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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
● The Nature of Money
● How the Quantity of Money is Measured
● The Banking System
● The Origins of the Money Supply
● Banks and Money Creation
● Why the Deposit Creation Formula Is Oversimplified
● The Need for Monetary Policy
● The Nature of Money
● How the Quantity of Money is Measured
● The Banking System
● The Origins of the Money Supply
● Banks and Money Creation
● Why the Deposit Creation Formula Is Oversimplified
● The Need for Monetary Policy
ContentsContents
Copyright © 2006 South-Western/Thomson Learning. All rights reserved.
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
● Barter versus Monetary Exchange
♦ A barter system (with no money) would be
awkward and extremely inefficient.
♦ Money greases the wheels of exchange and,
thus, makes the whole economy more
productive.
● Barter versus Monetary Exchange
♦ A barter system (with no money) would be
awkward and extremely inefficient.
♦ Money greases the wheels of exchange and,
thus, makes the whole economy more
productive.
The Nature of MoneyThe Nature of Money
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
The Nature of MoneyThe Nature of Money
● The Conceptual Definition of Money
♦ The functions of money:
■Medium of exchange
■Unit of account
■Store of value
♦ Money = whatever serves as the medium of
exchange
● The Conceptual Definition of Money
♦ The functions of money:
■Medium of exchange
■Unit of account
■Store of value
♦ Money = whatever serves as the medium of
exchange
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
● What Serves as Money?
♦ Societies have gradually moved from the use of
commodity monies to the use of money that
has no commodity backing at all.
● What Serves as Money?
♦ Societies have gradually moved from the use of
commodity monies to the use of money that
has no commodity backing at all.
The Nature of MoneyThe Nature of Money
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
● There is no single, obvious place to draw
the line between “money” and “near
money.”
● M1 = coins and paper money in
circulation, plus checkable deposits
● M2 = M1 + money market deposit
accounts, money market mutual funds, and
savings accounts
● There is no single, obvious place to draw
the line between “money” and “near
money.”
● M1 = coins and paper money in
circulation, plus checkable deposits
● M2 = M1 + money market deposit
accounts, money market mutual funds, and
savings accounts
How the Quantity of Money is MeasuredHow the Quantity of Money is Measured
FIGURE 2: Two Definitions of the Money Supply, January 2005FIGURE 2: Two Definitions of the
Money Supply, January 2005
Copyright © 2006 South-Western/Thomson Learning. All rights reserved.
M1 = $1361 billion
CurrencyOutside banks$710 billion
Othercheckabledeposits$321 billions
Checking depositsIn commercialBanks $330 billion
M2 = $6443 billion
Money marketmutual funds$704 billion
M1$1361 billion
Savingsdeposits
$4378 billion
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
● How Banking Began
♦ Fractional reserve banking began when
goldsmiths realized they could profitably lend
out a portion of the gold that had been
deposited with them for safekeeping.
● How Banking Began
♦ Fractional reserve banking began when
goldsmiths realized they could profitably lend
out a portion of the gold that had been
deposited with them for safekeeping.
The Banking SystemThe Banking System
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
The Banking SystemThe Banking System
● How Banking Began
♦ Three important features of the fractional
reserve banking system:
■Bank profitability
■Banks discretion over the money supply
■Exposure to bank runs
● How Banking Began
♦ Three important features of the fractional
reserve banking system:
■Bank profitability
■Banks discretion over the money supply
■Exposure to bank runs
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
The Banking SystemThe Banking System
● Principles of Bank Management: Profits
versus Safety
♦ To make a profit, a banker must take risks.
♦ But because the business is risky, the same
banker must also emphasize safety.
♦ The heart of banking is to be torn between the
two principles.
● Principles of Bank Management: Profits
versus Safety
♦ To make a profit, a banker must take risks.
♦ But because the business is risky, the same
banker must also emphasize safety.
♦ The heart of banking is to be torn between the
two principles.
FIGURE 1: Bank Failures in the United States, 1915-2003FIGURE 1: Bank Failures in the
United States, 1915-2003
Copyright © 2006 South-Western/Thomson Learning. All rights reserved.
1915 1920 1925 1930 1935 1940 19450
200
400
600
800
1,000
1,200
1,400
1,600
1,800
2,000
2,200
Year(a)
Number of Bank Failures
FDIC established
Great Depressionbegins
0
200
160
120
80
40
1945 1955 1965 1975 1985
Number of Bank Failures
1995 '03
(b)
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
The Banking SystemThe Banking System
● Bank Regulation
♦ Deposit insurance (FDIC)
■Eliminates the motive for customers to withdraw
funds because of bad news regarding the bank’s
finances
♦ Moral hazard
■When an individual is insured against risk, he/she
puts forth little effort to avoid risk
■FDIC could make the banking system less safe
● Bank Regulation
♦ Deposit insurance (FDIC)
■Eliminates the motive for customers to withdraw
funds because of bad news regarding the bank’s
finances
♦ Moral hazard
■When an individual is insured against risk, he/she
puts forth little effort to avoid risk
■FDIC could make the banking system less safe
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
The Banking SystemThe Banking System
● Bank Regulation
♦ Bank Supervision
■Needed to reduce moral hazard problem
■Ensures banks take only sensible, defensible risks
■Controls the money supply
♦ Reserve Requirements
■Helps control the money supply
● Bank Regulation
♦ Bank Supervision
■Needed to reduce moral hazard problem
■Ensures banks take only sensible, defensible risks
■Controls the money supply
♦ Reserve Requirements
■Helps control the money supply
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
● How Bankers Keep Books
♦ Banks keep balance sheets
■Assets = liabilities + net worth
♦ Assets include:
■Reserves
■Loans
♦ Liabilities include:
■Deposits owed to customers.
