MONEY, THE BANKING SYSTEM

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Lecture 9

• MONEY, THE BANKING SYSTEM THE FEDERAL RESERVE

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MONEY

• Anything that is regularly used in economic
  transactions or exchanges.

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THREE PROPERTIES OF MONEY

• 1. Money serves as a medium of exchange
• 2. Money serves as a unit of account
• 3. Money serves as a store of value

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MEDIUM OF EXCHANGE

• Money is accepted in economic exchanges
• Alternative to barter -- trading goods directly
  for goods
• For economic exchanges to occur using barter,
  double coincidence of wants must exist
• -- unless you want to trade something another
  person wants, and you want what the other person
  has to trade, this economic exchange could not
  occur

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UNIT OF ACCOUNT

• Money provides a convenient measuring rod when
  prices for all goods are quoted in terms of money
• It makes it easier to conduct economic
  transactions since there is a standard unit in
  which to do so

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STORE OF VALUE

• During a period of time, the value of money
  should not change
• Money is a somewhat imperfect store of value,
  thanks to inflation

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LIQUIDITY - 1

• Refers to the ease with which an asset can be
  converted into the economy's medium of exchange.
• Since money IS the economy's medium of exchange,
  it must be the most liquid store of value in the
  economy.

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LIQUIDITY - 2

• Other ways to store value include buying stocks,
  bonds, mutual funds, gold, silver, or owning a
  house or other valuable property. Since it takes
  some time and effort to convert these assets into
  money, they are all LESS liquid than money.

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HISTORY OF MONEY

• Throughout history, money can be divided into two
  general categories
• commodity money
• fiat money

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COMMODITY MONEY

• Commodity money is money that takes the form of a
  commodity with intrinsic value. Commodity money
  has value, in and of itself, beyond its value as
  the medium of exchange and the unit of account.
  The classic example of commodity money is gold
  and silver coins - you could always melt the
  coins down and the gold and silver would have its
  OWN value.

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FIAT MONEY

• Fiat money is money without intrinsic value that
  is used as money because of government decree.
• The US is an example of fiat money because the
  paper the is printed on has NO value outside of
  being the medium of exchange and the unit of
  account.
• Before moving from money to central banking,
  well first consider what the size of the US
  money stock is and how it is measured.

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MONEY STOCK

• The money stock is the quantity of money
  circulating in the economy Q Suppose you want
  to know the size of the US money stock. What
  should you count as money?
• A Currency and demand deposits, and a few other
  items (detailed in the following slides) but NOT
  credit cards.

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WHAT COUNTS AS MONEY

• Currency the paper bills and coins in the hands
  of the public.
• Demand deposits balances in bank accounts that
  depositors can access on demand by writing a
  check (or by using a debit card)
• Q How is the US money stock measured and
  reported?
• A Your textbook gives the two most important
  measures - M1 and M2

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COMPONENTS OF M1

• Currency held by the public 372 billion
• Demand deposits 389 billion
• Other checkable deposits 353 billion
• Travelers checks 9 billion
• Total of M1 1,123 billion
• Source Economic Report of the President,
  Washington, DC U.S. Government Printing Office,
  1996
• Approximately two-thirds of M1 consists of
  checking account balances
• Approximately one-third consists of currency

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COMPONENTS OF M1

• Currency held by public
• -- All currency held outside of bank vaults
• Demand deposits
• -- Deposits in checking accounts
• Other checkable deposits
• -- Introduced in the early 1980s to describe
  checking accounts that paid interest
• Travelers checks
• -- included in M1 since they are regularly
  used in economic exchanges

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CURRENCY IN THE ECONOMY

• 372 billion of currency amounts to over
  1,430 for every man, woman and child in the U.S.
  
• Most of the currency in the official
  statistics is not used in ordinary commerce in
  the U.S.
• Much is held abroad by wealthy people
• Some circulates in other countries along with
  local currencies
• Currency is also used in illegal transactions

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M2

• Broader definition of money
• Includes assets that are sometimes used in
  economic exchanges or can be readily turned into
  M1
• Consists of all assets in M1 plus other assets
  such as deposits in money market mutual funds
• These are funds in which individuals can invest,
  earn interest, and in some cases can be used to
  write checks
• Deposits in savings accounts are also included in
  M2.
• M2 for 1996 was 3,657.4 billion. Dividing M1 by
  M2 shows that M1 was 29.4 of M2 during 1996.

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WHY ARE THERE DIFFERENT MEASURES OF THE MONEY
STOCK?

• Because the assets that comprise M1 and M2 have
  varying degrees of liquidity. Notice that the
  assets included in M1 are very liquid, while the
  assets that are included in M2 are LESS liquid.
  You can think of M1 as the most liquid measure of
  the money stock, while M2 is a less liquid
  measure.

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BANKS AND THE MONEY SUPPLY - 1

• Q How do banks operate?
• A Banks accept money from people and keep that
  money safe until the depositor makes a withdrawal
  or writes a check on their account.

