sg26 - Chapter 10 MONEY, BANKS, AND THE FEDERAL RESERVE*...

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10
MONEY, BANKS,
AND THE FEDERAL
RESERVE*
* This is Chapter 26 in Economics .
K e y C o n c e p t s
What is Money?
Money is anything generally acceptable as a means of
payment, that is, a method of settling a debt. Money
has three functions:
♦ Medium of exchange — money is accepted in ex-
change for goods and services. Without money,
barter (exchanging one good directly for another)
would be necessary.
♦ Unit of account — prices are measured in units of
money.
♦ Store of value — money is exchangeable at a later
date. A low inflation rate makes money as useful as
possible as a store of value.
Currency is the bills and coins we use. Money consists
of currency plus deposits at banks and other depository
institutions. The two major measures of money in the
United States are:
♦ M1 — currency outside of banks plus travelers
checks plus checking deposits.
♦ M2 — M1 plus saving and time deposits and
money market mutual funds.
Liquidity means that an asset can be instantly con-
verted into a means of payment with little loss of value.
The assets in M2 that are not directly a means of pay-
ment are very liquid.
The deposits at depository institutions are money, but
the checks transferring these deposits from one person
to another are not money. Credit cards are not money;
they are a way to get an instant loan.
Depository Institutions
A depository institution is a firm that takes deposits
and then uses the deposits to make loans. Depository
institutions include commercial banks , thrift institu-
tions (savings and loan associations, savings banks, and
credit unions) and money market mutual funds.
A balance sheet shows that a bank’s liabilities plus its
net worth equal its assets. Banks divide their assets into
two broad components:
♦ Reserves — cash in the bank’s vault plus its depos-
its at Federal Reserve banks.
♦ Loans — liquid assets, investment securities, and
loans. These assets pay the bank a return.
Depository institutions provide four economic services:
♦ Create liquidity — bank deposits are highly liquid,
that is, easily convertible into money.
♦ Minimize cost of obtaining funds — borrowing
from one bank is cheaper than borrowing from a
variety of lenders.
♦ Minimize cost of monitoring borrowers — deposi-
tory institutions specialize in monitoring
borrowers.
♦ Pool risk — depository institutions reduce risk by
making loans to many borrowers.
Depository institutions face two types of regulation:
♦ Deposit insurance — deposits at most intermediar-
ies are insured by a federal agency.
♦ Balance sheet rules — intermediaries often face
equity capital requirements, reserve requirements,
deposit rules, and lending rules.
In the 1980s and 1990s, depository institutions were
largely deregulated.