Money and Banking
chapter thirteen
money and banking
CHAPTER OVERVIEW
Chapters 13, 14, and 15 form a conventional unit on money and banking. These chapters provide the foundation for the discussion of modern monetary theory and for the discussion and analysis of the monetarist and competing theories that follow.
Chapter 13 introduces the student to the U.S. financial system. The chapter first covers the nature and functions of money and then discusses the Federal Reserve System’s definition of the money supply. Next, the chapter addresses the question of what “backs” money by looking at the value of money, money and prices, and the management of the money supply. The demand for money is then covered, and it is followed by an introduction and discussion of the money market. Finally, there is a rather comprehensive description of the U.S. financial system, which focuses on the features and functions of the Federal Reserve System and recent developments in the U.S. financial system.
WHAT’S NEW
The entire chapter has been updated and streamlined with revised discussion of the structure and role of the Federal Reserve System. There are minor revisions to the End-of-Chapter Questions.
A “Consider This” box titled “Are Credit Cards Money?” has been added. In the previous edition this appeared in the website’s Analogies, Anecdotes, and Insights section.
The Last Word, “The Global Greenback,” has been updated.
INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to
1. List and explain the three functions of money.
2. Define the money supply, M1 and nearmonies, M2, and M3.
3. State three reasons why currency and checkable deposits are money and why they have value.
4. Identify two types of demand for money and the main determinant of each.
5. Describe the relationship between GDP and the interest rate and each type of money demand.
6. Explain what is meant by equilibrium in the money market and the equilibrium rate of interest.
7. Explain the relationship between bond prices and the money market.
8. Describe the structure of the U.S. banking system.
9. Explain why Federal Reserve Banks are central, quasipublic, and bankers’ banks.
10. Describe seven functions of the Federal Reserve System and point out which role is the most important.
11. Summarize and evaluate the arguments for and against the Federal Reserve System remaining an independent institution.
12. Describe the conditions that have caused the loss of market share of banks and thrifts to pension funds, insurance companies, mutual funds, and securities-related firms.
13. Identify three major changes continuing to occur in the financial services industry.
14. Define and identify terms and concepts listed at the end of the chapter.
COMMENTS AND TEACHING SUGGESTIONS
1. Definitions of the money supply are arbitrary, and this should be stressed. The definition of M1 changes over time as different instruments become acceptable as money.
2. Most students are fascinated by money and will find trivia on the subject interesting. If you would like to share some of that, consider using the following “Concept Illustration” that appeared on the website of the previous edition.
Concept Illustration … U.S. paper currency
Trivia can be interesting! Did you know these facts about U.S. currency (Federal Reserve Notes)?1
§ The Bureau of Engraving and Printing, a Division of the United States Treasury, prints Federal Reserve Notes in denominations of $1, $2, $5, $10, $20, $50, and $100. Since 1946, no $500, $1,000, $5,000, and $10,000 denominations have been printed.
§ Regional Federal Reserve Banks issue the currency and are identified by coding on the face of each bill: A1 = Boston; B2 = New York; C3 = Philadelphia; D4 = Cleveland; E5 = Richmond; F6 = Atlanta; G7 = Chicago; H8 = St. Louis; I9 = Minneapolis; J10 = Kansas City; K11 = Dallas; L12 = San Francisco.
§ The newly designed bills have several security features, some of which are readily visible. Examples: (1) A watermark depicts the same person as the portrait and is visible from both sides when held up to a light. (2) The same technique reveals a vertical security thread containing “USA” in the strip. (3) The numeral in the lower right corner looks bright green when examined head on, but shifts to dark green when the bill is held at an angle.
§ The circle on the right side of the back of the $1 bill contains symbolism representing the 13 original states. The burst of light above the eagle’s head contains 13 stars. The right claws hold an olive branch with 13 leaves and the left claws hold 13 arrows. (The eagle’s head is turned toward the olive branch.) The shield has 13 stripes. The ribbon held in the eagle’s beak contains the Latin motto: E Pluribus Unum, which has 13 letters and means “out of many, one.”
§ The unfinished pyramid in the left circle on the back of the $1 bill symbolizes striving toward growth and perfection. The eye inside the triangle represents the eternal eye of God. The Roman numerals at the base of the pyramid are “1776,” the founding year of the United States.
§ The average life of the $1 bill is 18 months. The $50 and $100 bills—handled less often—have average lives of 5 and 8 years, respectively.
§ Beginning in 1934 all U.S. paper currency was inscribed with “The United States of America Will Pay to the Bearer on Demand One [Five, Ten, etc.] Dollar [s] in Lawful Money.” In 1964 the inscription was replaced with “This Note is Legal Tender for Debts, Public and Private.”
§ The Federal Reserve estimates that only 3/100ths of 1 percent of total currency in circulation is counterfeited. Authorities seize about 75 percent of all counterfeited money before it is circulated.
§ If you accept a counterfeit bill, you are stuck with the loss. Don’t try to pass a known counterfeit bill to someone else, or you can be fined up to $5,000.
§ As long as you present what is clearly more than one-half a bill, a bank will accept it for deposit or replace it. The bank then sends the bill to a Federal Reserve Bank, which destroys it and issues another bill in its place.
Source: Federal Reserve System, “Fundamental Facts about U. S. Money,” 1998.
