The Money Supply Chapter 22

AN OVERVIEW OF MONEY WHAT IS MONEY? Money is anything that is generally accepted as a medium of exchange A Means of Payment, or Medium of Exchange A Store of Value A Unit of Account

AN OVERVIEW OF MONEY A Means of Payment, or Medium of Exchange barter The direct exchange of goods and services for other goods and services A barter system requires a double coincidence of wants for trade to take place medium of exchange, or means of payment What sellers generally accept and buyers generally use to pay for goods and services

AN OVERVIEW OF MONEY A Store of Value store of value An asset that can be used to transport purchasing power from one time period to another liquidity property of money The property of money that makes it a good medium of exchange as well as a store of value: It is portable and readily accepted and thus easily exchanged for goods The main disadvantage of money as a store value is that the value of money falls when the prices of goods and services rise

AN OVERVIEW OF MONEY A Unit of Account unit of account A standard unit that provides a consistent way of quoting prices

COMMODITY AND FIAT MONIES AN OVERVIEW OF MONEY COMMODITY AND FIAT MONIES commodity monies Items used as money that also have intrinsic value in some other use Example: gold fiat, or token, money Items designated as money that are intrinsically worthless

AN OVERVIEW OF MONEY Why would anyone accept worthless scraps of paper as money instead of something that has some values, such as gold? If your answer is “because the paper money is backed by gold or silver”, you are wrong There was a time when paper money in circulation were convertible directly into gold However, paper money is no longer backed by any commodity The public accepts paper money as a means of payment and a store of value because the government has taken steps to ensure that its money is accepted

AN OVERVIEW OF MONEY legal tender Money that a government has required to be accepted in settlement of debts Aside from declaring its currency legal tender, the government usually does one another thing to ensure that paper money will be accepted: It promises the public that it will not print paper money so fast that it loses its value currency debasement The decrease in the value of money that occurs when its supply is increased rapidly

MEASURING THE SUPPLY OF MONEY AN OVERVIEW OF MONEY MEASURING THE SUPPLY OF MONEY Recall that money is used to buy things (a means of payment); to hold wealth (a store value); and to quote prices (a unit of account) M1: Transactions Money M1, or transactions money Money that can be directly used for transactions M1 ≡ currency held outside banks + demand deposits + traveler’s checks + other checkable deposits

AN OVERVIEW OF MONEY Demand deposits or checking accounts Depositors have the right to go to the bank and cash in (demand) their entire checking account balances at any time This is why checking accounts are included as part of the amount of money you hold Checkable deposits is any deposit account with a bank on which a check can be written

AN OVERVIEW OF MONEY M2: Broad Money near monies Close substitutes for transactions money, such as savings accounts and money market accounts M2, or broad money M1 plus savings accounts, money market accounts, and other near monies M2 ≡ M1 + savings accounts + money market accounts + other near monies

AN OVERVIEW OF MONEY Beyond M2 There are no rules for deciding what is money and what is not Example: credit cards This poses problems for economists and those in charge of economic policy

AN OVERVIEW OF MONEY For our purposes, “money” will always refer to transactions money, M1 M1 is the sum of two general categories: Currency in circulation Deposits

AN OVERVIEW OF MONEY THE PRIVATE BANKING SYSTEM financial intermediaries Banks and other institutions that act as a link between those who have money to lend and those who want to borrow money

A HISTORICAL PERSPECTIVE: GOLDSMITHS HOW BANKS CREATE MONEY A HISTORICAL PERSPECTIVE: GOLDSMITHS Suppose you go to a goldsmith who is functioning only as a depositor and ask for a loan of 20 ounces of gold Suppose that the goldsmith has 100 ounces of gold on deposit in his safe and receipts for exactly 100 ounces of gold out to various people who deposited the gold If goldsmith decides he is tired of being a mere goldsmith and wants to become a real bank, he will loan some gold You actually want a slip of paper that represents 20 ounces of gold The goldsmith in essence “creates” money for you by giving you a receipt for 20 ounces of gold

