1 Banking and the Money Supply Chapter 29 © 2006 Thomson/South-Western

2 Definitions of the Money Supply: M1  Money aggregates: measures of the economy’s money supply – M1, M2, M3  M1: the narrowest measure of money supply: currency, including coins, held by  Non-banking public  Checkable deposits:  Deposits in financial institutions against which checks can be written and ATM or debit cards can be applied  Travelers checks

3 Definitions of the Money Supply: M2  Includes M1, plus  Savings deposits  Earn interest, but have no specific maturity date  Time deposits  called certificates of deposit, or CDs, specific maturity date  Money market mutual funds  carry additional restrictions

4 Definitions of the Money Supply: M3  Includes M2, plus  large-denomination time deposits ($100,000 or more)  M3 is less liquid than M2,  Which is less liquid than M1

5 Exhibit 1: Alternative Measures of the Money Supply

6 Credit Cards  Definitions of money include debit cards but not credit cards  Credit cards offer an easy way to get a loan from the card issuer  Money isn’t needed until the credit car holder must repay the credit card issuer  The credit card has not eliminated the use of money, merely delayed it

7 Debit Cards  Debit Card  Check card  Combines the functions of an ATM and check  Safer than credit cards  Disadvantages  Draw down checking account immediately  Cannot dispute bill or withhold or stop payment

8 Financial Intermediaries  Banks serve as financial intermediaries, or as go-betweens by bringing together the two sides of the money market  Banks reduce the transaction costs of channeling savings to credit worthy borrowers  Coping with asymmetric information  Reducing risk through diversification

9 Asymmetric Information  As lenders, banks try to identify borrowers who are willing to pay interest and are able to repay the loans  However, borrowers have more reliable information about their own credit history and financial plans than do lenders: in the market for loans there is asymmetric information – an inequality in what’s known by each party to the transaction

10 Asymmetric Information  Because they have experience in evaluating applicants, banks have a greater ability to cope with asymmetric information and draw up and enforce contracts than would an individual saver  Savers are better off dealing with banks

11 Reducing Risk  By developing a diversified portfolio of assets rather than lending funds to a single borrower, banks reduce the risk to each individual saver  A bank, in effect, lends a tiny fraction of each saver’s deposits to each of its many borrowers

12 Starting a Bank  Founders obtain a charter, or the right to operate, by appling to the state banking authority (for a state bank) or to the U.S. Comptroller of the Currency (for a national bank)  The founders invest $500,000 for shares which become the owner’s equity or the net worth of the bank  Part of this goes to the Fed to buy shares in their district bank, leaving $450,000

13 Exhibit 2: Home Bank’s Balance Sheet  Balance sheet shows a balance between the two sides of the bank’s accounts:  The left side lists the bank’s assets (any physical property or financial claim owned by the bank)  The right side lists the bank’s liabilities (an amount the bank owes) and net worth  Reflects the basic equality that Assets = Liabilities + Net Worth

14 Exhibit 3: Home Bank’s Balance Sheet after $1,000,000 Deposit Suppose a customer deposits $1,000,000 into a new checking account. In accepting this, the bank promises to repay the depositor that amount – it is a liability to the bank: bank’s assets and liabilities both increase by $1,000,000

15 Reserve Accounts  Recall that banks are required by the Fed to set aside, or to hold in reserve, a percentage of their checkable deposits  The dollar amount that must be held in reserve is called required reserves: checkable deposits multiplied by the required reserve ratio  The required reserve ratio dictates the minimum proportion of deposits the bank must hold in reserve

16 Reserve Accounts  The current reserve requirement is 10% on checkable deposits, held either as cash in the bank’s vault or as deposits at the Fed, but neither earns the bank any interest  In our example, Home Bank must therefore hold $100,000 as reserves ($1,000,000 *.10)

17 Reserve Accounts  If Home Bank deposits their required reserves with the FED, they now have $900,000 in excess reserves held as cash in the vault  Excess reserves have two additional uses  They can be used to make loans, or  To purchase interest-bearing assets, such as government bonds

18 Liquidity versus Profitability  Management of a bank must structure the portfolio of assets with an eye towards  Liquidity  Profitability  Liquidity is the ease with which an asset can be converted into cash without a significant loss of value – if all of its cash held is as reserves, it forgoes profits  At the other extreme, if the bank uses all its excess reserves to acquire high-yielding but illiquid assets, it will run into problems whenever withdrawals exceed new deposits

19 Federal Funds Market Federal funds market: a market for overnight lending and borrowing of reserves among banks; the market for reserves on account at the Fed  The interest rate paid on these loans is called the federal funds rate, the rate that the Fed targets as a tool of monetary policy

