Money, Banking, and Financial Institutions

Name: Money, Banking, and Financial Institutions
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Description: Money, Banking, and Financial Institutions

Money, Banking, and Financial Institutions
McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 1

Learning objectives – After reading this chapter students should be able to: Identify and explain the functions of money and the components of the money supply. Describe what “backs” the money supply, making us willing to accept it as payment. Identify and explain the main factors that contributed to the financial crisis of Explain the basics of a bank’s balance sheet and discuss why the U.S. banking system is called a “fractional reserve” system. Explain the distinction between a bank’s actual reserves and its required reserves. . LO2

Describe how a bank can create money Describe the multiple expansion of loans and money by the entire banking system. Define the monetary multiplier, explain how to calculate it, and demonstrate its relevance Discuss how the equilibrium interest rate is determined in the market for money. List and explain the goals and tools of monetary policy. Identify the mechanisms by which monetary policy affects GDP and the price level. LO2

Functions of Money Medium of exchange: Money can be used for buying and selling goods and services. Unit of account: Prices are the U.S. are quoted in dollars and cents. Store of value: Money allows us to transfer purchasing power from present to future. It is the most liquid (spendable) of all assets, a convenient way to store wealth. LO2

Components of the Money Supply 1. Narrow definition of money: M1 includes currency and checkable deposits (see Figure 34.1a). Currency (coins + paper money) held by public. (51% of M1) a. It is “token” money, which means its intrinsic value is less than actual value. The metal in a dime is worth less than 10¢. B. All paper currency consists of Federal Reserve Notes issued by the Federal Reserve. 2. Checkable deposits are included in M1, since they can be spent almost as readily as currency and can easily be changed into currency. (49% of M1) a. Commercial banks are a main source of checkable deposits for households and businesses. LO2

b. Thrift institutions (savings & loans, credit unions, mutual savings banks) also have checkable deposits. Money Definition: M2 = M1 + some near-monies which include: (See Figure 34.1b) Savings deposits and money market deposit accounts. Small-denominated time deposits (certificates of deposit) less than $100,000. Money market mutual fund balances, which can be redeemed by phone calls, checks, or through the Internet. LO2

C. CONSIDER THIS … Are Credit Cards Money? Credit cards are not money, but their use involves short‑term loans; their convenience allows you to keep M1 balances low because you need less for daily purchases. LO2

What “backs” the money supply? A. The government’s ability to keep its value stable provides the backing. B. Money is debt; paper money is a debt of Federal Reserve Banks and checkable deposits are liabilities of banks and thrifts because depositors own them. C. Value of money arises not from its intrinsic value, but its value in exchange for goods and services. 1. It is acceptable as a medium of exchange. 2. Currency is legal tender or fiat money. 3. The relative scarcity of money compared to goods and services will allow money to retain its purchasing power. Money’s purchasing power determines its value. Higher prices mean less purchasing power. LO2

Excessive inflation may make money worthless and unacceptable. An extreme example of this was German hyperinflation after World War I, which made the mark worth less than 1 billionth of its former value within a four-year period. Worthless money leads to use of other currencies that are more stable. Worthless money may lead to barter exchange system. Maintaining the value of money The government tries to keep supply stable with appropriate fiscal policy. Monetary policy tries to keep money relatively scarce to maintain its purchasing power, while expanding enough to allow the economy to grow. LO2

The Financial Crisis of 2007 and 2008 In 2007 and 2008 the malfunctioning U.S. financial system experienced the worst financial crisis since the Great Depression which led to problems in the credits markets and spread to the rest of the economy resulting in a recession. The Mortgage Default Crisis: In 2007 there were a huge number of defaults on home mortgages in the United States, mostly subprime loans which previously the Federal government had encouraged banks to make. When banks wrote-off these loans it reduced their reserves and their ability to loan out other funds. Banks and mortgage lenders packaged hundreds or thousands of mortgages together and sold them as bonds, believing that this would protect them from defaults on the mortgages. LO2

