MONEY, BANKS, AND THE FED

Chapter 13 & 14

THE MONEY SUPPLY

Anything that serves all of the following purposes can be thought of as money:Medium of exchange – Is accepted as payment for

goods and services (and debts).goods and services (and debts). Store of value – Can be held for future purchases. Standard of value – Serves as a measurement for

the prices of goods and services.

2

MODERN CONCEPTS

Money is anything generally accepted as a medium of exchange.

The “greenbacks” we carry around today are not the only form of “money” we usenot the only form of money we use.

Checking accounts can and do perform the same market functions as cash.

Credit cards are another popular medium of exchange but are not money. They are only a payment service with no store of

value in and of themselves. 3

DIVERSITY OF BANK ACCOUNTS

Some bank accounts are better substitutes for cash than others.

Money supply (M1): - Currency held by the public plus balances in transactions accountspublic, plus balances in transactions accounts.M1 includes currency in circulation, transaction-

account balances, and traveler’s checks. A transactions account is a bank account that

permits direct payment to a third party, for example, with a check.Largest component of Money Supply

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M2: M1 + SAVINGS ACCOUNTS, ETC.

M2 money supply – M1 plus balances in most savings accounts and money market mutual funds. Savings-account balances are almost as good a

substitute for cash as transaction-account balances.

How much money is available affects consumers’ ability to purchase goods and, services – aggregate demand.

M1 and M2 are fairly reliable benchmarks for gauging how much purchasing power market participants have.

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COMPOSITION OF THE MONEY SUPPLY

Money market mutual funds and deposits ($1027 billion)

M2($5383 billion)

Currency in circulation ($569 billion)

Transactions-account balances ($612 billion)

Savings account balances ($3167 billion)

Traveler’s checks ($8 billion)

M1($1189 billion)

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CREATION OF MONEY

The deposit of funds into a bank does not change the size of the money supply. It changes the composition of the money supply

(transfers from cash to transaction deposits).(transfers from cash to transaction deposits).When a bank lends someone money, it simply

credits that individual’s bank account.

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DEPOSIT CREATION

Deposit creation is the creation of transactions deposits by bank lending.

When a bank makes a loan, it effectively creates money because transactions-account balances are counted as part of the money supply.

There are two basic principles of the money supply: Transactions-account balances are a large portion of

our money supply. Banks can create transactions-account balances by

making loans.8

BANK REGULATION

The deposit-creation activities of banks are regulated by the government.

The Federal Reserve System limits the amount of bank lending thereby controlling the basic of bank lending, thereby controlling the basic money supply.

9

A MONOPOLY BANK

Assume a student deposits $100 from their piggy bank into the monopoly bank and receives a new checking account.

When someone deposits cash or coins in a When someone deposits cash or coins in a bank, they are changing the composition of the money supply, not its size.

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THE INITIAL LOAN

The monopoly bank loans $100 to the Campus Radio station and issues a checking account. This loan is accomplished by a simple bookkeeping

entry.entry. Total bank reserves have remained unchanged.Bank reserves are assets held by a bank to fulfill its

deposit obligations.Money has been created because the checking

account is considered to be money.

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SECONDARY DEPOSITS

In a one bank system, when Campus Radio uses the loan, the money supply does not contract, rather ownership of deposits change.

Bank reserves are only a fraction of total Bank reserves are only a fraction of total transaction deposits.

The reserve ratio is the ratio of a bank's reserves to its total deposits (Fed requirement).

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Reserve ratio =Bank reservesTotal deposits

THE T-ACCOUNT OF THE BANK

The books of a bank must always balance, because all of the assets of the bank must belong to someone (its depositors or its owners).owners).

13

MONEY CREATION

Assets Liabilities

University Bank

+$100.00 in i

+$100.00 in d it

Money Supply

Cash held by the public –$100T ti d itcoins deposits Transactions deposits

at bank +$100

Change in M 0

14

MONEY CREATION

Assets Liabilities

University Bank

+$100.00 in i

+$100.00 in t

Cash held by the public no changeT ti d it

Money Supply

coins

+$100 in loans

your account

+$100.00 in borrower’s

account

Transactions deposits at bank +$100

Change in M +$100

15

REQUIRED RESERVES

Required reserves are the minimum amount of reserves a bank is required to hold by government regulation; Equal to required reserve ratio times transactions deposits.

The minimum reserve requirement directly limits deposit-creation possibilities.

Required reserves = minimum reserve ratio X total deposits

16

A MULTIBANK WORLD

In reality, there is more than one bank. The ability of banks to make loans depends on

access to excess reserves.