HOW BANKS CREATE MONEY There will be receipts for 120 ounces of gold in circulation instead of the 100 ounces worth of receipts before your loan and the supply of money will have increased Goldsmiths-turned-bankers did face certain problems Once they started to make loans, their receipts outstanding (claims on gold) were greater than the amount of gold they have had in their vaults If the owners of the 120 ounces worth of gold receipts all presented their receipts and demanded their gold at the same time, the goldsmith would be in trouble run on a bank Occurs when many of those who have claims on a bank (deposits) present them at the same time

THE MODERN BANKING SYSTEM HOW BANKS CREATE MONEY THE MODERN BANKING SYSTEM A Brief Review of Accounting “The books always balance” Assets are things a firm owns that are worth something For a bank, these assets include the bank building, cash in its vaults, bonds, stocks, loans, cash on hand and deposits with Central Bank (as banks keep a certain portion of their deposits on hand as vault cash or on deposit with Central Bank)

HOW BANKS CREATE MONEY Liabilities are the firm’s debts-what it owes A bank’s liabilities are the promises to pay and its deposits Deposits are debts owned to the depositors, because when you deposit money in your account, you are in essence making a loan to the bank

HOW BANKS CREATE MONEY If we add up a firm’s assets and then subtract the total amount it owes to all those who have lent it funds, the difference is the firm’s net worth Assets − Liabilities ≡ Net Worth or Assets ≡ Liabilities + Net Worth

HOW BANKS CREATE MONEY To keep track of a bank’s financial position using a simplified balance sheet called a T-account The bank’s assets are listed on the left side and its liabilities and net worth are on the right side By definition, the balance sheet always balances, so that the sum of the items on the left side of T-account is exactly equal to the sum of the items on the right side

HOW BANKS CREATE MONEY T-Account for a Typical Bank (millions of dollars)

HOW BANKS CREATE MONEY A bank having $110 million in assets of which: $20 million are reserves (the deposits that the bank has made at Central Bank and its cash on hand) $90 million are loans reserves The deposits that a bank has at the Central Bank plus its cash on hand

HOW BANKS CREATE MONEY Why do banks hold reserves/deposits at Central Bank? The most important reason is the legal requirement that they hold a certain percentage of their deposit liabilities as reserves required reserve ratio The percentage of its total deposits that a bank must keep as reserves at the Central Bank If the reserve ratio is 20 percent, then a bank with deposits of $100 million must hold $20 million as reserves, either as cash or as deposits at Central Bank We assume that banks hold all of their reserves in the form of deposits at the Central Bank

HOW BANKS CREATE MONEY On the liabilities side: The bank has taken deposits of $100 million, so it owes this amount to its depositors The bank has a net worth of $10 million to its owners $110 million in assets - $100 million in liabilities = $10 million net worth

HOW BANKS CREATE MONEY When some item on a bank’s balance sheet changes, there must be at least one other change somewhere else to maintain balance If bank’s reserves increase by $1, then one of the following must also be true: Its other assets (loans) decrease by $1 Its liabilities (deposits) increase by $1 Its net worth increases by $1

excess reserves ≡ actual reserves − required reserves HOW BANKS CREATE MONEY THE CREATION OF MONEY Banks usually make loans up to the point where they can no longer do so because of the reserve requirement restriction A bank’s required amount of reserves is equal to the required reserve ratio times the total deposits in the bank excess reserves The difference between a bank’s actual reserves and its required reserves excess reserves ≡ actual reserves − required reserves Banks make loans up to the point where their excess reserves are zero

HOW BANKS CREATE MONEY If a bank has excess reserves, it has credit available and it can make loans A bank can make loans only if it has excess reserves When a bank makes a loan, it creates a demand deposit for the borrower This creation of a demand deposit causes the bank’s excess reserves to fall because the extra deposits created by the loan use up some the excess reserves the bank has on hand

