©2004 prentice hall publishing ayers/collinge, 1/e 1 chapter 13 “money, banking, and the federal...

1 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e

Chapter 13“Money, Banking, and the

Federal Reserve”

Chapter 13“Money, Banking, and the

Federal Reserve”

MACROECONOMICS: MACROECONOMICS: EXPLORE & APPLYEXPLORE & APPLYby Ayers and Collingeby Ayers and Collinge

MACROECONOMICS: MACROECONOMICS: EXPLORE & APPLYEXPLORE & APPLYby Ayers and Collingeby Ayers and Collinge


Learning ObjectivesLearning ObjectivesLearning ObjectivesLearning Objectives

1.1. Identify the types, functions, and Identify the types, functions, and liquidity of various money measures.liquidity of various money measures.

2.2. Describe key elements of the banking Describe key elements of the banking industry.industry.

3.3. Discuss how banks create money.Discuss how banks create money.

4.4. Describe the structure, functions, and Describe the structure, functions, and policy tools of the Federal Reserve .policy tools of the Federal Reserve .

1.1. Identify the types, functions, and Identify the types, functions, and liquidity of various money measures.liquidity of various money measures.

2.2. Describe key elements of the banking Describe key elements of the banking industry.industry.

3.3. Discuss how banks create money.Discuss how banks create money.

4.4. Describe the structure, functions, and Describe the structure, functions, and policy tools of the Federal Reserve .policy tools of the Federal Reserve .


Learning ObjectivesLearning ObjectivesLearning ObjectivesLearning Objectives

5.5. Work through the process of monetary Work through the process of monetary expansion using the deposit multiplier.expansion using the deposit multiplier.

6.6. Explain why the banking crisis of the Explain why the banking crisis of the 1980’s occurred and whether another 1980’s occurred and whether another banking crisis could happen.banking crisis could happen.

5.5. Work through the process of monetary Work through the process of monetary expansion using the deposit multiplier.expansion using the deposit multiplier.

6.6. Explain why the banking crisis of the Explain why the banking crisis of the 1980’s occurred and whether another 1980’s occurred and whether another banking crisis could happen.banking crisis could happen.


13.1 13.1 MONEYMONEY

MoneyMoney is whatever is commonly used in an is whatever is commonly used in an economy to buy and sell things.economy to buy and sell things.Without money, we would have to Without money, we would have to barterbarter (swap) one good for another, or produce (swap) one good for another, or produce on our own all of the goods and services on our own all of the goods and services we consume.we consume.

Both alternatives are inefficient.Both alternatives are inefficient.

Important qualities of money are its Important qualities of money are its portabilityportability and and divisibilitydivisibility..

MoneyMoney is whatever is commonly used in an is whatever is commonly used in an economy to buy and sell things.economy to buy and sell things.Without money, we would have to Without money, we would have to barterbarter (swap) one good for another, or produce (swap) one good for another, or produce on our own all of the goods and services on our own all of the goods and services we consume.we consume.

Both alternatives are inefficient.Both alternatives are inefficient.

Important qualities of money are its Important qualities of money are its portabilityportability and and divisibilitydivisibility..


Historically, gold was used as money.Historically, gold was used as money.Today, gold is no longer used as money Today, gold is no longer used as money rather, government issued currency and rather, government issued currency and coins are used as money.coins are used as money.Bank issued checks are the largest part of Bank issued checks are the largest part of the money we own.the money we own.Money performs the following functions:Money performs the following functions:

Medium of exchange.Medium of exchange.Store of value.Store of value.Unit of account.Unit of account.

Historically, gold was used as money.Historically, gold was used as money.Today, gold is no longer used as money Today, gold is no longer used as money rather, government issued currency and rather, government issued currency and coins are used as money.coins are used as money.Bank issued checks are the largest part of Bank issued checks are the largest part of the money we own.the money we own.Money performs the following functions:Money performs the following functions:

Medium of exchange.Medium of exchange.Store of value.Store of value.Unit of account.Unit of account.

MoneyMoneyMoneyMoney


Fiat moneyFiat money is money because the law says it is. is money because the law says it is.

Paper currency and current U.S. coins are Paper currency and current U.S. coins are examples of fiat money.examples of fiat money.

Because the government accepts fiat money, both Because the government accepts fiat money, both individuals and business accept it as legal tender.individuals and business accept it as legal tender.

Gold and silver coins, once a commonplace form Gold and silver coins, once a commonplace form of money in the U.S. are examples of commodity of money in the U.S. are examples of commodity money.money.

Commodity moneyCommodity money is made of precious metals. is made of precious metals.

Coins today are made of cheaper metals.Coins today are made of cheaper metals.

Fiat moneyFiat money is money because the law says it is. is money because the law says it is.

