ECON 151 – PRINCIPLES OF MACROECONOMICS

Chapter 15: Money,

Banking, and Central Banking

Materials include content from Pearson Addison-Wesley which has been modified
by the instructor and displayed with permission of the publisher. All rights reserved.
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Money
 Money
 Any medium that is universally accepted
in an economy both by sellers of goods and
services and by creditors as payment for
debts

15-2
Table 15-1 Types of Money

15-3
The Functions of Money
 The functions of money
 Medium of exchange
 Unit of accounting
 Store of value (purchasing power)
 Standard of deferred payment

15-4
The Functions of Money (cont'd)
 Medium of Exchange
 Any item that sellers will accept
as payment

 Barter
 The direct exchange of goods and services
for other goods and services without the use
of money

15-5
The Functions of Money (cont'd)
 Medium of exchange
 Money facilitates exchange by reducing
transaction costs associated with means-of-
payment uncertainty.
 Permits specialization, facilitates efficiencies

 Barter
 Simply a direct exchange
 Double coincidence of wants

15-6
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

15-7
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.

15-8
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

15-9
Liquidity
 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.

15-10
Figure 15-1 Degrees of Liquidity

The cost of holding money (its opportunity cost)

is the alternative interest yield obtainable by
holding some other asset.
Money is not backed by gold, silver, or even the
federal government. It is backed by the
confidence of those willing to accept it.
15-11
Monetary Standards,
or What Backs 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
15-12
Monetary Standards, or What Backs Money
 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 and
predictability of value.
15-13
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
 Economistsuse two basic approaches to define and
measure money.
 The transactions approach
 The liquidity approach
15-14
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
15-15
Defining Money (cont'd)
 The transactions approach to measuring
money: M1
 Currency

 Checkable (transaction) deposits

 Traveler’s checks not issued by banks

15-16
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.

15-17
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

15-18
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

15-19
Defining Money (cont'd)
 The liquidity approach to measuring
money: M2
 Near Moneys
 Assets that are almost money
 Highly liquid
 Easily converted to cash
 Time deposits are an example
15-20
Defining Money (cont'd)
 The liquidity approach: M2 is equal to M1
plus
1. Savings and small denomination
time deposits
2. Balances in retail money market
mutual funds
3. MMDAs

15-21
Defining Money (cont'd)
 M2
 Savings Deposits
 Interest-earning funds that can be withdrawn at
any time without payment of a penalty

 Depository Institutions
 Accept deposits from savers and lend those funds
out

15-22
Defining Money (cont'd)
 M2
 Money Market Deposit Accounts (MMDAs)
 Accounts issued by banks yielding a market rate of
interest with a minimum balance requirement and
a limit on transactions
 They have no minimum maturity

15-23
Defining Money (cont'd)
 M2
 Time Deposit
 A deposit in a financial institution that requires
notice of intent to withdraw or must be left for an
agreed period
 Early withdrawal may result in a penalty

 CD (Certificate of Deposit)
 Time deposit with fixed maturity
15-24
Defining Money (cont'd)
 M2
 Money Market Mutual Funds
 Funds obtained from the public that investment
companies hold in common
 Funds used to acquire short-maturity
credit instruments
 CD’s, U.S. government securities

15-25
Figure 15-2 Composition of the U.S. M1
and M2 Money Supply, 2007, Panel (a)

15-26
Figure 15-2 Composition of the U.S. M1
and M2 Money Supply, 2007, Panel (b)

15-27
Defining the U.S. Money Supply
 The M2 definition of money correlates best with
economic activity, although some business
people and policymakers prefer MZM.
 MZM (money-at-zero-maturity)
 MZM entails adding deposits without set
maturities to M1.
 MZM includes all MMFs but excludes all
deposits with fixed maturities.

15-28
Financial Intermediation and
Banks
 Most nations have a banking
system that encompasses two types
of institutions.
1. One type consists of private
banking institutions.
2. The other type of institution is a
central bank.

15-29
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.

15-30
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

15-31
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

15-32
Figure 15-4 The Process of
Financial Intermediation

15-33
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

15-34
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

15-35
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.
 Pensionfunds and investment companies are
examples.

15-36
Financial Intermediation
and Banks
 Assets
 Amounts owned
 The uses of funds by financial intermediaries

 Liabilities
 Amounts owed
 The sources of funds for financial
intermediaries
15-37
Table 15-2 Financial Intermediaries and
Their Assets and Liabilities

15-38
Financial Intermediation
and Banks (cont'd)
 Payment Intermediaries
 Institutions
that facilitate transfers of funds
between depositors who hold transactions
deposits with those institutions

15-39
Figure 15-5
How a
Debit-Card
Transaction
Clears

15-40
Financial Intermediation
and Banks (cont'd)
 Capital Controls
 Legal restrictions on the ability of a nation’s
residents to hold and trade assets
denominated in foreign currencies

 International Financial Intermediation

 Financing investment projects in more than
one country

15-41
Table 15-3
The World’s Largest Banks

15-42
Banking Structures
Throughout the World
 The ways that banks around the world differ
 Size
 United States has banks of various sizes

 Europe and Japan have a few large banks

 Legal
 Universal banking

 Limits on financial services such as insurance and bank

stock ownership
 Importance in financial system
 Major importance

 Part of a varied financial system (United States)

15-43
Banking Structures
Throughout the World (cont'd)
 Universal Banking
 An environment in which banks face few or no
restrictions on their powers to offer a full range of
financial services and to own shares of stock in
corporations

 World Index Fund

A portfolio of bonds issued in various nations whose
individual yields generally move in offsetting
directions, thereby reducing the overall risk of losses
15-44
Banking Structures
Throughout the World (cont'd)
 Central banks and their roles
1. Perform banking functions for their nations’
governments
2. Provide financial services for private banks
3. Conduct their nations’ monetary policies

15-45
The Federal Reserve System
 The Fed
 TheFederal Reserve System; the central
bank of the United States
 Themost important regulatory agency in the
U.S. monetary system
 Established in 1913 by the Federal Reserve
Act

15-46
The Federal Reserve System (cont'd)

 Organization of the Fed

 Board of Governors
 7 members, 14-year terms

 Federal Reserve Banks (12 Districts)

 25 branches

 Federal Open Market Committee (FOMC)

 BOG plus 5 presidents of district banks
15-47
Figure 15-6 Organization of the Federal
Reserve System

15-48
Figure 15-7
The Federal Reserve System

15-49
The Federal Reserve System (cont'd)

 Depository institutions
 7,500 commercial banks
 1,300 savings and loans
 11,000 credit unions

 All may purchase Fed services

15-50
The Federal Reserve System (cont'd)
 Functions of the Fed
1. Supplies the economy with fiduciary currency
2. Provides a payment-clearing system
3. Holds depository institutions’ reserves
4. Acts as the government’s fiscal agent
5. Supervises depository institutions
6. Acts as a “lender of last resort”
7. Regulates the money supply

15-51
Figure 15-8 The Volume and Value
of Federal Reserve Check Clearings Since
1985

15-52
ECON 151 – PRINCIPLES OF MACROECONOMICS

Chapter 15: Money,

Banking, and Central Banking

Materials include content from Pearson Addison-Wesley which has been modified
by the instructor and displayed with permission of the publisher. All rights reserved.
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