Students Again

The Functions of Money – To be used as money, money generally has a few basic properties. It isn’t necessary that a money has all ofd these properties, but in general, the more of these properties it has – the better it functions as money.

Medium of Exchange – allows people to use money in exchange for products directly. This is instead of requiring them to trade goods for goods (Barter) which has the major disadvantage of the “Double coincidence of wants: (the need for each person in a trade to have what the other person wants and want what the other person has).

Unit of Account – basically this means that money allows people to set prices in a common currency. For example: a chair doesn’t have to have millions of possible prices depending on what it is being traded for (1 chair = 5 dozen eggs = 1 hour of tax preparation service = I lawn mowing = etc. etc. etc.) We cab set the price in terms of money – and then allow all other prices to be comparable through the money system.

Store of Value – this means that we can sell a product today and “save” part of the value of that good over time. This way, we don’t have to have to have enough production at one time to buy a big ticket item – like a house. Can you imagine how many eggs we would have to have at one time to trade for a whole house? But this also refers to the need for money to retain it’s value over time (resist inflation). If money losses it’s value quickly – it would be useless to save money. Imagine what that would do to the housing industry!

Other properties that make for good money:
Portability: it should be light enough to carry easily
Divisibility: there should be multiple units of money (penny, nickel, dime, quarter, half dollar, dollar, $5, $10, $20, etc)

The Supply of Money: This is the amount of money available to the public. So it does not equal the money that the government has. We use three definitions of money – depending on how readily available the money is for spending (liquidity).

M1: The most liquid form of money. This is money that can be used immediately.

Currency: Coin + Paper Money (obviously this is instantly money – because it is money)

Commodity Money – money that has intrinsic value (it has value for some other use) like Gold, silver, gems etc all have other uses – other than as a store of value (money)

Fiat Money – money with no intrinsic value (or very minimal intrinsic value compared to its value as money), like paper currency

Federal Reserve Notes – the official term for our paper (fiat) money

Checkable Deposits – The balance of checking accounts and other accounts that are “like” checking accounts. This is instantly money because it is accepted as money at the check-out lane. In fact, one of the newer ways to use checkable deposits is the ATM card via a EFT (Electronic Funds Transfer)– and you’ll notice that the money comes out of the checking account – not the savings account.

Commercial Banks – can be organized as State banks (under a state charter) or as a Federal Bank (under a Federal Charter)

Thrifts – non-bank “banks”

• Credit Unions – this is the form of most thrifts. It used to have a lot of restrictions on membership, but most of those have been watered down over the years.
• Savings and Loans – Originally set up to make mortgage loans, they experienced severe losses in the 1980’s and are now freer to make other types of loans that are not so dependent on the state of the economy.
• Mutual Savings Banks – Non-banks that accept funds to be loaned as mortgages

These non-banks call checking accounts different things: CU’s call them share draft accounts, S&L’s call them Negotiable Orders of Withdrawal (NOWs) and Mutual Savings Banks call them Automatic Transfer Services (ATSs).

M1 = paper and coin currency in circulation plus checking account balances (and other forms of “checking accounts")

M2: This includes everything that is M1 PLUS a few things that are not quite as liquid (Near-Monies) .

• Savings Deposits – You would have to make two transactions to use a savings account to buy something. First – the withdrawal; second - the purchase. Even if you use the store’s ATM machine to withdraw money to use 5 feet from the ATM – it’s still two transactions.
• Small Time Deposits – these are any accounts with some limited ability to withdraw funds – like a CD, IRA etc. If it says “substantial penalty for early withdrawal – it’s probably M2). What’s “small”?: Anything under $100,000.
• Money Market Mutual Funds: You can often write a limited number of checks against a MMMF – which is a time deposit invested in a stock portfolio.

M3: includes all things in M2 (which includes M1) plus a few things:

• Large Time Deposits: Time deposits over $100,000.
• There are others but your book does not cover them.

What Backs the Money Supply? Today, the answer is basically “nothing” other than our willingness to accept it as money.

Money as Debt: currency is not purchasing power itself – it is a promise to pay. When we accept money – we get pieces of paper – but we don’t get the value of what we sold until we trade that money for something else.

Value of Money: The value of any money it determined by a few basic things

• Acceptability: if people lose faith in a currency, then it’s value as money is limited.
• Legal Tender: government declaring it to be “money”
• Relative Scarcity: If money becomes too commonplace – it loses it’s value. If it isn’t scarce – nobody is in need of it, therefor they aren’t willing to trade what they have for more of it.

Money and Prices

• The Purchasing Power of the Dollar: The value of money is related to the price level in the economy. As the price level rises (prices are rising) and each dollar will buy less of everything. The higher that price level gets, the less value the dollar has.

Value of the Dollar = 1 / Price Level

• Inflation and Acceptability: If the price level rises rapidly (inflation), then people may wish to hold their savings in something other than money. This is why many people buy gold or other commodities – instead of holding money as money, when the economy is experiencing inflation.

Stabilization of Money’s Value: It is in the best interest of the government and the agency charged with controlling the money supply (in the U.S. that agency is the FED – the Federal Reserve) to make sure that the value of the money supply is stable. They can use fiscal policy (government) and monetary policy (the FED) to help stabilize the value of the currency.

The curve for Money Supply is a straight vertical line – at whatever level of Money Supply that happens to exist at the time.

The Demand for Money: The amount of money that people want to keep in their hands as money (M1) – instead of in an investment of some kind (M2 or M3).

