Chapter 13 Money and Our Banking System. Copyright © 2005 Pearson Addison-Wesley. All rights...

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Chapter 13 Money and Our Banking System

Transcript of Chapter 13 Money and Our Banking System. Copyright © 2005 Pearson Addison-Wesley. All rights...

Page 1: Chapter 13 Money and Our Banking System. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.13-2 Learning Objectives List the functions of money.

Chapter 13

Money and Our Banking System

Page 2: Chapter 13 Money and Our Banking System. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.13-2 Learning Objectives List the functions of money.

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Learning Objectives

• List the functions of money.

• Explain the difference between the narrowest definition of money, M1, and the next broadest definition, M2.

• List four of the most important functions of the Federal Reserve System (Fed).

• Explain how the Fed can increase the money supply.

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Money

• Money is whatever people accept as money.

• Money’s principal functions are to serve as:

1. a medium of exchange, and

2. a unit of accounting.

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Medium of Exchange

• To say that money is a medium of exchange simply means that a seller will accept it as a means of payment for a good or service.

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Barter

• Without money, people would have to barter—exchange goods and services for other goods and services.

• Barter requires a double coincidence of wants, that is, each party to a transaction must want exactly what the other person has to offer.

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Money and Transaction Costs

• Money facilitates exchange by reducing the transaction costs associated with means-of-payment uncertainty.

• Individuals no longer have to hold a diverse collection of goods as an exchange inventory for bartering.

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Money and Specialization

• As a medium of exchange, money allows individuals to specialize in any area in which they have a competitive advantage, and to receive money payments for their labor.

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Money as a Unit of Accounting

• Money is the yardstick that allows people to compare the values of goods and services in relation to one another.

• By using money prices, people can determine whether one item is a better bargain than another.

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Liquidity

• An asset is liquid when it can easily be acquired or disposed of without high transaction costs and with relative certainty as to its value.

• Money is the most liquid asset.

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What Backs Money?

• In a fiduciary monetary system, the value of the payments in the form of currency and checks rests on the public’s confidence that such payments can be exchanged for goods and services.

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Fiat Money

• It is any form of money that is not backed by anything other than faith in its universal acceptance in trade.

• The U.S. dollar is fiat money. It has no intrinsic value.

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Depository Institutions

• These are financial institutions that accept money from savers, which is then lent out with interest.

• In addition to banks, there are thrift institutions–savings and loan associations, savings banks, and credit unions.

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Defining Money Supply as M1

• Money Supply is the amount of money in circulation.

• M1 includes all currency (bills and coins), all checkable deposits, plus traveler’s checks. M1 is the narrowest definition of money supply.

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Checkable Deposits

• These are deposit accounts against which a check can be written out.

• Checks are a way of transferring the ownership of deposits in financial institutions. They are normally accepted as a medium of exchange.

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Credit Cards are not part of the Money Supply

• Using a credit card is borrowing funds from the credit card issuer for a period of several days to a period of several months.

• The credit car company pays for the borrower’s transaction.

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M2: A Broader Definition of Money Supply

• M2 is equal to M1 plus the following near moneys:– Savings deposits and money market

deposit accounts,

– Small-denomination time deposits, and

– Funds held by individuals in money market mutual funds.

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Savings and Money Market Deposit Accounts

• Savings deposits are interest-bearing deposit accounts without set maturities.

• Money market deposit accounts are savings accounts with limited check-writing privileges.

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Time Deposits

• Time deposits have set maturities, meaning that the holder must keep the funds on deposit for a fixed length of time to be guaranteed a negotiated interest return.

• Small-denomination time deposits are accounts with balances under $100,000.

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Money Market Mutual Funds

• They are pools of funds from savers that managing firms use to purchase short-term financial assets, such as Treasury bills and large CDs issued by depository financial institutions.

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The Federal Reserve System

• The Federal Reserve System, also known as the Fed, is the most important regulatory agency in the United States’ monetary system.

• The Fed is considered the monetary authority–our central bank.

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Functions of the Fed

• Among its many functions, the Fed:– regulates the money supply,

– supplies the economy with paper currency and coins,

– provides for check collection and clearing, and

– holds reserves for the nation’s depository institutions.

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Fractional Reserve Banking

• Depository institutions do not keep 100 percent of their deposits on hand.

• They keep only a fraction of those deposits on hand as reserves.

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Required Reserves

• Since its creation in 1913, the Fed has set specific reserve requirements for many banks.

• Banks must hold a set percentage of their total deposits either as cash in their own vaults or as deposits in their Federal Reserve district bank.

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Expansion of the Money Supply

• A large portion of the money supply consists of funds that the Fed and customers deposit in banks.

• Because banks are not required to keep 100 percent of their deposits in reserve, they can use any new excess reserves to create new money.

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The Money Multiplier

• The money multiplier gives the change in the money supply per one dollar change in the banking system’s reserves.

1Potential money multiplier =

required reserve ratio

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Factors that reduce the Money Multiplier

• The potential money multiplier will not be realized if:– Banks keep excess reserves.

– There are currency leakages out of the system. For instance, if a loan is taken out as currency.

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E-Money

• One of the most important recent technological innovations in the banking system is the smart card.

• Each time a cardholder uses a smart card, the amount of a purchase is deducted automatically from the cardholder’s balance and credited to a retailer.

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Digital Cash

• Digital cash, also called e-cash, consists of funds contained on computer software stored on microchips and other computer devices.

• Its use will reduce the nation’s costs of transferring funds because people can store and instantaneously transmit digital cash along preexisting electronic networks.

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Key Terms and Concepts

• barter

• checkable deposits

• depository institutions

• digital cash

• Fed

• fiduciary monetary system

• fractional reserve

• liquidity

• medium of exchange

• money market deposit accounts

• money market mutual funds

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Key Terms and Concepts (cont.)

• money multiplier

• money supply

• near moneys

• reserve requirements

• reserves

• savings deposits

• small-denomination time deposits

• smart cards

• thrift institutions

• unit of accounting