Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE Definition of money and functions History of money Bank functions and regulations. Creation of money by banking system. Structure of Federal Reserve System. Tools for Monetary Policy.

HISTORY AND ROLE OF MONEY. The barter economy. No money. Trade requires coincidence of wants Specialization and trade fairly difficult. Money: anything generally acceptable as means of payment eliminates need for coincidence of wants

FUNCTIONS OF MONEY Medium of exchange Unit of account Store of value unique to money Unit of account not unique to money Store of value not a good store of value during inflationary times

TYPES OF MONEY Commodity money Coins Gold standard. e.g. gold, silver, tobacco desirable properties: durable, divisible, portable. Coins e.g. $10 of gold in $10 gold piece problems: shaving or changes in the market value of gold Gold standard. pure gold standard: gold coins traded as money and there is no paper money gold exchange standard: paper money traded that is backed by gold and can be converted to gold at a fixed rate

TYPES OF MONEY Fiat money paper money that is not “backed” by a commodity people cannot trade it for a commodity at a fixed nominal price. “legal tender” value is based on faith in the government that issues the currency. Confederate notes in Civil War.

MONEY IN U.S. HISTORY U.S. constitution gave Congress sole right to "coin money and regulate value thereof". Illegal for states to coin money. Bi-metallic standard initially. In the 1792 coin act, a $1 coin was quoted in terms of both silver and gold. 24.75 grains of gold =$1 371.25 grains of silver = $1

GRESHAM’S LAW Greshams Law: "bad money drives out good" Prior to 1834, 24.75 grains of gold was worth more than 371.25 grains of silver. Only silver coins circulated (a "silver standard" by default). After 1834, the reverse was true (a "gold standard" by default). If gold coin has 10 grains and silver has 30 grains, what happens if gold price is 5 times silver price? 2 times silver price? What happens to coin circulation of price of its metal rises relative to other metals? Wizard of Oz and bimetallic standard?

HISTORY OF BANKING Initially banks formed as “safekeeping” institutions. Gradually evolved to serve several functions: Create liquidity Minimize the cost of obtaining funds Minimize the cost of monitoring borrowers Pool risks

HISTORY OF BANKING IN U.S. States could not print or mint money, but privately owned banks could if licensed by the state government. Banks printed notes that were backed by gold or silver easier to trade avoided problems with weighing Banks found it profitable to print more notes than they had "reserves“ (gold/silver) for and loaned out the extra notes. Fractional reserve banking was started. Fractional reserve banking poses problems if there is a “bank run”.

Banks would print notes beyond reserves and extend loans. Assets Liabilities Reserves (gold) 100 Notes 100 Total 100 100 Banks would print notes beyond reserves and extend loans. Reserves 100 Notes 1000 Loans 900 ____ Total 1000 1000

With “fractional reserve banking”, the banking system “creates money” and lends it out. has only a fraction of liabilities on reserve. cannot satisfy customer’s demands if all want to withdraw deposits at once. Source of “bank panics”. News that loans are not likely to be paid back, customers will make a “run” on the bank. Droughts. Stock market crash. Effect of bank panic on economy?

Bank Panics and Deposit Insurance 7 major bank panics in the U.S. in the 1800s 2 in the early 1900s. Onset of the great depression in the 1930s, another bank panic occurred. In 1934, the federal government established FDIC to help reduce spread of bank panics. Deposit insurance has reduced bank panics in the U.S. Problems with deposit insurance Incentives created for risk taking. The Home State experience in Ohio.

Federal Reserve System established in 1913 by the Federal Reserve Act. first central bank of the United States conducts monetary policy and regulates banks. aims to stabilize the macroneconomy.

Federal Reserve System The Structure of the Fed The Board of Governors The regional Federal Reserve banks The Federal Open Market Committee. Conspiracy theory of the Fed. Some students will have heard about a “conspiracy theory of the Fed.” This theory, advanced by the ignorant, the misinformed, or the deceitful, is that the commercial banks own the Fed, which is run solely to benefit the banks to ensure that they earn large profits. Point out that commercial banks do indeed own the Fed—they own all the stock issued by the Fed. But Fed stock is not like shares in General Electric or Microsoft. The dividend on the Fed’s stock is fixed at 6 percent of the purchase price, and the stock cannot be sold in a marketplace. So this stock is a lousy investment What privileges come with the stock? Commercial banks elect six of the nine directors of their Federal Reserve Regional bank; each commercial bank’s votes are proportional to the stock it owns. But the directors of the regional banks are hardly key players in the Federal Reserve System. Essentially, the most important task they perform is nominating a president for the regional bank. The regional banks’ presidents are important. The directors, however, do not get much freedom in this choice because their nominee must be approved by the Board of Governors, which does not hesitate to veto anyone considered unacceptable. Moreover, the regional bank presidents gain their power from sitting on the FOMC. But there they are a minority because the voting members of the FOMC consist of five regional bank presidents and seven members of the Board of Governors. Because the board members are appointed by the president and approved by the Senate, the government thus wields the ultimate power in the Federal Reserve. The regional bank presidents must be approved by the publicly appointed board members and the board members constitute a majority on the FOMC.