Paper currency and current U.S. coins are Paper currency and current U.S. coins are examples of fiat money.examples of fiat money.

Because the government accepts fiat money, both Because the government accepts fiat money, both individuals and business accept it as legal tender.individuals and business accept it as legal tender.

Gold and silver coins, once a commonplace form Gold and silver coins, once a commonplace form of money in the U.S. are examples of commodity of money in the U.S. are examples of commodity money.money.

Commodity moneyCommodity money is made of precious metals. is made of precious metals.

Coins today are made of cheaper metals.Coins today are made of cheaper metals.



Commodity money is subject to Commodity money is subject to Gresham’s Gresham’s lawlaw – bad money drives out good. – bad money drives out good.

The practice of shaving the edges of commodity The practice of shaving the edges of commodity money forced people to bite it, weigh it, and money forced people to bite it, weigh it, and examine it carefully.examine it carefully.

Fiat money eliminates this problem, and is Fiat money eliminates this problem, and is designed so that it is not easily counterfeited.designed so that it is not easily counterfeited.

Governments of virtually all nations hold a Governments of virtually all nations hold a monopoly on the production of fiat money.monopoly on the production of fiat money.

Commodity money is subject to Commodity money is subject to Gresham’s Gresham’s lawlaw – bad money drives out good. – bad money drives out good.

The practice of shaving the edges of commodity The practice of shaving the edges of commodity money forced people to bite it, weigh it, and money forced people to bite it, weigh it, and examine it carefully.examine it carefully.

Fiat money eliminates this problem, and is Fiat money eliminates this problem, and is designed so that it is not easily counterfeited.designed so that it is not easily counterfeited.

Governments of virtually all nations hold a Governments of virtually all nations hold a monopoly on the production of fiat money.monopoly on the production of fiat money.



The The debit carddebit card immediately transfers the immediately transfers the amount of the purchase out of your amount of the purchase out of your checking account, and into the store’s checking account, and into the store’s deposit account.deposit account.

You can’t use your debit card to make a You can’t use your debit card to make a purchase unless you have the amount of the purchase unless you have the amount of the purchase in your account.purchase in your account.

In contrast, a In contrast, a credit cardcredit card provides you provides you with a loan in the amount of the purchase.with a loan in the amount of the purchase.

The The debit carddebit card immediately transfers the immediately transfers the amount of the purchase out of your amount of the purchase out of your checking account, and into the store’s checking account, and into the store’s deposit account.deposit account.

You can’t use your debit card to make a You can’t use your debit card to make a purchase unless you have the amount of the purchase unless you have the amount of the purchase in your account.purchase in your account.

In contrast, a In contrast, a credit cardcredit card provides you provides you with a loan in the amount of the purchase.with a loan in the amount of the purchase.

Money – Debit or CreditMoney – Debit or CreditMoney – Debit or CreditMoney – Debit or Credit


Liquidity: M1, M2, and M3Liquidity: M1, M2, and M3Liquidity: M1, M2, and M3Liquidity: M1, M2, and M3

When paper money and coins are When paper money and coins are deposited in banks, money changes form.deposited in banks, money changes form.Deposits into checking accounts create Deposits into checking accounts create demand deposits, demand deposits, also termedalso termed checkable checkable deposits.deposits.

More money is held in the form of checkable More money is held in the form of checkable deposits than in any other form.deposits than in any other form.These deposits are money because checks – These deposits are money because checks – orders to a bank to make payment – are orders to a bank to make payment – are generally accepted by sellers.generally accepted by sellers.

When paper money and coins are When paper money and coins are deposited in banks, money changes form.deposited in banks, money changes form.Deposits into checking accounts create Deposits into checking accounts create demand deposits, demand deposits, also termedalso termed checkable checkable deposits.deposits.

More money is held in the form of checkable More money is held in the form of checkable deposits than in any other form.deposits than in any other form.These deposits are money because checks – These deposits are money because checks – orders to a bank to make payment – are orders to a bank to make payment – are generally accepted by sellers.generally accepted by sellers.


Liquidity refers to how easily and quickly Liquidity refers to how easily and quickly something of value can be converted into something of value can be converted into spendable form. spendable form. Three definitions of money, termed the Three definitions of money, termed the monetary aggregatesmonetary aggregates, categorize various , categorize various types of money according to how liquid types of money according to how liquid they are. they are. The monetary aggregates include M1, The monetary aggregates include M1, M2, and M3.M2, and M3.

Liquidity refers to how easily and quickly Liquidity refers to how easily and quickly something of value can be converted into something of value can be converted into spendable form. spendable form. Three definitions of money, termed the Three definitions of money, termed the monetary aggregatesmonetary aggregates, categorize various , categorize various types of money according to how liquid types of money according to how liquid they are. they are. The monetary aggregates include M1, The monetary aggregates include M1, M2, and M3.M2, and M3.



