Chapter 13: Money and Banking

Chapter 13Money and Banking13-1Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Chapter Objectives13-2The four jobs of moneyWhat money isM1, M2, and M3The demand for moneyCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Chapter Objectives13-3The origins of bankingThe creation and destruction of moneyBranch banking and bank charteringThe FDICThe savings and loan debacleCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.13-4The Four Jobs of MoneyMedium of exchangeStandard of valueStore of valueStandard of deferred paymentCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Medium of ExchangeThe most important job of money is to serve as a medium of exchangeWhen any good or service is purchased, people use moneyMoney makes it easier to buy and sell because money is universally acceptedMoney, then, provides us with a shortcut in doing businessBy acting as a medium of exchange, money performs its most important function13-5Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Standard of Value13-6Money is a common denominator in which the relative value of goods and services can be expressedA job that pays $2 an hour would be nearly impossible to fill, while one paying $50 an hour would be swamped with applicationsDoes money work well as a standard of value? You tell meCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Store of Value13-7If you could buy 100 units of goods and services with $100 in 1982, how many units could you buy with $100 in 2000?Answer: you could have bought just 51 unitsDuring this period, inflation robbed the dollar of almost half of its purchasing powerOver the long run, particularly since World War II, money has been a very poor store of valueHowever, over relatively short periods of time, say, a few weeks or months, money does not lose much of its value Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Standard of Deferred Payment13-8Many contracts promise to pay fixed sums of money well into the futureA couple of examples are 30-year corporate bonds and a 20-year mortgageCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Standard of Deferred Payment13-9When Dave Winfield signed a 10-year, $23 million contract with the New York Yankees in 1980, he really got stuckBecause over the next 10 years the consumer price index went up by almost 59%Today when a professional ballplayer, entertainer, or virtually anyone else signs a long-term contract, she or he is generally protected by an escalator clause, which calls for increased payments to compensate for any future inflation Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Standard of Deferred Payment13-10How well does money do its job as a standard of deferred payment?About as well as it does as a store of valueUsually quite well in the short run, but not well at all over the long run of, say, three years or moreCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Money versus BarterWithout money, the only way to do business is by barteringFor barter to work, I must want what you have and you must want what I haveThis makes it pretty difficult to do business“Everything, then, must be assessed in money: for this enables men always to exchange their services, and so makes society possible”Aristotle, Nicomachean Ethics13-11Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Our Money SupplyMoney consist of coins, paper money, demand (or checking) deposits, and checklike deposits (commonly called NOW – or negotiable order of withdrawal – accounts) held by the nonbank publicCoins and paper money together are considered currencySix of every ten dollars in our money supply are demand deposits and other checkable depositsVirtually all the rest is currency Checks are not money but checking deposits are13-12Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.13-13Our Money SupplyCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Federal Reserve Statistical Release, April 5, 200113-14Our Money Supply: M1, M2, M3 Currency+ Demand deposits+ Other checkable deposits+ Traveler’s checks M1(traditionally our basic money supply) Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.13-15Our Money Supply: M1, M2, M3 Currency+ Demand deposits+ Other checkable deposits+ Traveler’s checks M1+ Savings deposits+ Small-denomination time deposits (less than $100,00)+ Money market mutual funds held by individuals M2 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.13-16Our Money Supply: M1, M2, M3 Currency+ Demand deposits+ Other checkable deposits+ Traveler’s checks M1+ Savings deposits+ Small-denomination time deposits (less than $100,00)+ Money market mutual funds held by individuals M2+ Large denomination time deposits (more than $100,00)+ Money market mutual funds held by institutions+ Other less liquid assets M3 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.13-17Our Money SupplyM1, M2, and M3, January 2001Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Federal Reserve BulletinOur Growing Money Supply13-18Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Annual Percentage Change in the Money Supply, M1, 1960-2000The Demand for MoneyThe amount of money people hold is called money balancesJohn Maynard Keynes noted that people had three reasons for holding moneyPeople hold money to make transactionsPeople hold money for precautionary reasonsPeople hold money to speculateEconomists have since identified four factors that influence the three Keynesian motives for holding moneyThe price levelIncomeThe interest rateCredit availability 13-19Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Keynesian Motives for Holding MoneyThe transaction motiveIndividuals have day-to-day purchases for which they pay in cash or by checkIndividuals take care of their rent or mortgage payment, car payment, monthly bills and major purchases by checkBusinesses need substantial checking accounts to pay their bills and meet their payrolls13-20Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Keynesian Motives for Holding MoneyThe precautionary motivePeople will keep money on hand just in case some unforeseen emergency arisesThey do not actually expect to spend this money, but they want to be ready if the need arises13-21Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Keynesian Motives