1. Money and the Banking System
Chapter 13
Money and the Banking System

2. “Money is whatever is generally accepted in exchange for goods and services—accepted not as an object to be consumed but as an object that represents a temporary abode of purchasing power to be used for buying still other goods and services.”
-- Milton Friedman

3. 1. What Is Money?

4. What Is Money?
A Medium of Exchange -- An asset that is used to buy and sell goods & services.
A Store of Value -- An asset that will allow people to transfer purchasing power from one period to another.
A Unit of Account -- The units of measurement used by people to post prices and keep track of revenues and costs.

5. 2. Why Is Money Valuable?

6. Why Is Money Valuable?
The main thing that makes money valuable is the same thing that generates value for other commodities:
The demand (for money) relative to its supply.
People demand money because it reduces the cost of exchange.
When the supply of money is limited relative to the demand, money will be valuable.

7. 3. The Supply of Money

8. The Supply of Money The components of the M1 money supply are:
Currency
Checking Deposits (including demand deposits and interest-earning checking deposits)
Traveler's checks
The M2 money supply is a broader measure that includes:
M1,
Savings,
Time deposits, and,
Money mutual funds.

9. Credit Cards Versus Money
Money is an asset.
The use of a credit card is merely a convenient way to arrange for a loan.
Credit card balances are a liability.
Thus, credit card purchases are not money.

10. 4. The Business of Banking

11. The Business of Banking
The banking industry includes:
savings and loans,
credit unions, and,
commercial banks.
Banks accept deposits and use part of them to extend loans and make investments.
Banks are profit-seeking institutions.
Banks play a central role in the capital (loanable funds) market:
They help to bring together people who want to save for the future with those who want to borrow in order to undertake investment projects.
The banking system is a fractional reserve system: Banks maintain only a fraction of their assets in reserves to meet the requirements of depositors.

12. Functions of Commercial Banking Institutions
SSETS
Vault cash
Reserves at the Fed
Loans outstanding
U.S. government securities
Other securities
Other assets
Total
Transaction deposits
Savings and time deposits
Borrowings
Other liabilities
Net worth
Consolidated Balance Sheet Of Commercial Banking Institutions,
Year-end 1998 (Billions Of Dollars) L
IABILITIES $ 9
3,316
793
443
690
$ 5,287
$ 665
2,656
985
560
421
Banks provide services and pay interest to attract transaction (checking), saving, and time deposits (liabilities).
Most of the deposits are invested and loaned out, providing interest income for the bank.
Banks hold a portion of their assets as reserves (either as cash or deposits with the Fed) to meet their daily obligations toward their depositors.

13. 5. How Banks Create Money by Extending Loans

14. How Banks Create Money by Extending Loans
Under a fractional reserve system, an increase in reserves will permit banks to extend additional loans and thereby expand the money supply (create additional checking deposits).
Bank
New Cash Deposits:
Actual Reserves
New Required
Reserves
Potential Demand Deposits
Created By Extending New Loans
Initial deposit (Bank A)
Second stage (Bank B)
Third stage (Bank C)
Fourth stage (Bank D)
Fifth stage (Bank E)
Sixth stage (Bank F)
Seventh stage (Bank G)
$1,000.00
800.00
$800.00
$200.00
640.00
160.00
512.00
128.00
409.60
102.40
327.68
81.92
262.14
65.54
52.43
209.71
All others (other banks)
1,048.58
209.71
838.87
Total
$5,000.00
$1,000.00
$4,000.00
When banks are required to maintain 20% reserves against demand deposits, the creation of $1,000 of new reserves will potentially increase the supply of money by $5,000.

15. How Banks Create Money by Extending Loans
The lower the percentage of the reserve requirement, the greater is the potential expansion in the money supply resulting from the creation of new reserves.
The fractional reserve requirement places a ceiling on potential money creation from new reserves.
The actual deposit multiplier will be less than the potential because:
Some persons will hold currency rather than bank deposits.
Some banks may not use all their excess reserves to extend loans.

16. Questions for Thought:
1. “People are poor because they don’t have very much money. Yet, central bankers keep money scarce. If people had more money, poverty could be eliminated.” Do you agree with this view? Why or why not?
2. What is a fractional reserve banking system? How does it influence the ability of banks to create money? Is it likely that banks will hold excess reserves? Why or why not?
3. Suppose you withdraw $100 from your checking account. How does this transaction affect (a) the supply of money, (b) the reserves of your bank, and, (c) the excess reserves of your bank?

17. 6. The Federal Reserve System

18. The Federal Reserve System
The Fed is the central bank of the U.S., responsible for the conduct of monetary policy.
Federal Reserve
Board of Governors
7 members appointed by
the president, with the
consent of the U.S. Senate
The Fed is a ‘banker’s bank.’
The Board of Governors of the Federal Reserve is at the center of the banking system in the U.S.
Twelve Federal Reserve
District Banks
(25 branches)
Open Market Committee
Federal Board of Governors
plus 5 Federal Reserve Bank
Presidents (alternating terms,
New York always represented)
The Board of Governors of the Federal Reserve is at the center of the banking system in the U.S.
The board sets all the rates and regulations for all depository institutions.
Commercial Banks
Savings & Loan Associations
Credit Unions
Mutual Savings Banks
The seven members of the Board of Governors also serve on the Federal Open Market Committee
The Public:
Households and Businesses
The FOMC is a 12-member board that establishes Fed policy with regard to the buying and selling of govt. securities.

19. The Federal Reserve System
The independence of the Federal Reserve System strengthens its ability to pursue long-term monetary policies.
This stems from:
the lengthy terms of the members of the Board of Governors (14 years), and,
the fact that the Fed’s revenues are derived from interest on the bonds that it holds rather than allocations from Congress.

