Money & Banking

Dr. Katie Sauer

Metropolitan State College of Denver (ksauer5@msudenver.edu)

Presented at Junior Achievement’s Elementary School Personal Financial Literacy Workshop

in collaboration with the Colorado Council for Economic Education

Session Overview

I. MoneyII. Money and BankingIII. The Federal Reserve SystemIV. The Fed’s Tools of Monetary Policy

I. Money

The social custom of using money for transactions is extraordinarily useful in a large, complex society.

The existence of money makes trade between people easier.

Imagine, for a moment, that there was no item in the economy widely accepted in exchange for goods and services.

People would have to rely on barter–the exchange of one good or service for another–to obtain the things they need.

Barter System

1. In order for a transaction to take place, there needs to be a double coincidence of wants.

2. There is no common measure of value.

5 pigs = ? shoes= ? haircuts= ? Insurance

Number of unique exchange rates in a barter economy:

N( N-1) 2

Monetary System

1. In order for a transaction to take place, a buyer must have money and the seller must accept money.

2. The value of every goods and service is measured in the same terms.

- in US, all goods and services are in valueddollars and cents

Barter System

3. Certain goods/services are not indivisible.

I want to buy 4 chairs from you.

I only have one cow, which is agreed to be worth more than 4 chairs.

It is hard for me to sell you part of a cow.

Monetary System

3. Money is fairly divisible.

Currency: pennies, nickels, quarters …

$1 $5 $10 $20 …

Electronic transfers:fractions of a penny

Barter System

4. Lack of standards for future payments.

Do I owe you a tank of gas or do I owe you something of equal value to a tank of gas?

5. Difficulty in storing wealth.

Some goods are durable, some are not.

Monetary System

4. Common standard for future payments.

All future payments can be made in money.

5. By definition, money must be able to store wealth for the future.

Money is the set of assets that people generally use to buy goods and services.

In order to be money, the asset has to fulfill 3 functions:1. medium of exchange: an item that buyers give to sellersin exchange for goods and services

ex: paper bills, coins, shells, cigarettes

2. unit of account: the “yardstick” that people use to postprices and record debts

ex: your Visa bill is denominated in dollars notchickens

3. store of value: the item can be used to transfer purchasing power from the present to the future

ex: diamonds are durable, milk is not

There are 2 kinds of money:

1. Commodity money takes the form of a commodity that has intrinsic value.

- the material that the money is made of has uses besidesmoney

ex: gold, silver, cigarettes

2. Fiat money has no intrinsic value; it is a material used as money by government decree.

- the general public also has to believe it has valueex: US paper bills

Don’t be Afraid of Fiat Money

Money is simply a means to an end. - it is a way to make transactions easier- it is a way to transfer purchasing power to the future

Money itself doesn’t matter to you … what matters is that you can trade the money for things you want and need, now or in the future.

- money is a tangible symbol of purchasing power

Trading money for gold serves no real purpose for you.

If you want to trade money for gold so you can trade gold for goods and services, the gold is no different than the paper currency.

Money is simply a societal agreement. (but a very important one)

Money in the US economy

The quantity of money in the US economy basically consists of cash and money in checkable bank accounts.

currency: paper bills and coins in the hands of the publicas of 2/21/2010 $930.7 billion (fms.treas.gov)

demand deposits: money in an account that can be accessed on demand by writing a check

as of 2/21/2010 $943.1 billion (fms.treas.gov)

fms.treas.gov

Another way to measure the quantity of money is to add in other types of bank accounts (savings, CDs, money market mutual funds).

- total amount of money in the US economy is about $8.5 trillion including these accounts

II. Money and Banking

The quantity of money in the economy is affected by the amount of money deposited in banks and they amount they lend out.

The US has a fractional reserve banking system. This means banks do not have to keep all deposits on hand, they can lend out a portion of them.

The fraction of deposits that a bank must keep on hand is called the reserve requirement ratio.

-aka reserve requirement, reserve ratio, required ratio

- For large banks, this ratio is 10%.

Ex: Suppose a bank has $200 million worth of deposits.

That bank has to keep at least (200m)(0.10) = $20million

on hand at all times.

It can lend out the other $180million if it wants to.

Because deposits are counted in the money supply, loans that become deposits will increase the money supply.

The banking system “creates” money.

So far, the original deposit of $1000 has become $1000 + $900 + $810 + $729

And the cycle will continue…

The maximum amount of money that can be created from an initial deposit is equal to

initial deposit x (1/rr)

1/rr is called the money multiplier.

If the required reserve ratio is 10%, the money multiplier equals:1/(0.10)= 10

So, if the initial deposit is $1000, the maximum amount of money that can be created in the banking system is

1000 x 10 = $10,000

Banking Institutions

Central Bank = institution which oversees the banking system and regulates the quantity of money in the economy

- “banking system’s bank”

Commercial Bank = 1. refers to any bank that is not an investment bank

- performs normal banking functions

2. a bank that mostly deals with deposits and loans from corporations or large businesses

Commercial Bank = institution which provides transactional, savings, and money market accounts and that accepts time deposits

- money market accounts = bank invests in government and corporate securities and pays the depositor interest based on current interest rates in those markets

- typically have a higher interest rate than savingsaccounts- typically require a higher minimum balance to earn interest or avoid monthly fees

- time deposits = deposit cannot be withdrawn for a certain term or period of time, unless a penalty is paid

- typically pay higher interest the longer the term

Savings Bank = institution who’s primary purpose is accepting savings deposits

- can perform other functions

Retail Bank = institution which executes transactions directly with consumers (rather than corporations or other banks).