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A MULTIBANK WORLD

Example: If a bank is required to hold $20 in reserves but has $100 currently, it can lend out the $80 excess. Excess reserves =Total reserves-Required reserves) Excess reserves Total reserves Required reserves)

So long as a bank has excess reserves, it can make loans.

18

CHANGES IN THE MONEY SUPPLY

The creation of transaction deposits via new loans is the same thing as creating money.

As the excess reserves are loaned out again, more deposits are created and thus more more deposits are created and thus more money is created.

19

DEPOSIT CREATION

Assets Liabilities

University Bank

Required Your

Assets Liabilities

Eternal Savings

Required Reserves $20Excess Reserves $80

Youraccount $100

Total Assets$100

Total Liabilities$100

Total Assets Total Liabilities

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 20

DEPOSIT CREATION

Assets Liabilities

University Bank

Required Your

Assets Liabilities

Eternal Savings

Required Reserves $36Excess Reserves $64Loans $80

Youraccount $100Campus Radio account $ 80

Total Assets$180

Total Liabilities$180

Total Assets Total Liabilities

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 21

DEPOSIT CREATION

Assets Liabilities

University Bank

Required Your

Assets Liabilities

Eternal Savings

Required AtlasRequired Reserves $20Excess Reserves $ 0Loans $80

Youraccount $100Campus Radio account $ 0

Total Assets$100

Total Liabilities$100

Required Reserves $16Excess Reserves $64

Atlas Antenna account $80

Total Assets$80

Total Liabilities$80

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 22

DEPOSIT CREATION

Assets Liabilities

University Bank

Required Your

Assets Liabilities

Eternal Savings

Required AtlasRequired Reserves $20Excess Reserves $ 0Loans $80

Youraccount $100Campus Radio account $ 0

Total Assets$100

Total Liabilities$100

Required Reserves $29Excess Reserves $51 Loans $64

Atlas Antenna account $80Herman’sHardwareaccount $64

Total Assets$144

Total Liabilities$144

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 23

THE MONEY MULTIPLIER

In a multi-bank system, deposits created by one bank invariably end up as reserves in another bank.

This process can theoretically continue until all This process can theoretically continue until all banks have zero excess reserves (no more loans can be made).

This is known as the money-multiplier process.

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THE MONEY MULTIPLIER

The money multiplier is the number of deposit (loan) dollars that the banking system can create from $1 of excess reserves.

Money multiplier = 1

Required reserve requirement

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THE MONEY MULTIPLIER

When a new deposit enters the banking system, it creates both excess and required reserves. The required reserves represent leakage from the

flow of money, since they cannot be used to create new loans.

Excess reserve can be used for new loans (often turned into transactions deposits elsewhere).

Some additional leakage into required reserves occurs, and further loans are made.

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THE MONEY MULTIPLIER

The entire banking system can increase the volume of loans by the amount of excess reserves multiplied by the money multiplier.

The money supply can be increased through The money supply can be increased through the process of deposit creation to this limit:

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Potential deposit creation = Excess reserves of banking system

X Money multiplier

THE MONEY MULTIPLIER PROCESS

The public

Required reserves

Excess reserves

Leakage into

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EXCESS RESERVES AS LENDING POWER

Each bank may lend an amount equal to its excess reserves and no more.

The entire banking system can increase the volume of loans by the amount of excess volume of loans by the amount of excess reserves multiplied by the money multiplier.

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THE MONEY MULTIPLIER AT WORK

Original deposit = $ 100.00Bank A loans: = $ 80.00 [=0.8 x $100.00]Bank B loans = $ 64.00 [=0.8 x $80.00]B k C l $ 51 20 [ 0 8 $64 00]Bank C loans = $ 51.20 [=0.8 x $64.00]

Total money supply = $ 500.00

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BANKS AND THE CIRCULAR FLOW

Banks perform two essential functions for the macro economy:Banks transfer money from savers to spenders by

lending funds (reserves) held on deposit.lending funds (reserves) held on deposit. The banking system creates additional money by

making loans in excess of total reserves.

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BANKS AND THE CIRCULAR FLOW

Market participants respond to changes in the money supply by altering their spending behavior (shifting the aggregate demand curve).curve).

32

BANKS IN THE CIRCULAR FLOW

Loan

s

Consumers

Sa

vin

g

IncomeDomestic consumption

Loan

s

Factor markets

Product markets

Business firms

BANKS

S

Investment expenditures

Sales receipts

Wages, dividends, etc.