20 How Banks Create Money  Notice the pattern of deposits and loans in the money creation process:  Each time a bank gets a fresh deposit, 10% goes to required reserves  The rest becomes excess reserves, which fuel new loans or other asset acquisitions  An individual bank can lend no more than its excess reserves  When the borrower spends the amount loaned, reserves at one bank usually fall, but total reserves in the banking system do not

21 How Banks Create Money  The recipient bank uses most of the new deposit to extend more loan, more checkable deposits  The potential expansion of checkable deposits in the banking system equals some multiple of the initial increase in reserves

22 Exhibit 7: Summary During each round, the increase in checkable deposits (1) minus the increase in required reserves (2) equals the potential increase in loans (3). Checkable deposits in this example can potentially increase by as much as $10,000.

23 Reserve Requirements and Money Expansion  Money multiplier: the multiple by which the money supply increases as a result of an increase fresh reserves in the banking system  The simple money multiplier equals the reciprocal of the required reserve ratio, or 1 / r, where r is the reserve ratio  It is the maximum multiple of fresh reserves by which the money supply can increase

24 Checkable Deposits / Money Supply  The formula for the multiple expansion of the money supply can be written as  Change in the money supply = Change in reserves x 1/r

25 Money Multiplier  The higher the reserve requirement, the greater the fraction of deposits that must be held as reserves and the smaller the money multiplier  Reserve requirement of 20% = money multiplier of 5  Reserve requirement of 5% = money multiplier of 20

26 Limitations on Money Expansion  Various leakages from the multiple expansion process reduce the size of the money multiplier. Assume that  Banks do not let excess reserves sit idle  Borrowers do something with the money  People do not choose to increase their cash holdings

27 Contraction of the Money Supply  Fed’s sale of government bonds reduces bank reserves, forcing banks to recall loans or to somehow replenish reserves and the same multiple contraction would work  For example, with a reserve requirement of 10%, a $1,000 sale of bonds would reduce the checkable deposits and the money supply by a maximum of $10,000

28 Tools for Controlling Reserves  The Fed has three tools for controlling reserves  Conducting open market operations, buying and selling of U.S. government bonds  Setting the discount rate, the interest rate the Fed charges for loans it makes to banks  Setting the required reserve ratio, the minimum fraction of reserves that banks must hold against deposits

29 Open Market Operations  Open market operations refers to the buying and selling of U.S. government bonds in the open market  To increase the money supply, the Fed buys U.S. bonds: open-market purchase  To reduce the money supply, the Fed sells U.S. bonds: open-market sale  Advantage of open-market operations  Relatively easy to carry out  Require no change in laws or regulations  Can be executed in any amount  The tool of choice by the Fed

30 Federal Funds Market  Through open-market operations, the Fed influences bank reserves and the federal funds rate  Recall that the federal funds rate is the interest rate banks charge one another for borrowing excess reserves at the Fed, typically overnight  Banks that are unable to meet their legal reserve requirements can borrow in the federal funds market

31 Federal Funds Market  The federal funds rate serves as a good indicator of the tightness of monetary policy  For example, suppose the Fed buys bonds in the open market and thereby increases reserves in the banking system  banks have more excess reserves  demand for excess reserves falls while the supply increases  the federal funds rate declines

32 Discount Rate  Discount rate is the interest rate the Fed charges on loans it makes to banks  Banks can borrow from the Fed when they need reserves to satisfy their reserve requirements  By lowering or raising the discount rate, the Fed encourages or discourages banks from borrowing, which alters reserves and affects the money supply

33 Discount Rate  A lower discount rate reduces the cost of borrowing, encouraging banks to borrow reserves from the Fed  more bank lending leads to an increase in the money supply  Higher discount rate increases the cost of borrowing reserves from the Fed  less bank lending leads to reduced money supply

34 Reserve Requirements  Reserve requirements are the regulations regarding the minimum amount of reserves that banks must hold to back up deposits

35 Reserve Requirements  If the Fed increases the reserve requirement, banks must hold more reserves  a reduction in the fraction of each dollar that can be lent out  reduces the banking system’s ability to create money

36 Reserve Requirements  Conversely, a decrease in the reserve requirement increases the fraction of each dollar on deposit that can be lent out, which increases the banking system’s ability to create money  Reserve requirements can be changed by a simple majority vote by the Board of Governors  Since even a small change in the reserve requirement can be disruptive, the Fed seldom employs this tool

37 Exhibit 8: Federal Reserve Bank Balance Sheet as of December 31, 2003 (millions of dollars)