- savings and transactional accounts, mortgages, personal loans, debit cards, credit cards, etc

Credit Union = cooperative financial institution that is owned and controlled by its members and operated for the purpose of promoting savings, providing credit at reasonable rates, and providing other financial services to its members.

Savings and Loan Association (aka Thrift)= taking deposits for savings and transaction accounts, make mortgages

- tend to be smaller than other banks and are more focused

on the local communities in which they operate

Investment Bank = financial institution that assists individuals, corporations and governments in raising capital

- underwriting and/or acting as the client's agent in the issuance of securities.

- assist companies involved in mergers and acquisitions

- services such as trading of derivatives, foreign exchange, commodities, and stocks

- they do not take deposits

III. The Federal Reserve System

The Federal Reserve (the Fed) is the Central Bank of the UnitedStates. federalreserve.gov

A Central Bank is an institution which oversees the banking system and regulates the quantity of money in the economy.

The Fed was created in 1913 after a series of bank failures.

The Federal Reserve System is comprised of-Board of Governors headquartered in Washington D.C. -Federal Open Market Committee-12 Regional District Banks

1. The Board of Governors (BoG) has 7 members who serve 14 year terms.

Their primary responsibility is the formulation of monetary policy.- sit on the Federal Open Market Committee

It also has regulatory and supervisory responsibilities over banks.

2. The Federal Open Market Committee (FOMC) makes decisions regarding the quantity of money in the economy.

The FOMC is most important monetary policymaking body of the Federal Reserve System.

The monetary policy is designed to promote economic growthfull employmentstable pricessustainable pattern of international trade and payments

At meetings they discuss economic conditions and decide how to adjust the money supply.

3. 12 Regional District Banks that serve as the operating arms of the nation's central banking system. (the banks’ bank)

- move currency in and out of circulation- check clearing- supervise/ examine banks- hold banks’ cash reserves and make loans to banks

IV. The Fed’s Tools of Monetary Policy

When the economy is sluggish, the Fed may want to try to stimulate it by lowering interest rates.

- firms do more investment when interest rates are low- economic activity increases

When the economy is experiencing inflation or is “heating up” too quickly, the Fed may want to try to slow it down by raising interest rates.

- firms do less investment when interest rates are high- economic activity decreases

1. The Fed controls the required reserve ratio. - hugely powerful tool- almost never used

This affects the amount of money that banks can lend out.- more lending means more economic activity

When the reserve requirement is raised:- banks are able to lend out less so the quantity of money in the economy falls - slows the economy down

When the reserve requirement is lowered:- banks are able to lend out more so the quantity of money in the economy rises - speeds the economy up

2. The Fed controls the discount rate, which is the interest rate that the Fed charges to banks for loans (BoG - every 6 weeks)

This is the only interest rate the Fed can directly control.

This interest rate usually just acts as a signal from the Fed to banks about what the Fed would like banks to do.

A higher discount rate: - means that it will be more costly for banks to borrow from the Fed (should they need to)

- so banks take this as a signal to lend out less (be less risky)

- when banks lend out less, the quantity of money in theeconomy falls

- economy slows down

A lower discount rate: - means that it will be less costly for banks to borrow from the Fed (should they need to)

- so banks take this as a signal to lend out more (okay to be more risky)

- when banks lend out more, the quantity of money in theeconomy rises

- economy speeds up

3. Open Market Operations are the purchase or sale of US government bonds by the Fed. (FOMC – every 6 weeks)

The Fed uses Open Market Operations to target the Federal Funds Rate.

- can’t control the Fed Funds Rate directly

The Federal Funds Rate is the rate that banks charge each other on short term loans. (overnight)

Why would banks borrow from each other overnight?- a bank might not have enough reserves on hand to meettheir requirement (made too many loans)

- books must balance at close of business

- borrow from another bank just overnight

When the Fed buys bonds:- banks receive cash in exchange for the bonds theywere holding

- banks have more cash reserves on hand so they are willing and able to lend it out to other banks

- this decreases the federal funds rate

- banks know it is cheap to borrow from a bank overnightso they are willing to make more loans

- quantity of money in the economy rises

- economy speeds up

When the Fed sells bonds:- banks receive bond certificates in exchange for their cash

- banks have less in cash reserves on hand so they are not as willing and able to lend it out to other banks

- this increases the federal funds rate

- banks know it is more expensive to borrow from a bank overnight so they want to make fewer loans

- quantity of money in the economy falls

- economy slows down

Summary of Policy Tools:

To slow down the economy, the Fed will decrease the quantity of money in the economy.

- raise the required reserve ratio- raise the discount rate- raise the federal funds target and sell bonds

To speed up the economy, the Fed will increase the quantity of money in the economy.

- lower the required reserve ratio- lower the discount rate- lower the federal funds target and buy bonds

The Fed, interest rates, and you:

The Fed directly sets the discount rate.The Fed indirectly controls the federal funds rate.

Banks charge each other the federal funds rate and areinfluenced by the discount rate.

Banks charge their best customers the “prime rate”, whichis based on the discount rate and federal funds rate.

The interest rate on consumer loans is often “prime + X”.- credit card- mortgage