33

FINANCING INJECTIONS The consumer saving is a leakage. A recessionary gap will emerge, creating

unemployment if additional spending by business firms, foreigners, or governments does not compensate for consumer saving at full employment.employment.

A substantial portion of consumer saving is deposited in banks which can be used to make loans, thereby returning purchasing power to the circular flow.

The banking system can create any desired level of money supply if allowed to expand or reduce loan activity at will.

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CONSTRAINTS ON DEPOSIT CREATION

There are three major constraints on deposit creation:Deposits – Consumers must be willing to use and

accept checks rather than cash.accept checks rather than cash.Borrowers – Consumers must be willing to borrow

the money that banks provide.Regulation – The Federal Reserve sets the ceiling

on deposit creation.

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WHEN BANKS FAIL

Because of the fractional reserve system, no bank can pay off its customers if they all sought to withdraw their deposits at one time.

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BANK PANICS

Occasional “runs” of depositors rushing to withdraw their funds have created panics in the past. As word spread, it became a self-fulfilling confirmation

of a bank’s insolvencyof a bank’s insolvency.

The resulting bank closing wiped out customer deposits, curtailed bank lending, and often pushed the economy into recession.

As their reserves dwindled, the ability of banks to create money evaporated and a chunk of money (bank deposits and loans) just disappeared.

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DEPOSIT INSURANCE

In 1933-34, the FDIC and FSLIC were created by Congress to ensure depositors that their money would be safe -- thus eliminating the motivation for deposit runs.motivation for deposit runs.

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INTRODUCTION: FEDERAL RESERVE

The fed’s control over the supply of money is the key mechanism of monetary policy.

• Monetary policy is the use of money and

The Federal Reserve maintains an excellent synopsis of the roles of the respective parts of the system here.

Monetary policy is the use of money and credit controls to influence macroeconomic activity.

FEDERAL RESERVE BANKS

Congress passed the Federal Reserve Act in 1913 to avert recurrent financial crises.

Each of the twelve (12) Federal Reserve banks act as a central banker for the private banks in act as a central banker for the private banks in their region.

FEDERAL RESERVE BANKS

The Federal Reserve performs the following services:

l Clears checks between private banksl Holds bank reserves.l Provides currency to the public.l Provides loans to private banks.

THE BOARD OF GOVERNORS

The Fed is controlled by a seven person Board of Governors.

Each governor is appointed to a 14-year term by the President (with confirmation by the U.S. ySenate). The President selects one of the governors to serve

as chairman for a 4-year term.

The long term is intended to give the Fed a strong measure of political independence.

THE FEDERAL OPEN MARKET COMMITTEE(FOMC)

The FOMC is a twelve member group (the seven governors along with five of the 12 regional Reserve bank presidents).

The FOMC oversees the daily activity of the Fed The FOMC oversees the daily activity of the Fed and meets every 4-5 weeks to review monetary policy and outcomes.

STRUCTURE OF THE FEDERAL RESERVE SYSTEM

Boardof

Governors(7 members)

Federal Open Market

Committee (12 members)

Federal Advisory Council and

other committees

Private banks(depository institutions)

Federal Reserve banks(12 banks, 24 branches)

(7 members)

MONETARY TOOLS

The Federal Reserve controls the money supply using the following three policy instruments:Reserve requirementsDiscount ratesDiscount ratesOpen-market operations

RESERVE REQUIREMENTS The Fed directly alters the lending capacity of

the banking system by changing the reserve requirement (to change the level of excess reserves).

Excess reserves = Total reserves –

The money multiplier determines how much in additional loans the banking system can make based on their excess reserves.

Required reserves

Available lending capacity of the banking system = excess reserves X

money multiplier

RESERVE REQUIREMENTS

By raising the required reserve ratio, the Fed can immediately reduce the lending capacity of the banking system.

A change in the reserve requirement causes a A change in the reserve requirement causes a change in:l Excess reserves.l The money multiplier.l The lending capacity of the banking system.

IMPACT OF AN INCREASED RESERVE REQUIREMENT

Required Reserve Ratio

20 percent 25 percent

Total deposits $100 billion $100 billionp

Total reserves 30 billion 30 billion

Required reserves 20 billion 25 billion

Excess reserves 10 billion 5 billion

Money multiplier 5 4

Unused lending capacity $ 50 billion $ 20 billion

THE DISCOUNT RATE

Excess reserves earn no interest. Banks have a tremendous profit incentive to

keep their reserves as close to their required reserve level as possiblereserve level as possible.

