McConnell 22nd edition

1. CHAPTER 34
Money, Banking, and Financial Institutions

2. ©2021 McGraw Hill Education. All rights reserved. No reproduction or further distribution without the prior written consent of McGraw Hill Education.
The Functions of Money
The Components of the Money Supply
What “Backs” the Money Supply?
The Federal Reserve and the Banking System
Fed Functions, Responsibilities, and Independence
The Financial Crisis of 2007 and 2008
34-2
Chapter Contents

3. Money
• Money: Anything that is generally accepted in payment for
goods or services or in the repayment of debt
• Important!! Term “money” defined in Economics is different
from commonly used word “money” in everyday conversation!
13-3

4. Example of Money
So, what can you use for payment at Wal-Mart, McDonald’s, and gas station?
• Currency (cash) including coins and bills
• Cash is an asset. If you have $20 bill, you can spend up to $20 worth of goods and
services (e.g. gasoline).
• Check & debit card (electronic version of check)
• A check is a means of payment, but it is worthless piece of paper unless you write a
payment and sign it.
• Can you write $23,770 check at Toyota dealer to purchase Prius? Yes, only if you
have that amount at your bank.
• You can write a check up to an amount in your checking account without bouncing
your check.
• Your checking account balance is money, not check itself.
• Credit card? Not really. Money must be an asset, not liability for holder.
13-4

5. U.S. Dollar Bills
• In modern U.S. economy we use dollar bills and coins as medium of
exchange.
• Dollar bills are called “Federal Reserve Note” because they are IOU
(note payable) issued by the Federal Reserve Banks. They are
assets for holders (households, firms, governments, and foreigners)
of IOUs, but liabilities for issuers (the Federal Reserves) of IOUs.
13-5

6. Money and Generally Accepted
• Money must be generally accepted by definition.
• In modern U.S. economy we use worthless paper money rather
than valuable commodity.
• We accept worthless paper money because we expect they are
accepted by others.
• If no one accepts money, money will seize its primary function in an
economy.
• The government guarantees its general acceptance by making it
“legal tender”.
13-6

7. Functions of Money
Money has three primary functions in any economy.
• Medium of Exchange
• Anything used to pay for goods and services
• Unit of Account
• Anything used to measure value in economy
• Store of Value
• A repository of purchasing power over time
LO34.1 34-7

8. Money as Medium of Exchange
• Monetary exchange: Exchange of goods through money
Ex. You have fish and want a loaf of bread.
(You) Fish  Money (???)  Bread (???)
• Since money comes between two goods in exchange, it is a
medium of exchange.
• Money increases efficiency in economy: Even though this
involves two exchanges, actually it will take less time for
exchanges. So, people can spend more time for production of
goods and services rather than exchange.
• Although we use paper and coins as money, any commodity can
serve as money in society. Example: Yap stone money, American
Indian Wampum. 13-8

9. Money as Unit of Account
• In the U.S. a value (price) of every good and service is
quoted in dollars and cents.
• By using “dollar and cent” as a standard unit of value, we can
easily compare value of one good with others.
• Ex. How much is a Big Mac? Around $2.19. How much is a
cheeseburger? About 99¢. So, you know which is more
valuable.
13-9

10. Money As Store of Value
• Money can keep its purchasing power over time.
• When you receive your paycheck, you do not need to spend
every dollar right at that moment. You can keep it in bank
account or cash on hand, and spend it later.
• Money is not unique in this function. There are many assets
which can serve as store of value.
• Example: stocks, bonds, bank accounts, Baseball cards
• Liquidity: the ease with which an asset can be converted
into medium of exchange (money)
• Money is the most liquid store of value.
13-10

11. Measuring Money Supply
• Money supply (Money aggregate): Amount of money in
economy
• M1 includes items used for medium of exchange:
• Currency (bills and coins)
• Checkable deposits
• Financial institutions offering checkable deposits
• Commercial banks
• Savings and loan associations
• Mutual savings banks
• Credit unions 13-11
Thrift Institutions

12. Money Definition M2
• M2 include items which can be converted to medium
of exchange very quickly (high liquidity)
• M1 plus near-monies.
• Savings deposits including money market deposit
accounts (MMDA).
• Small-denominated time deposits (CDs).
• Money market mutual funds (MMMF).
LO34.2 34-12

13. Components of Money Supplies M1 and M2
Source: Board of Governors of the Federal Reserve System.
LO34.2
34-13
• For M1, little less than
half is currency, and other
half is checkable deposits.
• For M2, majority
is saving and
MM deposits.

14. Money and Prices
• Prices affect purchasing power of money.
• Purchasing Power: Amount of goods and services
money can purchase.
• Hyperinflation renders money unacceptable.
• When there are too many money in public, prices of goods
increase and a purchasing power of money falls.
• Stabilizing money’s purchasing power:
• Intelligent management of the money supply—
monetary policy
LO34.3
34-14

15. Functions of Central Bank
• Each country has one central bank which is responsible for
• Conducting monetary policy.
• Regulating an amount of money supply in economy.
• Supervising banks.
• In the United States, the federal reserve system (the Fed) acts as
the central bank.
• The federal government have attempted to establish a single central
bank twice, but due to fear of concentration of economic and monetary
power, the Congress abolished such institutions.
• In 1931 the Congress established the twelve regional Federal Reserve
banks. 13-15

