Chapter 13

Money and Banking

McGraw-Hill/Irwin
2009 The McGraw-Hill Companies, All Rights Reserved

Learning Objectives
We will discuss the following interesting topics:
1. The three jobs of money.
2. What money is.
3. M1, M2, and M3.
4. The demand for money.
5. The origins of banking.
6. Branch banking and bank chartering.
7. The FDIC.
8. The savings and loan debacle.
9. Wal-Mart Bank?
10. Overdraft privileges.

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Money
Definition: any asset that can be used to make a
purchase

Many things have been used as money: corn, beads, whales

teeth, shells, stones, feathers, salt, cocoa beans, and, of
course, gold and silver.
Ideally, asset should be somewhat scarce, divisible, and
portable.

Three jobs of money:

Medium of exchange
Standard of value
Store of value

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Medium of Exchange
Defining job of moneyto serve as a vehicle to enable
transactions.
Makes it easier to buy and sell than relying on barter
Barter requires double coincidence of wants, meaning two
people each of whom wants what the other has to trade.

Must be universally accepted

Does not need to have intrinsic value (paper money)

To function as medium of exchange, we must feel

confident that people will accept money in exchange
for their goods and services.

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Standard of Value
Prices (expressed in money) are a common
denominator in which the relative value of goods and
services can be expressed.
If you buy a latte for $4, instead of a regular cup of coffee for
only $2, then the latte is at least twice as valuable to you.
If I will pay full-ticket price to see one movie in a first-run
theater, but decide to wait to see another on DVD, I am valuing
one movie more than the other.
If a company pays its CEO 1,000 times as much as its factory
workers, it is expressing the relative value of the services
provided by each.

While supply and demand set market prices, demand

curves are based on the relative value placed on
specific goods and services.
Question: What does priceless mean?
Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Store of Value
Money holds value better than many goods and
services.
If you paid your professor with food that you grew, the food
might spoil over time. Money doesnt spoil!

But inflation does devalue money over time:

Question: If you could buy 100 units of goods and services
with $100 in 1988, how many units could you buy with $100 in
2008?
Answer: You could have bought just 55 units.
During this period, inflation robbed the dollar of almost half of
its purchasing power.

Money is better store of value in the short run than in

the long run.
Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Our Money Supply

Money consists of:
Currency (coins and paper money)
Demand deposits (deposits in checking accounts)
Checklike deposits (commonly called NOWor Negotiable
Order of Withdrawalaccounts) held by the nonbank public

The following are NOT money:

Checks, debit cards, and electronic funds transfers are ways
of accessing your checking deposits, but they are not money.
Credit cards are ID cards that provide short-term loans from
issuing bank, not money.

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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M1 and M2
Currency
+ Demand deposits
+ Other checkable deposits
+ Travelers checks

= M1

M1
+ Savings deposits
+ Small-denomination time deposits
(less than $100,00)

M2 includes the basic money

supply, (M1), plus less liquid
forms of money.

+ Money market mutual funds held

by individuals

= M2
Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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M1 and M2, February 2008

(in billions of dollars)

Currency is more than 1/2 of M1, but 2/3 3/4 of U.S. currency
is held by foreigners, especially in countries with unstable currencies.
Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Annual Percentage Change in the Money

Supply, M1, 1960-2005

Fairly steady upward trend from 1960 to 1983

Greater fluctuations beginning in 1984
Federal Reserve controls growth of money supply.
Monetary policy increasingly important.
Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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The Demand for Money

The amount of money people hold is called money
balances.
John Maynard Keynes noted that people had three
motives for holding money (instead of buying longterm bonds):
1. Transactions motive: People hold money for purchases.
2. Precautionary motive: People hold money for rainy day.
3. Speculative motive: People hold money when they believe
interest rates will rise and they would be better off buying
bonds at higher rates in the future.

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Four Influences on the Demand for Money

Economists have since identified 4 factors that
influence how much money people want to hold:
1. Inflation: As prices increase, we need more money for
transactions.
2. Income: As income rises, people carry more money.
3. Interest rates: Quantity of money demanded decreases as
interest rates rise.
At high interest rates, buying bonds becomes more attractive.
The opportunity cost of cash increases.