Buyers of the mortgage-backed securities collected the mortgage payments as returns on their investment. The banks received a single up-front payment for the mortgage-backed securities. Banks lent a substantial amount of money to investment firms so that they could buy the mortgage-backed securities. The banks also bought mortgage-backed securities as investment. With the defaults the banks lost money on the loans that they still held, on the money they had loaned to investment funds for the purchase of mortgage-backed securities and on the mortgage-backed securities that they had purchased themselves LO2

Causes of the substantial number of defaults: Government programs that encouraged and subsidized home ownership for previous renters. Declining home prices. Lax standards by banks because they felt protected from defaults with the mortgage-backed securities. LO2

The Fractional Reserve System: Significance of fractional reserve banking: Banks can create money by lending more than the original reserves on hand. Lending policies must be prudent to prevent bank “panics” or “runs” by depositors worried about their funds. Also, the U.S. deposit insurance system prevents panics LO2

A Single Commercial Bank A balance sheet states the assets and claims of a bank at some point in time. All balance sheets must balance, that is, the value of assets must equal value of claims. 1. The bank owners’ claim is called net worth. 2. Non-owners’ claims are called liabilities. 3. Basic equation: Assets = liabilities + net worth. LO2

The Banking System: Multiple‑Deposit Expansion (all banks combined) The entire banking system can create an amount of money which is a multiple of the system’s excess reserves, even though each bank in the system can only lend dollar for dollar with its excess reserves. Three simplifying assumptions: 1. Required reserve ratio assumed to be 20 percent. 2. Initially banks have no excess reserves; they are “loaned up.” 3. When banks have excess reserves, they loan it all to one borrower, who writes check for entire amount to give to someone else, who deposits it at another bank. The check clears against original lender. LO2

The process will continue…
The Banking System (1) Acquired Reserves and Deposits (2) Required Reserves (3) Excess Reserves (1)-(2) (4) Amount Bank Can Lend; New Money Created = (3) Bank Bank A $ $ $ $80 Bank B $ $ $ $64 Bank C $ $ $ $51.20 Bank D $ $ $ $40.96 This table illustrates the creation of new money based on a single $100 deposit made into one bank. Each subsequent bank can lend a smaller portion of $100 after factoring in their reserve requirement, but overall total deposits in all banks will increase. The process will continue… LO4

The Banking System Bank A Bank B Bank C Bank D Bank E Bank F Bank G
(1) Acquired Reserves and Deposits (2) Required Reserves (Reserve Ratio = .2) (3) Excess Reserves (1)-(2) (4) Amount Bank Can Lend; New Money Created = (3) Bank Bank A Bank B Bank C Bank D Bank E Bank F Bank G Bank H Bank I Bank J Bank K Bank L Bank M Bank N Other Banks $100.00 80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 21.99 $20.00 16.00 12.80 10.24 8.19 6.55 5.24 4.20 3.36 2.68 2.15 1.72 1.37 1.10 4.40 $80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.59 $80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.59 This shows that, in total, the original $100 deposit will end up adding $400 in new money into the system. $400.00 LO4

The Monetary Multiplier
= 1 required reserve ratio R The money multiplier is a key measure in banking that helps to predict the money supply that will be available to drive economic growth. As you can see from the formula, if the reserve requirement is 20%, the money multiplier will be 1 divided by 0.2, which is 5. We can then use the money multiplier multiplied by the excess reserves to determine the maximum checkable-deposit creation that will be provided by the new money entering the system. LO5

System’s lending potential: Suppose a junkyard owner finds a $100 bill and deposits it in Bank A. The system’s lending begins with Bank A having $80 in excess reserves, lending this amount, and having the borrower write an $80 check which is deposited in Bank B. See further lending effects on Bank C. The possible further transactions are summarized in Table 13.2. Monetary multiplier is illustrated in Table 35.2. Formula for monetary or checkable deposit multiplier is: Monetary multiplier = 1/required reserve ratio or m = 1/R or 1/.20 in our example. LO2

