chapter 8 money and the banking system [money] is a machine for doing quickly and commodiously what...
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Chapter 8
Money and the Banking System
[Money] is a machine for doing quickly and commodiously what would
be done, though less quickly and commodiously, without it.
JOHN STUART MILL
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The Nature of Money
• Run on a bank– Many depositors
• Withdraw cash• All at once
• Banks - Heavily regulated– Money supply
• Important determinant of aggregate demand
– Safety of depositors
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Bank failures in the United States, 1915–2007
Figure 1 (a)
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Bank failures in the United States, 1915–2007
Figure 1 (b)
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The Nature of Money
• Barter– System of exchange
– Trade: one good for another
– Without money - intermediate step
– Desired: double coincidence of wants
• Money– Exchange
– Economy - more productive
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The Nature of Money
• Money– Medium of exchange
• Standard object - exchange goods & services
– Unit of account• Standard unit – quoting prices
– Store of value• Store wealth
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The Nature of Money
• Commodity money – object – Used as medium of exchange
– Substantial value in alternative uses
• Paper money = Fiat money– Decreed as money by government
– Little value as commodity
– Maintains value - medium of exchange
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How Quantity of Money is Measured
• Money supply M1– Narrowly defined
– Coins and paper money in circulation
– Traveler’s checks
– Conventional checking accounts
– Certain other checkable deposits• Banks• Savings institutions
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Two definitions of the money supply, December 2007
Figure 2
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How Quantity of Money is Measured
• Money supply M2– Broadly defined
– M1
– Money market deposit accounts
– Money market mutual funds
– Savings accounts
• Near moneys– Liquid assets
– Close substitutes for money10
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How Quantity of Money is Measured
• Asset’s liquidity– Ease – convert into cash
• Credit cards– Not included in money supply
• Convention: Money– Coins
– Paper money
– Checkable deposits
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The Banking System
• Fractional reserve banking system– Reserves - a fraction of deposits
– Features• Bank profitability
– Banks – businesses – earn profits
• Bank discretion over money supply– Create money
• Exposure to bank runs– Prudency
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The Banking System
• Bankers - reputation for prudence– Checking deposits - pure fiat money
– Sufficiently generous level of reserves • Minimize vulnerability to runs
– Cautious - loans and investments• Large losses – undermine confidence
• Banking - inherently risky business– Safe - cautious and prudent management
– Maximize profits – low reserves, high interest rates 13
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The Banking System
• Bank regulations– Deposit insurance - guarantees deposits
• Federal Deposit Insurance Corporation/ FDIC• Moral hazard problem
– If insured against consequences of risk– Engage in riskier behavior
– Bank supervision - Bank examinations
– Reserve requirements• Minimum amount of reserves
– Proportional to volume of deposits
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The Origins of the Money Supply
• Asset - item of value– Owned
• Liability - item of value– Owed / Debt
• Balance sheet - accounting statement• Left side: values of all assets• Right side: values of all liabilities & net worth
– Net worth = assets – liabilities
– Assets = Liabilities + Net worth15
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Balance sheet of Bank-a-mythica,
December 31, 2007
Table 1
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Assets Liabilities and Net Worth
AssetsReservesLoans outstandingTotalAddendum: Bank ReservesActual reservesRequired reservesExcess reserves
$1,000,000$4,500,000$5,500,500
$1,000,000$1,000,000 0
LiabilitiesChecking deposits
Net WorthStockholder’s equityTotal
$5,000,000
$500,000 $5,500,000
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Banks and Money Creation
• Deposit creation – process– Fractional reserve banking system
– Turns $1 of bank reserves
– Into several dollars of bank deposits
• Excess reserves– Reserves held in excess of legal minimum
– Earn no interest
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Changes in Bank-a-mythica’s balance sheet,
January 2, 2008
Table 2
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Assets Liabilities and Net Worth
Reserves Addendum: Changes in ReservesActual reservesRequired reservesExcess reserves
+$100,000
+$100,000+$ 20,000 +$ 80,000
Checking deposits +$100,000
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Banks and Money Creation
