Macro Chapter 13 Money and the Banking System

6 Learning Goals 1) 1)List and describe the functions of money 2) 2)Define the alternative measures of money and distinguish between M1 and M2 3) 3)Explain fractional reserve banking 4) 4)Investigate how banks create money by extending loans 5) 5)List the tools used by the Fed to control the money supply 6) 6)Analyze how those tools change the money supply

What is Money?

Imagine a world without money No currency, no coins, no checking deposits How would you be able to obtain stuff?

One way would be to barter- trade one good for another Problem: double coincidence of wants Watch video (illustration of barter working well): Book of Eli-barter exchange

Watch video (illustration of barter not working well): Planes, Trains and Automobiles- barter exchange

Money adds enormous efficiency gains to our economy Without money, the double coincidence of wants would make our economy a fraction of what it is today

Q13.1 If money were not used as a medium of exchange, 1.the gains from trade would be severely limited. 2.our standard of living would probably improve. 3.the transaction costs of exchange would be lower. 4.economic efficiency would increase.

Why do private persons in private transactions accept money? “The short answer is that each person accepts them because he is confident that others will. The pieces of green paper have value because everybody thinks they have value. Everybody thinks they have value because in his experience they have had value.” (Milton Friedman, Free to Choose) Value of money rests on a fiction

The Business of Banking

Watch video (brief explanation of how banks operate): It’s a Wonderful Life-bank run

Q13.2 If you have a checking account at a local bank, your bank account there is 1.an asset to the bank and an asset to you. 2.a liability of the bank and a liability of yours. 3.a liability of the bank and an asset to you. 4.an asset to the bank and a liability of yours.

Typical assets and liabilities of banks: Assets: –Vault cash –Reserves at the Fed –Loans to customers –Bonds (i.e. securities) Liabilities: –Checking deposits –Savings deposits –Borrowings

How Banks Create Money by Extending Loans

Here’s how excess reserves are used to “create” money: See files “deposit creation.pdf” and “deposit multiplier.pdf” on BB deposit creation.pdfdeposit multiplier.pdfdeposit creation.pdfdeposit multiplier.pdf

Key points: (1) Banks are required to keep a portion of their deposits as reserves at the Federal Reserve Bank –These are required reserves –Roughly equal to 10% of deposits (2) Banks may keep or loan out additional reserves –These are excess reserves –Excess reserves earn interest from the Federal Reserve, so the bank must decide where it’s earning the biggest return- by loaning them out or by keeping them with the Fed

Q13.3 Suppose you withdraw $1,000 from your checking account. If the reserve requirement is 20 percent, how does this transaction affect the supply of money and the excess reserves of your bank? 1.There is no change in the supply of money; your bank's excess reserves are reduced by $ There is no change in the supply of money; your bank's excess reserves are reduced by $ The money supply increases by $1,000, and the excess reserves of your bank are reduced by $ The money supply increases by $1,000, and the excess reserves of your bank are reduced by $200.

Q13.4 (MA) Suppose you deposit $1,000 into your checking account. If the reserve requirement is 10 percent, what impact does this transaction have? 1.The money supply increases 2.The money supply remains the same 3.The bank’s required reserves increase by $100 4.The bank’s required reserves decrease by $100 5.The bank’s required reserves increase by $900 6.The bank can make new loans of $900 7.The bank can make new loans of $1,000

The Federal Reserve System

Four tools of the Fed to control the money supply: 1)Reserve requirements 2)Open Market Operations 3)Extend loans 4) Interest paid on excess reserves

Expansionary Monetary Policy: Buy securities (i.e. bonds, Treasury or other) Extend more loans Reduce the interest rate paid on reserves

Restrictive Monetary Policy: Sell securities (i.e. bonds, Treasury or other) Extend fewer loans Increase the interest rate paid on reserves

Q13.5 If the Fed lends to member banks, what happens to reserves and the money supply? 1.Reserves increase and the money supply decreases. 2.Both increase. 3.Reserves decrease and the money supply increases. 4.Both decrease.

Open market operations is the key tool the Fed uses Open market operations is the buying and selling of bonds, usually US Treasury securities

Let’s see how this works: Create the following three T accounts Watch content video: Macro Chapter 13- money multiplier

AssetsLiabilities + Net Worth Bank: (make up your own name)

Suppose the Fed buys $100 of bonds Two-step process

AssetsLiabilities + Net Worth Required ReservesDeposits Excess Reserves BondsNet Worth Loans TotalTotal Step 1: The bond transaction

AssetsLiabilities + Net Worth Required ReservesDeposits Excess Reserves BondsNet Worth Loans TotalTotal Step 2: The actions of the bank

Results: New excess reserves at your bank = $100 Impact on money supply = $100 / 0.10 = $1,000

Q13.6 (MA) When the Fed sells Treasury Bonds on the open market, it will tend to 1.increase the money supply 2.decrease the money supply 3.increase interest rates 4.decrease interest rates

Q13.7 (MA) When the Fed buys Treasury Bonds on the open market, it will tend to 1.increase the money supply 2.decrease the money supply 3.increase interest rates 4.decrease interest rates

Question Answers: 13.1 = = = = 2, 3 & = = 2 & = 1 & 4