MONEY & BANKING

Topics: Lesson 1 to 09
Five Parts of Financial System
Five Core Principles of Money & Banking
Money & Payment System
Other Forms of Payment
Financial Intermediaries
Financial Instruments & Markets
The Value of Money
Present Value Concepts

I. QUICK INTRODUCTION TO MONEY AND BANKING

Q: Why isn't it a good idea for me to try to pay my home heating bill by giving economics
lectures to people at the power company?
A (the obvious answer, but not the full answer): The power company might not want my
lecturing services. But, suppose for a minute that the company did. Then we'd have a "double
coincidence of wants" - I want their heating services, and they want my lecturing services, and a
trade could be arranged. Still, that probably wouldn't be very efficient, since I already have a job
and not much free time. There's a much easier way to pay my bill - I can pay with money.
--Paying with money is more convenient and less time-consuming.
MONEY (anything that is generally accepted as payment) is more efficient than BARTER
(trading goods/services for goods/services). Barter requires a double coincidence of wants (you
want the good/service that the other guy has to offer, and he wants the good/service that you have
to offer); money does not, because everybody can find some use for money.

Q: Given that I'm paying the power company with money, why would it probably be a
waste of time to drive down to their office (which is 40 miles away) and pay in cash?
A: Because it's inconvenient and I don't need to. It's much easier to write a check and mail it in,
or to have money debited from my bank account (e.g., pay by phone, automatic monthly debit).
-- Since the funds in your checking account balance are easily available for spending (through an
ATM withdrawal, a debit card, pay by phone, etc.), they count as money, too.

--BANK DEPOSITS, followed by CASH IN CIRCULATION, are the main form of money
in our society.
---Banks make the monetary system a lot more efficient by reducing our need to carry a lot of
cash. People have long tended to use checks instead of cash for large purchases and bills.
Innovations in banking like debit cards, direct deposit, and automatic bill-paying reduce that
inconvenience even further, and also reduce such bank-related inconveniences of time spent
standing in line at the bank, writing checks, or visiting the ATM.
----So, then, MONEY may be the common thread in our economy, but BANKS make the supply
of money a lot more plentiful than it would otherwise be. Banks also make the "payments
system" a lot more efficient.
Definition: A BANK is a financial institution that accepts deposits and makes loans.
 THE FIVE PARTS OF THE FINANCIAL SYSTEM
. . . are money; financial institutions (including banks); financial instruments (including loans,
stocks, and bonds); financial markets (like the New York Stock Exchange); and central banks
(like the Federal Reserve System).

The way these five parts fit together can be represented, however crudely, as a pyramid/triangle,
with money at the base (a modern economy is monetary, or money-based, economy), central
banks at the top, and the other three in the middle. I drew it with financial institutions occupying
all of one side, and on the other side financial markets on top of financial instruments. (Check
your notes.)

FIVE PARTS OF FINANCIAL SYSTEM

1. MONEY
– To pay for purchases and store wealth
anything generally accepted as payment. It's useful because you can buy things with it, either
now or later (non-perishable, store of wealth. Contrast with, say, fish).
--Main types of money: bank deposits, cash.

