12 Money and the Banking System [Money] is a machine for doing quickly and commodiously what would be done, though less quickly and commodiously, without it. JOHN STUART MILL Money and the Banking System [Money] is a machine for doing quickly and commodiously what would be done, though less quickly and commodiously, without it. JOHN STUART MILL

●The Nature of Money ●How the Quantity of Money is Measured ●The Banking System ●The Origins of the Money Supply ●Banks and Money Creation ●Why the Deposit Creation Formula Is Oversimplified ●The Need for Monetary Policy ●The Nature of Money ●How the Quantity of Money is Measured ●The Banking System ●The Origins of the Money Supply ●Banks and Money Creation ●Why the Deposit Creation Formula Is Oversimplified ●The Need for Monetary Policy Contents Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

●Barter versus Monetary Exchange ♦A barter system (with no money) would be awkward and extremely inefficient. ♦Money greases the wheels of exchange and, thus, makes the whole economy more productive. ●Barter versus Monetary Exchange ♦A barter system (with no money) would be awkward and extremely inefficient. ♦Money greases the wheels of exchange and, thus, makes the whole economy more productive. The Nature of Money

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. The Nature of Money ●The Conceptual Definition of Money ♦The functions of money: ■Medium of exchange ■Unit of account ■Store of value ♦Money = whatever serves as the medium of exchange ●The Conceptual Definition of Money ♦The functions of money: ■Medium of exchange ■Unit of account ■Store of value ♦Money = whatever serves as the medium of exchange

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●What Serves as Money? ♦Societies have gradually moved from the use of commodity monies to the use of money that has no commodity backing at all. ●What Serves as Money? ♦Societies have gradually moved from the use of commodity monies to the use of money that has no commodity backing at all. The Nature of Money

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●There is no single, obvious place to draw the line between “money” and “near money.” ●M1 = coins and paper money in circulation, plus checkable deposits ●M2 = M1 + money market deposit accounts, money market mutual funds, and savings accounts ●There is no single, obvious place to draw the line between “money” and “near money.” ●M1 = coins and paper money in circulation, plus checkable deposits ●M2 = M1 + money market deposit accounts, money market mutual funds, and savings accounts How the Quantity of Money is Measured

FIGURE 2: Two Definitions of the Money Supply, January 2005 Copyright © 2006 South-Western/Thomson Learning. All rights reserved. M1 = $1361 billion Currency Outside banks $710 billion Other checkable deposits $321 billions Checking deposits In commercial Banks $330 billion M2 = $6443 billion Money market mutual funds $704 billion M1 $1361 billion Savings deposits $4378 billion

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●How Banking Began ♦Fractional reserve banking began when goldsmiths realized they could profitably lend out a portion of the gold that had been deposited with them for safekeeping. ●How Banking Began ♦Fractional reserve banking began when goldsmiths realized they could profitably lend out a portion of the gold that had been deposited with them for safekeeping. The Banking System

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. The Banking System ●How Banking Began ♦Three important features of the fractional reserve banking system: ■Bank profitability ■Banks discretion over the money supply ■Exposure to bank runs ●How Banking Began ♦Three important features of the fractional reserve banking system: ■Bank profitability ■Banks discretion over the money supply ■Exposure to bank runs

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. The Banking System ●Principles of Bank Management: Profits versus Safety ♦To make a profit, a banker must take risks. ♦But because the business is risky, the same banker must also emphasize safety. ♦The heart of banking is to be torn between the two principles. ●Principles of Bank Management: Profits versus Safety ♦To make a profit, a banker must take risks. ♦But because the business is risky, the same banker must also emphasize safety. ♦The heart of banking is to be torn between the two principles.

FIGURE 1: Bank Failures in the United States, Copyright © 2006 South-Western/Thomson Learning. All rights reserved ,000 1,200 1,400 1,600 1,800 2,000 2,200 Year (a) Number of Bank Failures FDIC established Great Depression begins Number of Bank Failures 1995 '03 (b)

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. The Banking System ●Bank Regulation ♦Deposit insurance (FDIC) ■Eliminates the motive for customers to withdraw funds because of bad news regarding the bank’s finances ♦Moral hazard ■When an individual is insured against risk, he/she puts forth little effort to avoid risk ■FDIC could make the banking system less safe ●Bank Regulation ♦Deposit insurance (FDIC) ■Eliminates the motive for customers to withdraw funds because of bad news regarding the bank’s finances ♦Moral hazard ■When an individual is insured against risk, he/she puts forth little effort to avoid risk ■FDIC could make the banking system less safe