The The M1M1measure of the money supply measure of the money supply is the most liquid. is the most liquid.

It includes the sum of currency and It includes the sum of currency and coins in the hands of the public, coins in the hands of the public, demand deposits, other checkable demand deposits, other checkable deposits, and travelers checks. deposits, and travelers checks.

M1 totaled $1.2 trillion in 2001.M1 totaled $1.2 trillion in 2001.



The The M2M2measure of the money supply measure of the money supply includes M1 plus the balances in includes M1 plus the balances in savings deposits, “small” time savings deposits, “small” time deposits, and balances in money deposits, and balances in money market mutual funds. market mutual funds.

M2 is slightly less liquid than M1, M2 is slightly less liquid than M1, and totaled $5.4 trillion in 2001. and totaled $5.4 trillion in 2001.



The The M3M3 measure of the money supply measure of the money supply includes M2 plus “large” time deposits (at includes M2 plus “large” time deposits (at least $100,000), and several other near least $100,000), and several other near monies. M3 is less likely to be spent than monies. M3 is less likely to be spent than the items in M2, and totaled $8.0 trillion the items in M2, and totaled $8.0 trillion in 2001. in 2001. Financial assets, such as stocks and bonds, Financial assets, such as stocks and bonds, are not counted in the money supply are not counted in the money supply figures. figures.



M2M1 1,176.0Savings deposits 2,437.1Small time deposits 932.9 Money market balances 934.7Total 5,480.0

M2M1 1,176.0Savings deposits 2,437.1Small time deposits 932.9 Money market balances 934.7Total 5,480.0

M1Currency

599.5Traveler’s checks 7.7Demand deposits 309.4 Other checkable deposits

259.4Total 1,176.0

M1Currency

599.5Traveler’s checks 7.7Demand deposits 309.4 Other checkable deposits

259.4Total 1,176.0

M3M1 1176.0

M2 5480.7Large denomination time deposits 802.5 Other M3 items 1,758.6 Total 8,041.8

M3M1 1176.0

M2 5480.7Large denomination time deposits 802.5 Other M3 items 1,758.6 Total 8,041.8



13.213.2MONEY AND BANKING IN THE U.S.MONEY AND BANKING IN THE U.S. 13.213.2MONEY AND BANKING IN THE U.S.MONEY AND BANKING IN THE U.S.

Banks are regulated by both state and Banks are regulated by both state and federal government.federal government.Bank regulation is designed to protect Bank regulation is designed to protect against unsound banking practices that against unsound banking practices that could bankrupt both depositors and could bankrupt both depositors and government insurance funds.government insurance funds.

For example, under the Glass-Steagle Act of For example, under the Glass-Steagle Act of 1933 banks were barred from offering insurance 1933 banks were barred from offering insurance and brokerage services.and brokerage services.The Glass-Steagle Act was abolished in 1999.The Glass-Steagle Act was abolished in 1999.

Banks are regulated by both state and Banks are regulated by both state and federal government.federal government.Bank regulation is designed to protect Bank regulation is designed to protect against unsound banking practices that against unsound banking practices that could bankrupt both depositors and could bankrupt both depositors and government insurance funds.government insurance funds.

For example, under the Glass-Steagle Act of For example, under the Glass-Steagle Act of 1933 banks were barred from offering insurance 1933 banks were barred from offering insurance and brokerage services.and brokerage services.The Glass-Steagle Act was abolished in 1999.The Glass-Steagle Act was abolished in 1999.


The Banking SystemThe Banking SystemThe Banking SystemThe Banking System

AssetsAssets LiabilitiesLiabilities

Vault Cash (part 1 of bank Vault Cash (part 1 of bank reserves)reserves)

Customer depositsCustomer deposits

Deposits held by the Federal Deposits held by the Federal reservereserve

(part 2 of bank reserves(part 2 of bank reservesFederal fundsFederal funds

LoansLoans Discount loansDiscount loans

SecuritiesSecurities Paid-in capitalPaid-in capital

OtherOther


• Banks hold a fraction of their deposits on reserve Banks hold a fraction of their deposits on reserve to meet the cash needs of their customers.to meet the cash needs of their customers.

• Banks are required by law to meet the reserve Banks are required by law to meet the reserve requirements imposed by the Fed.requirements imposed by the Fed.

• If the reserve requirement is 10%, then the banks If the reserve requirement is 10%, then the banks must hold at least $10 in reserves for every $100 must hold at least $10 in reserves for every $100 of customer deposits. of customer deposits.

• Reserves in excess of the Reserves in excess of the required reservesrequired reserves are are called called excess reservesexcess reserves..