3. The Federal Reserve Banks publish a number of excellent lowcost or free educational materials. A comprehensive guide to these, along with ordering information, is found in Public Information Materials, available from the Federal Reserve Bank in your district. It could be ordered from any district, or from the New York Federal Reserve Bank, 33 Liberty Street, New York, NY 10045. Address your requests to the Public Information Department of the district bank that you write. The Federal Reserve Bulletin contains a wealth of financial and economic statistics. Write The Board of Governors, Federal Reserve System, Washington, D.C. 20551 for subscription information or check their website given in the first web-based question.
4. As an inclass exercise, have the students collectively identify some or all of the Federal Reserve districts by finding the bank of issue on bills they have in their possession. On older currency notes the issuing bank is shown in the circle on the left side of the face of the bill. On the newer style of notes the name of the issuing Federal Reserve Bank does not appear on the bill, but the district number and corresponding letter of the alphabet do appear toward the upper left-hand corner (e.g., L12 denotes the San Francisco district). See if all twelve are represented among the bills present in your classroom.
5. Students may be curious why the name of the issuing bank no longer appears on the bill; it is one of the many anticounterfeiting measures appearing on the new style bills. The next generation of bills, introduced with the $20 bill in late 2002, adds more color variety and additional anti-counterfeiting features.
6. There is a lot of ignorance among the general population as to what gives money its value. An interesting experiment is to have students create their own money and attempt to spend it in the community. When their currency is refused in transactions, have students ask the vendors why it is refused and record the responses for later classroom discussion. This would, of course, have to be monitored closely. It is not illegal to create your own currency so long as you are not attempting to recreate or pass it off as legal tender. Student currency would have to look sufficiently different from genuine U.S. currency.
7. Ask students to give examples of each one of the functions of money and point out that in some contemporary countries, inflation has undermined these functions. In these countries, people often prefer U.S. dollars instead of their own currencies because their currencies don’t store value or work for long as a unit of account since prices change rapidly.
8. Discuss the use of barter as an alternative means of exchange in places like Russia and Ukraine. Ask students to relate examples of barter exchanges they have made. Note the conditions required for barter. Give students an opportunity to explain why barter exchanges are inconvenient.
9. The Federal Reserve banks, including their branches, offer guided tours of their facilities, and many of the district banks also have exhibits in their public lobby areas. It is definitely a good “field trip” if you have the opportunity to take your students. If not, the bank’s public information department may be willing to schedule a presentation at your institution.
STUDENT STUMBLING BLOCKS
1. It is hard for students to believe that nothing intrinsic backs the money supply. Make sure they realize that the gold in Fort Knox (or elsewhere) has no function in terms of the value of our money. Returning to the gold standard continues to be advocated by some. It is a good topic for debate.
2. Point out to the students that the phrase “central bank” refers to the Federal Reserve System and the Board of Governors. This system acts as our Central Bank, whereas other countries have a single institution as their central bank.
3. Another common error that students make is to equate money with income. Focus on the distinction between the amount of money in one’s possession and one’s income. This helps students to understand that money and income are not synonyms. For example, you could ask them to estimate how much M1 money they have at the moment in currency and checking. If they are typical, this will be much less than their annual income. In other words, the student’s average money supply is less than the student’s income. The concept of velocity is introduced later, but it could be mentioned at this point as a way of helping students to contrast the money supply with income concepts.
4. If you want students to understand why interest rates on bonds vary as described in Money Market section, you must explain carefully. If bond price : rate relationship is not important for you, focus only on money : rate relationships. See question 9 at end of chapter for practice on relating bond prices to interest rates.
LECTURE NOTES
I. Functions of Money
A. Medium of exchange: Money can be used for buying and selling goods and services.
B. Unit of account: Prices are quoted in dollars and cents.
C. Store of value: Money allows us to transfer purchasing power from present to future. It is the most liquid (spendable) of all assets, a convenient way to store wealth.
II. Supply of Money
A. Narrow definition of money: M1 includes currency and checkable deposits (see Table 13-1).
1. Currency (coins + paper money) held by public.
a. Is “token” money, which means its intrinsic value is less than actual value. The metal in a dime is worth less than 10¢.
b. All paper currency consists of Federal Reserve Notes issued by the Federal Reserve.
2. Checkable deposits are included in M1, since they can be spent almost as readily as currency and can easily be changed into currency.
a. Commercial banks are a main source of checkable deposits for households and businesses.
b. Thrift institutions (savings and loans, credit unions, mutual savings banks) also have checkable deposits.
3. Qualification: Currency and checkable deposits held by the federal government, Federal Reserve, or other financial institutions are not included in M1.
B. Money Definition: M2 = M1 + some near-monies which include (See Table 13-1)
1. Savings deposits and money market deposit accounts.
2. Certificates of deposit (time accounts) less than $100,000.
3. Money market mutual fund balances, which can be redeemed by phone calls, checks, or through the Internet.
C. Money Definition: M3 = M2 + large certificates of deposit (time accounts) of $100,000 or more (See Table 13-1)
D. Which definitions are used? M1 will be used in this text, but M2 is watched closely by the Federal Reserve in determining monetary policy.
1. M2 and M3 are important because they can easily be changed into M1 types of money and influence people’s spending of income.
2. The ease of shifting between M1, M2, and M3 complicates the task of controlling the spendable money supply.
3. The definition becomes important when authorities attempt to measure and control the money supply.
E. CONSIDER THIS … Are Credit Cards Money?