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Banking and the Money Supply

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© 2003 South-Western/Thomson Learning

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Financial Intermediaries

Banks serve as financial intermediaries, or as go-betweens by bringing together the two sides of the money market

Banks reduce the transaction costs of channeling savings to credit worthy borrowers

Coping with Asymmetric InformationReducing risk through diversification

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Starting a BankTo obtain a charter, or the right to operate, they must apply to the state banking authority (state bank) or to the U.S. Comptroller of the Currency (national bank)

The founders invest $500,000 for shares which become the owner’s equity or the net worth of the bank

Part of this goes to the FED to buy shares in their district bank $450,000 left

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Exhibit 2: Home Bank’s Balance Sheet

Assets Liabilities and Net Worth

Building and furniture $ 450,000 Net worth $500,000

Stock in district Fed 50,000

Total $500,000 Total $500,000

Balance sheet shows a balance between the two sides of the bank’s accounts. The left side lists the bank’s assets (any physical property or financial claim owned by the bank) and the right side lists the bank’s liabilities (an amount the bank owes) and their net worth

The balance sheet reflects the basic equality that Assets = Liabilities + Net Worth

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Exhibit 3: Home Bank’s Balance Sheet after $1,000,000 Deposit

Assets Liabilities and Net Worth

Cash $1,000,000 Checkable deposits $1,000,000

Building and furniture $450,000 Net worth $500,000

Stock in district Fed 50,000

Total $1,500,000 Total $1,500,000

Now suppose a customer deposits $1,000,000 into a new checking account. In accepting this, the bank promises to repay the depositor that amount it is a liability to the bank

This deposit increases the bank’s assets and liabilities by $1,000,000

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Reserve AccountsRecall that banks are required by the FED to set aside, or to hold in reserve a percentage of their checkable deposits

The dollar amount that must be held in reserve is called required reserves

Checkable deposits multiplied by the required reserve ratio

The required reserve ratio dictates the minimum proportion of deposits the bank must hold in reserve

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Reserve Accounts

The current reserve requirement is 10% on checkable deposits

These required reserves are held either as cash in the bank’s vault or as deposits at the FED, but neither earns the bank any interest

In our example, Home Bank must therefore hold $100,000 as reserves ($1,000,000 * .10)

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Reserve Accounts

If Home Bank deposits their required reserves with the FED, they now have $900,000 in excess reserves held as cash in the vault

Excess reserves have two additional uses

They can be used to make loans, or To purchase interest-bearing assets, such as government bonds

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ReservesSince reserves earn no interest, banks usually try to keep excess reserves to a minimum

The federal funds market provides for day-to-day lending and borrowing among banks of excess reserves on account at the FED

The interest rate paid on these loans is called the federal funds rate, and it is this rate that the FED targets as a tool of monetary policy

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Exhibit 4: Changes in Home Bank’s Balance Sheet After Home Bank Lends You $1,000

Suppose Home Bank has already used its $900,000 in excess reserves to make loans and buy government bonds and has no excess reserves left. Further, let’s assume there are no excess reserves in the banking system.

To start the money creation process, suppose the Fed buys a $1,000 U.S. government bond from a securities dealer, with the transaction handled by Home Bank. The Fed pays the dealer by crediting Home Bank’s reserve account with $1,000, so Home Bank can increase the dealer’s checking account by $1,000.

Where did the Fed get these reserves? It makes them up – creates them out of thin air. The securities dealer has exchanged one asset, a U.S. bond, for another asset, checkable deposit. Since a U.S. bond is not money but checkable deposits are, the money supply increases by $1,000 in this first round. Exhibit 4 shows the changes in Home Bank’s balance sheet as a result of the Fed’s bond purchase.

Assets Liabilities and Net Worth

Reserves At Fed + 1,000 Checkable deposits + 1,000

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Suppose you as one of Home Bank’s customers apply for a $900 loan which is approved and the bank increases your checking account by $900. Home Bank has converted your promise to repay, your IOU, into a $900 checkable deposit this action increases the money supply by $900.

Home Bank must set aside 10% of the initial deposit as required reserves they now have $900 in excess reserves.

The money supply has increased by a total of $1,900 to this point – the $1,000 increase in the securities dealer’s checkable deposit and now the $900 increase in your checkable deposits.

Home Bank’s loans increase by $900 on the assets side because your IOU becomes the bank’s asset and the liability side has increased by the same amount because of the checkable deposit Home Bank has created $900 in checkable deposits based on your promise to repay your loan.

Assets Liabilities and Net Worth

Loans + 900 Checkable deposits + 900

Exhibit 5: Changes in Home Bank’s Balance Sheet After the Bank Makes a $900 Loan

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Check Clearing

When you spend the $900, your college promptly deposits the check into its checking account at Merchant’s TrustThis increases the college account by $900 and sends your check to the Fed which transfers $900 in reserves from Home Bank’s account to Merchants Trust’s account and then sends the check to Home Bank, which reduces your checkable deposits by $900The Fed has thereby cleared your check by setting the claim of Merchants Trust

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Exhibit 6: Change in Merchants Trust’s Balance Sheet After an $810 Loan

Assets Liabilities and Net Worth

Loans + 810 Checkable deposits + 810

Merchants Trust now has $900 more in reserves on deposit with the Fed. After setting aside $90 in required reserves, it now has $810 in excess reserves.

Suppose they now loan this money to someone else as shown in Exhibit 6. At this point checkable deposits in the banking system, and the money supply in the economy have increased by a total of $2,710 ( = $1,000 + $900 + $810), all engendered by the Fed’s original $1,000 bond purchase.