EXCESS RESERVES AND BORROWINGS

7

4Excess reserves

1930

3

2

1

1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

Borrowings atFederal Reserve banks

THE FEDERAL FUNDS MARKET

The federal funds market is where a bank that finds itself short of reserves can turn to other banks for help.

The federal funds rate is the interest rate for The federal funds rate is the interest rate for inter-bank reserve loans.Reserves borrowed in this manner are called

“federal funds” and are lent for short periods -usually overnight.

SALE OF SECURITIES

A bank that is low on reserves can also sell securities.

Banks use some of their excess reserves to purchase government bondspurchase government bonds.

DISCOUNTING

Discounting refers to the Federal Reserve lending of reserves to private banks. A bank can deal with a reserve shortage by going to

the Fed’s “discount window” to borrow reserves directlydirectly.

The discount rate is the rate of interest the Federal Reserve charges for lending reserves to private banks.

By raising or lowering the discount rate, the Fed changes the cost of money for banks and the incentive to borrow reserves.

OPEN-MARKET OPERATIONS

Open-market operations are the principal mechanism for directly altering the reserves of the banking system.

The portfolio decision is the choice of how The portfolio decision is the choice of how (where) to hold idle funds.

People do not hold all their idle funds in transactions accounts or cash.

HOLD MONEY OR BONDS

The Fed’s open-market operation focus on the portfolio choices people make.

The Fed attempts to influence the choice by making bonds more or less attractive, as gcircumstances warrant.

When the Fed buys bonds from the public, it increases the flow of deposits (reserves) to the banking system.Bond sales by the Fed reduce the flow.

OPEN MARKET OPERATIONS

O

Buyers spend

account balances

Fed SELLS bonds Reserves decrease

Open market

operations

Fed BUYS bonds

Sellers deposit

bond proceeds

BanksThe Fed

Reserves increase

The Public

THE BOND MARKET

Not all of us buy and sell bonds, but a lot of consumers and corporations do.

A bond is a certificate acknowledging a debt and the amount of interest to be paid each year and the amount of interest to be paid each year until repayment.

Like other markets, the bond market exists whenever and however bond buyers and sellers get together.

BOND YIELDS

The current yield paid on a bond is the rate of return on a bond.

n It is the annual interest payment divided by

Yield =Annual interest payment

Price paid for bond

n It is the annual interest payment divided by the bond’s price.

BOND YIELDS

A principal objective of Federal Reserve open market activity is to alter the price of bonds, and therewith their yields.

The less you pay for a bond the higher its yield The less you pay for a bond, the higher its yield. Federal Reserve open-market activity alters the

price of bonds, and their yields. By doing so, the Fed makes bonds a more or

less attractive alternative to holding money.

OPEN MARKET ACTIVITY

Open market operations are Federal Reserve purchases and sales of government bonds for the purpose of altering bank reserves.

If the Fed offers to pay a higher price for bonds If the Fed offers to pay a higher price for bonds, it will effectively lower bond yields and market interest rates.

By buying bonds, the Fed increases bank reserves.

OPEN-MARKET PURCHASES

Federal OpenMarket Committee

Regional FederalReserve bank

St 1 FOMC h

Privatebank

Step 2: Bond seller deposits Fed check

Step 3: Bank deposits check at Fed bank, as a reserve credit

Public

Step 1: FOMC purchases government bonds; pays for bonds with Federal

Reserve check

THE FED FUNDS RATE

Fed funds rate act as a market signal of the changing reserve flows. If the Fed is pumping more reserves into the

banking system, the federal funds rate will decline.banking system, the federal funds rate will decline. If the Fed is reducing bank reserve by selling bonds,

the federal funds rate will increase.

INCREASING THE MONEY SUPPLY To increase the money supply, the Fed can:

Lower reserve requirements. Increases excess reserves with which they will increase the

money supply through deposit creation (loans).

Reduce the discount rate.M k th t f b i g f th F d h Makes the cost of borrowing reserves from the Fed cheaper, which are used to make more loans.

The effectiveness of lowering the discount rate depends primarily on the difference in the new discount rate and the rate that banks charge their loan customers.

Buy bonds. By purchasing bonds, the Fed places money in bank reserves

who will then increase the money supply even more through additional loans.

FEDERAL FUNDS RATE

When market interest rates fall due to Fed bond purchases, individual banks have an incentive to borrow any excess reserves available to increase loan creation.available to increase loan creation.

The Fed has shifted from money-supply targets to interest targets.

MONEY, BANKS, AND THE FED

End of Chapter 13 & 14