Maximum deposit expansion possible is equal to: excess reserves x monetary multiplier. Figure 35.1 illustrates this process. Higher reserve ratios generate lower money multipliers. a. Changing the money multiplier changes the money creation potential. b. Changing the reserve ratio changes the money multiplier but be careful! It also changes the amount of excess reserves that are acted on by the multiplier. Cutting the reserve ratio in half will more than double the deposit creation potential of the system. The process is reversible. Loan repayment destroys money, and the money multiplier increases that destruction. LO2

The fundamental objective of monetary policy is to aid the economy in achieving full‑employment output with stable prices. 1. To do this, the Fed changes the nation’s money supply. 2. To change money supply, the Fed manipulates size of excess reserves held by banks. Monetary policy has a very powerful impact on the economy; Ben Bernanke, the head of the U.S. Federal Reserve System, and Jean-Claude Trichet, the president of the European Central Bank, are often listed as among the most powerful people in the world. LO2

The Demand for Money: Two Components A. Transactions demand, Dt, is money kept for purchases and will vary directly with GDP (Key Graph 36.1a). B. Asset demand, Da, is money kept as a store of value for later use. Asset demand varies inversely with the interest rate, since that is the price of holding idle money (Key Graph 36.1b). C. Total demand will equal quantities of money demanded for assets plus that for transactions (Key Graph 36.1c). LO2

Demand for Money + = (c) Total demand for (a) (b) money, Dm
and supply (a) Transactions demand for money, Dt (b) Asset demand for money, Da 10 7.5 5 2.5 Sm + = Rate of interest, i percent 5 The total demand for money is the sum of the transactions demand for money plus the asset demand for money. The transactions demand for money is assumed to be vertical as it depends on GDP rather than the interest rate. The asset demand for money is inversely related to the interest rate, meaning as interest rates go up, the amount of money demanded goes down. When we introduce the supply of money into the graphs, we find an equilibrium point for money. Dt Da Dm 50 100 150 200 50 100 150 200 50 100 150 200 250 300 Amount of money demanded (billions of dollars) Amount of money demanded (billions of dollars) Amount of money demanded and supplied (billions of dollars) LO1

The Equilibrium Interest Rate and Bond Prices A. Key Graph 36.1c illustrates the money market. It combines demand with supply of money. B. If the quantity demanded exceeds the quantity supplied, people sell assets like bonds to get money. This causes bond supply to rise, bond prices to fall, and a higher market rate of interest. C. If the quantity supplied exceeds the quantity demanded, people reduce money holdings by buying other assets like bonds. Bond prices rise, and lower market rates of interest result (see example in text). LO2

Tools of Monetary Policy A. Open‑market operations refer to the Fed’s buying and selling of government bonds. 1. Buying securities will increase bank reserves and the money supply (see Figure 36.2) a. If the Fed buys directly from banks, then bank reserves go up by the value of the securities sold to the Fed. See impact on balance sheets using text example. b. If the Fed buys from the general public, people receive checks from the Fed and then deposit the checks at their bank. Bank customer deposits rise and therefore bank reserves rise by the same amount. Follow text example to see the impact. i. Banks’ lending ability rises with new excess reserves. ii. Money supply rises directly with increased deposits by the public. LO2

Tools of Monetary Policy
Fed buys bonds from commercial banks Assets Liabilities and Net Worth Federal Reserve Banks + Securities + Reserves of Commercial Banks (a) Securities (b) Reserves As part of their open-market operations, the Fed will buy or sell government bonds. If they purchase the bonds from commercial banks, the commercial banks are in effect transferring part of their holding of securities to the Fed, which creates new reserves for the banks in their accounts at the Fed. By increasing the commercial banks’ reserves in the U.S., the Fed has increased their lending capacity. Commercial Banks Assets Liabilities and Net Worth Securities (a) +Reserves (b) LO2