Federal Reserve System The Board of Governors: 7 members appointed by the president and confirmed by Senate. terms are for 14 years and overlap so that one position becomes vacant every 2 years. President appoints one member to a (renewable) four-year term as chairman. Each of the 12 Federal Reserve Regional Banks has a nine-person board of directors and a president.

Federal Reserve System The District Banks: Monitor economic conditions within region. Regulate banks within region. Serve as clearinghouse for checks. Replace currency

Federal Reserve System Federal Open Market Committee (FOMC) Main policy-making group in the Federal Reserve System. members of the Board of Governors, the president of the FRB of NY, and the 11 presidents of other regional Federal Reserve banks of whom, on a rotating basis, 4 are voting members. meets every six weeks to formulate monetary policy.

Components of the Money Supply Bank reserves bank deposits at the Federal Reserve + cash Monetary base currency held by the nonbank public + bank reserves. M1 currency outside banks, traveler’s checks, and checking deposits owned by individuals and businesses. M2 M1 plus time deposits, savings deposits, and money market mutual funds and other deposits.

How do banks create money? Suppose that there is $100 million of cash and no bank system. A bank now begins and $90 million of cash is deposited in the bank in exchange for checking account (demand deposit) balances. The bank’s owners invest $5 million in plant and equipment and thus have $5 million of owner’s equity. The bank’s balance sheet is now:

How do banks create money? The balance sheet Assets Liabilities Cash 90 m. Demand deposits Plant & equipment 5 m. Owner’s equity Total assets 95 m. Total Liabilities Note: The balance sheet requires that total assets equal total liabilities.

How do banks create money? Fed sets a reserve ratio (let’s suppose it’s 25%). Implying bank must have 25% of it’s demand deposits on reserve. Reserves = cash + deposits at Fed. Bank can increase demand deposits by creating new loans to customers until it no longer has any excess reserves. required reserves = rr * demand deposits Maximum demand deposits = (1/rr) * reserves

How do banks create money? The balance sheet Assets Liabilities Cash 90 m. Demand deposits 90m360 m. Loans 0270 m Owner’s equity 5 m. Plant & equipment Total assets 95m365 m. Total Liabilities Note: The bank system created $270 million of additional money by creating new demand deposits for borrowers (loans). This assumes that none of the new loans/demand deposits are withdrawn as cash.

How Banks Create Money Deposits lead to a multiplier effect on M1 as banks convert a $1 deposit into several dollars of demand deposits. To illustrate, assume rr=25% A new deposit of $100,000 is made. The bank keeps $25,000 in reserve and lends $75,000. This loan is credited to someone’s bank deposit. The person spends the deposit and another bank now has $75,000 of extra deposits. This bank keeps $18,750 on reserve and lends $56,250.

