Banking and the Money Supply

1
Macro
ECON
McEachern 2008-2009
15
CHAPTER
Banking and the Money Supply
Designed by Amy McGuire, B-books, Ltd.
2
Money Aggregates

• Money aggregates
• Measure of money supply
• Defined by the Fed
• M1 Narrow definition of money
• Currency (including coins)
• Nonbanking public
• Checkable deposits
• Bank deposits
• Write checks to third parties
• Travelers checks

LO1
3
Money Aggregates

• Currency Fiat money
• Federal Reserve Notes
• U.S. Bureau of Engraving and Printing
• Issued by Liabilities of
• 12 Federal Reserve Banks
• 60 - abroad
• Coins
• U.S. Mint

LO1
4
Faking It
LO1

• The Supernote Counterfeit 100 note
• High quality
• Sequential numbers
• Polymer security thread
• Redesign every 7 to 10 years
• Additional colors
• Most popular counterfeit
• Domestic 20 note
• International 100 note

Case Study
5
Money Aggregates

• M2 Broader definition of money
• M1
• Savings deposits
• Earn interest no specific maturity date
• Small-denomination time deposits
• Certificates of deposits, CDs
• Earn interest specific maturity date
• Money market mutual fund accounts
• Restrictions

LO1
6
Exhibit 1
LO1
Measures of the Money Supply (July 2007)
7
Money Aggregates

• Credit cards
• Loan from the card issuer
• Repay later
• Dispute a charge
• Not part of money supply
• Debit cards
• From checking account
• Part of M1

LO1
8
How Banks Work
LO2

• Banks earn profit
• Attract deposits from savers
• Lend to borrowers
• Banks are financial intermediaries
• Reduce transaction costs
• Cope with asymmetric information
• Reduce risk through diversification

9
Starting a Bank
LO2

• Home Bank obtains a charter
• Net worth Owners equity
• Shares of stock in the bank
• Balance sheet
• Assets Liabilities Net worth
• Asset owned by bank
• Physical property
• Financial claim
• Stock in district Fed
• Liabilities owned by bank

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Exhibit 2
LO2
Home Banks Balance Sheet
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Exhibit 3
LO2
Home Banks Balance Sheet After 1,000,000
Deposit Into Checking Account
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Reserve Accounts
LO2

• Required reserve
• Dollar amount
• Must be held in reserve
• Required by Fed
• Required reserve ratio
• Percentage of checkable deposits (10)
• Must be held in reserve
• Reserves (Earn no interest)
• Cash in banks vault
• Deposits at the Fed
• Excess reserves

13
Liquidity vs. Profitability
LO2

• Liquidity
• Ease to convert assets into cash
• Safety
• Profitability
• Federal funds markets
• Day-to-day lending and borrowing
• Among banks
• Excess reserves on account at the Fed
• Interest federal funds rate

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How Banks Create Money

• Creating money through excess reserves
• Round one
• Fed buys 1,000 U.S. government bond
• Creates reserves
• Money supply 1,000
• Required reserves 100
• Excess reserves 900

LO3
15
Exhibit 4
LO3
Changes in Home Banks Balance Sheet After Fed
Buys a 1,000 Bond from Securities Dealer
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How Banks Create Money

• Creating money through excess reserves
• Round two
• 900 loan
• Money supply 900
• Required reserves 90
• Excess reserves 810

LO3
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Exhibit 5
LO3
Changes in Home Banks Balance Sheet After
Lending 900 to You
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How Banks Create Money

• Creating money through excess reserves
• Round three
• 810 loan
• Money supply 810
• Required reserves 81
• Excess reserves 729

LO3
19
Exhibit 6
LO3
Changes in Merchants Trusts Balance Sheet After
Lending 810 to English Major
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How Banks Create Money

• Creating money through excess reserves
• Round four and beyond
• Excess reserves new loans
• Required reserves 10 of new checkable deposits
• Excess reserve maximum amount for loans
• Money supply expansion

LO3
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How Banks Create Money

• Creating money through excess reserves
• A summary of rounds
• Fed 1,000 injection in fresh reserves
• Increased excess reserves
• Money supply increase Up to 10,000
• Checkable deposits
• Banking system
• Eliminates excess reserves
• Expand money supply

LO3
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Exhibit 7
LO3
Summary of the Money Creation Resulting from the
Feds Purchase of 1,000 U.S. Government Bond
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Reserve Requirements Money Expansion

• Assumptions
• No bank holds excess reserves
• Borrowed funds dont sit idle
• People dont want to hold more cash

LO3
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Reserve Requirements Money Expansion

• Required reserve ratio r
• Money multiplier
• Simple money multiplier 1/r
• Change in the money supply Change in fresh
  reserves 1/r

LO3
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Limitations of Money Expansion

• Leakages from expansion
• Smaller money multiplier
• Cash preferred to checking accounts
• People hold money
• Fewer excess reserves

LO3
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Multiple Contraction of Money Supply

• The Fed sells a 1,000 bond
• Money supply -1,000
• Required reserves -900
• Recall loans
• Money supply -900
• Required reserves -810
• Maximum effect
• Decrease money supply Original decrease in
  reserve requirements 1/r

LO3
27
Banking on the Net
LO3

• Virtual banks
• Never close
• Smaller operation costs
• Higher interest rates
• E-banking
• Banks
• Speeds processing
• Lowers costs
• Depositors
• Convenience

Case Study
28
The Feds Tools of Monetary Control

• Open-market operations
• Buy/sell U.S. government bonds
• The discount rate
• Interest rate, the Fed
• For loans made to banks
• The required reserve ratio
• Minimum fraction of reserves

LO4
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Open-Market Operations

• Increase money supply
• The Fed buys U.S. bonds
• Open-market purchase
• Reduce money supply
• The Fed sells U.S. bonds
• Open-market sale

LO4
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Open-Market Operations

• Tool of choice for the Fed
• Influences bank reserves
• Influences federal funds rate
• Interest rate
• Borrowing among banks
• Of excess reserves at the Fed

LO4
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The Discount Rate

• Discount rate
• Interest rate charged by the Fed
• Loans to banks
• Bank borrow Discount window
• Satisfy reserve requirements
• The Fed
• Lender of last resort

LO4
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The Discount Rate

• Primary discount rate
• Secondary discount rate
• Signal to financial markets
• Monetary policy
• Emergency tool
• Injecting liquidity

LO4
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Reserve Requirements

• Required reserve ratio
• Money creation for each dollar of fresh reserves
• Disruptive
• Banking system

LO4
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Coping with Financial Crisis

• Regulation of financial markets
• Prevents major disruptions and financial panics
• Sufficient liquidity
• Financial system

LO4
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The Fed Is a Money Machine

• Assets
• U.S. government bonds, 90
• Earns interest
• Liabilities
• Federal Reserve notes, 90
• Fed pays no interest
• The Fed is a money machine
• Supplies Federal Reserve notes
• Main asset earns interest
• Main liability no interest payment

LO4
36
Exhibit 8
LO4
Federal Reserve Bank Balance Sheet as of August
22, 2007 (Billions)