PART SIX Money, Banking, and Monetary Policy

Chapter 15: Money and Banking Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

The Functions of Money The three functions of money are: medium of exchange unit of account store of value Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

The Components of the Money Supply Two definitions of the U.S. money supply are M1 and M2. M1 is the narrowest definition of the money supply, whereas M2 is a more broadly defined money supply. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Money Definition: M1 M1 money = currency + checkable deposits Currency includes coins and paper money. All coins in circulation are token money. Paper money, issued by the Federal Reserve Banks, are known as Federal Reserve Notes. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Money Definition: M1 Checkable deposits (checkbook money) are a large component of the stock of money in the U.S.. These are deposits in commercial banks and “thrifts” or savings institutions against which checks may be written. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Institutions That Offer Checkable Deposits Commercial banks are the primary deposit institutions in the U.S.. These institutions accept deposits, offer checking accounts and make loans. Thrift institutions include savings and loan associations (S&Ls), credit unions and mutual savings banks. These “thrifts” offer savings and checking accounts. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

M1 Exception Currency held at commercial banks and other financial institutions is excluded from M1 and other measures of the money supply. This prevents the error of double counting. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Money Definition. M2 M2 money = M1 + near monies Near monies are financial assets that do not directly serve as a medium of exchange but can be easily converted into M1. Near monies include savings deposits (including money market deposit accounts), small time deposits (less than $100,000), and money market mutual funds. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

What “Backs” the Money Supply? The U.S. money supply is guaranteed by government’s ability to keep the value of money relatively stable. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Value of Money Money has value because of its acceptability, legal tender designation, and relative scarcity. Government has decreed currency as legal tender; paper money is a valid and legal means of payment of debt. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Money and Prices The purchasing power of money is the amount of goods and services a unit of money will buy. The purchasing power of the dollar varies inversely with the price level. If the price level rises, the purchasing power of the dollar falls, and vice versa. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Money and Prices Inflation may also affect the purchasing power of money and its acceptability. When the government prints too much money, the purchasing power of money declines. Also, runaway inflation may significantly reduce the purchasing power of the dollar and may cause it to cease being used as a medium of exchange. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

The Federal Reserve System and The Banking System A key element of the U.S. banking system is the Federal Reserve System (the “Fed”). The Fed consists of the Board of Governors of the Federal Reserve and 12 regional Federal Reserve Banks. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

The Federal Reserve System and The Banking System Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

The Federal Reserve System and The Banking System Board of Governors The seven-member group that supervises and controls the money and banking system of the U.S.. The 12 Federal Reserve Banks The 12 banks chartered by the U.S. government to control the money supply and perform other functions. They collectively serve as the nation’s “central bank” and also serve as bankers’ bank. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

The Federal Reserve System and The Banking System Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

The Federal Reserve System and The Banking System Federal Open Market Committee (FOMC) The FOMC is the 12 member Federal Reserve group determines the purchase and sale policies of the Federal Reserve Banks in the market for U.S. securities. The Federal Reserve Bank in New York City conducts most of the Fed’s open market operations. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

The Federal Reserve System and The Banking System Commercial Banks and Thrifts Of the approximately 7600 commercial banks, three-fourths are state banks, while the remaining one-fourth are national banks, chartered by the Federal government to operate nationally. The 11,400 thrift institutions are regulated by agencies separate and apart from the Board of Governors and the Federal Reserve Banks. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Fed Functions and Responsibilities The Fed performs the following functions. Issues currency Sets reserve requirements and holds reserves Lends money to banks and thrifts Provides the banking system with a means for collecting checks Acts as a fiscal agent for the Federal government Supervises the operation of banks Controls the money supply Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Fed Reserve Independence The Federal Reserve is an independent agency of the government. This protects the Fed from political pressure so that it could effectively control the money supply and interest rates to foster price-level stability. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

The Fractional Reserve System The U.S. has a fractional reserve banking system. A fractional reserve banking system is one in which banks and thrifts are required to hold less than 100 percent of their checkable- deposit liabilities as cash reserves. Only a portion of the total money supply is held in reserve as currency. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

A Single Commercial Bank The fractional reserve banking system can be better understood by analyzing a commercial bank’s balance sheet. A balance sheet is a statement of the assets, liabilities, and net worth of a firm, individual, or institution at some time. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

