Introduction to Money and Banking zThis chapter -- covers some basic fundamentals on Money and Banking. In this way, it helps us to become more familiar with how Monetary Policy works. zMoney -- Facilitator of Trade.

Specific Roles of Money as a Facilitator of Trade zMedium of Exchange -- Money is exchanged for goods and services zStandard of Value -- Value is measured in dollars (the “price tag”)

zStandard of Deferred Payments -- Loans and financial instruments are denominated in terms of money. zStore of Value -- People can use money when they wish.

Definitions of Money zM1 = Currency held by the public + Travelers Checks + Checkable Deposits zM2 = M1 + Savings Deposits + Small Time Deposits + Money Market Mutual Funds

Definitions of Money Supply Components zCurrency Held by the Public -- Paper money and coin held by consumers and firms. zCheckable Deposits -- bank deposits which customers can write checks upon.

Other Bank Deposits zSavings Deposits -- No checkable privileges, but customers can withdraw funds at any time without penalty. zTime Deposits -- A contract specifying payment of principal and interest in an explicit way over a given interval. Withdrawal before maturity results in penalty.

Money Market Mutual Funds zoffered by private institutions (not banks) zpools investor funds zinvests in short-term bonds zpays interest based upon overall portfolio zrestricted checkability (based upon minimum size of check)

Quirks -- Defining Money zM1 emphasizes medium of exchange function of money. M2 represents a broader measure. zCheckable deposits, not checks, are included in the money supply definitions. zCredit card purchases are not included in money supply definitions.

Liquidity of Financial Assets zLiquidity -- how easily an asset can be converted into a medium of exchange. zRanking (most to least) based upon liquidity: (1) Currency, (2) Checkable Deposits, (3) Savings Deposits, (4) Time Deposits.

The Role of Interest Rates zThe Interest Rate -- compensates financial investors for inconvenience due to holding asset (e.g. loss of liquidity). zRanking (most to least) based upon interest rate: (1) Time Deposits, (2) Savings Deposits, (3) Checkable Deposits, (4) Currency.

Types of Banks zCommercial Banks (full service) zSavings and Loans (consumer mortgages) zSavings Banks (consumer mortgages and consumer loans) zCredit Unions (consumer loans)

Banks as Financial Intermediaries zFinancial Intermediary -- An institution that borrows from lenders, then loans to borrowers.

The Role of Financial Intermediaries zTakes advantage of institutional fact of life -- lenders want to “lend small”, but borrowers want to “borrow large”. zPools small savers funds into large amount, available for private borrowers (e.g. mortgages, businesses).

The Bank’s Balance Sheet Assets Liabilities + Equity zAssets -- Market value of items in your possession. zLiabilities -- Amounts owed to other parties. zEquity = Assets - Liabilities

Working With Assets, Liabilities, and Equity zNote: Definition of equity implies: Assets = Liabilities + Equity (Balance sheets balance!).

A Balance Sheet Example  Consider a house that you buy worth $120,000. You take out a mortgage of $100,000. Assets Liabilities + Equity House $120,000 Mortgage $100,000 Equity $20,000

The Bank’s Major Liabilities and Equity (1) Deposits (D) -- Checking, Savings, and Time Deposits of bank customers. (2) Borrowings (BORR) -- Funds borrowed by banks, usually for very short-term adjustments. (3) Equity (E) = Total Assets - Total Liabilities

The Bank’s Major Assets (1) Reserves (R) -- vault cash of banks plus deposits at the Federal Reserve -- Non-interest earning -- Purpose: to back up customer withdrawals from deposits

Fundamental Balance Sheet Rule zAny customer withdrawal from any of their deposits (checkable deposits or savings and time deposits) must be met with an equal decrease in reserves.

An Example: Customer Withdrawal zCustomer withdraws $200 from their savings deposit at Chase. Chase  R - $200  D - $200

New Customer Deposits and the Acquisition of Reserves zExample: Customer deposits $300 in their checkable deposit (D). Chase  R + $300  D + $300

Other Assets (2) Holdings of Bonds (B) -- source of revenue from interest. (3) Loans (L) -- revenue source preferred to bonds. -- less liquid  higher interest rate -- more personal aspect

Inherent Instabilities in Banking zLoan Default -- borrower fails to repay loan, bank loses assets and equity. zProfits Versus Safety -- tradeoff between having enough reserves to meet depositors’ withdrawal needs versus making sufficient profits from loaning the funds.

Bank Regulation -- Dealing With Banking Instabilities zCapital Requirements -- minimum equity-asset ratio to absorb loan defaults. zDiscount Window -- Federal Reserve serves as outlet for banks to borrow reserves for emergency withdrawal needs.

zDeposit Insurance (provided by the Federal Deposit Insurance Corporation, or FDIC) -- guarantees reimbursement up to $100,000 per depositor if their bank fails. zReserve Requirements -- mandating a “minimum safety Level” of reserves.

Reserve Requirements: The “Minimum Safety Level” zFederal Reserve: issues a reserve ratio on customer deposits (r D ) with the provision that, at any time R > (r D )(D)

Decomposition of Reserves zRequired Reserves (RR), RR = (r D )(D) zExcess Reserves (ER), ER = R - RR zEquivalent Ways to Express Reserve Requirement R  RR, or ER  0

Bank Loaning -- Balance Sheet Description Consider the following example. (r D = 0.10) Chase R $4000 D $15000 L $9000 E $1000 B $3000

Computing Required and Excess Reserves Chase r D = 0.10 R $4000 D $15000 L $9000 E $1000 B $3000 RR = (r D )(D) = (0.10)($15000) = $1500 ER = R - RR = $ $1500 = $2500

Chase Makes Loan of $2500 Step #1 -- Loan is Approved Chase R $4000 D $17500 L $11500 E $1000 Bonds $3000 Borrower signs loan contract, receives check from bank.

Step #2 -- Loan is Spent Chase R $1500 D $15000 L $11500 E $1000 B $3000 Seller deposits check in her bank. Fleet  R + $2500  D + $2500

Bank Loaning and the Money Supply zConsider from previous example, Fleet gets new deposits ($2500) while Chase has the same as before. zTherefore M2 changes by $2500, the amount of the loan. zResult – bank loaning changes the money supply by the amount of the loan.

Loaning and the Banking System Seller deposits check in her bank. Fleet  R + $2500  D + $2500 zFleet now can make a loan. zAs funds from Fleet’s loan get deposited in another bank, the process continues…