The Business of Banking and the Money Supply Process Banking and Money Supply

What Are Banks? Investment banks. Central Banks Commercial Banks Savings Banks Credit Unions

Bank Liabilities and Net Worth Checkable deposits Nontransaction deposits Borrowings Net worth

Bank Assets Cash Items Securities Loans Other Assets

Example Bank of 331 Assets Liabilities Loans $300 Demand Deposits $200 Reserves $20 Non Transactions Dep $100 Securities $10 Borrowings $75 Other Assets $100 Net worth (Equity) $65 $430 $430

Balance Sheet of U.S. Commercial Banks, 2003

3 sorts of risk Liquidity Risk- The risk that at any given time, banks will not able to pay its depositors and meet its reserve requirements. Bank Failure Credit Risk- The risk that borrowers may default Interest rate risk- if market interest rate changes cause profits to fluctuate.

Managing Capital Adequacy Important variables which stakeholders look at: ROA- net after tax profit/Bank assets, ROE- net after tax profit/Bank equity

Risk of Bank Runs Banks’ loans cannot be liquidated quickly, even if they are short term Short-term depositors lack information about the quality of banks’ loans. Same public goods problem prevents private providers from publicizing banks’ problems If depositors hear others are withdrawing, they know it may cause a bankruptcy Banks are in unstable equilibrium

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Money Supply What is the major way in which the fed attempts to guide the banking system and the economy? Adjusting the money supply—increasing and decreasing the liquidity in the system.

Why is money supply important? Affects price levels Affects interest rates Affects growth rate Affects exchange rates *Refresher- MS has many definitions- for now, we stick with M1=currency+deposits

The Money Supply Process (Model to explain the size and variability of money supply)

Three groups affect the money supply process: – Central bank: responsible for monetary policy – Depository institutions (banks): accept deposits and make loans – Non-bank public: holds money as currency and deposits, and demands loans

What is the Monetary Base? Technically- it is the liabilities of the Fed Monetary Base= currency in circulation+ reserves (B=C+R) Federal currency in circulation is a liability (to the non-bank public) Cash kept in banks is called vault cash and is counted as part of reserves. Bank reserves are assets held by banks that they can collect from the fed but…

Reserves.. Bank reserves pay no interest- so to banks, holding reserves gives them no money. By law, commercial banks are made to hold a certain amount of bank reserves (called ‘required reserves) So.. total reserves= required reserves+ excess reserves. The percentage of deposits of a bank that are require to be held as reserves is called the required reserve ratio (what purpose?)

Fed’s assets Gold Government Securities (U.S treasury obligations) Discount loans (loans it makes to banks at a particular interest rate- the interest rate is called the discount rate)

B. Banks’ balance sheet

Changing the Monetary Base The Fed changes the monetary base by changing the levels of its assets. Two major ways: 1- Open market operations 2- Discount loans

Open market operations In an open market purchase the Fed buys government bonds and increases the base. Say the fed wanted to increase money supply by $1 million. It makes a check payable from the Fed to the seller of the bond (either the non-bank public or a bank). This draws out the securities that were there in the system and replaces it with either currency (if the bank or public wants to hold it as currency) or with reserves (if the bank puts it into reserves). In either case since B=C+R, the base increases (either C goes up by $1 million or R does or some proportion of both)

The Effect of Open Market Operations

Fill in the blanks In order to decrease the money base the Fed ____ government securities. As a result the non-bank public and/or the banks_____ the government securities with their deposit accounts and or reserves. As a result, C + R _______ which results in B _______

The discount loan The Fed can also change reserves and the base through changes in discount loans. Fed sets discount rate (rate at which banks borrow from the fed). When this is low, banks will borrow more, thereby increasing reserves. Discount loans are a less effective method than the OMO method, because banks have to choose to borrow for reserves to go up.

The Effect of Discount Loans

Determinants of the BASE: BASE=C+R Fed-OMO -Discount lending -Reserves -Currency in circulation Banks-Vault cash -Deposits at Fed ReservesBASE Non-bank public -Deposits checks -Holds currency -Reserves -Currency in circulation

The Simple Deposit Multiplier The money multiplier links monetary base changes to changes in the money supply.