2. FINANCIAL INSTRUMENTS
-- To transfer wealth from savers to investors and to transfer risk to those best equipped to bear it.
--defn.: A financial instrument is a formal obligation that entitles one party to receive
payments and/or a share of assets from another party.
---Exs.: loans, stocks, bonds. Even an ordinary bank loan is a financial instrument. Securities is a
name that commonly refers to financial instruments that are traded on . . .
3. FINANCIAL MARKETS
-- To Buy and sell financial instruments
--defn.: places or networks where financial instruments can be sold quickly and cheaply.
---Exs.: New York Stock Exchange, U.S. Treasury's online auction site for its bonds.
4. FINANCIAL INSTITUTIONS
-- To provide access to financial markets
--defn.: firms that provide savers and borrowers with access to financial instruments and
financial markets. Among other services, they allow individuals to earn a decent return on their
money while at the same time avoiding risk.
---Exs.: banks, insurance companies, mutual funds, brokerage houses.
5. CENTRAL BANKS
-- To Monitor financial Institutions and stabilize the economy
--defn.: A central bank is a large financial institution that handles the government's
finances, regulates the supply of money and credit in the economy, and serves as the bank
to commercial banks. (That last part means that commercial banks deposit some of their
reserves at the central bank, and the central bank is the "lender of last resort" to commercial
banks in times of crisis.)
---Exs.: the Federal Reserve System of the U.S., the European Central Bank (ECB; for countries
using the Euro).
 THE FIVE CORE PRINCIPLES OF MONEY AND BANKING
1. TIME has value.
a. Time affects the value of financial instruments.
b. Interest payments exist because of time properties of financial instruments
A dollar today is worth more than a dollar a year from now. Why is this? (Several reasons:
inflation erodes the buying power of money over time; having the money now means you can
spend it now; having the money now means you can invest it and turn it into more money.) Later,
we'll relate this principle to the concept of present discounted value of future payments, or what
they're worth today taking into account the interest you could be earning in the interim.
--An important aspect of the time value of money is that interest compounds over time. Ex. in
book: a $10,000 car loan, at 6%. If you repaid the entire loan in one lump sum a year later, you'd
pay $10,000 (original amount plus $600 interest). But in the example, the loan is to be paid off in
monthly payments over four years, or 48 monthly payments of $235, and the total repayment is
$11,280. Why? Interest compounds, or accumulates, from month to month.

2. RISK requires compensation.

a. In a world of uncertainty, individuals will accept risk only if they are compensated in some
form
For securities like stocks and bonds, the higher the risk, the higher the return has to be. For
individuals, minimizing the risk of such things as accidents, illness, and theft is worth the
expense of monthly insurance premiums. (A note on usage: "Risk" refers to your potential losses,
financial and otherwise, not merely to the probability of unwanted events. For example, fire
insurance might not reduce the likelihood of your house burning down, but it will compensate
you for the damage from your house burning down.)

3. INFORMATION is the basis for decisions.

a. The collection and processing of information is the basis of foundation of the financial system
This rather general sentence relates to money, banking, and finance because we live in a world of
imperfect information. It is hard for financial transactions to take place when one or both parties
lack adequate information about the other, because one party could easily end up getting burned.
As a result, banks and other financial institutions that make loans gather a considerable amount
of information about their potential borrowers before advancing them money. The collection and
provision of company financial information by government agencies like the Securities and
Exchange Commission can aid the growth of financial markets by making them more
transparent, thus reducing the information barrier for potential investors. Recent advances in
computer and communications technology have greatly helped the spread of financial
information, thereby paving the way for the growth of important new financial markets like the
junk-bond market.
4. MARKETS set prices and allocate resources.
a. The “places” where buyers and sellers “meet” are the core of the economic system

Financial institutions and markets, by connecting savers with borrowers, allow for people's
leftover money (savings) to be channeled into productive investment in capital (e.g., new
technology, machinery, buildings). Financial markets for assets like stocks and bonds allow some
companies, especially well-established companies, to obtain funds for new capital investment
more cheaply than they could borrow from a bank.

5. STABILITY improves welfare (i.e., well-being).

a. A stable economy reduces risk and improves everyone's welfare

-Imagine that your next job pays you $3,500 a month (or $42,000 a year). Now imagine that your
boss proposes to change your monthly pay to $1,000 times the roll of a die. That is, you'd have
an equal chance of receiving $1,000, $2,000, $3,000, $4,000, $5,000, and $6,000, and the
average of those numbers (or the expected value of your monthly pay) would still be $3,500.
Would you do it? Most people would say no way.
--Real-life example: Professors at the college are officially paid on a nine-month schedule (i.e.,
nothing in June, July, and August), but we have the option of being paid the same amount
stretched out over 12 months. I don't know of a single person who chose the 9-month option.
Even though it's not really risky, because the irregularity is known in advance, it could be hard to
manage.
--In the interest of stability in the financial sector, governments have created central banks to try
to guard against bank failures and financial panics. The tasks of central banks have grown in
recent years, as they are now expected to keep inflation low and stable, and also to avoid or
minimize recessions.
--Bank deposit insurance is another example of a government intervention for the sake of
financial and social stability.

A handy device for memorizing those five principles is the (inelegant) acronym "TRIMS" - for Time, Risk,
Information, Markets, Stability. They're worth memorizing, as we will be returning to them again and again
in this course.