Tools of Monetary Policy
Fed sells bonds to commercial banks Assets Liabilities and Net Worth Federal Reserve Banks - Securities - Reserves of Commercial Banks (a) Securities (b) Reserves If the Fed sells government bonds to commercial banks, the opposite effect occurs. The banks lose reserves, which will reduce their lending capacity. Commercial Banks Assets Liabilities and Net Worth + Securities (a) - Reserves (b) LO2

Open Market Operations
Fed buys $1,000 bond from a commercial bank New Reserves $5000 Bank System Lending Total Increase in the Money Supply, ($5,000) $1000 Excess Reserves When the U.S. Fed buys government bonds from commercial banks, it increases the assets of the Fed and increases the reserves of the commercial banks. This will increase the lending ability of the commercial banks in the United States. LO2

Open Market Operations
Fed buys $1,000 bond from the public Check is Deposited New Reserves $1000 Total Increase in the Money Supply, ($5000) $200 Required Reserves $800 Excess Initial Checkable Deposit $4000 Bank System Lending When the Fed buys government bonds from the public, the effect is much the same. The assets of the Fed increase, and as the public deposits the funds into a commercial bank, its reserves and lending ability will increase. LO2

When Fed buys bonds from bankers, reserves rise and excess reserves rise by same amount since no checkable deposit was created. When Fed buys from public, some of the new reserves are required reserves for the new checkable deposits. Conclusion: When the Fed buys securities, bank reserves will increase and the money supply potentially can rise by a multiple of these reserves. Note: When the Fed sells securities, points a‑e above will be reversed. Bank reserves will go down, and eventually the money supply will go down by a multiple of the banks’ decrease in reserves. LO2

How the Fed attracts buyers or sellers: i. When Fed buys, it raises demand and price of bonds, which in turn lowers effective interest rate on bonds. The higher price and lower interest rates make selling bonds to Fed attractive. ii.When Fed sells, the bond supply increases and bond prices fall, which raises the effective interest rate yield on bonds. The lower price and higher interest rates make buying bonds from Fed attractive. LO2

B. The reserve ratio is another “tool” of monetary policy. It is the fraction of reserves required relative to their customer deposits. 1. Raising the reserve ratio increases required reserves and shrinks excess reserves. Any loss of excess reserves shrinks banks’ lending ability and, therefore, the potential money supply by a multiple amount of the change in excess reserves. Lowering the reserve ratio decreases the required reserves and expands excess reserves. Gain in excess reserves increases banks’ lending ability and, therefore, the potential money supply by a multiple amount of the increase in excess reserves. LO2

Changing the reserve ratio has two effects. a. It affects the size of excess reserves. b. It changes the size of the monetary multiplier. For example, if ratio is raised from 10 percent to 20 percent, the multiplier falls from 10 to 5. Changing the reserve ratio is very powerful since it affects banks’ lending ability immediately. It could create instability, so Fed rarely changes it. LO2

C: The third “tool” is the discount rate, which is the interest rate that the Fed charges to commercial banks that borrow from the Fed. An increase in the discount rate signals that borrowing reserves is more difficult and will tend to shrink excess reserves. A decrease in the discount rate signals that borrowing reserves will be easier and will tend to expand excess reserves. LO2

For several reasons, open‑market operations give the Fed most control of the four “tools.” Open‑market operations are most important. This decision is flexible because securities can be bought or sold quickly and in great quantities. Reserves change quickly in response. The reserve ratio is rarely changed since this could destabilize bank’s lending and profit positions. Changing the discount rate has become a passive tool of monetary policy. During the financial crisis of , banks borrowed billions as the discount rate was decreased by the Fed. LO2