• Banks hold a fraction of their deposits on reserve Banks hold a fraction of their deposits on reserve to meet the cash needs of their customers.to meet the cash needs of their customers.

• Banks are required by law to meet the reserve Banks are required by law to meet the reserve requirements imposed by the Fed.requirements imposed by the Fed.

• If the reserve requirement is 10%, then the banks If the reserve requirement is 10%, then the banks must hold at least $10 in reserves for every $100 must hold at least $10 in reserves for every $100 of customer deposits. of customer deposits.

• Reserves in excess of the Reserves in excess of the required reservesrequired reserves are are called called excess reservesexcess reserves..



Loans are an asset of banks and they represent Loans are an asset of banks and they represent promises by borrowers to repay.promises by borrowers to repay.

One interest rate on loans to customers that is One interest rate on loans to customers that is widely know is the bank prime lending rate.widely know is the bank prime lending rate.

Securities, purchased by banks, in the form of Securities, purchased by banks, in the form of bonds, are interest paying investments.bonds, are interest paying investments.Banks mostly purchase federally issued short-term Banks mostly purchase federally issued short-term

bonds called treasury bills (T-bills)bonds called treasury bills (T-bills)The Federal Deposit Insurance Corporation The Federal Deposit Insurance Corporation

(FDIC) insures deposit accounts up to (FDIC) insures deposit accounts up to $100,000. $100,000.

Loans are an asset of banks and they represent Loans are an asset of banks and they represent promises by borrowers to repay.promises by borrowers to repay.

One interest rate on loans to customers that is One interest rate on loans to customers that is widely know is the bank prime lending rate.widely know is the bank prime lending rate.

Securities, purchased by banks, in the form of Securities, purchased by banks, in the form of bonds, are interest paying investments.bonds, are interest paying investments.Banks mostly purchase federally issued short-term Banks mostly purchase federally issued short-term

bonds called treasury bills (T-bills)bonds called treasury bills (T-bills)The Federal Deposit Insurance Corporation The Federal Deposit Insurance Corporation

(FDIC) insures deposit accounts up to (FDIC) insures deposit accounts up to $100,000. $100,000.



Bank deposits are liabilities because they Bank deposits are liabilities because they are funds owed to depositors.are funds owed to depositors.

Banks also raise funds by borrowing, both Banks also raise funds by borrowing, both from each other, and from the Federal from each other, and from the Federal Reserve.Reserve.

Funds borrowed from other banks are Funds borrowed from other banks are called called federal funds.federal funds.

The interest rate that banks charge on The interest rate that banks charge on loans to other banks is called the loans to other banks is called the federal federal funds rate.funds rate.

Bank deposits are liabilities because they Bank deposits are liabilities because they are funds owed to depositors.are funds owed to depositors.

Banks also raise funds by borrowing, both Banks also raise funds by borrowing, both from each other, and from the Federal from each other, and from the Federal Reserve.Reserve.

Funds borrowed from other banks are Funds borrowed from other banks are called called federal funds.federal funds.

The interest rate that banks charge on The interest rate that banks charge on loans to other banks is called the loans to other banks is called the federal federal funds rate.funds rate.



Borrowings by banks from the Fed are called Borrowings by banks from the Fed are called discount loans.discount loans. With a “discount” interest on the loan is paid when With a “discount” interest on the loan is paid when

the loan is made.the loan is made. The rate of interest charged to banks when they The rate of interest charged to banks when they

borrow from the Fed is called the borrow from the Fed is called the discount rate.discount rate. In addition to banks there are other In addition to banks there are other financial financial

intermediariesintermediaries (bank like institutions), that (bank like institutions), that accept funds from savers in order to make accept funds from savers in order to make loans or investments. loans or investments.

Borrowings by banks from the Fed are called Borrowings by banks from the Fed are called discount loans.discount loans. With a “discount” interest on the loan is paid when With a “discount” interest on the loan is paid when

the loan is made.the loan is made. The rate of interest charged to banks when they The rate of interest charged to banks when they

borrow from the Fed is called the borrow from the Fed is called the discount rate.discount rate. In addition to banks there are other In addition to banks there are other financial financial

intermediariesintermediaries (bank like institutions), that (bank like institutions), that accept funds from savers in order to make accept funds from savers in order to make loans or investments. loans or investments.



