Money and Banking

Chapter 13

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

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Learning Objectives

1. List and discuss the three jobs of money.

2. Explain what money is.

3. Distinguish among M1, M2, and M3.

4. Analyze the demand for money.

5. Discuss the origins of banking.

6. Define and discuss branch banking and bank chartering.

7. Summarize the savings and loan debacle.

8. Describe and analyze the 2008 financial meltdown.

9. Discuss overdraft privileges.

After this chapter, you should be able to:

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Money Definition: any asset that can be used to make a

purchase.• Many things have been used as money: corn, beads, whales’

teeth, shells, stones, feathers, salt, cocoa beans, and, of course, gold and silver.

• Ideally, the asset should be somewhat scarce, divisible, and portable.

Three jobs of money:• Medium of exchange• Standard of value• Store of value

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Medium of Exchange

Defining job of money—to serve as a vehicle to enable transactions.

• Makes it easier to buy and sell than relying on barter Barter requires “double coincidence of wants,” meaning

two people each of whom wants what the other has to trade.

• Must be universally accepted• Does not need to have intrinsic value (paper money)

To function as medium of exchange, we must feel confident that people will accept money in exchange for their goods and services.

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Standard of Value

Prices (expressed in money) are a unit of measurement in which the relative value of goods and services can be expressed.

• If you buy a latte for $4, instead of a regular cup of coffee for only $2, then the latte is at least twice as valuable to you.

• If I will pay full-ticket price to see one movie in a first-run theater, but decide to wait to see another on DVD, I am valuing one movie more than the other.

• If a company pays its CEO 1,000 times as much as its factory workers, it is expressing the relative value of the services provided by each.

While supply and demand set market prices, demand curves are based on the relative value placed on specific goods and services.

Question: What does “priceless” mean?

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Store of Value

Money holds value better than many goods and services.

• If you paid your professor with food that you grew, the food might spoil over time. Money doesn’t spoil!

But inflation does devalue money over time: • Question: If you could buy 100 units of goods and services

with $100 in 1988, how many units could you buy with $100 in 2008?

• Answer: You could have bought just 55 units.• During this period, inflation robbed the dollar of almost half of

its purchasing power.

Money is better store of value in the short run than in the long run.

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Our Money Supply

Money consists of:• Currency (coins and paper money)• Demand deposits and other checkable deposits

Deposits in checking accounts are money.

The following are NOT money:• Checks, debit cards, and electronic funds transfers are

ways of accessing your checkable deposits, but they are not money.

• Credit cards are ID cards that provide short-term loans from issuing bank, not money.

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M1 and M2, February 2010(in billions of dollars)

Currency is more than 1/2 of M1, but 2/3 – 3/4 of U.S. currency is held outside the United States. In countries with unstable currencies, dollars serve as a better medium of exchange.

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Annual Percentage Change in the Money Supply, M1, 1960-2009

Fairly steady upward trend from 1960 to 1983 Greater fluctuations beginning in 1984

• Federal Reserve controls growth of money supply. • Monetary policy increasingly important.

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Questions for Thought or Discussion

Can each of the following serve as a medium of exchange, a standard of value, and a store of value?

• U.S. Dollar bills• Credit card• Debit card• Balance in your checkbook • Euro coins

Why do we have the federal government, through the Federal Reserve, issue money? What are the advantages of a national currency?

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The Demand for Money

The amount of money people hold is called money balances.

John Maynard Keynes noted that people had three motives for holding money (instead of buying long-term bonds):

1. Transactions motive: People hold money for purchases.

2. Precautionary motive: People hold money for “rainy day.

3. Speculative motive: People hold money when they believe interest rates will rise and they would be better off buying bonds at higher rates in the future.

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Four Influences on the Demand for Money

Economists have since identified 4 factors that influence how much money people want to hold:

1. Inflation: As prices increase, we need more money for transactions.

2. Income: As income rises, people carry more money.

3. Interest rates: Quantity of money demanded decreases as interest rates rise.

At high interest rates, buying bonds becomes more attractive. The opportunity cost of cash increases.

4. Credit availability: As credit cards and bank loans are more available, people hold less money in cash or checking accounts.

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Bank Deposits and Money Creation

U.S. banks do not print or issue money anymore.

But demand deposits are part of the money supply, so banks play an important role in how money is “created.”

