The Banking System and the Money Supply

1
The Banking System and the Money Supply

• What is money?
• How is it measured?
• How is money created or destroyed in the economy?
• Need to understand this before we study how
  changes in money supply and demand affect the
  economy.

2
What Counts as Money

• Money has several useful functions
• Provides a unit of account
• Serves as store of value
• Means of payment
• Money is an asset that is widely accepted as a
  means of payment
• Credit card is accepted for payment, but not an
  asset
• Stocks and bonds, gold bars are assets but not
  accepted as payment

3
Measuring the Money Supply

• Money Supply
• Total amount of money held by the public
• Several ways measure money supply
• Assets that are widely accepted for payment and
  are relatively liquid
• A liquid asset can be converted to cash quickly
  and at little cost
• An illiquid asset can be converted to cash only
  after a delay, or at considerable cost

4
Assets and Their Liquidity

• Most liquid asset is cash in the hands of the
  public
• Then asset categories of about equal liquidity
• Demand deposits
• Checking accounts held by households and firms in
  banks
• Other checkable deposits
• Similar to demand deposits (e.g. automatic
  transfers from savings accounts)
• Travelers checks
• Savings-type accounts
• Less liquid than checking-type accounts, since
  you cannot write checks
• Deposits in money market mutual funds
• Time deposits (sometimes called certificates of
  deposit, or CDs)
• Require you to keep your money in the bank for a
  specified period of time (usually six months or
  longer)

5
M1 And M2

• Standard measure of money stock is M1
• Sum of the first four assets in our list
• M1 cash in the hands of the public demand
  deposits other checking account deposits
  travelers checks
• When economists or government officials speak
  about money supply, they usually mean M1
• Another measure of money supply, M2, adds some
  other assets to M1
• M2 M1 savings-type accounts Money Market
  Mutual Funds balances small denomination time
  deposits
• Other official measures of money supply besides
  M1 and M2 that add in assets that are less liquid
  than those in M2
• M1 and M2 are the most popular, and most commonly
  used, definitions

6
M1 and M2
7
Components of M1 Sept 2009
8
M1 And M2

• M1 and M2 exclude many things that used as a
  means of payment (such as credit cards)
• Technological advancesnow and in the futurewill
  continue trend toward new and more varied ways to
  make payments (such as electronic cash)
• We will assume money supply consists of just two
  components
• Cash in the hands of the public and demand
  deposits
• Our definition of the money supply corresponds
  closely to liquid assets that our national
  monetary authoritythe Federal Reservecan control

9
The Banking System Financial Intermediaries

• What are financial intermediaries?
• Firms that specialize in
• Assembling loanable funds from households and
  firms whose revenues exceed their expenditures
• Channeling those funds to households and firms
  (and sometimes the government) whose expenditures
  exceed revenues
• An intermediary combines a large number of small
  savers funds into custom-designed packages
• Then lends them to larger borrowers
• Charge a higher interest rate on funds they lend
  than rate they pay to depositors to earn profit

10
The Banking System

• Why do lenders (households) need their loans
  intermediated?
• Intermediaries reduce risk for depositors
  (lenders) by spreading their money among several
  borrowers.
• Lenders earn higher rates at lower risk than if
  they individually bargained with borrowers.

11
The Banking System Financial Intermediaries

• There are four types of depository institutions
• Savings and Loan associations
• Mutual savings banks
• Credit unions
• The above three types of institutions take money
  from depositors and make mainly mortgage or
  consumer loans.
• Commercial banks (make mortgage, business,
  consumer loans).

12
Commercial Banks

• A commercial bank (or just bank for short) is a
  private corporation that provides services to the
  public
• Owned by its stockholders
• For our purposes, most important service is to
  provide checking accounts
• Enables banks customers to pay bills and make
  purchases without holding large amounts of cash
  that could be lost or stolen
• Banks provide checking account services in order
  to earn a profit from lending out that money as
  well as checking account fees

13
A Banks Balance Sheet

• A balance sheet is a list that provides
  information about financial condition of a bank
  at a particular point
• In one column, banks assets are listed
• On the other side, the banks liabilities are
  listed
• What are the assets of a bank?
• Bonds- A promise to pay back borrowed funds,
  issued by a corporation or government agency
• Loans- An agreement to pay back borrowed funds,
  signed by a household or non corporate business
• Cash in the Vault
• Account with the Federal Reserve
• What are these and why does the bank hold them?

14
A Banks Balance Sheet

• Vault cash and accounts with Federal Reserve
• On any given day, some of the banks customers
  might want to withdraw more cash than other
  customers are depositing
• Banks are required by law to hold reserves
• Sum of cash in vault and accounts with Federal
  Reserve
• Required reserve ratio tells banks the fraction
  of their checking accounts that they must hold as
  required reserves
• Set by Federal Reserve

15
A Banks Balance Sheet

• Liabilities
• Demand Deposits
• Net Worth Total assets Total liabilities
• Include net worth on liabilities side of balance
  sheet because it is, in a sense, what bank would
  owe to its owners if it went out of business
• A balance sheet always balances!! On the left
  hand side are assets and on the right are
  liabilities Net Worth.