Example Let us take bank A. This is the bank from which the Fed has bought $10 of securities. Let us assume that the fed has set a 10% rrr (required reserve ratio). The fact means that since this money has not come from a deposit, it can lend this out to a business. So it creates a checking account for the firm and puts this money in it so that.. Bank A has the following balance sheet Assets Liabilities Securities = -$10 Deposits = $10 Reserves = $10 Loans = $10

But things don’t stop there… Let us assume that the firm which has taken a loan spends all of its money on tools and equipment. Let us assume that this money is now deposited in bank B. There is still a 10% rrr (required reserve ratio). Now since this money has from a deposit, the bank B has to keep 10% as reserves so that it keeps $1. It now has excess reserves of $9 which it wants to lend out. Now.. Bank B has the following balance sheet Assets Liabilities Reserves = $1 Deposits = $10 Loans = $9

But things don’t stop there either Let us assume that the firm which has taken a loan from bank B now spends all of its money on tools and equipment. Let us assume that this money is now deposited in bank C. There is still a 10% rrr (required reserve ratio). Now since this money has from a deposit, the bank B has to keep 10% as reserves so that it keeps 90 cents (10% of $ 9). It now has excess reserves of $8.10 which it wants to lend out. Now.. Bank B has the following balance sheet Assets Liabilities Reserves = $0.9 Deposits = $9 Loans = $8.1

The simple deposit multiplier and the process of multiple deposit creation What is happening here. Deposits have increased as follows: $10 in bank A+$9 in bank B+$8.1 in bank C+.. Multiple deposits are created Formula:  D=  R+  R[1-.1]+  R [1-.1] Formula:  D=  R+  R[1-rrr]+  R[1-rrr] Simple deposit multiplier:  D =  R {1/(rrr)}; where D = deposits, R = reserves, and R/D = required reserve ratio. So in our example, deposits would increase as follows  D =  R {1/(rrr)}  D= 10{1/.1}=10/.1=$100

Decisions of the Nonbank Public change this… The simple deposit multiplier model incorrectly assumes no currency and no excess reserves. Behavior of the nonbank public and banks influences the money supply. The ratio of cash to checkable deposits is called the currency-deposit ratio, (C/D). Changes in C/D by nonbank public will change the money supply.

Table 17.2 Determinants of the Currency-Deposit Ratio

Bank Behavior: Excess Reserves and Discount Loans Banks sometimes hold excess reserves, reducing the size of the money multiplier. Banks’ decisions to incur discount loans affect the size of the monetary base. Banks generally hold small levels of excess reserves, but the amount fluctuates over time. The level of discount loans is determined by banks.

Decisions by banks affect Excess Reserves/Deposits ratio – Principal determinant = opportunity cost of holding reserves. – Empirical fact: er = inversely related to the interest rate

Figure 17.4 Excess Reserves and Discount Loans ( )

Table 17.3 Determinants of Excess Reserves and Discount Loans

Deriving the Money Multiplier and the Money Supply The money supply equals the money multiplier times the monetary base. The monetary base = nonborrowed base + discount loans. The money multiplier depends on the required reserve ratio, ER/D, and C/D.

C. The money multiplier The money multiplier m is such that: Money Supply = m * Monetary Base M = m * BASE m = M/BASE m = (C + D) / (C + R) m = (C + D) / (C + RR + ER) m = (C/D + 1) / (C/D + RR/D + ER/D) m = (cu +1) / (cu + rrr + er) M= [(cu +1) / (cu + rrr + er)] Base

Money multiplier: a special case m = (cu +1) / (cu + rr + er) From: m = (cu +1) / (cu + rr + er), If the public holds no currency and banks hold no reserves, that is, cu = 0 and er = 0 then we get the simple deposit multiplier (m’): m’ = 1/rr = 1/(RR/D)

Example Let ER=0, rrr=10%, C/D=30%, what happens to the money supply if central bank buys $10 million of govt securities?  M= [(cu +1) / (cu + rrr + er)]  Base =[(1+0.3)/( )] $10 million =(1.3/0.4)* $10 million=$32.5 million

Decomposing the money multiplier m=(cu+1)/(cu+res+eres) FedSets rrrr Banks-Issue loans - Borrow from Fed or in FFM erm Non-bank public -Holds currency -makes deposits -demands loans cu er

E. Money multiplier and the business cycle The money multiplier usually falls during recessions Causes: high liquidity preference by the public (high cu) and by banks (high er) Changes in the money multiplier dampen or amplify changes in the BASE. – Ex: , M fell by 28% even though BASE grew by 20%

Variables in the Money Supply Process

Accounting for Changes in the Money Supply (M1),