for Holding MoneyThe speculative motiveWhen interest rates are very low you don’t stand to lose much holding your assets in the form of moneyAlternatively, by tying up your assets in the form of bonds, you actually stand to lose money should interest rates riseYou would be locked into very low ratesThis motive is based on the belief that better opportunities for investment will come along and that, in particular, interest rates will rise13-22Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Four Influences on the Demand for MoneyThe price levelAs the price level rises, people need to hold higher money balances to carry out day-to-day transactionsAs the price level rises, the purchasing power of the dollar declines, so the longer you hold money, the less that money is worthEven though people tend to cut down on their money balances during periods of inflation, as the price level rises people will hold larger money balances13-23Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Four Influences on the Demand for MoneyIncomeThe more you make, the more you spendThe more you spend, the more money you need to hold as cash or in your checking accountTherefore as income rises, so does the demand for money balances13-24Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Four Influences on the Demand for MoneyInterest ratesThe quantity of money demanded (held) goes down as interest rates riseThe alternative to holding your assets in the form of money is to hold them in some type of interest bearing paperAs interest rates rise, these assets become more attractive than money balances13-25Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Four Influences on the Demand for MoneyCredit availabilityIf you can get credit, you don’t need to hold so much moneyThe last three decades have seen a veritable explosion in consumer credit in the form of credit cards and bank loansOver this period, increasing credit availability has been exerting a downward pressure on the demand for money13-26Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Four Influences on the Demand for MoneyFour generalizationsAs interest rates rise, people tend to hold less moneyAs the rate of inflation rises, people tend to hold more moneyAs the level of income rises, people tend to hold more moneyAs credit availability increases, people tend to hold less money13-27Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Demand Schedule for Money13-28Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Three Demands for MoneyTotal Demand for Money13-29Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.This is the sum of the transaction demand, precautionary demand, and speculative demand for money shown in the previous slideTotal Demand for Money and the Supply of Money13-30Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The interest rate of 7.2 percent is found at the intersection of the total demand for money and the supply of money (M)Since at any given time the supply of money (M) is fixed it can be represented as a vertical lineDetermination of the Interest Rate13-31Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Prime Rate of Interest Charged by Banks on Short-Term Business Loans, 1978-2001Although the prime rate is set by the nation’s largest banks, it is strongly influenced by actions of the Federal Reserve Board of Governors13-32Who Controls the Interest Rates?People who borrow moneyplayersBanksrefereeThe FEDcoachCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.13-33Keeping Track of Interest RatesCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Wall Street Journal, Dec. 11, 1989Wall Street Journal, Dec. 7, 1989Note how the rates all move up and down virtually in lockstep, while maintaining the same distances from each other.All interest rates move up and down together.Banking: A Short History13-34Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.What is the goldsmith’s reserve ratio when there are 1,000 receipts in circulation and 1,000 coins the safe?Answer: 100 percentBanking: A Short History13-35Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.What is the goldsmith’s reserve ratio when there are 1,000 receipts in circulation and 500 coins the safe?Answer: 50 percentBanking: A Short History13-36Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.What is the goldsmith’s reserve ratio when there are 1,000 receipts in circulation and 250 coins the safe?Answer: 25 percentModern BankingA bank is a financial institution that accepts deposits, makes loans, and offers checking accountsBanks keep about 2% of their deposits in the form of vault cashAll the nation’s commercial banks, credit unions, savings and loan associations, and mutual savings banks now have to keep up to 10% of their checking deposits on reserveThis means “on the books”Remember, checking deposits are bookkeeping entries13-37Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Modern BankingCommercial BanksUntil the passage of the Depository Institutions Deregulation and Monetary Control Act of 1980, only commercial banks were allowed to issue checking depositsThey were the only institutions clearly recognized as banksCommercial banks account for the bulk of checkable depositsThere are slightly more than 9,000 commercial banks in the United StatesThey hold nearly all demand deposits and almost half of total savings deposits13-38Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Modern BankingMutual Savings BanksMostly operated in the northeastern United States, these institutions were created in the 19th century to encourage savings by the “common people”They traditionally made small personal loans, but today, like savings and loan associations, they offer the same range of services as commercial banksThere are nearly 1,600 mutual savings banks13-39Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Modern BankingSavings and Loan AssociationsAlthough originally established to finance home building, these associations also offer most of the services offered by commercial banksThe nearly 1,100 S&Ls invest more than three quarters of their savings deposits in home mortgages13-40Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Modern BankingCredit UnionsAlthough there are nearly 11,000 credit unions in the United States, they