16
A Banks Balance Sheet

• Assets (million)
• Property and buildings 5
• Government Corporate Bonds 25
• Loans 65
• Cash in Vault 2
• Accounts with Federal Reserve 8
• Total 105

• Liabilities (million)
• Demand Deposits 100
• Net Worth 5
• Total Liabilities and Net Worth 105

17
The Federal Reserve System

• Every large nation controls its money supply with
  a central bank
• A nations principal monetary authority
• Most developed countries established central
  banks long ago
• Englands central bankBank of Englandwas
  created in 1694
• France established Banque de France in 1800
• United States established Federal Reserve System
  in 1913

18
The Federal Reserve System

• An interesting feature of Federal Reserve System
  is its peculiar status within government
• Strictly speaking, it is not even a part of any
  branch of government
• Both President and Congress exert some influence
  on Fed through their appointments of key
  officials

19
The Federal Open Market Committee

• Federal Open Market Committee (FOMC)
• A committee of Federal Reserve officials that
  establishes U.S. monetary policy
• Most economists regard FOMC as most important
  part of Fed
• Not even President of United States knows details
  behind the decisions, or what FOMC actually
  discussed at its meeting, until summary of
  meeting is finally released
• Committee exerts control over nations money
  supply by buying and selling bonds in public
  (open) bond market

20
The Functions of the Federal Reserve

• Federal Reserve, as overseer of the nations
  monetary system, has a variety of important
  responsibilities including
• Supervising and regulating banks
• Acting as a bank for banks
• Issuing paper currency
• Check clearing
• Controlling money supply

21
The Fed and the Money Supply

• How does the Fed change the money supply?
• It buys or sells government bonds to bond
  dealers, banks, or other financial institutions
• Actions are called open market operations
• Two assumptions to simplify our analysis of open
  market operations
• Households and business are satisfied holding the
  amount of cash they are currently holding
• Any additional funds they might acquire are
  deposited in their checking accounts
• Any decrease in their funds comes from their
  checking accounts
• Banks never hold reserves in excess of those
  legally required by law

22
How the Fed Increases the Money Supply

• To increase money supply, the Fed will buy
  government bonds
• Called an open market purchase
• Suppose Fed buys 1,000 bond from Lehman Brothers
• Gives Lehman Brothers 1000
• Lehman Brothers deposits this in its checking
  account in Bank A
• Fed has injected reserves into the system and two
  important things have happened
• Money supply has increased
• Demand deposits (part of money supply) have
  increased by 1,000
• Bank A now has excess reserves (reserves in
  excess of required reserves)
• If required reserve ratio is 10 bank has excess
  reserves of 900 to lend

23
How the Fed Increases Money Supply

• The bank (Bank A) will issue a check to the
  borrower for 900 who will deposit it in her bank
  (Bank B). Money supply increases by 900.
• Increase in money supply10009001900
• Now Bank B has 900 of deposits, of which it only
  needs to keep 90. So it lends out 810 to a
  borrower who deposits it in her bank (Bank C).
  Money supply increases again by 810.
• Increase in money supply19008102710
• Now Bank C will keep (0.10810) or 81 dollars in
  reserve and lend out the remaining (810-81)729.
  Money Supply increases by 729.
• Increase in money supply27107293439
• And so on

24
The Demand Deposit Multiplier

• This is beginning to look like a multiplier.
• Increase in money supply is
• 1000(0.91000)(0.9)21000(0.9)31000..
• 1000(10.9(0.9)2 (0.9)3.)
• 1000(1/(1-0.9))(1/0.10)1000

25
The Demand Deposit Multiplier

• How much will demand deposits increase in total?
• Each bank creates less in demand deposits than
  the bank before
• In each round, a bank lent 90 of deposit it
  received
• Demand deposit multiplier is number by which we
  must multiply injection of reserves to get total
  change in demand deposits
• Size of demand deposit multiplier depends on
  value of required reserve ratio set by Fed

26
The Demand Deposit Multiplier

• For any value of required reserve ratio (RRR),
  formula for demand deposit multiplier is 1/RRR
• Using general formula for demand deposit
  multiplier, can restate what happens when Fed
  injects reserves into banking system as follows
• ?DD (1 / RRR) x ?Reserves
• Since weve been assuming that the amount of cash
  in the hands of the public (the other component
  of the money supply) does not change, we can also
  write
• ?Money Supply (1 / RRR) x ?Reserves

27
The Feds Influence on the Banking System as a
Whole

• Can also look at what happened to total demand
  deposits and money supply from another
  perspective
• Where did additional 1,000 in reserves end up?
• In the end, additional 1,000 in reserves will be
  distributed among different banks in system as
  required reserves
• After an injection of reserves, demand deposit
  multiplier stops workingand the money supply
  stops increasingonly when all reserves injected
  are being held by banks as required reserves
• In the end, total reserves in system have
  increased by 1,000
• Amount of open market purchase