Financial System Promotes Economic Efficiency

The Financial System makes it Easier to Trade

 Facilitate Payments - bank checking accounts

 Channel Funds from Savers to Borrowers
 Enable Risk Sharing - Classic examples are insurance and forward markets
1. Facilitate Payments - bank checking accounts

 Cash transactions (Trade “value for value”). Could hold a lot of cash on hand to pay for things
 Financial intermediaries provide checking accounts, credit cards, debit cards, ATMs
 Make transactions easier

2. Channel Funds from Savers to Borrowers

 Lending is a form of trade (Trade “value for a promise”)
 Give up purchasing power today in exchange for purchasing power in the future.
 Savers: have more funds than they currently need; would like to earn capital income
 Borrowers: need more funds than they currently have; willing and able to repay with interest in
the future.

WHY IT IS IMPORTANT?
 Allows those without funds to exploit profitable investment
opportunities.
o Commercial loans to growing businesses;
o Student loans (investment in human capital)

 Financial System allows the timing of income and

expenditures to be decoupled.
o Household earning potential starts low, grows and
decline with age
o Financial system allows households to borrow when young to prop up
consumption (house loans, car loans)

3. Enable Risk Sharing

 The world is an uncertain place. The financial system allows trade in risk. (Trade “value for a
promise”)
 Two principal forms of trade in risk are insurance and forward contracts.
 Suppose everyone has a 1/1000 chance of dying by age 40 and one would need $1 million to
replace lost income to provide for their family.
 What are your options to address this risk?

MONEY AND THE PAYMENT SYSTEM

The dictionary has several definitions of money. In ordinary conversation we commonly use the
word money to mean income ("he makes a lot of money") or wealth ("she has a lot of money").
In this course (and in macroeconomics courses in general), we use a different definition, namely
the one given in the chapter 1 notes:
money = anything that is generally accepted as payment
This is the (macro)economist's usage of the term money. And, to reiterate, in the context of this
course:
“Money is an asset that is generally accepted as payment for goods and services or repayment of debt.”

MONEY is not the same thing as INCOME or WEALTH

While money, income and wealth are all measured in some currency unit, they differ
significantly in their meaning.
 People have money if they have large amounts of currency or big bank accounts at a point in
time. (Stock variable)
 Someone earns income (not money) from work or investments over a period of time. (Flow
variable)
 People have wealth if they have assets that can be converted into more currency than is
necessary to pay their debts at a point in time. (Stock variable)

If money is something generally accepted as payment, then counts as money?

A: Obviously, cash -- dollar bills, coins -- is a form of money.
Q: Is there anything else that counts as money?
A: Checking account deposits. (And the broader measures of the money supply include all other
types of bank accounts as well.)
Q: Are credit cards money?
A: No. They're not legal tender. What a credit-card purchases really represents is just an
extremely convenient, pre-approved loan. It's only part of the transaction, since the merchant
then goes to the bank that issued the credit card to get money, and the bank sends you a bill
which must be paid with money.
Q: Are assets like stocks and bonds money?
A: No. They have value, but they are generally not used or accepted as payment. Financial
instruments are not money.
When economists talk about the "money supply," we mean something very different from
national income (~GDP) or national wealth. The money supply is a lot smaller than national
income or national wealth. Generally speaking,
money supply = cash in circulation + bank account deposits
-- There are several measures of the money supply, or "monetary aggregates." The narrowest,
and simplest, is "M1," or "transactions money," which corresponds closely to the things that are
most generally accepted as payment, namely cash (in circulation) and checking deposits. M2,
which used to be called "broad money," includes most other bank account deposits as well as
money-market funds. We'll discuss them in more detail later in these notes.
CHARACTERITICS /FUNCTIONS OF MONEY

1. Means of payment (medium of exchange) -- Because money is a generally accepted form of payment,
you can use it to buy things.