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. The Banking System ●Bank Regulation ♦Bank Supervision ■Needed to reduce moral hazard problem ■Ensures banks take only sensible, defensible risks ■Controls the money supply ♦Reserve Requirements ■Helps control the money supply ●Bank Regulation ♦Bank Supervision ■Needed to reduce moral hazard problem ■Ensures banks take only sensible, defensible risks ■Controls the money supply ♦Reserve Requirements ■Helps control the money supply

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●How Bankers Keep Books ♦Banks keep balance sheets ■Assets = liabilities + net worth ♦Assets include: ■Reserves ■Loans ♦Liabilities include: ■Deposits owed to customers. ●How Bankers Keep Books ♦Banks keep balance sheets ■Assets = liabilities + net worth ♦Assets include: ■Reserves ■Loans ♦Liabilities include: ■Deposits owed to customers. The Origins of the Money Supply

TABLE 1: Balance Sheet of Bank- a-mythica, Dec. 31, 2004 Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

Banks and Money Creation ●The Limits to Money Creation by a Single Bank ♦Banks can lend money in their vault that is above the minimum required reserve ratio. ♦In doing so, they create new money. ●The Limits to Money Creation by a Single Bank ♦Banks can lend money in their vault that is above the minimum required reserve ratio. ♦In doing so, they create new money.

TABLE 2: Bank-a-mythica’s Balance Sheet, Jan. 2, 2005 Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

TABLE 3: Bank-a-mythica’s Balance Sheet, Jan. 3-6, 2005 Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

TABLE 4: Bank-a-mythica’s Balance Sheet, Jan. 2-6, 2005 Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

Banks and Money Creation ●Multiple Money Creation by a Series of Banks ♦When all banks make loans with funds they have that are above the required reserve ratio, the society’s money supply expands. ●Multiple Money Creation by a Series of Banks ♦When all banks make loans with funds they have that are above the required reserve ratio, the society’s money supply expands.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Banks and Money Creation ●Multiple Money Creation by a Series of Banks ♦  deposits = (1/m) x  reserves ■Assumes banks keep the minimum reserve ratio, m ■Assumes all new money held in the form of deposits ■Oversimplified deposit multiplier formula ●Multiple Money Creation by a Series of Banks ♦  deposits = (1/m) x  reserves ■Assumes banks keep the minimum reserve ratio, m ■Assumes all new money held in the form of deposits ■Oversimplified deposit multiplier formula

TABLE 5: Changes in First National Bank’s Balance Sheet Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

TABLE 6: Changes in Second National Bank’s Balance Sheet Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

FIGURE 3: The Chain of Multiple Deposit Creation Copyright © 2006 South-Western/Thomson Learning. All rights reserved. $400,000 $268,928 $236,160 $195,200 $144,000 (3) $80,000 Loans $100,000 $500,000 $336,160 $295,200 $244,000 $180,000 Running Sums (2) $100,000 Deposits $67,232 $59,040 $48,800 $36,000 (1) $20,000 Reserves And so on... $40,960 deposit $32,768 lent out$8,192 on reserve $51,200 deposit $40,960 lent out$10,240 on reserve $64,000 deposit $51,200 lent out$12,800 on reserve $80,000 deposit $64,000 lent out$16,000 on reserve $100,000 deposit $80,000 lent out$20,000 on reserve

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Banks and Money Creation ●The Process in Reverse: Multiple Contractions of the Money Supply ♦Deposits, and with them the money supply, contract when reserves are reduced. ■Banks reduce their loan commitments. ■Calculation of the contraction in the money supply utilizes the same formula as for money expansion.

TABLE 7: Changes in Balance Sheet of Bank-a-mythica Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

TABLE 8: Changes, Balance Sheet of First National Bank Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

●Individuals hold some portion of additions to their money in the form of cash. ●Banks sometimes hold reserves above the required minimum. ●Individuals hold some portion of additions to their money in the form of cash. ●Banks sometimes hold reserves above the required minimum. Why the Deposit Creation Formula Is Oversimplified

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. The Need for Monetary Policy ●Left uncontrolled, banks would: ♦Reduce the money supply in a recession ♦Increase the money supply during boom periods ●Changes in the money supply would exacerbate the business cycle. ●One reason for monetary policy, therefore, is to prevent this behavior on the part of banks. ●Left uncontrolled, banks would: ♦Reduce the money supply in a recession ♦Increase the money supply during boom periods ●Changes in the money supply would exacerbate the business cycle. ●One reason for monetary policy, therefore, is to prevent this behavior on the part of banks.