Eco 200 – Principles of Macroeconomics

Chapter 13: Money and Banking

Money Money = any item that is generally

accepted as a means of payment for goods and services

Common functions of money: medium of exchange unit of account store of value standard of deferred payment

Money does not always serve in the last three of these functions.

Evolution of money Commodity money Token money Fiat money (legal tender) Electronic transfers Gresham’s law – “bad money

drives out good”

Monetary aggregates: M1 M1 = those items that serve as a

medium of exchange M1 = currency (including coins) +

checkable deposits + traveler’s checks

Note that credit does not serve as money

M2 and M3 M2 = M1 + savings deposits +

small denomination (< $100,000) time deposits + retail money market mutual fund balances

M3 = M2 + repurchase agreements + Eurodollar deposits

Global money Sales among industrialized countries usually

conducted in the currency of the seller Sales between industrialized and developing

countries are usually conducted in the developed country’s currency

Currencies of industrialized countries dominate international transactions

International reserve currency – used to settle debts between governments (dollar, pound, euro, and yen are most commonly used)

Composite currencies ECU – introduced in 1979 – value

tied to weighted average of national currencies of EU – (replaced by the euro)

Special drawing rights – average of the values of the dollar, euro, yen, and pound – created in 1970 by the IMF

Banking Commercial banks – traditionally

offered only checking accounts Thrift institutions – traditionally

offered only savings accounts Financial deregulation in the 1980s

eliminated the last remaining distinctions between commercial banks and thrift institutions

Financial intermediation Direct finance – loans made directly from lenders

to borrowers Financial intermediation – banks (and other

financial intermediaries) accept deposits and make loans

Financial intermediaries receive profits fr5om the difference in interest rates on loans and deposits

Reasons for financial intermediation: economies of scale lowers transaction costs Savers and borrowers have different time

horizons

U.S. Banking Dual banking system: national and

state chartered banks Multistate branching is a recent

phenomenon

Bank failures High failure rates in the 1930s and

1980s Federal Deposit Insurance

Corporation (FDIC) – created in 1933 – insures deposits up to $100,000

International banking Eurocurrency markets – deposits held in

currencies that differ from the currency of the country in which the bank is located

Eurocurrency deposits are not subject to U.S. banking laws and offer higher interest rates (along with higher risk)

International banking facilities – since 1981- bookkeeping systems that allow U.S. banks to participate in offshore banking activities

Fractional reserve banking system Banks create money whenever a loan is

issued. Reserve requirement (set by Federal Reserve

Board) = fraction of deposits that must be held as reserves

Reserves = vault cash + deposits at Fed Banks may loan their excess reserves Required reserves = reserve requirement x

deposits Excess reserves = total reserves – required

reserves

T-accounts and deposit multiplier

Initial assumptions: no currency holdings no excess reserves

Deposit expansion multiplier = 1/reserve requirement (shown on board)

Actual expansion is less due to: excess reserve holdings currency holdings