Key Interest RatesKey Interest RatesKey Interest RatesKey Interest Rates

YearYear Prime RatePrime RateFederal Funds Federal Funds

RateRateDiscount RateDiscount Rate

19791979 12.6712.67 11.2011.20 10.2910.29

19801980 15.2615.26 13.3513.35 11.7711.77

19811981 18.8718.87 16.3916.39 13.4213.42

18921892 14.8514.85 12.2412.24 11.0111.01

19831983 10.7910.79 9.099.09 8.508.50

19841984 12.0412.04 10.2310.23 8.808.80

19851985 9.939.93 8.108.10 7.697.69


Key Interest Rates (continued)Key Interest Rates (continued)Key Interest Rates (continued)Key Interest Rates (continued)



1986 8.33 6.80 6.32

1987 8.21 6.66 5.66

1988 9.32 7.57 6.20

1989 10.87 9.21 6.93

1990 10.01 8.10 6.98

1991 8.46 5.69 5.45

1992 6.25 3.52 3.25


Key Interest Rates (continuedKey Interest Rates (continued))Key Interest Rates (continuedKey Interest Rates (continued))



19931993 6.006.00 3.023.02 3.003.00

19941994 7.157.15 4.214.21 3.603.60

19951995 8.838.83 5.835.83 5.215.21

19961996 8.278.27 5.305.30 5.025.02

19971997 8.448.44 5.465.46 5.005.00

19981998 8.358.35 5.355.35 4.924.92

19991999 8.008.00 4.974.97 4.624.62


Key Interest Rates (continued)Key Interest Rates (continued)Key Interest Rates (continued)Key Interest Rates (continued)



20002000 9.239.23 6.246.24 5.735.73

20012001 6.916.91 3.883.88 3.403.40

20022002 4.754.75 1.791.79 1.251.25


How Banks Create MoneyHow Banks Create MoneyHow Banks Create MoneyHow Banks Create Money

o When a bank makes a loan, the quantity When a bank makes a loan, the quantity of money in the economy increases.of money in the economy increases.

o Currency inside of bank vaults is not is Currency inside of bank vaults is not is not counted as a part of the money not counted as a part of the money supply. supply. o If a loan is received as currency, the amount If a loan is received as currency, the amount

of currency in the hands of the public is of currency in the hands of the public is greater than before the loan. greater than before the loan.

o When a bank makes a loan, the quantity When a bank makes a loan, the quantity of money in the economy increases.of money in the economy increases.

o Currency inside of bank vaults is not is Currency inside of bank vaults is not is not counted as a part of the money not counted as a part of the money supply. supply. o If a loan is received as currency, the amount If a loan is received as currency, the amount

of currency in the hands of the public is of currency in the hands of the public is greater than before the loan. greater than before the loan.


How Banks Create MoneyHow Banks Create MoneyHow Banks Create MoneyHow Banks Create Money

Homestead University National Bank: Balance Sheet Changes When A Loan is Made

Loans $18,000 Customer Deposits $18,000Assets Liabilities

Homestead University National Bank: Balance Sheet Changes When A Loan is Spent

Reserves -$18,000 Customer Deposits -$18,000Assets Liabilities

Homestead University National Bank: Balance Sheet Changes When A Loan is Repaid

Reserves $18,000Loans -$18,000

Assets Liabilities


13.3MEETING THE FED

13.3MEETING THE FED• The Federal Reserve performs the The Federal Reserve performs the

central banking functions at the heart of central banking functions at the heart of the monetary system.the monetary system.

• The U.S. central bank is called the Fed, The U.S. central bank is called the Fed, short for short for Federal Reserve systemFederal Reserve system..

• It was created by the Federal Reserve It was created by the Federal Reserve Act of 1913 in response to recurring bank Act of 1913 in response to recurring bank failures.failures.

• The act sought to provide a central bank The act sought to provide a central bank contribute to U.S. economic stability.contribute to U.S. economic stability.

• The Federal Reserve performs the The Federal Reserve performs the central banking functions at the heart of central banking functions at the heart of the monetary system.the monetary system.

• The U.S. central bank is called the Fed, The U.S. central bank is called the Fed, short for short for Federal Reserve systemFederal Reserve system..

• It was created by the Federal Reserve It was created by the Federal Reserve Act of 1913 in response to recurring bank Act of 1913 in response to recurring bank failures.failures.

• The act sought to provide a central bank The act sought to provide a central bank contribute to U.S. economic stability.contribute to U.S. economic stability.


As our central bank performing its role As our central bank performing its role of stabilizing the economy, the Fed does of stabilizing the economy, the Fed does the following:the following:

Functions as a banker’s bank.Functions as a banker’s bank.

Functions as a lender of last resort.Functions as a lender of last resort.

Supervises banks.Supervises banks.

Conducts monetary policy.Conducts monetary policy.

Issues currency.Issues currency.

Clears checks.Clears checks.

As our central bank performing its role As our central bank performing its role of stabilizing the economy, the Fed does of stabilizing the economy, the Fed does the following:the following:

Functions as a banker’s bank.Functions as a banker’s bank.

Functions as a lender of last resort.Functions as a lender of last resort.

Supervises banks.Supervises banks.

Conducts monetary policy.Conducts monetary policy.

Issues currency.Issues currency.