28
How the Fed Decreases the Money Supply

• Fed can decrease money supply by selling
  government bonds
• An open market sale of government bonds
• What happens when the Fed sells 1000 worth of
  government bonds to Merrill Lynch?
• Merrill Lynch will pay the Fed with a 1000 check
  on its bank (Bank 1).
• Bank 1 has lost demand deposits worth 1000 and
  reserves worth 1000.
• Money Supply reduces by 1000
• Bank 1 can reduce reserves by 100. So it is 900
  short of reserves
• Calls in 900 worth of loans from a borrower
• The borrower repays the money from his demand
  deposits with Bank 2. Bank 2 now has lost
  reserves and demand deposits worth 900.
• Money supply reduced by 1000900
• Bank 2 is 810 short of reserves. So it calls in
  loans worth 810. These come out of demand
  deposits and reserves from Bank 3
• Money supply reduced by 1000900810
• And so on

29
How the Fed decreases money supply

• Each time a bank calls in a loan, demand deposits
  are destroyed
• Total decline in demand deposits will be a
  multiple of initial withdrawal of reserves
• Keeping in mind that a withdrawal of reserves is
  a negative change in reserves
• Can still use our demand deposit
  multiplier1/(RRR)and our general formula
• ?DD (1/RRR) x ?Reserves

30
Some Important Provisos About the Demand Deposit
Multiplier

• Although process of money creation and
  destruction as weve described it illustrates the
  basic ideas, formula for demand deposit
  multiplier1/RRRis oversimplified
• In reality, multiplier is likely to be smaller
  than formula suggests, for two reasons
• Weve assumed that as money supply changes,
  public does not change its holdings of cash
• Weve assumed that banks will always lend out all
  of their excess reserves

31
Other Tools for Controlling the Money Supply

• While other tools can affect the money supply,
  open market operations have two advantages over
  them
• Precision and secrecy
• This is why open market operations remain Feds
  primary means of changing money supply

32
Other Tools for Controlling the Money Supply

• There are two other tools Fed can use to increase
  or decrease money supply
• Changes in required reserve ratio (Currently 10)
• Decreasing the required reserve ratio sets off
  the process of deposit creation (through
  increased lending)
• Changing the Discount Rate
• The rate at which the Fed lends to banks.
• Reducing/Increasing the rate would mean that
  banks could borrow more/less, increase/reduce
  reserves and increase/decrease the money supply
• Neither of these tools are used much till
  recently
• Discount Rate has been changed recently.

33
Using the Theory Bank Failures and Banking
Panics

• A bank failure occurs when a bank cannot meet its
  obligations to those who have claims on the bank
• Includes those who have lent money to the bank,
  as well as those who deposited their money there
• Historically, many bank failures have occurred
  when depositors began to worry about a banks
  financial health
• Run on the bank
• An attempt by many of a banks depositors to
  withdraw their funds
• Ironically, a bank can fail even if it is in good
  financial health, with more than enough assets to
  cover its liabilities
• Just because people think bank is in trouble
• Banking panic occurs when many banks fail
  simultaneously

34
Using the Theory Bank Failures and Banking
Panics

• Banking panics can cause serious problems for the
  nation
• Hardship suffered by people who lose their
  accounts when their bank fails
• Even when banks do not fail, withdrawal of cash
  decreases banking systems reserves
• Money supply can decrease suddenly and severely,
  causing a serious recession
• Banking panic of 1907 convinced Congress to
  establish Federal Reserve System
• But creation of Fed did not, in itself, solve
  problem
• Great Depression is a good example of this
  problem
• Officials of Federal Reserve System, not quite
  grasping seriousness of the problem, stood by and
  let it happen

35
Using the Theory Bank Failures and Banking
Panics

• For five-year period ending in May 2003, a total
  of 26 banks failedan average of about 6 per year
• Why the dramatic improvement?
• Federal Reserve learned an important lesson from
  Great Depression
• It now stands ready to inject reserves into
  system more quickly in a crisis
• In 1933 Congress created Federal Deposit
  Insurance Corporation (FDIC) to reimburse those
  who lose their deposits
• FDIC has had a major impact on the psychology of
  banking public
• FDIC protection for bank accounts has not been
  costless. Insurance costs for banks, which are
  passed on as fees to depositors.
• Also banks worry less about the quality of their
  loans and need to be regulated by the Fed.

36
Figure 4 Bank Failures in the United States,
1921-2002
37
Bank Failures Some Recent Numbers

• 2000 2
• 2001 4
• 2002 11
• 2003 3
• 2004 4
• 2005 0
• 2006 0
• 2007 3
• 2008 26
• 2009 111 so far

38
The Most Recent Bank Panic (2008)

• In July 2008, IndyMac, a California based bank
  suffered a panic
• http//www.youtube.com/watch?vmf3R5jtlCrw
• http//www.youtube.com/watch?vZ5AfVVk8KJk
• What happens when a bank fails?
• http//www.cbsnews.com/video/watch/?id4852631n