A Single Commercial Bank We will analyze the following transactions. 1. Creating a Bank 2. Acquiring Property and Equipment 3. Accepting Deposits 4. Depositing Reserves in a Federal Reserve Bank 5. Clearing a Check Drawn Against the Bank 6. Granting a Loan (Creating Money) Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Creating a Bank To create a bank, an individual must secure a state or national charter and sell stock certificates to buyers. This creates outstanding stock certificates and cash on hand equal to the value of the certificates. Balance Sheet 1 AssetsLiabilities and net worth Cash $250,000Stock shares$250,000 Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Acquiring Property and Equipment The bank’s owners must then acquire property (a building) and equipment. It uses cash on hand to make these purchases. Balance Sheet 2 AssetsLiabilities and net worth Cash $10,000Stock shares$250,000 Property $240,000 Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Accepting Deposits Once the bank is operating, suppose businesses and citizens open up accounts and deposit $100,000 in the bank. Balance Sheet 2 AssetsLiabilities and net worth Cash$110,000Checkable Property $240,000 deposits $100,000 Stock shares$250,000 Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Depositing Reserves in a Federal Reserve Bank All commercial banks and thrifts that provide checkable deposits must by law keep required reserves. Required reserves are an amount of funds equal to a specified percentage of the bank’s own deposit liabilities. Required reserves must be kept on deposit with the Federal Reserve Bank or held as cash in the bank’s vault. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Depositing Reserves in a Federal Reserve Bank The “specified percentage” of checkable deposit liabilities that a commercial bank must be keep as reserves is known as the reserve ratio. Reserve bank’s required reserves ratio bank’s checkable-deposit liabilities Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved. =

Depositing Reserves in a Federal Reserve Bank If the Fed sets a reserve ratio of 20 percent, the bank must hold $20,000 in required reserves ($100,000 x.2 = $20,000) Balance Sheet 3 AssetsLiabilities and net worth Cash$108,000Checkable Reserves $2,000 deposits $100,000 Property $240,000 Stock shares$250,000 Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Depositing Reserves in a Federal Reserve Bank If the bank decides to hold all its cash in reserves with the Fed, then its cash amount will be zero. Balance Sheet 4 AssetsLiabilities and net worth Cash$0Checkable Reserves $110,000 deposits $100,000 Property $240,000 Stock shares$250,000 Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Depositing Reserves in a Federal Reserve Bank When a bank holds more in reserves then is required, it holds excess reserves. Excess reserves are actual bank or thrift reserves minus legally required reserves. Actual reserves are the funds that a bank or thrift has on deposit at the Federal Reserve Bank or is holding as vault cash. Our bank has $90,000 (=$110,000 - $20,000) in excess reserves. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Clearing a Check Drawn against the Bank Suppose a bank customer writes a $50,000 check against her deposit account. As the check clears through the Federal Reserve Bank, it reduces our bank’s reserves by $50,000. The bank also reduces its customer’s deposit account by $50,000. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Clearing a Check Drawn against the Bank Balance Sheet 5 AssetsLiabilities and net worth Reserves $60,000Checkable Property $240,000 deposits $50,000 Stock shares$250,000 Whenever a check is drawn against one bank and deposited in another bank, collection of that check will reduce both the reserves and the checkable deposit of the bank on which the check is drawn. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Granting a Loan (Creating Money) Suppose a bank customer desire a loan from our bank of $50,000. When the loan is approved, the customer signs a promissory note to repay the loan plus some amount of interest in the future. The customer’s deposit account increases by $50,000 and the bank’s loans increase by $50,000. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Granting a Loan (Creating Money) When a bank makes loans, it creates money. Balance Sheet 6 AssetsLiabilities and net worth Reserves $60,000Checkable Loans $50,000 deposits $100,000 Property $240,000 Stock shares$250,000 Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Granting a Loan (Creating Money) If the borrower turns around and writes a check for $50,000 to another individual, this changes the balance sheet. When the individual deposits the check into his account somewhere else, the check is collected and clears in the same manner described in balance sheet 5. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Granting a Loan (Creating Money) The bank’s assets and liabilities are both reduced by $50,000. Balance Sheet 7 AssetsLiabilities and net worth Reserves $10,000Checkable Loans $50,000 deposits $50,000 Property $240,000 Stock shares$250,000 Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

The Banking System: Multiple-Deposit Expansion An individual bank can only lend an amount equal to its excess reserves, but the commercial banking system can lend by a multiple of its excess reserves. The banking system magnifies any original excess reserves into a larger amount of newly created checkable-deposit money. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

The Monetary Multiplier The monetary multiplier, m, is the multiple of its excess reserves by which the banking system can expand checkable deposits and thus the money supply by making new loans. 1 required reserve ratio or, m = 1/R Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved. = Money Multiplier

The Monetary Multiplier The maximum checkable-deposit creation, D, is equal to total excess reserves, E, times the monetary multiplier, or, in symbols, D = E x m For example, if R =.20, m = 5 (1/.20). If excess reserves is $80, then D = $80 x 5 = $400. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Reversibility: The Multiple Destruction of Money Just as banks can create money through loans, money is destroyed when loans are paid off. Loan repayment sets off a process of multiple destruction of money akin to the multiple creation process. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.