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

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