4. Credit availability: As credit cards and bank loans are more

available, people hold less money in cash or checking
accounts.

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Bank Deposits and Money Creation

U.S. banks do not print or issue money anymore.
But demand deposits are part of the money supply, so
banks play an important role in how money is created.
To understand modern banking, lets start with a short
history of banking.

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Goldsmiths as Bankers
In Medieval Europe, people would store their gold
coins with the local goldsmith, who had a safe.
Goldsmith gave them receipts for a certain amount of gold.
Gradually, the receipts began to circulate as paper money.

Goldsmiths realized that everyone did not come for

their gold at the same time.
They began to lend out gold coins from the safe.
Next, they began to lend out receipts for gold.

Banking system created when the number of receipts

was greater than coins in safe.
Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Reserve Ratio
Money created through loans.
More receipts were circulating than gold in safes.

To be reliable, bank (or goldsmith) had to keep enough gold coins

for anyone who came to cash in their receipts.
Reserve ratio:

Number of coins in safe

Number of receipts in circulation

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Reserves in vault
Demand deposits

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Calculating Reserve Ratio

A. What is the
goldsmiths reserve
ratio when there are
1,000 receipts in
circulation and 1,000
coins the safe?

Answer: 100%

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Calculating Reserve Ratio #2

Try calculating the

reserve ratio for B
and C.

Answers: 50% and

25%

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Modern Banking
A bank is a financial institution that accepts deposits,
makes loans, and offers checking accounts.
Like the goldsmiths, banks lend out some of their
deposits and keep some as reserves:
They pay interest to their depositors.
They charge higher interest rates to their borrowers.

Profit incentive is to keep reserves low:

Banks would prefer a low reserve ratio, around 2%.
Federal regulators make them keep around 10% of their
checking deposits on reserve, to ensure stability of banking
system.

Government regulation prevents runs on banks.

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Kinds of Banks
Commercial Banks (7,100 in U.S.)
Commercial banks account for the bulk of checkable deposits.
Usually have the word bank in their name.

Savings and Loan Associations (almost 500)

Originally established to finance home building.
The nearly 500 S&Ls invest more than 3/4 of their savings deposits
in home mortgages.

Mutual Savings Banks (1,000)

Concentrated in the northeastern U.S.
Created in the 19th century to encourage savings.

Credit Unions (10,000)

Cooperatives that generally serve specific employee, union, or
community groups.
Account for less than 5% of savings in U.S.

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Banking Deregulation
Lines between different kinds of banks has blurred
since passage of the Depository Institutions
Deregulation and Monetary Control Act of 1980.
Before, only commercial banks had checking accounts.
Now, many S&L associations, mutual savings banks, and
credit unions offer most of the same services as commercial
banks.

Further deregulation in 1994 permitted internet

banking.
Deregulation designed to increase competition.
But it has led to mergers and acquisitions, so in actuality
there is less competition.

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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The Top Ten American Banks, Ranked by

Assets, February 2008
There has been a
trend toward
consolidation of
banking industry
over last 25 years.
These top ten banks
hold nearly 2/3 of all
bank deposits in the
U.S.
Consolidation has
also led to
economies of scale,
enabling banks to
offer more services.
Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Worlds Top Ten Banks, Ranked by Assets,

March 2008

Banking is an increasingly global industry.

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Welfare Banks
Consolidation has led to a polarization of banking.
Offer high-end customers new services
Increase fees, raise minimum balances, and close branches in
less-profitable areas
Harder for working families and poor to access banks

Market response: Check-cashing stores

Charge fees to cash paychecks and benefit checks
Sell money orders (instead of checks)
But poor can least afford these high fees

American Bankers Association is blocking legislation

requiring banks to cash U.S.-issued Social Security
and welfare checks and provide other services to poor.
Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Questions for Thought and Discussion

Do you have a checking account or savings account?
Where do you bank? Has your bank merged (perhaps
changed its name) in recent years?
Have minimum balances or fees increased?

Have bank branches opened or closed in your

neighborhood?
Are there check-cashing stores in your neighborhood or any
neighborhoods you know?

Do check-cashing stores exploit their customers by

charging high fees?
Is using their services voluntary?
What drives up the price of these services?