HOW BANKS CREATE MONEY Balance Sheets of a Bank in a Single-Bank Economy

HOW BANKS CREATE MONEY Assume there is only one private bank in the country The required reserve ratio is 20 percent The bank starts off with nothing: Panel 1 Someone deposits $100 in the bank The bank deposits the $100 with the central bank and it now has $100 in reserves: Panel 2 The bank now has assets (reserves) of $100 and liabilities (deposits) of $100

HOW BANKS CREATE MONEY If the required reserve ratio is 20 percent, the bank has excess reserves of $80 How much can the bank lend and still meet the reserve requirement? (Suppose no cash withdrawal) With $80 of excess reserves, the bank can have up to $400 of additional deposits The $100 in reserves plus $400 in loans (as deposits) equal $500 in deposits With $500 in deposits and a required reserve ratio of 20 percent, the bank must have reserves of $100 (that is 20 percent of $500): Panel 3 The bank can lend no more than $400 because it reserve requirement must not exceed $100

HOW BANKS CREATE MONEY The money supply (M1) equals cash in circulation plus deposits Before the initial deposit, the money supply was $100 ($100 cash and no deposits) After the deposit and the loans, the money supply is $500 (no cash and $500 in deposits) When loans are converted into deposits, the supply of money can change

HOW BANKS CREATE MONEY What happens when there are many banks? Assume that I make an initial deposit of $100 in bank 1 and the bank deposits the entire $100 with the Central Bank: Panel 1 All loans that a bank makes are withdrawn from the bank as the individual borrowers write checks to pay for merchandise After my deposit, bank 1 can make a loan up to $80 to Person X, because given 20 percent required reserve ratio, it needs to keep only $20 of its $100 deposit as reserves

HOW BANKS CREATE MONEY The Creation of Money When There Are Many Banks

HOW BANKS CREATE MONEY Bank 1’s balance sheet at the moment of the loan to Person X appears in Panel 2 Bank 1 now has loans of $80 It has credited Person X’s account with the $80, so its total deposits are $180 ($80 in loans plus $100 in reserves) Person X then writes a check for $80 for another good to sold by Person Y Person Y deposits Person X’s check in bank 2

HOW BANKS CREATE MONEY When the check clears, bank 1 transfers $80 in reserves to bank 2 Bank 1’s balance sheet: Panel 3 Bank 1’s assets include reserves of $20 and loans of $80; its liabilities are $100 in deposits Both sides balance: The bank’s reserves are 20 percent of its deposits and is fully loaned up

HOW BANKS CREATE MONEY Look at bank 2 Because bank 1 has transferred $80 in reserves to bank 2, now it has $80 in deposits and $80 in reserves: Panel 1, bank 2 Its reserve requirement ratio is also 20 percent, so it has excess reserves of $64 on which it can make loans Assume bank 2 loans the $64 to Person Z to pay for a good sold by Person T and Person Z writes a check for $64 payable to Person T The final position of bank 2 (transfer of $64 in reserves to bank 3) is reserves of $16, loans of $64 and deposits of $80: Panel 3, bank 2

HOW BANKS CREATE MONEY Person T deposits Person Z’s check in its account with bank 3 Bank 3 has excess reserves, because it has added $64 to its reserves With a reserve requirement ratio of 20 percent, bank 3 loan out $51.20 (80 percent of $64, leaving 20 percent in required reserves to back the $64 deposit): Panel 3, bank 3 As the process is repeated over, the total amount of deposits created is $500, the sum of the deposits in each of the banks

HOW BANKS CREATE MONEY THE MONEY MULTIPLIER An increase in bank reserves leads to a greater than one-for-one increase in the money supply Economists call the relationship between the final change in deposits and the change in reserves that caused this change the money multiplier Stated somewhat differently, the money multiplier is the multiple by which deposits can increase for every dollar increase in reserves

HOW BANKS CREATE MONEY Reserves increased by $100 when the $100 in cash was deposited in a bank The amount of deposits increased by $500 ($100 from the initial deposits, $400 from the loans made by banks from their excess reserves) The money multiplier is $500/$100=5