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BANKS AND THE MONEY SUPPLY - 2

• Q Do banks keep all of our money in their vault?
• A No. The US banking system is called fractional
  reserve banking. Bankers understand that it is
  not necessary to keep 100 of a depositors money
  on hand at all times. As a result, bankers take
  some of our money and loan it out to other
  people.

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FRACTIONAL RESERVE BANKING

• Fractional Reserve Banking is a banking system in
  which banks hold only a fraction of deposits as
  reserves
• The reserve ratio is the fraction of deposits
  that banks hold as reserves. Minimum reserve
  ratios are set by the Fed.

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BANKS AS FINANCIAL INTERMEDIARIES

• Help bring savers and investors together.
• By using expertise and powers of diversification,
  financial intermediaries reduce risk to savers
  and allow investors to obtain funds on better
  terms.
• A typical commercial bank accepts funds from
  savers in the form of deposits.
• The bank then turns the money around and makes
  loans to businesses.

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BALANCE SHEET

• Has two sides -- assets and liabilities
• Liabilities are the source of funds for the bank
• -- Your deposits to a current account are an
  example of liabilities
• Assets are the uses of the funds
• -- Loans are an example of a banks assets
• The difference between assets and liabilities is
  call its net worth
• Net Worth Assets - Liabilities

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RESERVES

• Assets which are not lent out
• Banks used to be required by law to hold a
  fraction of their deposits as reserves and not
  make loans with this fraction of deposits. It
  was called required reserves
• Banks often chose to hold additional reserves
  beyond what was required these were called
  excess reserves
• A banks reserves are the sum of its required and
  excess reserves
• Reserves can either be cash kept in a banks
  vaults or deposits with the Federal Reserve.
• Banks do not earn any interest on these reserves

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THE PROCESS OF MONEY CREATION

• AN EXAMPLE
• A bank has deposits of 1,000
• Banks are required to keep 10 of deposits as
  reserves and hold no excess reserves
• The reserve ratio, in this case, is 0.1
• The bank in this example will keep 100 in
  reserves and make loans totaling 900

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THE PROCESS OF DEPOSIT CREATION CHANGES IN
BALANCE SHEETS
First Bank of Hollywood Assets Liabilities 100
reserves 1,000 deposit 900 loans
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THE PROCESS OF DEPOSIT CREATION CHANGES IN
BALANCE SHEETS
First Bank of Hollywood Assets Liabilities 100
reserves 1,000 deposit 900 loans
Second Bank of Burbank Assets Liabilities 90
reserves 900 deposit 810 loans
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THE PROCESS OF DEPOSIT CREATION CHANGES IN
BALANCE SHEETS
First Bank of Hollywood Assets Liabilities 100
reserves 1,000 deposit 900 loans
Second Bank of Burbank Assets Liabilities 90
reserves 900 deposit 810 loans
Third Bank of Venice Assets Liabilities 81
reserves 810 deposit 729 loans
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THE PROCESS OF DEPOSIT CREATION CHANGES IN
BALANCE SHEETS
First Bank of Hollywood Assets Liabilities 100
reserves 1,000 deposit 900 loans
Second Bank of Burbank Assets Liabilities 90
reserves 900 deposit 810 loans
Third Bank of Venice Assets Liabilities 81
reserves 810 deposit 729 loans
Fourth Bank of Pasadena
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THE PROCESS OF DEPOSIT CREATION CHANGES IN
BALANCE SHEETS
First Bank of Hollywood Assets Liabilities 100
reserves 1,000 deposit 900 loans
Second Bank of Burbank Assets Liabilities 90
reserves 900 deposit 810 loans
Third Bank of Venice Assets Liabilities 81
reserves 810 deposit 729 loans
Fourth Bank of Pasadena Fifth bank of Compton
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MONEY MULTIPLIER - 1

• It tells what the total increase in checking
  account deposits would be for any initial cash
  deposit
• 1 / reserve ratio
• In the banking system, an initial cash deposit
  triggers additional rounds of deposits and
  lending by banks
• This leads to a multiple expansion of deposits
• The money creation process and the money
  multiplier also works in reverse

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MONEY MULTIPLIER - 2

• In our example, the original deposit created
  1,000 in reserves at the bank. The money
  multiplier is equal to 10 (1/0.1). Therefore, the
  original 1,000 deposit will eventually turn into
  10,000 of deposits.

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MONEY MULTIPLIER - 3

• The change in the money supply, M1, will be the
  change in deposits plus the change in currency
  held by the public
• In example, the money supply, M1, increased by
  9,000 ( 10,000 - 1,000

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MONEY MULTIPLIER

• As of 1995, in the United States, were required
  to hold 10 on all checkable deposits exceeding
  54 million
• Since large banks would face a 10 reserve
  requirement on any new deposits, a money
  multiplier of 10 would be expected
• The money multiplier in the United States is
  actually between 2 and 3, however
• This reduced multiplier is because people hold
  part of their loans in cash, the funds are not
  available for the banking system to lend out
• The money multiplier would also be less if banks
  held excess reserves

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FED TOOLS FOR CONTROLLING THE MONEY SUPPLY

• The Fed has 3 main tools for controlling the size
  of the money supply
• Open Market Operations
• Reserve Requirements
• The Discount Rate

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OPEN MARKET OPERATIONS - 1

• The Fed can buy or sell government bonds to
  increase or decrease the money supply.
• When the Fed BUYS bonds, the money supply is
  INCREASED.
• Here is why The Fed pays for the bonds it buys
  with money that was not currently a part of the
  money supply - hence, when the Fed buys bonds it
  simply increases the total amount of money in
  circulation.