How Banks Create Money The process continues and keeps repeating with smaller and smaller loans at each “round.” A money creation experiment. The process through which banks “create money” can be a dark and mysterious secret to the students. Indeed, even though the text contains a superb description of the process, students still manage to end up confused. The first prerequisite to students understanding the process is that they be comfortable with balance sheets shown in the form of T-accounts, and it is well worth spending time on them to make sure students understand what they are and what they show. This will be the first time some students have ever had to interpret a balance sheet, and it is key that they understand that assets are what are owned, liabilities are what are owed, by the institution for which the balance sheet is constructed; and that the two sides must balance. Mark Rush (our study guide author and supplements czar) tackles the problem of getting students to understand bank money creation head-on by (again) involving the class in a demonstration. Prepare by decorating a piece of green paper with currency-like symbols. (For instance, Mark draws a seal and around it write “In Rush We Trust.” You may write the same slogan, but substituting your name for his probably will be more effective; an alternative is to use “play money”). Label this piece of paper a “$100 bill.” In class use one of the students by handing him the bill. Tell him that he has decided to deposit it in his bank and ask him his bank’s name. On the chalkboard draw a balance sheet for the bank with deposits of $100, reserves of $10, and loans of $90. Tell the students that the required reserve ratio is 10 percent, so this bank currently has no excess reserves. Now, instruct the student to deposit the money in his bank, which coincidentally happens to be run by the student next to him. Show the class what happens to the balance sheet and how the bank now has excess reserves of $90. Clearly the “banker” will loan these reserves to the next student in the class, who wants a $90 dollar loan so she can take a bus ride to some nearby dismal location. (Being located in Gainesville, Florida, Mark picks on the city of Stark, home to Florida’s electric chair and a town with an apt name.) When the loan takes place, rip the $100 bill so that only about nine tenths of it is given as the loan. This student pays the money to Greyhound—coincidentally the next student. Ask the name of Greyhound’s bank and draw an initial balance sheet for this bank identical to the initial balance sheet of the first bank. Greyhound deposits the money in the bank—the next student in the row. Work with the balance sheets to show what happens to the first bank and what happens to the second bank. Clearly the first one no longer has excess reserves but the second bank now has $81 of excess reserves ($90 of additional deposits minus $9 of required reserves). The second bank will make a loan, which you can act out with more students in the class, again ripping off nine tenths of the remaining bill. Work through the point where the second loan winds up deposited in a third bank and then stop to take stock. At this point the quantity of money has increased by $90 in the second bank and $81 in the third, for a total increase—so far—of $171. The students will clearly see that this loaning and reloaning process is not yet over and that the quantity of money will increase by still more. Moreover (and more important) the students will grasp how banks “create money.”

How do banks create money? Summary of money creation process. monetary base = nonbank cash + bank reserves M1 = nonbank cash + demand dep. DDmax = (1/rr)* bank reserves The Fed controls the money supply through its control over the monetary base and the deposit multiplier (1/rr).

Fed Tools Open market operations. The Fed buys (sells) government securities in the open market to increase (decrease) the money supply. Discount window lending. The Fed loans reserves to member banks and charges the discount rate. Reserve requirements. The Fed sets the required reserve ratio. Rarely used.

OPEN MARKET OPERATIONS. If the Fed wants to increase the amount of bank reserves buy government securities from member banks banks give up government bonds and receive deposit at the Fed or cash. By buying government securities Fed created new reserves that multiply into new loans and demand deposits (remember the deposit multiplier). If the Fed sold government securities, reserves and M1 would decrease.

DISCOUNT WINDOW LENDING. The Fed lends banks reserves at the “discount rate”. The higher the discount rate, the less likely banks are to borrow reserves to increase the money supply. The federal funds rate is the interest rate that banks charge each other for a loan of reserves. The federal funds rate tracks the discount rate fairly closely. If the Fed wants to increase reserves in the sytem, it would lower the discount rate.

THE RESERVE REQUIREMENT. If the Fed increases the reserve requirement the deposit multiplier (1/rr) falls the amount of demand deposits that banks can create for a given amount of reserves is reduced. [Note: you may ignore the “money multiplier” discussed in text. Focus only on “deposit multiplier”]

OTHER FACTORS INFLUENCING THE MONEY SUPPLY The amount of cash people choose to hold Cash in bank multiplies Cash outside bank does not. The type of deposits people make. the reserve requirement is higher on demand deposits (about 3%) than on certificates of deposit. If people switch between different types of accounts, the “average” reserve requirement and money multiplier will change.

Changes in the money supply The balance sheet COB=$10m; rr=25% Assets Liabilities Cash 90 m. Demand deposits 360 m. Loans 270 m Owner’s equity 5 m. Plant & equipment Total assets 365 m. Total Liabilities Suppose the Fed purchases $10 m. of government securities. What is the effect on: Loans Demand deposits M1

Changes in the money supply The balance sheet COB=$10m; rr=25% Assets Liabilities Cash 90 m. Demand deposits 360 m. Loans 270 m Owner’s equity 5 m. Plant & equipment Total assets 365 m. Total Liabilities Suppose the public withdraws $10m. Of DD as cash. What is the effect on: Loans Demand deposits M1

Changes in the money supply The balance sheet COB=$10m; rr=25% Assets Liabilities Cash 90 m. Demand deposits 360 m. Loans 270 m Owner’s equity 5 m. Plant & equipment Total assets 365 m. Total Liabilities Suppose the Fed reduces the rr to 20% What is the effect on: Loans Demand deposits M1