16. Organizational Structure of the Federal
Reserve System
Three main organizational components of the Federal Reserve
System:
• Regional Federal Reserve banks
• Board of Governors
• Federal Open Market Committee
LO34.4
34-16

17. Federal Reserve and Its Relationship to the Public
LO34.4
34-17

18. Regional Federal Reserve Banks
• The U.S. is divided into twelve Federal Reserve districts.
• Each district has one Federal Reserve bank.
• Ex. Federal Reserve Bank of Richmond covers states of Maryland,
Virginia, North Carolina, and South Carolina.
• By dividing into twelve districts, no one Federal Reserve bank can
dominate in the U.S. economy.
• Regional Federal Reserve banks act like “bankers’ bank”
• Clearing checks
• Hold deposits of banks as reserves
• Setting a discount rate and making discount loans to banks in their districts
• Issuing new currency and withdrawing damaged currency
13-18

19. The 12 Federal Reserve Districts
Source: Federal Reserve Bulletin, Board of Governors of the Federal
Reserve System.
LO34.4
34-19

20. U.S. Dollar Bills
• U.S. dollar bills are issued by the Federal Reserve banks.
13-20
Emblem of the Federal
Reserve System
“Federal Reserve Note” means
IOU (note payable) issued by
the Federal Reserve System.
Federal Reserve Bank of
San Francisco issued
this note.

21. Member Banks and Other Depository Institutions
• All national banks are required to be members of the Federal
Reserve System.
• Currently, about 38% of the commercial banks are members of
the Federal Reserve System.
• Member banks are stockholders of the regional Federal reserve
bank.
• Depository Institutions Deregulation and Monetary Control Act of
1980 requires all depository institutions (member and
nonmember banks) to hold required reserves.
• 4,600 commercial banks + 7,000 thrift institutions 13-21

22. Global Perspective 34.1
Source: "The World's Largest Public Companies 2018," Forbes.
LO34.4
THE WORLD’S 12 LARGEST FINANCIAL INSTITUTIONS, 2018
34-22

23. Board of Governors
• The Board of Governors acts like the headquarter of the Federal
Reserve System.
• Located in Washington, D.C.
• Seven members of the Board of Governors are appointed by the president of
the United States and confirmed by the Senate.
• Each member serves for nonrenewable 14-year term and comes from
different districts.
• The chairman of the Board of Governors is chosen from the seven governors.
• Serves for renewable four-year term.
• Acts like the CEO of the Federal Reserve System.
• Jerome Powell is the current chairman.
13-23

24. Federal Open Market Committee
• The Federal Open Market Committee (FOMC)
• Makes decisions on monetary policy.
• the conduct of open market operations
• setting a target rate on federal funds
• Meets eight times a year
• Consists of twelve members: the seven members of the Board of
Governors, the president of the Federal Reserve Bank of New
York, and the presidents of four other Federal Reserve banks.
• Directed by the chairman of the Board of Governors
13-24

25. Functions of Federal Reserve
• Issue currency (Regional Federal Reserve banks)
• Set reserve requirements (Board of Governors)
• Lend money to banks (Regional Federal Reserve banks)
• Collect checks (Regional Federal Reserve banks)
• Act as a fiscal agent for U.S. government (Board of
Governors)
• Supervise banks (Regional Federal Reserve banks & Board of
Governors)
• Control the money supply (FOMC)
LO34.5
34-25

26. Federal Reserve Independence
• Established by Congress as an independent agency
• It is not a part of the federal government.
• Protects the Fed from political pressures
• Long-term appointment of Board of Governors reduces
influence of any U.S. presidents
• Enables the Fed to take actions to increase interest
rates in order to stem inflation as needed
LO34.5
34-26

27. Global Perspective 36.1 (Chapter 36)
LO36.2
36-27
CENTRAL BANKS, SELECTED NATIONS

28. The Financial Crisis of 2007 and 2008
• Mortgage Default Crisis
• Many causes:
• Government programs that encouraged home
ownership
• Declining real estate values
• Bad incentives provided by mortgage-backed securities
LO34.6
34-28

29. Securitization
• Securitization: The process of slicing up and bundling groups of
loans into new securities (mortgage backed securities).
• Loan repayments are used to service mortgage-backed security holders
(paying interests and principals)
• “Underwater” homeowners abandoned homes and mortgages.
• Many borrowers are risky borrowers with low or no credit (subprime
loans).
• As mortgage loans defaulted, the system collapsed.
• Since without loan repayments mortgage-backed securities will default.
LO34.6
34-29

30. TARP
• Troubled Asset Relief Program (TARP):
• Allocated $700 billion to make emergency loans
• Used to purchase risky mortgage-backed securities held by
financial institutions.
• Saved several institutions from failure
• Example: Citi Group, GM, Fannie Mae
• Federal Reserve as Lender of last resort
• When large financial institutions are about to go bankrupted,
no one can lend to save those institutions, but the Federal
Reserves.LO34.6
34-30

31. Post-Crisis Policy Changes
• Wall Street Reform and Consumer Protection Act
• Designed to prevent practices thought to have
caused the financial crisis
• Mitigate moral hazard problem
LO34.6
34-31

32. The Last Word: Too Big to Fail. Too Big to Jail?
•Fed had to act as lender of last resort for both
solvent and insolvent firms
•Increased moral hazard
34-32