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Banks are a Form of Financial Intermediaries

Financial intermediaries channel funds from savers to
borrows.
Not all financial intermediaries are banks:
Sometime business borrowers dispense with financial
middlemen altogether by borrowing directly from savers.
The U.S. Treasury does this every month by issuing new bonds,
certificates, notes, and bills.
Large business borrows by issuing relatively short-term
commercial paper and long-term bonds.

Money market funds, pension funds, insurance companies,

and consumer finance companies all invest their contributions
by lending money or buying stocks and bonds.
Subprime mortgages are generally issued by nonbank
financial intermediaries (Countrywide Credit, Household
International).
Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Home Mortgage Market

Just over 2/3 of all American families own their homes.
Nearly all have outstanding mortgages.

In the home mortgage market, banks and other

financial intermediaries differentiate between the
relatively well off and the less fortunate.
Conventional market: Banks, savings & loans, and credit
unions make loans to middle-class and well-off homeowners.
Subprime market: Caters to poorer homeowners and has
interest rates that are double that in conventional markets.

Debate exists over whether higher rates are justified by

higher risk of default or constitute price gouging.

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Subprime Mortgage Crisis

In recent years, housing prices have been escalating,
creating a price bubble.
Homeowners traded up to more expensive homes and used
equity for consumer borrowing.
Speculators flipped homes to get quick profits.
Mortgage lenders aggressively marketed Subprime mortgages
with flexible rates to those who could barely afford them.

Housing market began its decline in 2007.

Supply > Demand Falling prices
Subprime borrowers began to default on loans
Countrywide and other Subprime lenders in financial trouble

Should Congress bail out low-income borrowers?

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Bank Regulation
Unlike some forms of business, someone cannot just
decide to open a bank.
To operate a bank you must get a state or national
charter.

More than two-thirds of the nations banks have state

charters.
The rest have national charters. All nationally chartered
banks must join the Federal Reserve System.

To get a bank charter you need to demonstrate:

1. That your community needs another bank.
2. That you have enough capital to start a bank.
3. That you are of good character.

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Bank Branches
Three types of banking have evolved under various
state laws:
1. Unrestricted branch banking: a bank may open branches
throughout the state.
2. Limited branch banking: a bank may be allowed to open
branches only in contiguous communities.
3. Unit banking in which state law forbids any branching
whatsoever.

Interstate banking was technically illegal until 1994:

Some banks owned banks in multiple states but operated

them as separate entities.
Passage of the Riegle-Neal Interstate Banking and
Branching Act of 1994 swept away the last barriers to
opening branches in different states.

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Questions for Thought and Discussion

Automated teller machines (ATMs) expand bank
services, especially since you can withdraw funds from
other banks than your own.
Should banks be allowed to charge fees to noncustomers who use their ATM?
Six out of seven ATM users dont pay surcharges.

What might happen if fees were banned? How would

profit-maximizing banks respond?
Why do some convenience stores offer no-fee ATM
machines?
Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Key Regulator: The Federal Deposit Insurance

Corporation (FDIC)

After the massive bank failures of the 1930s, Congress

set up the FDIC.
Aim of 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 fail.
Each depositor insured up to $100,000.

More than 99 percent of banks are members of FDIC.

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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The Savings and Loan Debacle

In early 1990, the financial press was calling the S&L
debacle the greatest financial scandal in the history of
the United States.
Incompetence, inordinate risk-taking, poor supervision,
and outright fraud all played prominent roles in the
decline and fall of the savings and loan industry.
The federal government ended up paying perhaps
$200 billion to clean up the mess.
Depositors were paid off.
Hundreds of failed S&Ls were shut down.
Surviving S&Ls are now more closely supervised.
Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Current Issue: Overdraft Privileges

Definition: If you didnt have enough money in your
account to cover the check you wrote, your check used
to bounce.
Now, you just pay an overdraft fee of $15$35 per overdraft.
It is possible to incur several overdrafts before you become
aware of it.
Essentially, this is a high-interest-rate loan.

Issue really comes down to truth in lending.

Banks could be more forthcoming about the cost of the
overdraft privileges they so freely extend.

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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