McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Money and Banks

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. What Is Money? Without money, you would have to use barter to get items you want. Barter is the direct exchange of one good for another, without the use of money.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Money Supply Anything that serves all of the following purposes can be thought of as money: –Medium of exchange –Store of value –Standard of value

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Money Supply Medium of exchange – Is accepted as payment for goods and services (and debts).

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Money Supply Store of value – Can be held for future purchases. Standard of value – Serves as a measurement for the prices of goods and services.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 use. Checking accounts can and do perform the same market functions as cash.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. M1: Cash and Transactions Accounts Money supply (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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. M1: Cash and Transactions Accounts The distinguishing feature of transaction accounts is that they permit direct payment to a third party (by check or debit card).

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. M2: M1 + Savings Accounts, etc. How much money is available affects consumers’ ability to purchase goods and, services – aggregate demand. –Aggregate demand is the total quantity of output demanded at alternative price levels in a given time period, ceteris paribus.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Composition of the Money Supply Currency in circulation ($677 billion) Transactions-account balances ($651 billion) Savings account balances ($3,408 billion) Money market mutual funds and deposits ( $1,549 billion) Traveler’s checks ($8 billion) M2 ($6,293 billion) M1 ($1,336 billion)

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Creation of Money Currency is printed. Coins are minted.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Deposit Creation When a bank lends someone money, it simply credits that individual’s bank account. Deposit creation is the creation of transactions deposits by bank lending.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Deposit Creation When a bank makes a loan, it effectively creates money because transactions- account balances are counted as part of the money supply.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Deposit Creation 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 money supply.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. A Monopoly Bank When someone deposits cash or coins in a bank, they are changing the composition of the money supply, not its size.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. A Monopoly Bank Assume a student deposits $100 from their piggy bank into the monopoly bank and receives a new checking account.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Initial Loan Monopoly bank loans $100 to Campus Radio station by crediting its checking account. Money has been created because checking accounts are money.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Initial Loan Total bank reserves have remained unchanged. Bank reserves are assets held by a bank to fulfill its deposit obligations.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Secondary Deposits In a one bank system, when Campus Radio uses the loan, the proceeds of the loan are re-deposited in monopoly bank.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Fractional Reserves 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Fractional Reserves The Federal Reserve System requires banks to maintain some minimum reserve ratio.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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. Required reserves = minimum reserve ratio X total deposits

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Required Reserves A minimum reserve requirement directly limits deposit-creation possibilities.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. A Multibank World In reality, there is more than one bank. The ability of banks to make loans depends on access to excess reserves. –Example: If a bank is required to hold $20 in reserves but has $100 currently, it can lend out the $80 excess.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Excess Reserves Excess reserves are bank reserves in excess of required reserves. Excess reserves = Total reserves – Required reserves

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Excess Reserves Excess reserves are reserves a bank is not required to hold. So long as a bank has excess reserves, it can make loans.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Changes in the Money Supply The creation of transaction deposits via new loans is the same thing as creating money.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. More Deposit Creation As the excess reserves are loaned out again, more deposits are created and thus more money is created.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 banks have zero excess reserves (no more loans can be made).

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Money Multiplier The money multiplier is the number of deposit (loan) dollars that the banking system can create from $1 of excess reserves.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Money Multiplier 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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Money Multiplier The money supply can be increased through the process of deposit creation to this limit: Potential deposit creation = Excess reserves of banking system X Money multiplier

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Money Multiplier Process Required reserves Excess reserves Leakage into The public

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Excess Reserves as Lending Power Each bank may lend an amount equal to its excess reserves and no more. The banking system can increase the volume of loans by the amount of excess reserves multiplied by the money multiplier.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Money Multiplier at Work

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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. –The banking system creates additional money by making loans in excess of total reserves.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Banks and the Circular Flow By making loans, banks help to transfer income from savers to spenders. When doing so, banks help maintain any desired rate of aggregate demand.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Banks in the Circular Flow Loans Factor markets Product markets Business firms Consumers BANKS Saving Investment expenditures Sales receipts Wages, dividends, etc. Income Domestic consumption

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Financing Injections The consumer saving is a leakage. A substantial portion of consumer saving is deposited in banks. Bank deposits can be used to make loans, which returns purchasing power to the circular flow.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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. –Borrowers – Borrowers must be willing to borrow the money that banks provide. –Regulation – The Federal Reserve sets the ceiling on deposit creation.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. When Banks Fail In the past, “runs” of depositors rushing to withdraw their funds have created panics. Bank closed, wiping out customer deposits, curtailing lending, and often pushing the economy into recession. In the early part of the Great Depression ( ), 9000 banks failed.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Deposit Insurance The FDIC and FSLIC were created by Congress in , to ensure depositors that their money would be safe -- thus eliminating the motivation for deposit runs.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The S & L Crisis The economic conditions in the 1970s saw many S&Ls stuck earning money on low- interest, long-term loans (mortgages etc.) while having to pay out short-term high- interest fees to their customers.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The S & L Crisis Competition from new financial institutions (e.g. money-market mutual funds) enticed deposits away from S&Ls. Consequently, many S&Ls failed.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Bank Bailouts S&L failures cost the federal government billions – over $60 billion in 1992 alone – as the FSLIC and FDIC paid off depositors.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Bank Bailouts The Resolution Trust Corporation was created in 1989 to manage the outstanding loans of banks the federal government had to bail out.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Money and Banks