To understand modern banking, let’s start with a short history of banking….

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Goldsmiths as Bankers In Medieval Europe, people would store their gold

coins with the local goldsmith, who had a safe. • Goldsmith gave them receipts for a certain amount of gold.• Gradually, the receipts began to circulate as paper money.

Goldsmiths realized that everyone did not come for their gold at the same time.

• They began to lend out gold coins from the safe.• Next, they began to lend out receipts for gold.

Banking system created when the number of receipts was greater than coins in safe.

• A reserve system works as long as people circulate the receipts instead of demanding all the gold at once.

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Reserve Ratio

Money is created through loans.• More receipts were circulating than gold in safes.

To be reliable, the bank (or goldsmith) had to keep enough gold coins for anyone who came to cash in their receipts.

Today, banks keep dollars in their vaults or at the Federal Reserve.• The reserve system means they lend out some, but not all, of their dollars.

Reserve ratio:

Number of coins in safe

Number of receipts in circulation

Reserves in vault

Demand deposits

=

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Calculating Reserve Ratio

A. What is the goldsmith’s reserve ratio when there are 1,000 receipts in circulation and 1,000 coins the safe?

Answer: 100%

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Calculating Reserve Ratio #2

Try calculating the reserve ratio for B and C.

Answers: 50% and25%

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Modern Banking A bank is a financial institution that accepts deposits,

makes loans, and offers checking accounts. Like the goldsmiths, banks lend out some of their

deposits and keep some as reserves:• They pay interest to their depositors.• They charge higher interest rates to their borrowers.

Profit incentive is to keep reserves low: • Banks would prefer a low reserve ratio, around 2%.• Federal regulators make them keep around 10% of their

checking deposits on reserve, to ensure stability of banking system.

Government regulation prevents runs on banks.

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Kinds of Banks Banking is legally defined as accepting deposits.

• Commercial Banks (6,800 in U.S.) Commercial banks account for the bulk of checkable deposits. Usually have the word “bank” in their name.

• Savings and Loan Associations (800 in U.S.) Originally established to finance home building. The 800 S&Ls invest more than 3/4 of their savings deposits in

home mortgages.• Mutual Savings Banks (1,300 in U.S.)

Concentrated in the northeastern U.S. Created in the 19th century to encourage savings.

• Credit Unions (8,000) Cooperatives that generally serve specific employee, union, or

community groups. Account for less than 5% of savings in U.S.

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Banking Deregulation

Lines between different kinds of banks has blurred since passage of the Depository Institutions Deregulation and Monetary Control Act of 1980.

• Before, only commercial banks had checking accounts.• Now, many S&L associations, mutual savings banks, and

credit unions offer most of the same services as commercial banks.

Further deregulation in 1994 permitted internet banking.

Deregulation designed to increase competition.• But it has led to mergers and acquisitions, so in actuality

there is less competition.

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The Top Ten American Banks, Ranked by Assets, February 2010

There has been a trend toward consolidation of banking industry over last 25 years.

These top ten banks hold $3.2 trillion of $7.7 trillion bank deposits in the U.S.

Consolidation has

also led to economies of scale, enabling banks to offer more services.

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World’s Top Ten Banks, Ranked by Assets,March 2010

Banking is an increasingly global industry.

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“Welfare Banks”

Consolidation has led to a polarization of banking. • Offer high-end customers new services• Increase fees, raise minimum balances, and close branches in

less-profitable areas• Harder for working families and poor to access banks

Market response: Check-cashing stores• Charge fees to cash paychecks and benefit checks• Sell money orders (instead of checks)• But poor can least afford these high fees

American Bankers Association is blocking legislation requiring banks to cash U.S.-issued Social Security and welfare checks and provide other services to poor.

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Questions for Thought and Discussion Do you have a checking account or savings account?

• Where do you bank? Has your bank merged (perhaps changed its name) in recent years?

• Have minimum balances or fees increased?

Have bank branches opened or closed in your neighborhood?

• Are there check-cashing stores in your neighborhood or any neighborhoods you know?

Do check-cashing stores “exploit” their customers by charging high fees?

• Is using their services voluntary?• What drives up the price of these services?

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Banks are a Form of Financial Intermediaries

Financial intermediaries channel funds from savers to borrows.