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OPEN MARKET OPERATIONS - 2

• When the Fed SELLS bonds, the money supply is
  DECREASED.
• Here is why The Fed sells bonds in the market
  and receives cash in return for the bonds it
  sells. Once the Fed receives the cash, this cash
  is taken OUT of circulation - therefore, the size
  of the money supply is decreased.

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RESERVE REQUIREMENTS

• By controlling reserve ratios that banks must
  keep, the Fed also controls the amount of money
  that banks can lend out.
• In the previous slide, we showed how bank lending
  increases the money supply. However, when the Fed
  increases reserve ratios, they reduce the amount
  of money banks can lend and also reduce the size
  of the money supply.
• When the Fed lowers reserve ratios, they increase
  the amount of money banks can lend out and also
  increase the size of the money supply.

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THE DISCOUNT RATE - 1

• Another function of the Fed is to loan money to
  banks in the economy. Banks may need these loans
  for several reasons
• Emergency borrowing is one reason - banks that
  are in trouble have the Fed as the lender of last
  resort - this Fed function serves to calm
  depositors at troubled banks.
• Another reason banks borrow from the Fed is to
  meet reserve requirements. In the course of
  business, banks may make too many loans, or have
  unusually large withdrawals by their depositors.

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THE DISCOUNT RATE - 2

• The result of either (or both) of these
  situations is that the bank will NOT have met its
  reserve requirements.
• Regardless of the reason prompting a bank to
  borrow from the Fed, the loan from the Fed to the
  bank increases the bank's reserves. As we now
  know, the new reserves allow the banking system
  to generate more money.

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THE DISCOUNT RATE - 3

• The discount rate is a tool for controlling the
  money supply because it represents the cost to
  banks of borrowing from the Fed (banks pay
  interest to the Fed on the loan). A higher
  discount rate will discourage banks from
  borrowing reserves from the Fed. A lower discount
  rate encourages borrowing.

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THE STRUCTURE OF THE FEDERAL RESERVE

• Created in 1913 following a series of financial
  panics
• Congress created the Federal Reserve System to be
  a bankers bank or central bank
• As a lender of last resort, the Federal Reserve
  would be there to lend funds to banks, reducing
  some of the adverse consequences of a panic

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THE STRUCTURE OF THE FEDERAL RESERVE

• There are three distinct subgroups
• Federal Reserve Banks
• The Board of Governors
• The Federal Open Market Committee

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FEDERAL RESERVE BANKS

• The United States is divided into 12 Federal
  Reserve districts, each of which has a Federal
  Reserve Bank
• Provide advice on monetary policy
• Take part in decision making on monetary policy
• Provide liaison between the Fed and the banks in
  their district

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THE FEDERAL RESERVE BANKS OF THE
CONTINENTAL UNITED STATES
Minneapolis
Boston
New York
Chicago
San Francisco
Cleveland
Kansas City
Philadelphia
Richmond
St. Louis
Atlanta
Dallas
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THE BOARD OF GOVERNORS

• The true seat of power over the monetary system
• Headquartered in Washington, DC
• Seven members of the board are appointed for
  staggered 14-year terms by the President and must
  be confirmed by the Senate
• The Chairman of the Board of Governors, the
  principal spokesman for monetary policy in the
  country, serves a four-year term as chairman

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FEDERAL OPEN MARKET COMMITTEE ( FOMC )

• Decisions on monetary policy made by the FOMC
• A 12-person board consisting of seven members of
  the Board of Governors, the president of the New
  York Federal Reserve, plus presidents of four
  other regional Federal Reserve Banks
• Presidents of the regional banks other than New
  York serve on a rotating basis
• Seven non-voting bank presidents attend meetings
  and provide their views
• The chairman of the Board of Governors also
  serves as chairman of the FOMC
• The FOMC makes the actual decisions on changes in
  the money supply

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THE STRUCTURE OF THE FEDERAL RESERVE
CHAIR
Federal Reserve Banks
Board of Governors 7 members
12 presidents
Federal Open Market Committee ( FOMC ) Board of
Governors plus 5 bank presidents
Decisions about monetary policy
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INDEPENDENCE OF THE FEDERAL RESERVE

• The chairman of the Federal Reserve is required
  to report to Congress on a regular basis
• Although the Federal Reserve operates with
  independence, it is a creation of Congress
• The U.S. Constitution gives Congress the power to
  coin money and regulate the value thereof
• In practice, the Fed takes its actions first and
  reports to Congress after the fact