Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 27 Money and Banking

Copyright © 2008 Pearson Addison-Wesley. All rights reserved In this chapter you will learn to 2. Describe the roles of commercial banks and central banks in modern banking systems. 1. Describe the various functions of money, and how money has evolved over time. 3. Explain how commercial banks create money through the process of taking deposits and making loans. 4. Describe the M1 and M2 measures of the money supply.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved The Nature of Money What Is Money? Money is a medium of exchange. If there were no money, goods would have to be exchanged in a system of barter. Barter is very inefficient due to the double coincidence of wants. Money makes it unnecessary.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Money is also used as a store of value. - without high inflation, money retains its value Finally, money is used as a unit of account. - used to keep our financial accounts LESSONS FROM HISTORY 27.1 Hyperinflation and the Value of Money The Nature of Money

Copyright © 2008 Pearson Addison-Wesley. All rights reserved The Origins of Money Money has evolved over time, taking various different forms: Metallic money: - years ago, the market value of the metal was equal to the face value of the coin - this led to debasing  Gresham’s Law Paper money: - paper money was initially backed by precious metal - often referred to as bank notes (issued by banks)

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Fractionally backed paper money: - goldsmiths and banks began to issue more notes than the amount of gold held in their vaults Fiat money: - money that is neither backed by nor convertible into anything else - decreed by the government to be legal tender Today, almost all currency is fiat money. The Origins of Money

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Modern Money: Deposit Money Money held as deposits with commercial banks and other financial institutions is called deposit money.  Bank deposits are an important part of the money supply. As in the past, banks create money by issuing more promises to pay (deposits) than they have in cash reserves.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved The Banking System Most banking systems have: - a central bank - many financial intermediaries A central bank acts as a bank to the banking system: - usually a government-owned institution - through it, the government conducts monetary policy

Copyright © 2008 Pearson Addison-Wesley. All rights reserved The basic functions of the Fed are to: act as banker to commercial banks act as banker for the federal government regulate the money supply regulate, support, and monitor financial institutions and markets Most of our discussion will focus on the Fed’s role in controlling the money supply  monetary policy The Federal Reserve System Created by an act of Congress in 1913.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Table 27.1 The Balance Sheet of the Federal Reserve System, End of January 2007 (millions of dollars)

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Commercial Banks A commercial bank is a privately owned, profit-seeking institution that provides a variety of financial services: - accepts deposits - makes loans - provides credit-card services - offers wealth-management services APPLYING ECONOMIC CONCEPTS 27.1 The Structure of the Federal Reserve System

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Table 27.2 Consolidated Balance Sheet of U.S. Commercial Banks, December 2006 (billions of dollars)

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Reserves Banks’ cash reserves are normally quite small because only a small fraction of depositors want their money at any time. A bank’s reserve ratio is the fraction of deposit liabilities that it actually holds as reserves - either vault cash or deposits with the central bank A bank’s target reserve ratio is the fraction of deposits it wishes to hold as reserves.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved The U.S. banking system is a fractional-reserve system Any reserves in excess of target reserves are called excess reserves - these are central to the process of “money creation” Fractional Reserve Banking

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Money Creation by the Banking System Some Simplifying Assumptions Suppose: - banks invest only in loans - there are only demand deposits - all banks have a fixed target reserve ratio - there is no cash drain from the banking system

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Table 27.3 The Initial Balance Sheet of Incidental Bank (IB)

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Table 27.4 IB’s Balance Sheet Immediately after a New Deposit of $100

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Table 27.5 IB’s Balance Sheet after Making a New Loan of $80

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Table 27.6 Changes in the Balance Sheets of Second-Round Banks

Copyright © 2008 Pearson Addison-Wesley. All rights reserved A single new deposit begins a long sequence of deposit creation. With the target reserve ratio of 20%, the new deposit of $100 creates a total expansion of deposits of $500. With no cash drain, a banking system with a target reserve ratio of v will change its deposits by 1/v times any change in reserves (the new deposit). ΔDeposits = (1/v) ΔReserves The Creation of Deposit Money

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Table 27.7 The Sequence of Loans and Deposits after a Single New Deposit of $100

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Table 27.8 Change in the Combined Balance Sheets of All the Banks in the System Following the Multiple Expansion of Deposits

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Excess Reserves and Cash Drains Deposit creation does not happen automatically; it depends on the decisions of bankers. A cash drain: - if households hold a fraction of their deposits in cash, the deposit-creation process is dampened If c is the currency-deposit ratio, the final change in deposits will be given by:

Copyright © 2008 Pearson Addison-Wesley. All rights reserved The Money Supply The money supply is the total quantity of money that is in the economy at any time - several definitions of “money” In general, Money supply = Currency + Deposits

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Kinds of Deposits The long-standing distinction between money and other highly liquid assets was: - money was a medium of exchange that did not earn interest - other assets earned interest but were not a medium of exchange Today this distinction is very blurred.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Definitions of the Money Supply The narrowest definition of money is M1: M1 = currency + checkable deposits A broader definition is M2: M2 = M1 + saving deposits + money market deposit accounts

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Table 27.9 Two Measures of the Money Supply in the United States, December 2006 (billions of dollars)

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Near Money and Money Substitutes Near money: - assets that are a store of value and are readily converted into a medium of exchange - short-term bonds - term deposits Money substitutes: - things that serve as a temporary medium of exchange but are not a store of value - credit cards

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Choosing a Measure The Role of the Federal Reserve There is no single, timeless definition of money. New financial assets are continually being developed that serve some of the functions of money. We have seen how commercial banks can expand reserves into deposit money. The Federal Reserve has great influence over the amount of reserves in the banking system. Money Measures and the Fed