2. Unit of measurement (unit of account) -- You can use it to price things, e.g., in dollars and cents. Ex.:
new textbook is $120, Wall St. Journal (WSJ) subscription is $20, phone call on Sprint is 10 cents a
minute. Quoting prices in terms of dollars, the American unit of account, is a lot easier than quoting prices
in terms of other goods -- e.g., money & banking textbook = 6 WSJ subscriptions or 1,200 minutes of
long-distance calling; WSJ subscription = 1/6 textbook = 200 long-distance minutes; 1 long-distance
minute = 1/1200 textbook = 1/200 WSJ subscription. That's six barter prices to deal with, as compared
with just three dollar prices. (The number of barter prices goes up exponentially as the number of goods
and services increases. If we added a fourth commodity -- say, pizza -- to the mix, there would be twelve
barter prices.)

3. Store of value -- an asset in its own right, and not a bad one -- while cash earns no interest, it's
perfectly liquid (convertible into cash) and has no default risk. Money in bank accounts earns some
interest and is guaranteed against default by Federal Deposit Insurance

THE EVOLUTION OF MONEY AND THE PAYMENTS SYSTEM

Money came into being thousands of years ago as a superior alternative to barter (trading goods and
services directly for other goods and services).

COMMODITY MONEY - money made up from precious metals or other commodities that have
INTRINSIC VALUE (are valuable in their own right).
- Examples of commodity money could include gold, cows, and pretty shells.

COMMODITY-BACKED MONEY came later. This is money that draws its value from a commodity (ex.:
gold) but does not involve physically handling that commodity on a regular basis. An example is U.S.
currency under the gold standard (~1873-1933), when people regularly used paper money that was
issued by banks but was redeemable for gold according to a fixed ratio of grams per dollar. People also
used U.S. gold certificates issued by the government, which also were paper notes redeemable for gold
at a fixed ratio.

FIAT MONEY (most recently)- currency, usually paper currency, which by government decree (i.e., "by
fiat") is legal tender and which is not officially convertible into gold or other precious metal.

Fiat money is the type of money we have today. Although our dollar bills have great
value and are accepted all over the world, they do not have intrinsic value, because
they are not really useful other than as money. Take away their monetary value
(imagine, for example, that the government says they're no longer legal tender, or
that people lose their faith in U.S. dollars), and they become mere pieces of paper

Advantages of Fiat Money

 Fewer resources are used to produce money.
 The quantity of money in circulation can be determined by rational human judgment rather than
by discovering further mineral deposits—like gold or diamonds

Disadvantage
 A corrupt or pressured government might issue excessive amounts of money, thereby unleashing
severe inflation.
CHEQUES
Instructions to the bank to take funds from your account and transfer those funds to the person or firm
whose name is written in the “Pay to the Order of” line

OTHER FORMS OF MONEY

A rapidly increasing share of our transactions in recent decades are electronic
transactions, such as credit-card transactions. Lately there has been the rise of E-
MONEY (payment arrangments that exist only in electronic form and involve
transfers of money). Some forms of e-money:

* DEBIT CARD: works like a credit card but transfers funds from your personal bank
account.
* AUTOMATIC BILL-PAYING: whereby money is transferred straight from your
bank account to the phone company, the power company, the local tax collector,
according to prior arrangements you have made. Pay-by-phone works similarly.
* E-CASH: (like Paypal;) arrangement by which you set up an account on the
Internet that is linked to your bank account. When you buy things on the Internet
through this arrangement, your bank account is debited by the amount spent.
*STORE VALUE CARDS: Retail businesses are experimenting with new forms of electronic
payment. Prepaid cellular cards, Internet scratch cards, calling cards etc
-- Are these money? Yes and no. All three provide access to your bank account,
which is already in the money supply. These are really just more efficient and
convenient ways of making payments than the old ones.

MEASURING MONEY

“a measure of the ease an asset can be turned into a means of payment (Money).”
 Different Definitions of money based upon degree of liquidity.
 Federal Reserve System defines monetary aggregates.

The Fed used to keep track of a broader monetary aggregate, M3, which included
everything in M1 and M2 plus large CD's, institutionally-held money-market funds,
and two key sources of borrowed funds for banks, term repurchase agreements
(repos) and term Eurodollars. The Fed stopped keeping track of M3 in late 2005,
after deciding that it contained no relevant economic information that was not
already in M2.
THE MONEY SUPPLY

Q: First, why should we care about the money supply?