Transactions Demand: We all require a certain amount of money each day to buy the things we need to buy - like lunch money. Our demand for money for transactions depends on the price level (if lunch costs more – we need more cash), but does not really depend on interest rates (no matter what savings accounts are offering as interest – the Big Mac Meal still costs $4.50 – so we still need $4.50 each day).

Asset Demand: The demand for money that depends on the interest rate on savings accounts (and other investments). The higher the rate of interest on the investment, the more of our money we want to stay invested (to get the most out of the high rate we want most of our money earning interest). If the interest rates are low – there is less opportunity cost of holding money as cash, so we hold more money as cash.

Asset Demand for Money is also known as the Speculative Demand for Money.

Total Money Demand: Adding the two types of Money Demand you get a curve that looks like the Asset Demand for Money curve – it reacts to the change in the interest rate. It is further to the right than Asset Demand because it also includes the money we demand for transactions.

The Money Market:

The Money Market is the interaction of the Money Demand Curve and the Money Supply Curve. The intersection of these curves is the equilibrium point and determines the interest rate in the economy (i*).

Adjustment to a Decline in the Money Supply: If Money Supply decreases then the MS curve shifts left – and the new equilibrium is at a higher interest rate (i’). Why does the interest rate rise? As money becomes scarcer, banks need to attract money to the bank in order to make loans (and earn money). As people keep more money in the bank, they will have less on hand (the level of MD is lower).

Adjustment to an Increase in the Money Supply: If the money supply increases (from MS to MS’’) and the interest rate drops to i’’. What happens is that the flood of easy money makes it unnecessary for banks to offer high interest rates to attract money to make loans. They offer lower interest rates on savings and fewer dollars come to the bank (low opportunity cost of holding money).

The Federal Reserve and the Banking System -

Historical Background: In the early 20th century there was a particularly bad bank panic (lots of bank failures) in 1907 (1907 Banking Crisis) and Congress decided they should take steps to make sure it didn’t happen again. They passed the Federal Reserve Act of 1913 – which created the Federal Reserve Bank System.

Board of Governors: The FED (Federal Reserve System) is run by a 7 person board called the Board of Governors. Each member is appointed to a 14 year term – and the terms of office are staggered (one governor is appointed every two years). The Governors are appointed by the President and confrimed by the Senate.

Federal Open Market Committee (FOMC): This committee is responsible for performing what is called Open market Operations (OMO). It consists of 12 members:

• The 7 members of the Board of Governors
• the President of the NY Regional Fed
• 4 of the other 11 regional Fed Presidents on a rotating basis

The 12 Federal Reserve Banks: The FED has 12 regional branches – which perform the duties of the FED. Those branches are located in:

1. Boston
2. NYC
3. Philadelphia
4. Cleveland
5. Richmond
6. Atlanta
7. Chicago
8. St. Louis
9. Minneapolis
10. Kansas City
11. Dallas
12. San Francisco

Central bank: While the FED is our central bank – it isn’t a central bank in the traditional sense. It isn’t one bank – it’s a system (part of our traditional American resistance to big centralized government).

Quasi-Public Banks: The Regional FEDs are owned by the banks they serve – but are led by administrators appointed by government.

Bankers’ Banks: The FED is a bank for banks – and does not have private citizens as customers. The accounts at the FED banks are banks’ bank accounts. They make loans to banks – not corporations or individuals.

Commercial Banks and Thrifts:

• 7,800 commercial banks (3/4 state-chartered banks, ¼ federally chartered banks)
• 11,800 thrifts (mostly CU’s (10,300), plus S&L’s and Mutual Savings banks)

Fed Functions and the Money Supply -

• issuing currency – the FED is responsible for providing the necessary currency to run the economy. They use issuing currency as one way to perform monetary policy.
• setting Reserve Requirement and holding reserves – the FED requires Banks to hold a portion of each deposit at the FED to help stabilize the banking system. They can change the rate required to be held at the FED as a tool of Monetary Policy
• lending money to bank and thrifts – the FED lends money to banks and thrifts to make loans or to use as reserves at the FED. They charged an interest rate for this loan – called the discount rate (often incorrectly called the prime rate in the press). Changing this discount rate is another tool for performing monetary policy.
• providing check collections – the FED’s collect checks and clear them by transferring funds from one banks account at the FED to another bank’s account. The banks then technically have received that money from the bank the check was written from – and can then deposit that money in the account of their customer.
• acting as fiscal agent for federal government – the Federal government has it’s accounts at the FED rather than a private bank.
• supervising banks – the FED checks the books of banks to make sure that they are making a wise economic choices – a balanced loan portfolio etc. If they are not, they can refuse to make loans to these banks as well as other measures to make the bank want to change their loan portfolio.
• controlling the money supply – the FED uses the Money Supply to effect the interest rates and through that to make monetary policy.

Federal Reserve Independence: The FED is designed to be independent from societal pressures and political control. If a president serves two terms and appoints a Board of Governors member every two years – he will appoint his 4th of the 7 FED Board of Govs when he is about to leave office. In the same way, since the term of office is 14 years – there is minimal pressure to do what the appointing president wants them to do.

Recent Developments in Money and Banking:

1. The Relative Decline of Banks and Thrifts
2. Financial services industry
3. Consolidation among Banks and Thrifts
4. Convergence of Services Provided by Financial Institutions
5. Globalization of Financial Markets
6. Electronic Transactions