Not all financial intermediaries are banks:• Sometime business borrowers dispense with financial

middlemen altogether by borrowing directly from savers. The U.S. Treasury does this every month by issuing new

bonds, certificates, notes, and bills. Large business borrows by issuing relatively short-term

commercial paper and long-term bonds.• Money market funds, pension funds, insurance companies,

and consumer finance companies all invest their contributions by lending money or buying stocks and bonds.

• Subprime mortgages are generally issued by nonbank financial intermediaries (Countrywide Credit, Household International).

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Home Mortgage Market

Just over 2/3 of all American families own their homes.• Nearly all have outstanding mortgages.

In the home mortgage market, banks and other financial intermediaries differentiate between the relatively well off and the less fortunate.

• Conventional market: Banks, savings & loans, and credit unions make loans to middle-class and well-off homeowners.

• Subprime market: Caters to poorer homeowners and has interest rates that are double that in conventional markets.

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Subprime Mortgage Crisis

After 2001, housing prices escalated, creating a “price bubble.”

• Homeowners traded up to more expensive homes and used equity for consumer borrowing.

• Speculators “flipped” homes to get quick profits.• Mortgage lenders aggressively marketed Subprime mortgages

with flexible rates to those who could barely afford them.

Housing market began its decline in 2007. • Supply > Demand Falling prices • Subprime borrowers began to default on loans• Countrywide and other Subprime lenders in financial trouble• Some of these mortgages were “bundled” into securities and

these lost value quickly.

Ripple effect throughout economy.

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Bank Regulation

Unlike some forms of business, someone cannot just decide to open a bank.

To operate a bank you must get a state or national charter.

• More than two-thirds of the nation’s banks have state charters.

• The rest have national charters. All nationally chartered banks must join the Federal Reserve System.

To get a bank charter you need to demonstrate:1. That your community needs another bank.

2. That you have enough capital to start a bank.

3. That you are of good character.

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Bank Branches

Three types of banking have evolved under various state laws:

1. Unrestricted branch banking: a bank may open branches throughout the state.

2. Limited branch banking: a bank may be allowed to open branches only in contiguous communities.

3. Unit banking in which state law forbids any branching whatsoever.

Interstate banking was technically illegal until 1994: • Some banks owned banks in multiple states but operated

them as separate entities.• Passage of the Riegle-Neal Interstate Banking and

Branching Act of 1994 swept away the last barriers to opening branches in different states.

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Questions for Thought and Discussion

Automated teller machines (ATMs) expand bank services, especially since you can withdraw funds from other banks than your own.

• Should banks be allowed to charge fees to non-customers who use their ATM?

Six out of seven ATM users don’t pay surcharges.

• What might happen if fees were banned? How would profit-maximizing banks respond?

• Why do some convenience stores offer “no-fee” ATM machines?

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Key Regulator: The Federal Deposit Insurance Corporation (FDIC)

After the massive bank failures of the 1930s, Congress set up the FDIC.

• Aim of FDIC is to avert bank panics by assuring the public that the federal government stands behind the bank, ready to pay off depositors, if it should fail.

• 140 insured banks went under in 2009, compared with 3 in 2007 and 25 in 2008.

Each depositor insured up to $250,000. • This was raised in response to 2008 financial crisis.• The cap will return to $100,000 in 2014.

More than 99 percent of banks are members of FDIC.

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U.S. Bank Failures, 2000-2009

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The Savings and Loan Debacle

In early 1990, the financial press was calling the S&L debacle the greatest financial scandal in the history of the United States.

Incompetence, inordinate risk-taking, poor supervision, and outright fraud all played prominent roles in the decline and fall of the savings and loan industry.

The federal government ended up paying perhaps $200 billion to clean up the mess.

Depositors were paid off. Hundreds of failed S&Ls were shut down. Surviving S&Ls are now more closely supervised.

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Current Issue: Overdraft Privileges

Definition: If you didn’t have enough money in your account to cover the check you wrote, your check used to bounce.

• Now, you just pay an overdraft fee of $15–$35 per overdraft.• It is possible to incur several overdrafts before you become

aware of it. • Essentially, this is a high-interest-rate loan.

Issue really comes down to truth in lending. • Banks could be more forthcoming about the cost of the

overdraft privileges they so freely extend.