Monetary Policy and Equilibrium GDP
Equilibrium real GDP and the Price level (a) The market for money (b) Investment demand Rate of Interest, i (Percent) Amount of money demanded and supplied (billions of dollars) Sm1 Sm2 Sm3 Amount of investment (billions of dollars) Price Level Real GDP (billions of dollars) AS 10 8 6 P3 AD3 I=$25 P2 AD2 I=$20 Dm ID AD1 I=$15 An expansionary monetary policy that shifts the money supply curve rightward in (a) lowers the interest rate from 10% to 8% which results in the investment spending in (b) to increase from $15 to $20 billion and causes aggregate demand to increase. This shifts the aggregate demand curve rightward from AD1 to AD2 in (c) so that real output rises to the full employment level Qf along the horizontal dashed line. Conversely, a restrictive monetary policy will cause the money supply curve to shift leftward, thereby increasing the interest rate, decreasing investment and aggregate demand. $125 $150 $175 $15 $20 $25 Q1 Qf Q3 LO4

Monetary Policy and Equilibrium GDP
Equilibrium real GDP and the Price level (d) Equilibrium real GDP and the Price level Price Level Real GDP (billions of dollars) AS Price Level Real GDP (billions of dollars) AS c b P3 P3 a AD3 I=$25 AD3 I=$25 P2 P2 AD4 I=$22.5 AD2 I=$20 AD2 I=$20 AD1 I=$15 AD1 I=$15 In (d), the economy at point a has an inflationary output gap because it is producing above potential output. Q1 Qf Q3 Q1 Qf Q3 LO4

Expansionary Monetary Policy
Problem: Unemployment and Recession CAUSE-EFFECT CHAIN Fed buys bonds, lowers reserve ratio, lowers the discount rate, or increases reserve auctions Excess reserves increase Federal funds rate falls Money supply rises This chain illustrates the causes and effects of expansionary monetary policy. When faced with the problems of unemployment and recession, the Fed takes actions to increase the money supply, which should eventually lead to real GDP rising. Unfortunately, it is not an immediate reaction so the Fed may overshoot the mark, which can lead to inflation. Interest rate falls Investment spending increases Aggregate demand increases Real GDP rises LO4

Restrictive Monetary Policy
Problem: Inflation CAUSE-EFFECT CHAIN Fed sells bonds, increases reserve ratio, increases the discount rate, or decreases reserve auctions Excess reserves decrease Federal funds rate rises Money supply falls In times of inflation, the Fed practices restrictive monetary policy and decreases the supply of money, which should lead to a decrease in the inflation rate. However, because prices tend to be inflexible, if the Fed is not careful, their actions can lead to a recession. Interest rate rises Investment spending decreases Aggregate demand decreases Inflation declines LO4

Targeting the Federal Funds Rate The Federal funds rate is the interest rate that banks charge each other for overnight loans. Banks lend to each other from their excess reserves, but because the Fed is the only supplier of Federal funds (the currency used as reserves), it can set the Federal funds rate and then use open-market operations to make sure that rate is achieved. 1. The Fed will increase the availability of reserves if it wants the Federal funds rate to fall (or keep it from rising). 2. Reserves will be withdrawn if the Fed wants to raise the Federal funds rate (or keep it from falling). LO2

Targeting the Federal Funds Rate The Fed may use an expansionary monetary policy if the economy is experiencing a recession and rising rates of unemployment. Restrictive monetary policy is used to combat rising inflation. 1. The initial step is for the Fed to announce a higher target for the Federal funds rate, followed by the selling of bonds to soak up reserves. Raising the reserve ratio and/or discount rate is also an option. 2. Reducing reserves will produce results opposite of what we saw for an expansionary monetary policy. LO2

a. The reduced supply of Federal funds will raise the Federal funds rate to the new target. b. Multiple contraction of the money supply, through the money multiplier process (Chapter 35). 3. Restrictive monetary policy results in higher interest rates, including the prime rate. LO2

Money, Banking, and Financial Institutions

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Money, Banking, and Financial Institutions

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