A: The money supply (Ms) matters because it affects three very important things: the price level,
inflation, and economic recessions:

(1) Price level: higher levels of the Ms are a direct cause of higher price levels.
-- Likewise, increases in the money supply tend to cause the general price level to increase.
-- Inflation (an increase in the price level) is often described as "too much money chasing too few goods."
When the money supply increases faster than the productive capacity of the economy, inflation is the
usual result.
(2) Inflation: faster Ms growth rates tend to cause higher rates of inflation
-- From international comparisons we see a tight relationship between money (M2) growth rates and
inflation rates. A hyperinflation (explosive growth of prices, inflation rates of over 50% per month, or well
over 1000% per year) is impossible without extremely rapid money-supply growth.

---- [Refer to Cecchetti's Figure 2.4, which shows a graph of M2 growth rates and inflation rates for 1960-2004.
M2 growth rates were highly correlated with inflation rates in 1960-1980; in 1990-2004, there is basically no
correlation, as inflation has been relatively low and stable. The low and stable inflation may owe something to
slower M2 growth rates during that span and the preceding decade, as the public has come to trust the Fed to keep
money-supply growth and inflation at moderate levels.]

Q: Since money supply growth is inflationary, and perfect price stability (0% inflation) seems like an ideal,
wouldn't we be better off keeping the money supply perfectly stable, and not increasing it at all?
------ A: No. Money demand (people's demand for money for their transactions and savings) increases
virtually every year as the volume of transactions (real GDP) increases, and if the money supply did not
keep pace with money demand, then the economy would run into serious problems -- cash shortages,
sky-high interest rates, and probably recession. In general...
(3) Recessions may be caused by steep declines in the M s growth rate
-- In the past 50 years, there have been eight recessions, and every single one of them was preceded by
a notable decline in the money (M2) growth rate. Then again, not every decline in the M2 growth rate was
followed by a recession -- thus the old joke that "economists have predicted twelve of the last eight
recessions."

Q: Suppose that people transfer $100 million from checking accounts into
money-market funds. How will M1 be affected? How will M2 be affected?
A: M1 will fall by $100 million. M2 will not be affected (because the $100 million
drop in checking deposits is exactly offset by a $100 million increase in money-
market funds).

PRICES AND INFLATION

Aggregate price level: an index of the average prices of goods and
services in the economy

1. Fixed-weight Index - CPI

which measures the average price of a representative "basket" of consumer goods
and services,
(Track changes in the typical household’s cost of living)

CPI in any month equals

The price level is an index, which has been set equal to 100 for a chosen base year, which we use as a
basis for comparisons. Comparisons with a base of 100 are easy because the percent change calculation
reduces to simple subtraction -- just subtract 100 from the current price level, and you've got the total
percent change in prices since the base year.

-- Ex.: Currently the base year for the CPI is the average of three years, 1982-84. The CPI was about
196 in December 2005, which means that consumer prices on average were 196% as high, or 96%
higher, in December 2005 than they were in 1982-84.

Inflation A continual increase in price level

Deflation A continual decrease in price level

Inflation rate the yearly percent change in the price level

To calculate the inflation rate for a given year, from price-level figures for consecutive years (or
monthly figures that are twelve months apart):
 (Price level in that year) - (Price level in the previous year)
Inflation rate = ----------------------------------------------------------------------------- (* 100%)
(Price level in the previous year)

(Price level in that year)

OR { ------------------------------------------- - 1 } * 100%
(Price level in the previous year)

Ex.:
Q: Suppose the Consumer Price Index was equal to 200 in 2004 and 206 in 2005. (If the base year is still
1982-84, then prices were 100% higher in 2004 than in 1982-84 and 106% higher in 2005 than in 1982-
1984. What was the inflation rate in 2005?
A: Inflation rate = (206-200)/200 = 6/200 = 3/100 (*100%) = 3%.
-- (Note: It is customary to report the inflation rate to one decimal place, so we'll report it as 3.0%.)

2. Deflator – GDP or Personal Consumption Expenditure Deflator

which deals with the prices of goods and services in all the different components of GDP
(consumption, business investment, government purchases, net exports) and is used to adjust
measured GDP for inflation (i.e., to convert nominal GDP into real GDP).

also called the implicit price deflator for GDP, measures the price of output relative to its price in the base
year. It reflects what’s happening to the overall level of prices in the economy

GDP Deflator = (Nominal GDP / Real GDP) ×100