1. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Money and Banks Chapter 13

2. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Introduction n This chapter answers the following questions: l What is money? l How is money created? l What role do banks play in the circular flow of income and spending?

3. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin What Is Money? n Without money, you would have to use barter to get items you want. n Barter is the direct exchange of one good for another, without the use of money.

4. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin What Is Money? n The use of money in market transactions depends on sellers’ willingness to accept money as a medium of exchange.

5. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin What Is Money? n Without money, the process of acquiring goods and services would be more difficult and time-consuming.

6. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Money Supply n Anything that serves all of the following purposes can be thought of as money: l Medium of exchange l Store of value l Standard of value

7. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Purposes of Money n Medium of exchange – Is accepted as payment for goods and services (and debts).

8. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Purposes of Money n Store of value – Can be held for future purchases. Standard of value n Standard of value – Serves as a measurement for the prices of goods and services.

9. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Many Types of “Money” n After the colonies became an independent nation, the U.S. Constitution prohibited the federal government from issuing paper money. n Money was instead issued by state chartered banks.

10. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Many Types of “Money” n Between 1789 and 1863, paper bills were issued by state banks. l Over 30,000 different paper bills were issued by 1600 banks in 34 states.

11. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Many Types of “Money” n People preferred to be paid in gold, silver, or other commodities rather than the uncertain paper currency.

12. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Many Types of “Money” n The first paper money issued by the federal government was called “greenbacks” and was printed in 1861 to finance the Civil War.

13. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Many Types of “Money” n The National Banking Act of 1863 gave the federal government permanent authority to issue money.

14. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Modern Concepts n Money is anything generally accepted as a medium of exchange. n The “greenbacks” we carry around today are not the only form of “money” we use.

15. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Modern Concepts n Checking accounts can and do perform the same market functions as cash. n They must be included into our concept of money.

16. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Modern Concepts n Credit cards are another popular medium of exchange but are not money. n They are only a payment service with no store of value in and of themselves.

17. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Diversity of Bank Accounts n There are many forms of “bank” accounts. n Some bank accounts are better substitutes for cash than others.

18. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin M1: Cash and Transactions Accounts n Money supply (M1): - Currency held by the public, plus balances in transactions accounts. n M1 includes currency in circulation, transaction-account balances, and traveler’s checks.

19. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin M1: Cash and Transactions Accounts n A transactions account is a bank account that permits direct payment to a third party, for example, with a check. n Transaction-account balances are the largest component of the money supply.

20. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin M1: Cash and Transactions Accounts n The distinguishing feature of transaction accounts is that they permit direct payment to a third party (by check or debit card).

21. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin M2: M1 + Savings Accounts, etc. n M2 money supply – M1 plus balances in most savings accounts and money market mutual funds. n Savings-account balances are almost as good a substitute for cash as transaction- account balances.

22. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin M2: M1 + Savings Accounts, etc. n How much money is available affects consumers’ ability to purchase goods and, services – aggregate demand. l Aggregate demand is the total quantity of output demanded at alternative price levels in a given time period, ceteris paribus.

23. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin M2: M1 + Savings Accounts, etc. n The official measures of the money supply (particularly M1 and M2) are fairly reliable benchmarks for gauging how much purchasing power market participants have.

24. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Composition of the Money Supply Currency in circulation ($569 billion) Transactions-account balances ($612 billion) Savings account balances ($3167 billion) Money market mutual funds and deposits ( $1027 billion) Traveler’s checks ($8 billion) M2 ($5383 billion) M1 ($1189 billion)

25. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Creation of Money n The deposit of funds into a bank does not change the size of the money supply. n It changes the composition of the money supply (transfers from cash to transaction deposits).

26. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Deposit Creation n When a bank lends someone money, it simply credits that individual’s bank account.

27. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Deposit Creation n Deposit creation is the creation of transactions deposits by bank lending. n When a bank makes a loan, it effectively creates money because transactions- account balances are counted as part of the money supply.

28. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Deposit Creation n There are two basic principles of the money supply: l Transactions-account balances are a large portion of our money supply. l Banks can create transactions-account balances by making loans.

29. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Bank Regulation n The deposit-creation activities of banks are regulated by the government. n The Federal Reserve System limits the amount of bank lending, thereby controlling the basic money supply.

30. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin A Monopoly Bank n Assume a student deposits $100 from their piggy bank into the monopoly band and receives a new checking account.

31. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin A Monopoly Bank n When someone deposits cash or coins in a bank, they are changing the composition of the money supply, not its size.

32. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Initial Loan n The monopoly bank loans $100 to the Campus Radio station and issues a checking account. n This loan is accomplished by a simple bookkeeping entry.

33. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Initial Loan n Total bank reserves have remained unchanged. n Bank reserves are assets held by a bank to fulfill its deposit obligations.

34. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Initial Loan n Money has been created because the checking account is considered to be money.

35. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Secondary Deposits n In a one bank system, when Campus Radio uses the loan, the money supply does not contract, rather ownership of deposits change.

36. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Fractional Reserves n Bank reserves are only a fraction of total transaction deposits. n The reserve ratio is the ratio of a bank's reserves to its total deposits.

37. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Fractional Reserves n The Federal Reserve System requires banks to maintain some minimum reserve ratio.

38. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The T-account of the Bank n The books of a bank must always balance, because all of the assets of the bank must belong to someone (its depositors or its owners).

39. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Money Creation AssetsLiabilities University Bank +$100.00 in coins +$100.00 in deposits Money Supply Cash held by the public–$100 Transactions deposits at bank+$100 Change in M0

40. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Money Creation AssetsLiabilities University Bank +$100.00 in coins +$100 in loans +$100.00 in your account +$100.00 in borrower’s account Cash held by the public no change Transactions deposits at bank+$100 Change in M+$100 Money Supply

41. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Required Reserves n Required reserves are the minimum amount of reserves a bank is required to hold by government regulation; Equal to required reserve ratio times transactions deposits. Required reserves = minimum reserve ratio X total deposits

42. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Required Reserves n The minimum reserve requirement directly limits deposit-creation possibilities.

43. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin A Multibank World n In reality, there is more than one bank. n The ability of banks to make loans depends on access to excess reserves.

44. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin A Multibank World n Example: If a bank is required to hold $20 in reserves but has $100 currently, it can lend out the $80 excess.

45. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Excess Reserves n Excess reserves are bank reserves in excess of required reserves. Excess reserves = Total reserves – Required reserves

46. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Excess Reserves n So long as a bank has excess reserves, it can make loans. n Excess reserves are reserves a bank is not required to hold.

47. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Changes in the Money Supply n The creation of transaction deposits via new loans is the same thing as creating money.

48. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin More Deposit Creation n As the excess reserves are loaned out again, more deposits are created and thus more money is created.

49. Deposit Creation AssetsLiabilities University Bank Required Reserves$20 Excess Reserves$80 Your account $100 Total Assets $100 Total Liabilities $100 AssetsLiabilities Eternal Savings Total AssetsTotal Liabilities © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

50. Deposit Creation AssetsLiabilities University Bank Required Reserves$36 Excess Reserves$64 Loans$80 Your account $100 Campus Radio account$ 80 Total Assets $180 Total Liabilities $180 AssetsLiabilities Eternal Savings Total AssetsTotal Liabilities © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

51. Deposit Creation AssetsLiabilities University Bank Required Reserves$20 Excess Reserves$ 0 Loans$80 Your account $100 Campus Radio account$ 0 Total Assets $100 Total Liabilities $100 AssetsLiabilities Eternal Savings Required Reserves$16 Required Reserves$64 Atlas Antenna account $80 Total Assets $80 Total Liabilities $90 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

52. Deposit Creation AssetsLiabilities University Bank Required Reserves$20 Excess Reserves$ 0 Loans$80 Your account $100 Campus Radio account$ 0 Total Assets $100 Total Liabilities $100 AssetsLiabilities Eternal Savings Required Reserves$29 Required Reserves$51 Loans$64 Atlas Antenna account$80 Herman’s Hardware account$64 Total Assets $144 Total Liabilities $144 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

53. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Money Multiplier n In a multi-bank system, deposits created by one bank invariably end up as reserves in another bank.

54. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Money Multiplier n This process can theoretically continue until all banks have zero excess reserves (no more loans can be made).

55. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Money Multiplier n This is known as the money-multiplier process.

56. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Money Multiplier n The money multiplier is the number of deposit (loan) dollars that the banking system can create from $1 of excess reserves.

57. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Money Multiplier n When a new deposit enters the banking system, it creates both excess and required reserves.

58. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Money Multiplier n The required reserves represent leakage from the flow of money, since they cannot be used to create new loans.

59. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Money Multiplier n Excess reserve can be used for new loans. n Once those loans are made, they typically become transactions deposits elsewhere in the banking system.

60. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Money Multiplier n Some additional leakage into required reserves occurs, and further loans are made.

61. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Money Multiplier n The entire banking system can increase the volume of loans by the amount of excess reserves multiplied by the money multiplier.

62. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Money Multiplier n The money supply can be increased through the process of deposit creation to this limit: Potential deposit creation = Excess reserves of banking system X Money multiplier

63. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Money Multiplier Process Required reserves Excess reserves Leakage into The public

64. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Excess Reserves as Lending Power n Each bank may lend an amount equal to its excess reserves and no more.

65. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Excess Reserves as Lending Power n The entire banking system can increase the volume of loans by the amount of excess reserves multiplied by the money multiplier.

66. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Money Multiplier at Work

67. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Banks and the Circular Flow n Banks perform two essential functions for the macro economy: l Banks transfer money from savers to spenders by lending funds (reserves) held on deposit. l The banking system creates additional money by making loans in excess of total reserves.

68. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Banks and the Circular Flow n Market participants respond to changes in the money supply by altering their spending behavior (shifting the aggregate demand curve).

69. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Banks in the Circular Flow Loans Factor markets Product markets Business firms Consumers BANKS Saving Investment expenditures Sales receipts Wages, dividends, etc. Income Domestic consumption

70. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Financing Injections n The consumer saving is a leakage.

71. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Financing Injections n A recessionary gap will emerge, creating unemployment if additional spending by business firms, foreigners, or governments does not compensate for consumer saving at full employment.

72. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Financing Injections n A substantial portion of consumer saving is deposited in banks. n These and other bank deposits can be used to make loans, thereby returning purchasing power to the circular flow.

73. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Financing Injections n The banking system can create any desired level of money supply if allowed to expand or reduce loan activity at will.

74. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Constraints on Deposit Creation n There are three major constraints on deposit creation: l Deposits – Consumers must be willing to use and accept checks rather than cash. l Borrowers – Consumers must be willing to borrow the money that banks provide. l Regulation – The Federal Reserve sets the ceiling on deposit creation.

75. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin When Banks Fail n Because of the fractional reserve system, no bank can pay off its customers if they all sought to withdraw their deposits at one time.

76. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Bank Panics n Occasional “runs” of depositors rushing to withdraw their funds have created panics in the past. n As word spread, it became a self-fulfilling confirmation of a bank’s insolvency.

77. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Bank Panics n The resulting bank closing wiped out customer deposits, curtailed bank lending, and often pushed the economy into recession.

78. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Bank Panics n As their reserves dwindled, the ability of banks to create money evaporated and a chunk of money (bank deposits and loans) just disappeared.

79. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Bank Panics n In the early part of the Great Depression (1930-1933), 9000 banks failed.

80. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Deposit Insurance n In 1933-34, the FDIC and FSLIC were created by Congress to ensure depositors that their money would be safe -- thus eliminating the motivation for deposit runs.

81. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The S & L Crisis n The economic conditions in the 1970s saw many S&Ls stuck earning money on low- interest, long-term loans (mortgages etc.) while having to pay out short-term high- interest fees to their customers.

82. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The S & L Crisis n Competition from new financial institutions (e.g. money-market mutual funds) enticed deposits away from S&Ls. n Consequently, many S&Ls failed.

83. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Bank Bailouts n S&L failures cost the federal government billions – over $60 billion in 1992 alone – as the FSLIC and FDIC paid off depositors.

84. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Bank Bailouts n The Resolution Trust Corporation was created in 1989 to manage the outstanding loans of banks the federal government had to bail out. n Parts of the bailout funds were recouped from this effort.

85. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Money and Banks End of Chapter 13