6/12/20141 Money and Banking Chapter 09

2 Outline The Functions of Money The Functions of Money The Components of Money Supply The Components of Money Supply What Backs the Money Supply? What Backs the Money Supply? The Federal Reserve and the Banking System The Federal Reserve and the Banking System The Fractional Reserve System The Fractional Reserve System

6/12/20143 Outline A Commercial Bank A Commercial Bank The Banking System: Multiple-Deposit Expansion The Banking System: Multiple-Deposit Expansion

6/12/20144 The Functions of Money Medium of exchange Medium of exchange Unit of account Unit of account Store of value Store of value

6/12/20145 The Functions of Money Store of valueMedium of exchangeUnit of account = Allows people to transfer purchasing power from the present to the future. - Is usable for buying & selling G&S. - Allows society to escape the complications of barter. - Is used as a yardstick for measuring the relative worth of G&S and resources. - Enables buyers and sellers to easily compare prices of G&S and resources. Liquidity = the ease with which an asset can be converted into cash. (Cash is perfectly liquid.)

6/12/20146 The Components of Money Supply Money definition: M1 Money definition: M1 –Currency: coins + paper money –Checkable deposits –Institutions that offer checkable deposits –Two qualifications

6/12/20147 M1 CurrencyCheckable deposits Issued by the U.S. Treasury Money outside banksMoney inside banks Issued by the Federal Reserve System Token money (face value unrelated to intrinsic value) Paper moneyCoins+Issued by Commercial banks Thrift institutions Checkbook money (deposits in banks or thrifts against which checks may be written)

6/12/20148 The Components of Money Supply Money definition: M2 Money definition: M2 –Savings deposit, including money market deposit account –Small (less than $100,000) time deposits –Money market mutual funds

M2 Savings deposits, including MMDAs M1 + Near-monies (can be readily converted into currency or checkable deposits) Small time deposits (< $100,000) MMMFs Savings deposits, including MMDAs Small time deposits (< $100,000) MMMFs Savings deposits, including MMDAs Small time deposits (< $100,000)

6/12/ The Components of Money Supply

6/12/ What Backs the Money Supply? Value of money Value of money –Acceptability –Legal tender –Relative scarcity Money and prices Money and prices – The purchasing power of the dollar – Inflation and acceptability

6/12/ What Backs the Money Supply? The money supply is backed (guaranteed) by the governments ability to keep the value of money relatively stable. The money supply is backed (guaranteed) by the governments ability to keep the value of money relatively stable.

6/12/ Value of money Relative scarcityAcceptabilityLegal tender The demand for and supply of money determine the value or purchasing power of monetary unit People accept currency and checkable deposits as a medium of exchange Paper money is a valid and legal means of payment of any debt that was contracted in dollars.

6/12/ Money and prices The purchasing power (PP) of the dollar PP = $1 / CPI Inflation and acceptability High inflation => Low PP => Lower acceptability CPI rises => PP falls CPI falls => PP rises Low inflation => stable PP => High acceptability

6/12/ The Federal Reserve and the Banking System Board of Governors Board of Governors The 12 Federal Reserve banks The 12 Federal Reserve banks FOMC FOMC Commercial banks and thrifts Commercial banks and thrifts Fed functions and responsibilities Fed functions and responsibilities Federal Reserve independence Federal Reserve independence

6/12/ The Federal Reserve and the Banking System

6/12/ Federal Reserve Districts

6/12/ The Federal Reserve and the Banking System Fed functions and responsibilities Fed functions and responsibilities – Issuing currency – Setting reserve requirements and holding reserves – Lending money to financial institutions – Providing for check collection – Acting as fiscal agent – Supervising banks – Controlling the money supply

6/12/ The Federal Reserve -- Functions and Responsibilities Issuing currency Setting reserve requirements and holding reserves Lending money to financial institutions Providing for check collection Acting as fiscal agent Supervising banks Controlling the money supply

6/12/ The Fractional Reserve System A banking system in which banks and thrifts are required to hold less than 100 percent of their checkable deposits liabilities are reserves. A banking system in which banks and thrifts are required to hold less than 100 percent of their checkable deposits liabilities are reserves. Two characteristics: Two characteristics: – Banks can create money through lending – Banks are vulnerable to panics or runs.

6/12/ A Single Commercial Bank Transaction 1: Creating a bank Transaction 1: Creating a bank Transaction 2: Acquiring property and equipment Transaction 2: Acquiring property and equipment Transaction 3: Accepting deposits Transaction 3: Accepting deposits

6/12/ A Single Commercial Bank Creating a bank Balance sheet 1 Assets Liabilities & net worth Cash$250,000Stock shares$250,000

6/12/ A Single Commercial Bank Acquiring property & equipment Balance sheet 2 Assets Liabilities & net worth Cash$10,000Stock shares$250,000 Property$240,000

6/12/ A Single Commercial Bank Accepting deposits Balance sheet 3 Assets Liabilities & net worth Checkable deposits $100,000 Stock shares$250,000Property$240,000 Cash$110,000

6/12/ A Single Commercial Bank Transaction 4: Depositing reserves in a Federal Reserve bank Transaction 4: Depositing reserves in a Federal Reserve bank – Required reserve – Excess reserve Transaction 5: Clearing a check drawn against the bank Transaction 5: Clearing a check drawn against the bank Transaction 6: Granting a loan (creating money) Transaction 6: Granting a loan (creating money)

6/12/ A Single Commercial Bank Depositing reserves in a Federal Reserve bank Balance sheet 4 Assets Liabilities & net worth Checkable deposits $100,000 Stock shares$250,000Property$240,000 Reserves$110,000 Cash$0

6/12/ A Single Commercial Bank Clearing a check drawn against the bank Balance sheet 5 Assets Liabilities & net worth Checkable deposits $50,000 Stock shares$250,000Property$240,000 Reserves$60,000 Cash$0

6/12/ A Single Commercial Bank Granting a loan (Creating money) – When a loan is negotiated Balance sheet 6a Assets Liabilities & net worth Checkable deposits $100,000 Stock shares$250,000Property$240,000 Loans$50,000 Reserves$60,000

6/12/ A Single Commercial Bank Granting a loan (Creating money) – After a check is drawn on the loan Balance sheet 6b Assets Liabilities & net worth Checkable deposits $50,000 Stock shares$250,000Property$240,000 Loans$50,000 Reserves$10,000

6/12/ The Banking System: Multiple Deposit Expansion Assumptions: Assumptions: – Reserve ratio = 20% – Banks are loaned up, i.e. they keep no excess reserves – The single borrower will write a check for the entire amount and give it to someone else who will deposit the check to another bank

6/12/ The Banking System: Multiple Deposit Expansion Bank Acquired Reserves & Deposits (CD) Required Reserves (RR) Excess Reserves (ER) Amount Bank Can Lend = Loans = New Money Created rr = 20% (1)(2) = (1)x.2(3) = (1)-(2)(4) = (3) A$100.00$20.00$80.00 B $16.00$64.00 C $12.80$51.20 …………… All banks $500.00$100.00$ Monetary multiplier (mm) = 1 / rr = 5

6/12/ The Banking System: Multiple Deposit Expansion

6/12/ The Banking System: Multiple Deposit Expansion The banking systems lending potential The banking systems lending potential – Loans = ER x mm = CD x (1 – rr) x mm The monetary multiplier The monetary multiplier – mm = 1 / rr Reversibility: the multiple destruction of money Reversibility: the multiple destruction of money – Money is created when banks make loans – Money is destroyed when loans are paid off

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