Clears checks.Clears checks.

Meet the FEDMeet the FEDMeet the FEDMeet the FED


The Fed is an independent, free from political The Fed is an independent, free from political pressures, arm of government.pressures, arm of government.

To further insulate the Fed from political pressure, To further insulate the Fed from political pressure, it is divided into three components.it is divided into three components.The Board of GovernorsThe Board of Governors, which is responsible , which is responsible

for the overall direction of the Federal Reserve for the overall direction of the Federal Reserve and its policies.and its policies.

The Federal Open Market Committee (FOMC)The Federal Open Market Committee (FOMC),, which conducts monetary policy.which conducts monetary policy.

The Federal Reserves BanksThe Federal Reserves Banks, which regulate and , which regulate and provide a variety of services for banks.provide a variety of services for banks.

The Fed is an independent, free from political The Fed is an independent, free from political pressures, arm of government.pressures, arm of government.

To further insulate the Fed from political pressure, To further insulate the Fed from political pressure, it is divided into three components.it is divided into three components.The Board of GovernorsThe Board of Governors, which is responsible , which is responsible

for the overall direction of the Federal Reserve for the overall direction of the Federal Reserve and its policies.and its policies.

The Federal Open Market Committee (FOMC)The Federal Open Market Committee (FOMC),, which conducts monetary policy.which conducts monetary policy.

The Federal Reserves BanksThe Federal Reserves Banks, which regulate and , which regulate and provide a variety of services for banks.provide a variety of services for banks.

Meet the FEDMeet the FEDMeet the FEDMeet the FED


Influencing The Money SupplyInfluencing The Money SupplyInfluencing The Money SupplyInfluencing The Money Supply

• The principle method the Fed uses to influence The principle method the Fed uses to influence the money is called the money is called open market operations.open market operations.

• Open market operations occur when the Fed Open market operations occur when the Fed enters the financial marketplace to buy or sell enters the financial marketplace to buy or sell government securities, such as treasury bonds. government securities, such as treasury bonds. – When the Fed sells government securities the When the Fed sells government securities the

money supply decreases.money supply decreases.– When the Fed buys government securities When the Fed buys government securities

the money supply increases.the money supply increases.

• The principle method the Fed uses to influence The principle method the Fed uses to influence the money is called the money is called open market operations.open market operations.

• Open market operations occur when the Fed Open market operations occur when the Fed enters the financial marketplace to buy or sell enters the financial marketplace to buy or sell government securities, such as treasury bonds. government securities, such as treasury bonds. – When the Fed sells government securities the When the Fed sells government securities the

money supply decreases.money supply decreases.– When the Fed buys government securities When the Fed buys government securities

the money supply increases.the money supply increases.


Influencing The Money SupplyInfluencing The Money SupplyInfluencing The Money SupplyInfluencing The Money Supply

Assets LiabilitiesReserves $10,000 Customer Deposits $10,000

Bank Balance Sheet Changes: Public Sells Bonds

Assets LiabilitiesBonds $10,000Reserves -$10,000

Bank Balance Sheet Changes: Bank Sells Bonds

Assets LiabilitiesReserves -$10,000 Customer deposits $10,000

Bank Balance Sheet Changes: Public Purchases Bonds

Assets LiabilitiesReserves -$10,000Bonds $10,000

Bank Balance Sheet Changes: Banks Purchases Bonds


The Money MultiplierThe Money MultiplierThe Money MultiplierThe Money Multiplier

The The money multipliermoney multiplier shows the total shows the total effect on the money supply of each dollar effect on the money supply of each dollar of open market operations.of open market operations.

Depending upon the size of the reserve Depending upon the size of the reserve requirement, changes in the money requirement, changes in the money supply are magnified by a multiple supply are magnified by a multiple amount.amount.

Banks are able to make loans up to the Banks are able to make loans up to the amount of their excess reserves.amount of their excess reserves.

The The money multipliermoney multiplier shows the total shows the total effect on the money supply of each dollar effect on the money supply of each dollar of open market operations.of open market operations.

Depending upon the size of the reserve Depending upon the size of the reserve requirement, changes in the money requirement, changes in the money supply are magnified by a multiple supply are magnified by a multiple amount.amount.

Banks are able to make loans up to the Banks are able to make loans up to the amount of their excess reserves.amount of their excess reserves.


The Money MultiplierThe Money MultiplierThe Money MultiplierThe Money Multiplier

The total of new money created when the money The total of new money created when the money supply expansion is complete depends on the size of the supply expansion is complete depends on the size of the money multiplier.money multiplier.