hold less than 5% of total savings depositsCredit unions offer a full range of financial servicesThey specialize in small consumer loansCredit unions are cooperatives that generally serve specific employee, union, or community groups13-41Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Modern BankingThe Banking Act of 1980 blurred the distinction between commercial banks and the three other depository institutionsThe main distinction – that before 1980 only commercial banks were legally allowed to issue checking accounts – was swept away in 198013-42Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Bank LendingBanks borrow money at low interest rates and lend money out at much higher interest ratesCurrently, banks pay either zero or up to maybe 3% interest on most deposits – and perhaps 1 or 2 points more if you leave your money on deposit for a few yearsBanks charge about 7% for fixed rate mortgages, a bit more for business loans, and about 18% on credit card loans13-43Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Financial IntermediariesFinancial intermediaries channel funds from savers to borrowsBasically, they repackage the flow of deposits, insurance premiums, pension contributions, and other forms of savings into larger chunks$10,000, $1 million, $50 million, or even moreThey pay low rates of interest to their lenders and charge relatively high rates to their borrowersSometime business borrowers dispense with financial middlemen altogether by borrowing directly from saversThe U.S. Treasury does this every month by issuing new bonds, certificates, notes, and billsLarge business borrows by issuing relatively short-term commercial paper and long-term bonds13-44Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Home Mortgage MarketIn the home mortgage market banks and other financial intermediaries differentiate between the relatively well off and the less fortunateJust over two thirds of all American families own their homesNearly all have outstanding mortgagesThe conventional market provided well off homeowners mortgages at interest rates in the seven-to-eight range in 2000 and 2001The subprime market caters to poorer home homeowners and has interest rates that are double what they are in the conventional market13-45Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Welfare Banks“Welfare banks” are check cashing storesYou will find one in virtually every poor neighborhoodThey usually charge a fee of 1 to 3% of the value of the check, but some charge as much as 20%Why don’t poor people go to banks? There are usually no banks in poor neighborhoods If you don’t have a required minimum balance, banks also charge pretty stiff fees People receiving public assistance are not allowed to have bank accounts13-46Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Creation and Destruction of MoneyBanks create money by making loansThis money is created out of nothingThis money is new money in the form of additional demand depositsMoney is destroyed when a loan is repaidWhen a loan is repaid, demand deposit accounts go downThis money disappears back into nothingThe interest that was paid does not disappear The Federal Reserve can affect the bank’s ability to create money by increasing or decreasing the bank’s reserve requirements13-47Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Bank RegulationBranch BankingBanking is legally defined as accepting depositsBranch banking , therefore, would be the acceptance of deposits at more than one location13-48Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Bank RegulationThe three types of branch bankingThree types of branch banking have evolved under various state lawsUnrestricted branch banking under which a bank may open branches through out the stateLimited branch banking under which a bank may be allowed to open branches only in contiguous communities Unit banking in which state law forbids any branching whatsoever13-49Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Bank RegulationAutomated teller machines (ATMs)Why shift to ATMs?Processing a teller transaction costs more than double what an ATM transaction costBy the end of 2000 there were about 250,000 ATMs doing more than 13 billion transaction a yearThis could lead to a decline in branch offices13-50Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Bank RegulationAutomated teller machines (ATMs)Should banks be allowed to charge fees to noncustomers?Virtually all bankers and most economists would answer “Yes!”Six out of seven ATM users don’t pay surchargesFees only hit users who go to ATMs not owned by their own bankBanning ATM surcharges would leave consumers with fewer choicesWe would all have to make do with fewer machines and longer lines13-51Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Bank RegulationState and Nationally Chartered BanksTo operate a bank you must get a charterMore than two-thirds of the nation’s banks have state charters, the rest have national chartersTo get a bank charter you need to demonstrate three thingsThat your community needs a bank or an additional bankThat you have enough capital to start a bankThat you are of good character13-52Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Bank RegulationState and Nationally Chartered BanksTo summarizeAll nationally chartered banks must join the Federal Reserve SystemAll Federal Reserve member banks must join the FDICOnly a small percentage of the state-chartered banks are members of the Federal ReserveNearly all banks are members of the FDIC13-53Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Bank RegulationInterstate BankingUntil 1994 interstate banking was technically illegal, although banks managed to engage in this practice by buying banks in other states and operating them as separate entitiesThe passage of the Riegle-Neal Interstate Banking and Branching Act of 1994 swept away the last barriers to opening branches in different states13-54Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Bank RegulationThe Federal Deposit Insurance Corporation (FDIC)After the massive bank failures of the 1930s, Congress set up the FDICThe whole idea of the 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 failThe FDIC would rather pay another bank to take over ailing institutions rath