Money multiplier ≡ 1/required reserve ratio HOW BANKS CREATE MONEY money multiplier The multiple by which deposits can increase for every dollar increase in reserves; equal to 1 divided by the required reserve ratio Money multiplier ≡ 1/required reserve ratio

FUNCTIONS OF THE CENTRAL BANK The crucial role is to control the money supply The Central Bank also performs several important functions for banks Clearing interbank payments Regulating the banking system Assisting banks in a difficult financial position Managing exchange rates and the nation’s foreign exchange reserves

HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY WHAT IS THE ROLE OF RESERVES? The required reserve ratio establishes a link between the reserves of the commercial banks and the deposits (money) that commercial banks are allowed to create The reserve requirement determines how much a bank has available to lend If the required reserve ratio is 20 percent, each of 1 TL of reserves can support 5 TL in deposits As the money supply is equal to the sum of deposits inside banks and the currency in circulation outside of banks, reserves provide the power the Central Bank needs to control the money supply

HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY If the Central Bank wants to increase the supply of money, it creates more reserves, thereby freeing banks to create additional deposits by making more loans If it wants to decrease the money supply, it reduces reserves Three tools are available to the Central Bank for changing the money supply: (1) changing the required reserve ratio (2) changing the discount rate (3) engaging in open market operations

HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: THE REQUIRED RESERVE RATIO Assume the initial required reserve ratio is 20 percent Panel 1: Central Bank’s balance sheet Reserves are $100 billion Currency outstanding is $100 billion The total value of Central Bank’s assets is $200 billion that is assumed to be all in government securities Assume no excess reserves The $100 billion in reserves supports $500 billion in deposits at the commercial banks The money multiplier equals 1/required reserve ratio=1/0.2=5 Thus $100 billion in reserves can support $500 billion in deposits The supply of money is $600 billion: $100 billion in currency and $500 billion in deposits at the commercial banks

HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: THE REQUIRED RESERVE RATIO

The money multiplier is 1/0.125=8 HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: THE REQUIRED RESERVE RATIO Suppose the Central Bank wants to increase the supply of money to $900 billion If it lowers the required reserve ratio from 20 percent to 12.5 percent (Panel 2), then the same $100 billion of reserves could support $800 billion in deposits The money multiplier is 1/0.125=8 The total money supply would be $800 billion in deposits plus the $100 billion in currency, a total of $900 billion

The result is a decrease in the money supply HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: THE REQUIRED RESERVE RATIO Decreases in the required reserve ratio allow banks to have more deposits with the existing volume of reserves As banks create more deposits by making loans, the supply of money (currency plus deposits) increases If the Central Bank wants to restrict the supply of money, it can raise the required reserve ratio, in which case banks will find that they have insufficient reserves and must therefore reduce their deposits by “calling in” some of their loans The result is a decrease in the money supply

HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY THE DISCOUNT RATE discount rate Interest rate that banks pay to the Central Bank to borrow from it

HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: THE DISCOUNT RATE Assume there is only one bank in the country and the required reserve ratio is 20 percent The initial position of Central Bank: Panel 1 Assets: $160 securities Liabilities: $80 reserves and $80 currency The initial position of bank: Panel 1 Assets: $80 reserves and $320 loans Liabilities: $400 deposits The money supply (currency plus deposits) is $480

HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: THE DISCOUNT RATE

HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: THE DISCOUNT RATE In Panel 2, the bank has borrowed $20 from the Central Bank By using this $20 as a reserve, the bank can increase its loans by $100, from $320 to $420 As required reserve ratio of 20 percent gives a money multiplier of 5; having excess reserves of $20 allows the bank to create an additional $100 in deposits The money supply thus increased from $480 to $580

HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: THE DISCOUNT RATE Bank borrowing from the Central Bank leads to an increase in the money supply The Central Bank can influence bank borrowing, and thus the money supply, through the discount rate: The higher the discount rate, the higher the cost of borrowing, and the less borrowing banks will want to do

HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: OPEN MARKET OPERATIONS open market operations The purchase and sale by the Central Bank of government securities in the open market; a tool used to expand or contract the amount of reserves in the system and thus the money supply The most significant tool

HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: OPEN MARKET OPERATIONS When the Central Bank purchases a security, the quantity of reserves expands, increasing the money supply When the Central Bank sells a security (or bond), the quantity of reserves reduces, decreasing the money supply

HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: OPEN MARKET OPERATIONS Suppose that the Central Bank wants to decrease the supply of money If it can reduce the volume of bank reserves on the liabilities side of its balance sheet, it will force banks in turn to reduce their own deposits (to meet the required reserve ratio) Since these deposits are part of the supply of money, the supply of money will contract

HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: OPEN MARKET OPERATIONS What happens if the Central Bank sells some of its holdings of government securities to the public? The Central Bank’s holdings of government securities must decrease How do in return the purchasers of securities pay for what they have bought? By writing checks drawn on their banks and payable to the Central Bank

HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: OPEN MARKET OPERATIONS In Panel 1, the Central Bank has $100 billion of government securities Its liabilities consist of $20 billion of deposits (that are the reserves of commercial banks) and $80 billion of currency With the required reserve ratio at 20%, the $20 billion of reserves can support $100 billion of deposits in the commercial banks The commercial banking system is fully loaned up Zeynep has assets of $5 billion and no debts, so her net worth is $5 billion (look at Panel 1)

HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: OPEN MARKET OPERATIONS The Central Bank sells $5 billion in government securities to Zeynep Zeynep pays for the securities by writing a check to the Central Bank, drawn on her bank The Central Bank then reduces the reserve account of her bank by $5 billion Look at Panel 2 The supply of money (currency plus deposits) has fallen from $180 billion to $175 billion

HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: OPEN MARKET OPERATIONS

HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: OPEN MARKET OPERATIONS As a result of the Central Bank’s sale of securities, the amount of reserves has fallen from $20 billion to $15 billion, while deposits have fallen from $100 billion to $95 billion With a required reserve ratio of 20 percent, banks must have 0.2X$95=$19 billion in reserves Banks are under their required reserve ratio by $4 billion So, banks must decrease their loans and their deposits

HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: OPEN MARKET OPERATIONS The final equilibrium position is Panel 3 Commercial banks have reduced their loans by $20 billion The change in deposits from Panel 1 to Panel 3 is $25 billion that is 5 times the size of the change in reserves that the Central Bank brought through its $5 billion open market sale of securities That is our money multiplier The change in money (-$25 billion) is equal to the money multiplier (5) times the change in reserves (-$5 billion)

HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: OPEN MARKET OPERATIONS What happens when the Central Bank purchases a government security? Suppose Ali holds $100 in Treasury bill, which the Central Bank buys from him The Central Bank writes him a check for $100 and Ali then take the $100 check and deposit it in his bank This increases the reserves of his bank by $100 and begins a new episode in the money expansion story

HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: OPEN MARKET OPERATIONS With a reserve requirement ratio of 20%, his bank can now lend out $80 If that $80 is spent and ends up back in a bank, that bank can lend $64 and so forth The Central Bank can expand the money supply by buying government securities from people who own them

HOW THE CENTRAL BANK CONTROLS THE MONEY SUPPLY: OPEN MARKET OPERATIONS We can sum up the effect of these open market operations this way: An open market purchase of securities by the Central Bank results in an increase in reserves and an increase in the supply of money by an amount equal to the money multiplier times the change in reserves An open market sale of securities by the Central Bank results in a decrease in reserves and a decrease in the supply of money by an amount equal to the money multiplier times the change in reserves

THE SUPPLY CURVE FOR MONEY To begin with, the Central Bank’s choice of the value for the money supply does not depend on the interest rate We can draw the money supply curve as a vertical line Assume that the money supply curve is vertical

THE SUPPLY CURVE FOR MONEY Interest rate Money supply Money supply