Money supply = Money Multiplier x Monetary baseMoney supply = Money Multiplier x Monetary base

Deposit multiplier = 1/Percentage reserve requirementDeposit multiplier = 1/Percentage reserve requirement


13.4 EXPLORE & APPLY13.4 EXPLORE & APPLYThe Banking Crisis of the 1980’sThe Banking Crisis of the 1980’s

13.4 EXPLORE & APPLY13.4 EXPLORE & APPLYThe Banking Crisis of the 1980’sThe Banking Crisis of the 1980’s

Two rounds of legislation, 50 years apart set Two rounds of legislation, 50 years apart set the stage for the banking crisis of the 1908’s.the stage for the banking crisis of the 1908’s. In the 1930’s in response to widespread bank In the 1930’s in response to widespread bank

failures Congress created the Federal Deposit failures Congress created the Federal Deposit Insurance Corporation, and enacted the Glass-Insurance Corporation, and enacted the Glass-Steagal Act.Steagal Act.

The Depository Institutions Deregulation and The Depository Institutions Deregulation and Monetary Control Act of 1980 was passed.Monetary Control Act of 1980 was passed. This relaxed restrictions on interest rates and bank This relaxed restrictions on interest rates and bank

investments. investments.

Two rounds of legislation, 50 years apart set Two rounds of legislation, 50 years apart set the stage for the banking crisis of the 1908’s.the stage for the banking crisis of the 1908’s. In the 1930’s in response to widespread bank In the 1930’s in response to widespread bank

failures Congress created the Federal Deposit failures Congress created the Federal Deposit Insurance Corporation, and enacted the Glass-Insurance Corporation, and enacted the Glass-Steagal Act.Steagal Act.

The Depository Institutions Deregulation and The Depository Institutions Deregulation and Monetary Control Act of 1980 was passed.Monetary Control Act of 1980 was passed. This relaxed restrictions on interest rates and bank This relaxed restrictions on interest rates and bank

investments. investments.


The Banking Crisis of the 1980’sThe Banking Crisis of the 1980’sThe Banking Crisis of the 1980’sThe Banking Crisis of the 1980’s

As a result of the act, banks began to raise As a result of the act, banks began to raise interest rates during the 80’s in competition for interest rates during the 80’s in competition for depositors.depositors.

Banks were ignoring risk and simply looking at Banks were ignoring risk and simply looking at interest rates. interest rates.

This is an example of “moral hazard”, which This is an example of “moral hazard”, which occurs when people choose riskier behavior occurs when people choose riskier behavior because insurance has lowered the price of risk. because insurance has lowered the price of risk.

As a result of the act, banks began to raise As a result of the act, banks began to raise interest rates during the 80’s in competition for interest rates during the 80’s in competition for depositors.depositors.

Banks were ignoring risk and simply looking at Banks were ignoring risk and simply looking at interest rates. interest rates.

This is an example of “moral hazard”, which This is an example of “moral hazard”, which occurs when people choose riskier behavior occurs when people choose riskier behavior because insurance has lowered the price of risk. because insurance has lowered the price of risk.


The Banking Crisis of the 1980’sThe Banking Crisis of the 1980’sThe Banking Crisis of the 1980’sThe Banking Crisis of the 1980’s

The government guaranteed deposits The government guaranteed deposits above $100,000.above $100,000.They also encouraged the merger of They also encouraged the merger of

insolvent banks with sound banks.insolvent banks with sound banks.

The 1990’s brought a healthier economic The 1990’s brought a healthier economic climate with restored bank profitability climate with restored bank profitability and reduced numbers of bank failures.and reduced numbers of bank failures.

The government guaranteed deposits The government guaranteed deposits above $100,000.above $100,000.They also encouraged the merger of They also encouraged the merger of

insolvent banks with sound banks.insolvent banks with sound banks.

The 1990’s brought a healthier economic The 1990’s brought a healthier economic climate with restored bank profitability climate with restored bank profitability and reduced numbers of bank failures.and reduced numbers of bank failures.


o moneymoneyo barterbartero medium of exchangemedium of exchangeo store of valuestore of valueo unit of accountunit of accounto fiat moneyfiat moneyo Gresham’s lawGresham’s lawo demand depositdemand deposit

o moneymoneyo barterbartero medium of exchangemedium of exchangeo store of valuestore of valueo unit of accountunit of accounto fiat moneyfiat moneyo Gresham’s lawGresham’s lawo demand depositdemand deposit

o liquidityliquidityo M1M1o M2M2o M3M3o bank reservesbank reserveso required reservesrequired reserveso excess reservesexcess reserves

o liquidityliquidityo M1M1o M2M2o M3M3o bank reservesbank reserveso required reservesrequired reserveso excess reservesexcess reserves

Terms Along the WayTerms Along the WayTerms Along the WayTerms Along the Way


o bondsbondso federal funds ratefederal funds rateo discount ratediscount rateo Federal Reserve Federal Reserve