When the $810 is spent and deposited the check in an account at Fidelity Bank, Fidelity credits the depositor’s account with $810 and sets the check to the Fed for clearance. Fed reduces Merchants Trust reserves by $810 and increases Fidelity’s by the same amount.

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Round Three and BeyondNotice the pattern of deposits and loans

Each time a bank gets a fresh deposit, 10% goes to required reservesThe rest becomes excess reserves, which fuel new loans or other asset acquisitions

An individual bank can lend no more than its excess reserves

When the borrower spends the amount loaned, reserves at one bank usually fall, but total reserves in the banking system do not

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Round Three and Beyond

The recipient bank uses most of the new deposit to extend more loans more checkable deposits

The potential expansion of checkable deposits in the banking system equals some multiple of the initial increase in reserves

The example just discussed makes certain assumptions to be noted later

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Exhibit 7: Summary

Increase inIncrease inRequired Increase inCheckable Deposits Reserves Loans

Bank (1) (2) (3) = (1)–(2)

1. College Bank $ 1,000 $ 100 $ 900

2. Merchants Trust 900 90 810

3. Fidelity Bank 810 81 729

All remaining rounds 7,290 729 6,561

Total $10,000 $1,000 $9,000

During each round, the increase in checkable deposits (1) minus the increase in required reserves (2) equals the potential increase in loans (3). Checkable deposits in this example can potentially increase by as much as $10,000.

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Reserve Requirements and Money Expansion

The multiple by which the money supply increases as a result of an increase in the banking system’s reserves is called the money multiplier

The simple money multiplier equals the reciprocal of the required reserve ratio, or 1 / r, where r is the reserve ratio

In our example the reserve ratio was 10% or 0.1 the simple money multiplier equals 10

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Checkable Deposits / Money Supply

The formula for the multiple expansion of checkable deposits can be written as

Change in checkable deposits (or the money supply) = Change in reserves x 1/r

Thus, for our example, the initial deposit of $1,000 increase in fresh reserves by the Fed could support up to $10,000 in new checkable deposits or the money supply

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Money Multiplier

The higher the reserve requirement, the greater the fraction of deposits that must be held as reserves the smaller the money multiplier

Reserve requirement of 20% money multiplier of 5Reserve requirement of 5% money multiplier of 20

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Limitations on Money Expansion

Various leakages from the multiple expansion process reduce the size of the money multiplier. That is, we assumed that

Banks do not let excess reserves sit idle - reasonable since the profit incentive will generally lead banks to minimize the amount of excess reserves idleBorrowers do something with the money - seems likely, since people would not borrow unless they had a use for fundsPeople do not choose to increase their cash holdings - in fact, some amount of this may be held as cash, which reduces the money multiplier

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Contraction of the Money SupplyIn our example, we focused on the process whereby money was created

The process would work in reverse if the Fed reduced bank reserves, thereby reducing the money supply

The Fed’s sale of government bonds reduces bank reserves, forcing banks to recall loans or to somehow replenish reserves and the same multiple contraction would work

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Contraction of the Money Supply

For example, with a reserve requirement of 10%, a $1,000 sale of bonds would reduce the checkable deposits and the money supply by a maximum of $10,000

The process of reducing checkable deposits or the money supply would be the same as illustrated in the expansion illustration

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Tools for Controlling Reserves

The Fed has three tools for controlling reserves hence checkable deposits money supply

Conducting open market operations buying and selling of U.S. government bondsSetting the discount rate, the interest rate the Fed charges for loans it makes to banksSetting the required reserve ratio, which is the minimum fraction of reserves that banks must hold against deposits

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Open Market OperationsOpen market operations refers to the buying and selling of U.S. government bonds in the open market

To increase the money supply, the Fed buys U.S. bonds open-market purchaseTo reduce the money supply, the Fed sells U.S. bonds open-market sale

Advantage of open-market operationsRelatively easy to carry outRequire no change in laws or regulationsCan be executed in any amountFor these reasons, this is the tool of choice by the Fed

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Discount RateDiscount rate is the interest rate the Fed charges on loans it makes to banks

Banks can borrow from the Fed when they need reserves to satisfy their reserve requirements

By lowering or raising the discount rate, the Fed encourages or discourages banks from borrowing, which alters reserves and affects the money supply

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Discount Rate

A lower discount rate reduces the cost of borrowing, encouraging banks to borrow reserves from the Fed more bank lending increase in the money supply

Higher discount rate increases the cost of borrowing reserves from the Fed less bank lending reduced money supply

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Discount Rate

Since there is no guarantee that banks will necessarily borrow more even if the discount rate is reducedThat is, if business prospects look poor and if banks view lending as risky, then even a lower discount rate may not entice banks to borrow from the FedAs a result, the Fed uses the discount rate more as a signal to financial markets about its monetary policy than as a tool for changing the money supply

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Reserve Requirements

Reserve requirements are the regulations regarding the minimum amount of reserves that banks must hold to back up deposits they influence how much money the banking system can create with each dollar of fresh reservesIf the Fed increases the reserve requirement, banks must hold more reserves a reduction in the fraction of each dollar that can be lent out reduces the banking system’s ability to create money

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Reserve Requirements

Conversely, a decrease in the reserve requirement increases the fraction of each dollar on deposit that can be lent out which increases the banking system’s ability to create moneyReserve requirements can be changed by a simple majority vote by the Board of GovernorsHowever, since even a small change in the reserve requirement can be disruptive, the Fed seldom employs this tool