gold.
  • Then, Goldsmiths realized that they could lend
    out some of this gold without any fear of running
    out. Now there were more claims than there were
    ounces of gold.

How Banks Create Money
  • A run on a goldsmith (or a modern-day bank)
    occurs when many people present their claims at
    the same time.

The Modern Banking System
  • A brief review of accounting
  • Assets liabilities / Net Worth, or
  • Assets / Liabilities Net Worth
  • A banks most important assets are its loans.
    Other assets include cash on hand (or vault cash)
    and deposits with the Fed.
  • A banks liabilities are its debtswhat it owes.
    Deposits are debts owed to the banks depositors.

The Modern Banking System
  • The Federal Reserve System (the Fed) is the
    central bank of the United States.

The Modern Banking System
  • Reserves are the deposits that a bank has at the
    Federal Reserve bank plus its cash on hand.
  • The required reserve ratio is the percentage of
    its total deposits that a bank must keep as
    reserves at the Federal Reserve.

T-Account for a Typical Bank
  • The balance sheet of a bank must always balance,
    so that the sum of assets (reserves and loans)
    equals the sum of liabilities (deposits and net

The Creation of Money
  • Banks usually make loans up to the point where
    they can no longer do so because of the reserve
    requirement restriction (or up to the point where
    their excess reserves are zero).

The Creation of Money
  • When someone deposits 100 in a bank, and the
    bank deposits the 100 with the central bank, the
    bank has 100 in total reserves.

The Creation of Money
  • If the required reserve ratio is 20, the bank
    has excess reserves of 80. With 80 of excess
    reserves, the bank can have up to 400 of
    additional deposits. The 100 in reserves plus
    400 in loans equal 500 in deposits.

The Creation of Money
The Money Multiplier
  • The money multiplier is the multiple by which
    deposits can increase for every dollar increase
    in reserves.
  • In the example above, the required reserve ratio
    is 20. Each dollar increase in reserves could
    cause an increase in deposits of 5 when there is
    no leakage out of the system. An additional 100
    of reserves result in additional deposits of 500.

The Federal Reserve System
The Federal Reserve System
  • The Federal Open Market Committee (FOMC) sets
    goals regarding the money supply and interest
    rates and directs the operations of the Open
    Market Desk in New York.
  • The Open Market Desk is an office in the New York
    Federal Reserve Bank from which government
    securities are bought and sold by the Fed.

Functions of the Federal Reserve
The Fed performs important functions for banks
  • Clearing interbank payments.
  • Regulating the banking system.
  • Assisting banks in a difficult financial
  • Managing exchange rates and the nations foreign
    exchange reserves.
  • Control of mergers between banks.

Functions of the Federal Reserve
The Fed performs important functions for banks
  • Examination of banks to ensure that they are
    financially sound.
  • Setting of reserve requirements for all financial
  • Lender of last resort The Fed provides funds to
    troubled banks that cannot find any other sources
    of funds.

The Federal Reserve Balance Sheet
The Federal Reserve Balance Sheet
  • Although it is unrelated to the money supply, the
    Feds gold counts as an asset on its balance
  • The largest of the Feds assets, by far, consists
    of government securities purchased over the
  • A dollar bill is a liability, or IOU, of the Fed.

How the Federal ReserveControls the Money Supply
  • Three tools are available to the Fed for changing
    the money supply
  • changing the required reserve ratio
  • changing the discount rate and
  • engaging in open market operations.

The Required Reserve Ratio
  • The required reserve ratio establishes a link
    between the reserves of the commercial banks and
    the deposits (money) that commercial banks are
    allowed to create.
  • If the Fed wants to increase the money supply,
    the Fed can decrease the required reserve ratio,
    which allows the bank to create more deposits by
    making loans.

The Required Reserve Ratio
The Discount Rate
  • The discount rate is the interest rate that banks
    pay to the Fed to borrow from it.
  • Bank borrowing from the Fed leads to an increase
    in the money supply. The higher the discount
    rate, the higher the cost of borrowing, and the
    less borrowing banks will want to do.

The Discount Rate
The Discount Rate
  • Moral suasion is the pressure that was exerted in
    the past by the Fed on member banks to discourage
    them from borrowing heavily.
  • On January 9, 2003, the Fed announced a new
    procedure that sets the discount rate above the
    rate that banks pay to borrow in the private
    market. It is thus clear that the Fed is not
    using the discount rate as a tool to try to
    change the money supply on a regular basis.

Open Market Operations
  • Open market operations is the purchase and sale
    by the Fed of government securities in the open
    market a tool used to expand or contract the
    amount of reserves in the system and thus the
    money supply.
  • Open market operations is by far the most
    significant tool of the Fed for controlling the
    supply of money.

The Mechanics ofOpen Market Operations
Open Market Operations
  • An open market purchase of securities by the Fed
    results in an increase in reserves and an
    increase in the supply of money by an amount
    equal to the money multiplier times the change in

Open Market Operations
  • An open market sale of securities by the Fed
    results in a decrease in reserves and a decrease
    in the supply of money by an amount equal to the
    money multiplier times the change in reserves.

Open Market Operations
  • Open market operations are the Feds preferred
    means of controlling the money supply because
  • they can be used with some precision,
  • are extremely flexible, and
  • are fairly predictable.

The Supply Curve for Money
  • Through open market operations, the Fed can have
    the money supply be whatever value it wants.
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