SystemSystemo open market open market

operationsoperationso monetary base monetary base

o bondsbondso federal funds ratefederal funds rateo discount ratediscount rateo Federal Reserve Federal Reserve

SystemSystemo open market open market

operationsoperationso monetary base monetary base

o money multipliermoney multipliero deposit multiplierdeposit multiplier

o money multipliermoney multipliero deposit multiplierdeposit multiplier

Terms Along the WayTerms Along the WayTerms Along the WayTerms Along the Way


Test YourselfTest YourselfTest YourselfTest Yourself

1.1. Barter is most likely to occur when Barter is most likely to occur when a.a. money takes the form of commodity money takes the form of commodity

money.money.b.b. M1 is the dominant form of money.M1 is the dominant form of money.c.c. Gresham’s law requires people to Gresham’s law requires people to

barter.barter.d.d. there is no money.there is no money.

1.1. Barter is most likely to occur when Barter is most likely to occur when a.a. money takes the form of commodity money takes the form of commodity

money.money.b.b. M1 is the dominant form of money.M1 is the dominant form of money.c.c. Gresham’s law requires people to Gresham’s law requires people to

barter.barter.d.d. there is no money.there is no money.



2.2. The U.S. one dollar coin is an example of The U.S. one dollar coin is an example of a.a. commodity money.commodity money.b.b. fiat moneyfiat moneyc.c. money that is neither commodity money nor money that is neither commodity money nor

fiat money.fiat money.d.d. something that looks like money, but is not something that looks like money, but is not

since it is coined from nearly worthless since it is coined from nearly worthless metals.metals.

2.2. The U.S. one dollar coin is an example of The U.S. one dollar coin is an example of a.a. commodity money.commodity money.b.b. fiat moneyfiat moneyc.c. money that is neither commodity money nor money that is neither commodity money nor

fiat money.fiat money.d.d. something that looks like money, but is not something that looks like money, but is not

since it is coined from nearly worthless since it is coined from nearly worthless metals.metals.



3.3. Which is NOT a function of money?Which is NOT a function of money?

a.a. Standard of measurement.Standard of measurement.

b.b. Unit of account.Unit of account.

c.c. Store of value.Store of value.

d.d. Medium of exchange.Medium of exchange.

3.3. Which is NOT a function of money?Which is NOT a function of money?

a.a. Standard of measurement.Standard of measurement.

b.b. Unit of account.Unit of account.

c.c. Store of value.Store of value.

d.d. Medium of exchange.Medium of exchange.



4.4. A bank’s total reserves equalA bank’s total reserves equal

a.a. required reserves.required reserves.

b.b. excess reserves.excess reserves.

c.c. required reserves + excess reserves.required reserves + excess reserves.

d.d. required reserves – excess reserves.required reserves – excess reserves.

4.4. A bank’s total reserves equalA bank’s total reserves equal

a.a. required reserves.required reserves.

b.b. excess reserves.excess reserves.

c.c. required reserves + excess reserves.required reserves + excess reserves.

d.d. required reserves – excess reserves.required reserves – excess reserves.



5.5. If the money supply equals $100 and the If the money supply equals $100 and the money multiplier equals 10, then the money multiplier equals 10, then the monetary base must equal?monetary base must equal?

a.a. $1.000.$1.000.b.b. $100.$100.c.c. $10.$10.d.d. an amount that cannot be determined an amount that cannot be determined

by the information given.by the information given.

5.5. If the money supply equals $100 and the If the money supply equals $100 and the money multiplier equals 10, then the money multiplier equals 10, then the monetary base must equal?monetary base must equal?

a.a. $1.000.$1.000.b.b. $100.$100.c.c. $10.$10.d.d. an amount that cannot be determined an amount that cannot be determined

by the information given.by the information given.



6.6. If the reserve requirement were 20% and the If the reserve requirement were 20% and the FED purchased $100 of securities in an open FED purchased $100 of securities in an open market purchase, then the money supply market purchase, then the money supply could potentially expand by a maximum ofcould potentially expand by a maximum of

a.a. $5.$5.

b.b. $20.$20.

c.c. $100.$100.

d.d. $500.$500.

6.6. If the reserve requirement were 20% and the If the reserve requirement were 20% and the FED purchased $100 of securities in an open FED purchased $100 of securities in an open market purchase, then the money supply market purchase, then the money supply could potentially expand by a maximum ofcould potentially expand by a maximum of

a.a. $5.$5.

b.b. $20.$20.

c.c. $100.$100.

d.d. $500.$500.


The End!The End!Next Chapter 14Next Chapter 14

““Monetary Policy Monetary Policy and Price Stability"and Price Stability"

©2004 prentice hall publishing ayers/collinge, 1/e 1 chapter 13 “money, banking, and the federal...

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