Lecture Essentials of economics (3/e): Chapter 14 - Brue, McConnell, Flynn

Chapter 14

Money, Banking,
and Financial
Institutions

McGraw­Hill/Irwin

Copyright © 2014 by The McGraw­Hill Companies, Inc. All rights reserved
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Functions of Money 

• Medium of exchange
• Used to buy/sell goods
• Unit of account
• Goods valued in dollars
• Store of value
• Hold some wealth in money form
• Liquid
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Money Definition M1

• M1
• Currency
• Checkable deposits
• Institutions offering checkable deposits

• Commercial banks
• Savings and loan associations
• Mutual savings banks
• Credit unions
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Money Definition M2

• M2
• M1 plus near-monies
• Savings deposits including money
market deposit accounts (MMDA)
• Small-denominated time deposits
• Money market mutual funds
(MMMF)

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Money Definitions
Money supply, M2
$9001 billion

Currency
50%

Savings deposits, including
money market deposit accounts
61%

M1
22%

Checkable
deposits
50%
Money supply, M1
$1935 billion
Source: Federal Reserve System

Small time
deposits
9%

Money market
mutual funds
8%
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What “Backs” the Money Supply?

• Guaranteed by government’s ability to
•
•

keep value stable
Money as debt
Why is money valuable?

• Acceptability
• Legal tender
• Relative scarcity
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What “Backs” the Money 
Supply?

• Prices affect purchasing power of
•
•

money
Hyperinflation renders money
unacceptable
Stabilizing money’s purchasing power
• Intelligent management of the
money supply—monetary policy
• Appropriate fiscal policy
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Federal Reserve — Banking System

• Historical background
• Board of Governors
• 12 Federal Reserve Banks
• Serve as the central bank
• Quasi-public banks

• Banker’s bank
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Federal Reserve — Banking System
Board of Governors
Federal Open Market Committee

12 Federal Reserve Banks

Commercial banks

Thrift institutions
(savings and loan associations,
mutual savings banks,
credit unions)

The public
(households and
businesses)

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Federal Reserve — Banking System
The 12 Federal Reserve Banks

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Federal Reserve — Banking System

• Federal Open Market Committee
• Aids Board of Governors in setting
•

monetary policy
• Conducts open market operations
Commercial banks and thrifts
• 6,800 commercial banks
• 8,700 thrifts
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Federal Reserve Functions

•
•
•
•
•
•
•

Issue currency
Set reserve requirements
Lend money to banks
Collect checks
Act as a fiscal agent for U.S. government
Supervise banks

Control the money supply
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Federal Reserve Independence

• Established by Congress as an
•
•

independent agency
Protects the Fed from political
pressures
Enables the Fed to take actions to
increase interest rates in order to
stem inflation as needed
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Global Snapshot
World’s 12 Largest Financial Institutions, 2011
Assets (billions of U.S. dollars)
BNP Paribas (France)

2,681

Deutsche Bank (Germany)

2,557

HSBC Holdings (U.K.)

2,468

Barclays (U.K.)

2,328

Royal Bank of Scotland (U.K.)

2,266

Bank of America (U.S.)

2,265

Mitsubishi UFJ (Japan)

2,177

Crédit Agricole (France)

2,131

JP Morgan Chase (U.S.)

2,118

Citigroup (U.S.)

1,914

ICBC (China)

1,724

Mizuho Financial (Japan)

1,667
Source: Forbes Global 2000, www.forbes.com
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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 bonds
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The Financial Crisis of 2007 and 
2008

• Securitization — the process of

•
•

LO5

slicing up and bundling groups of
loans into new securities
As loans defaulted, the system
collapsed
“Underwater” homeowners
abandoned homes and mortgages
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The Financial Crisis of 2007 and 
2008

• Failures and near-failures of financial

•

firms
• Countrywide: second largest lender
• Washington Mutual: largest lender
• Wachovia
Other firms came close

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The Financial Crisis of 2007 and 
2008

• Troubled Asset Relief Program
(TARP)
• Allocated $700 billion to make
emergency loans
• Saved several institutions from
failure

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Postcrisis U.S. Financial 
Services 

• Major categories of financial institutions
• Commercial banks
• Thrifts
• Insurance companies
• Mutual Fund companies
• Pension funds
• Securities firms
• Investment banks
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Major Categories of Financial Institutions
Institution

Description

Examples

Commercial
banks

State and national banks that provide checking and
savings accounts and make loans

JPMorgan Chase,
Bank of America,
Citibank, Wells Fargo

Thrifts

Savings and loan associations, mutual savings banks,
credit unions that offer checking and savings accounts
and make loans

Charter One, New
York Community
Bank

Insurance
companies

Firms that offer policies through which individuals pay
premiums to insure against loss

Prudential, New York
Life, Northwestern
Mutual, Hartford

Mutual Fund
companies

Firms that pool customer deposits to purchase stocks
or bonds

Fidelity, Vanguard,
Putnam, Janus, T.
Rowe Price

Pension funds

Institutions that collect savings from workers
throughout their working years and then invest the
funds to pay retirement benefits

TIAA-CREF,
Teamsters’ Union,
CalPERs

Securities firms

Firms that offer security advice and buy and sell stocks
and bonds for clients

Merrill Lynch, Smith

Barney, Charles
Schwab

Investment
banks

Firms that help corporations and governments raise
money by selling stocks and bonds

Goldman Sachs,
Morgan Stanley,
Deutsche Bank,
Nomura Securities
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Postcrisis U.S. Financial Services 

• Wall Street Reform and Consumer
Protection Act
• Passed to help prevent many of
the practices that led to the crisis
• Critics say it adds heavy
regulatory costs

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Fractional Reserve System

• The goldsmiths
• Stored gold and gave a receipt
• Receipts used as money by public
• Made loans by issuing receipts
• Characteristics:
• Banks create money through lending
• Banks are subject to “panics”
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Fractional Reserve System

• Balance sheet
• Assets = Liabilities + Net worth
• Both sides balance
• Necessary transactions
• Create a bank
• Accept deposits
• Lend excess reserves
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A Single Commercial Bank
Transaction #1
Vault cash: cash held by the bank
Creating a Bank

Balance Sheet 1: Wahoo Bank
Assets
Cash

Liabilities and Net Worth
$250,000 Stock shares

$250,000

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A Single Commercial Bank
Transaction #2
Acquiring property and equipment
Acquiring Property and Equipment
Balance Sheet 2: Wahoo Bank

Assets
Cash
Property

Liabilities and Net Worth
$ 10,000 Stock shares
240,000

$250,000

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