• Multiple money creation– Initial deposit $100,000– Increase reserves
• Required reserves $20,000• Excess reserves $80,000
– Extend more loans $80,000• Increase deposits $80,000• Increase reserves
– Required reserves– Excess reserves
• Extend more loans 19
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Changes in Bank-a-mythica’s balance sheet,
January 3–6, 2008
Table 3
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Assets Liabilities and Net Worth
Loans outstandingReserves Addendum: Changes in ReservesActual reservesRequired reservesExcess reserves
+$80,000-$80,000
-$80,000
No change-$80,000
No change
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Changes in Bank-a-mythica’s balance sheet,
January 2–6, 2008
Table 4
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Assets Liabilities and Net Worth
ReservesLoans outstanding Addendum: Changes in ReservesActual reservesRequired reservesExcess reserves
+$20,000+$80,000
+$20,000+$20,000 No change
Checking deposits +$100,000
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Changes in First National Bank’s balance sheet
Table 5
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Assets Liabilities and Net Worth
ReservesLoans outstanding Addendum: Changes in ReservesActual reservesRequired reservesExcess reserves
+$16,000+$64,000
+$16,000+$16,000 No change
Checking deposits +$80,000
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Changes in Second National Bank’s balance sheet
Table 6
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Assets Liabilities and Net Worth
ReservesLoans outstanding Addendum: Changes in ReservesActual reservesRequired reservesExcess reserves
+$12,800+$51,200
+$12,800+$12,800 No change
Checking deposits +$64,000
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Banks and Money Creation
• Assumptions– Each bank
• Holds exactly 20% required reserves
– Each loan recipient• Redeposits proceeds - next bank
• Sum of infinite geometric progression
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RRRR
11
...1 32
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The chain of multiple deposit creation
Figure 3
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Banks and Money Creation
• Reserve ratio = m– R=1-m
– Deposits • Expand by 1/m of each $1 of new reserves
• Money multiplier – ratio of – Newly created bank deposits
– To new reserves – Change in money supply=(1/m) ˣ Change in reserves
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Banks and Money Creation
• Multiple contractions of money supply– Deposit destruction
– Withdrawal $100,000
– Decrease reserves $100,000• Need $80,000 to meet reserve requirement
– Outstanding loans – paid off $80,000• Borrowers – withdrawal $80,000• Decrease reserves• Loans – paid off
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Changes in the balance sheet of Bank-a-mythica
Table 7
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(a)
Assets Liabilities and Net Worth
Reserves Addendum: Changes in ReservesActual reservesRequired reservesExcess reserves
-$100,000
-$100,000-$20,000 -
$80,000
Checking deposits -$100,000
(b)
Assets Liabilities and Net Worth
Reserves Loans outstanding
Addendum: Changes in ReservesActual reservesRequired reservesExcess reserves
+$80,000-$80,000
+$80,000
No change+$80,000
No change
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Changes in the balance sheet of First National Bank
Table 8
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(a)
Assets Liabilities and Net Worth
Reserves
Addendum: Changes in ReservesActual reservesRequired reservesExcess reserves
-$80,000
-$80,000-$16,000 -
$64,000
Checking deposits -$80,000
(b)
Assets Liabilities and Net Worth
Reserves Loans outstanding
Addendum: Changes in ReservesActual reservesRequired reservesExcess reserves
+$64,000-$64,000
+$64,000
No change+$64,000
No change
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Money-Creation Formula Is Oversimplified
• Oversimplified money multiplier– Accurate - very particular circumstances:
1.Every recipient of cash• Must redeposit cash - another bank• Doesn’t hold cash
2.Every bank• Must hold reserves - legal minimum
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Money-Creation Formula Is Oversimplified
• If individuals & business firms– Hold more cash
– Limited• Multiple expansion of bank deposits
– Fewer dollars of cash• Available for use as reserves
– Smaller money supply
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Money-Creation Formula Is Oversimplified
• If banks– Keep excess reserves
– Limited• Multiple expansion of bank deposits
– Smaller supply of money
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The Need for Monetary Policy
• During a recession– Banks - reduce money supply
• Increase excess reserves• Decrease lending
– Less creditworthy applicants
– Aggravate recession
– Need government intervention
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The Need for Monetary Policy
• During an economic boom– Banks – expand money supply
– Undesirable momentum to economy• Inflation
– Need government intervention
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