20. The Federal Reserve Districts10
Kansas City
San
Francisco 12 9
Minneapolis 7
Chicago 1
Boston 4
Cleveland 2
New York
Philadelphia 3 5
Richmond 8
St. Louis
Washington, D.C.
(Board of Governors) 6
Atlanta 11
Dallas
The map indicates the 12 Federal Reserve districts and the city in which the district bank is located.
Each district bank monitors the commercial banks in their region and assists them with the clearing of checks.
The Board of Governors of the Federal Reserve System is located in Washington D.C.

21. 7. The Three Tools the Fed Uses to Control the Money Supply

22. The Three Tools the Fed Uses to Control the Money Supply
Reserve requirements: -- a % of a specified liability category (for example transaction accounts) that banking institutions are required to hold as reserves against that type of liability.
When the Fed lowers the required reserve ratio, it creates excess reserves and allows banks to extend additional loans, expanding the money supply.
Raising the reserve requirements has the opposite effect.

23. The Three Tools the Fed Uses to Control the Money Supply
Open Market Operations: -- the buying and selling of U.S. Government securities (national debt in the form of bonds) by the Fed.
This is the primary tool used by Fed.
When the Fed buys bonds the money supply will expand, because:
the bond buyers will acquire money, and,
bank reserves will increase, placing banks in a position to expand the money supply through the extension of additional loans.
When the Fed sells bonds the money supply will contract because:
bond buyers are giving up money in exchange for securities, and,
the reserves available to banks will decline, causing them to extend fewer loans.

24. The Three Tools the Fed Uses to Control the Money Supply
Discount Rate: -- the interest rate the Fed charges banking institutions for borrowed funds.
An increase in the discount rate is restrictive (decreases the money supply) because it discourages banks from borrowing from the Federal Reserve to extend new loans.
A reduction in the discount rate is expansionary (increases the money supply) because it makes borrowing from the Federal Reserve less costly.

25. Monetary Base and Money Supply
Currency a
($434)
Checking deposits
($642)
$434
$47
monetary base = $481
(currency + bank reserves)
a Traveler’s checks are included in this category.
The monetary base (currency plus bank reserves) provides the foundation for the money supply.
Currency in circulation contributes directly to the money supply . . .
while bank reserves provide the underpinnings for checking deposits.
Fed actions that alter the monetary base will affect the money supply:
By increasing reserve requirements, buying bonds, or increasing the discount rate, the Fed can reduce the money supply.
By decreasing reserve requirements, selling bonds, or decreasing the discount rate, the Fed can increase the money supply.

26. 8. The Difference Between the Fed and the Treasury

27. The Difference Between the Fed and the Treasury
The U.S. Treasury:
Is concerned with the finance of the federal government.
Issues bonds to the general public to finance the budget deficits of the federal government.
Does not determine the money supply.
The Federal Reserve:
Is concerned with the monetary climate for the economy.
Does not issue bonds.
Determines the money supply — primarily through its buying and selling of bonds issued by the U.S. Treasury.

28. 9. Ambiguities in the Meaning and Measurement of the Money Supply

29. Ambiguities in the Meaning and Measurement of the Money Supply
Interest earning checking deposits
Less costly to hold than currency and demand deposits.
Their introduction in the early 1980’s changed the nature of the M1 money supply.
Widespread use of the U.S. dollar outside of the United States
More than one-half and perhaps as much as two-thirds of U.S. currency is held overseas.
This reduces the reliability of the M1 money supply measure.

30. Ambiguities in the Meaning and Measurement of the Money Supply
Sweeping of various interest-earning checking accounts into Money Market Deposit Accounts
The increasing availability of low-fee stock and bond mutual funds
Debit Cards and Electronic Money
Summary:
Recent financial innovations and other structural changes have blurred the meaning of money and reduced the reliability of the various money supply measures.
In the Computer-Age, continued change in this area is likely.

31. The Changing Nature of M1
Year
1975
1980
1985
1990
1995
150
300
450
600
750
900
1050
1200
1997
Billions of Dollars
Total =
$1,076
Interest-Earning
Checkable
Deposits M1
$245
Demand Deposits
$397
Currency a
$434
As the result of deregulation during the 1980’s, interest earning checkable deposits grew rapidly and they now account for approximately one quarter of the M1 money supply.
Since the opportunity cost of holding these other checkable deposits is less than for other forms of money, the money supply today is not comparable to the money supply prior to 1980.

32. The Growth Rate of the M1 and M2 Money Supply: 1970-1998
1975
1980
1985
1990
1995
2000 15 10 5 -5
Year
Annual Percentage Change M1 M2
Here we present the annual growth rates for both the M1 and M2 money supply figures.
Since the mid-1980’s, the variability of the M1 supply has been much greater than that for M2 due greatly to the regulatory changes and innovations in financial markets that have changed the very nature of M1.

33. Questions for Thought:
1. How will the following actions affect the money supply?
  (a) A reduction in the discount rate.
(b) An increase in the reserve requirements.
(c) The purchase by the Fed of $100 million of U.S. securities from a commercial bank.
(d) The sale by the U.S. Treasury of $100 million of newly issued bonds to a commercial bank.
(e) An increase in the discount rate.
(f) The sale by the Fed of $200 million of U.S securities to a private investor.
2. How has the nature of the M1 money supply changed in recent years? How have these changes influenced the usefulness of M1 as an indicator of monetary policy?
3. Who is the current chairman of the Board of Governors of the Fed?

34. End Chapter 13