● How Bankers Keep Books
♦ Banks keep balance sheets
■Assets = liabilities + net worth
♦ Assets include:
■Reserves
■Loans
♦ Liabilities include:
■Deposits owed to customers.
The Origins of the Money SupplyThe Origins of the Money Supply
TABLE 1: Balance Sheet of Bank-a-mythica, Dec. 31, 2004TABLE 1: Balance Sheet of Bank-
a-mythica, Dec. 31, 2004
Copyright © 2006 South-Western/Thomson Learning. All rights reserved.
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
Banks and Money CreationBanks and Money Creation
● The Limits to Money Creation by a Single
Bank
♦ Banks can lend money in their vault that is
above the minimum required reserve ratio.
♦ In doing so, they create new money.
● The Limits to Money Creation by a Single
Bank
♦ Banks can lend money in their vault that is
above the minimum required reserve ratio.
♦ In doing so, they create new money.
TABLE 2: Bank-a-mythica’sBalance Sheet, Jan. 2, 2005TABLE 2: Bank-a-mythica’s
Balance Sheet, Jan. 2, 2005
Copyright © 2006 South-Western/Thomson Learning. All rights reserved.
TABLE 3: Bank-a-mythica’sBalance Sheet, Jan. 3-6, 2005TABLE 3: Bank-a-mythica’s
Balance Sheet, Jan. 3-6, 2005
Copyright © 2006 South-Western/Thomson Learning. All rights reserved.
TABLE 4: Bank-a-mythica’sBalance Sheet, Jan. 2-6, 2005TABLE 4: Bank-a-mythica’s
Balance Sheet, Jan. 2-6, 2005
Copyright © 2006 South-Western/Thomson Learning. All rights reserved.
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
Banks and Money CreationBanks and Money Creation
● Multiple Money Creation by a Series of
Banks
♦ When all banks make loans with funds they
have that are above the required reserve ratio,
the society’s money supply expands.
● Multiple Money Creation by a Series of
Banks
♦ When all banks make loans with funds they
have that are above the required reserve ratio,
the society’s money supply expands.
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
Banks and Money CreationBanks and Money Creation
● Multiple Money Creation by a Series of
Banks
♦ ∆ deposits = (1/m) x ∆ reserves
■Assumes banks keep the minimum reserve ratio, m
■Assumes all new money held in the form of
deposits
■Oversimplified deposit multiplier formula
● Multiple Money Creation by a Series of
Banks
♦ ∆ deposits = (1/m) x ∆ reserves
■Assumes banks keep the minimum reserve ratio, m
■Assumes all new money held in the form of
deposits
■Oversimplified deposit multiplier formula
TABLE 5: Changes in First National Bank’s Balance SheetTABLE 5: Changes in First
National Bank’s Balance Sheet
Copyright © 2006 South-Western/Thomson Learning. All rights reserved.
TABLE 6: Changes in Second National Bank’s Balance SheetTABLE 6: Changes in Second
National Bank’s Balance Sheet
Copyright © 2006 South-Western/Thomson Learning. All rights reserved.
FIGURE 3: The Chain of Multiple Deposit CreationFIGURE 3: The Chain of Multiple
Deposit Creation
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•
•
•
$400,000
$268,928
$236,160
$195,200
$144,000
(3)
$80,000
Loans
•
•
•
$100,000
•
•
•
$500,000
$336,160
$295,200
$244,000
$180,000
Running Sums
(2)
$100,000
Deposits
$67,232
$59,040
$48,800
$36,000
(1)
$20,000
Reserves
And so on . . .
$40,960 deposit
$32,768 lent out $8,192 on reserve
$51,200 deposit
$40,960 lent out $10,240 on reserve
$64,000 deposit
$51,200 lent out $12,800 on reserve
$80,000 deposit
$64,000 lent out $16,000 on reserve
$100,000 deposit
$80,000 lent out $20,000 on reserve
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
Banks and Money CreationBanks and Money Creation
● The Process in Reverse: Multiple
Contractions of the Money Supply
♦ Deposits, and with them the money supply,
contract when reserves are reduced.
■Banks reduce their loan commitments.
■Calculation of the contraction in the money supply
utilizes the same formula as for money expansion.
● The Process in Reverse: Multiple
Contractions of the Money Supply
♦ Deposits, and with them the money supply,
contract when reserves are reduced.
■Banks reduce their loan commitments.
■Calculation of the contraction in the money supply
utilizes the same formula as for money expansion.
TABLE 7: Changes in Balance Sheet of Bank-a-mythicaTABLE 7: Changes in Balance
Sheet of Bank-a-mythica
Copyright © 2006 South-Western/Thomson Learning. All rights reserved.
TABLE 8: Changes, Balance Sheet of First National BankTABLE 8: Changes, Balance
Sheet of First National Bank
Copyright © 2006 South-Western/Thomson Learning. All rights reserved.
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
● Individuals hold some portion of additions
to their money in the form of cash.
● Banks sometimes hold reserves above the
required minimum.
● Individuals hold some portion of additions
to their money in the form of cash.
● Banks sometimes hold reserves above the
required minimum.
Why the Deposit Creation Formula Is OversimplifiedWhy the Deposit Creation Formula Is Oversimplified
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
The Need for Monetary PolicyThe Need for Monetary Policy
● Left uncontrolled, banks would:
♦ Reduce the money supply in a recession
♦ Increase the money supply during boom periods
● Changes in the money supply would exacerbate the business cycle.
● One reason for monetary policy, therefore, is to prevent this behavior on the part of banks.
● Left uncontrolled, banks would:
♦ Reduce the money supply in a recession
♦ Increase the money supply during boom periods
● Changes in the money supply would exacerbate the business cycle.
● One reason for monetary policy, therefore, is to prevent this behavior on the part of banks.