The Banking System and the Money Supply

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• Chapter 11
• The Banking System and the Money Supply

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What Counts as Money

• Money has several useful functions
• Provides a unit of account
• Standardized way of measuring value of things
  that are traded
• Serves as store of value
• One of several ways in which households can hold
  their wealth
• Yet credit cards are not considered money, even
  though you can use them to buy things
• Why is this?
• A more formal definition of money helps to answer
  questions like this
• Money is an asset that is widely accepted as a
  means of payment
• Only assetsthings of value that people owncan
  be considered as money
• Only things that are widely acceptable as a means
  of payment are regarded as money

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Measuring the Money Supply

• Amount of money in circulation can affect
  macroeconomy
• Money Supply
• Total amount of money held by the public
• In practice, measuring money supply is not as
  straightforward as it might seem
• Governments have decided best way to deal with
  them is to have different measures of the money
  supply
• In effect, alternative ways of defining what is
  and what is not money
• Each measure includes a selection of assets that
  are widely acceptable as a means of payment and
  are relatively liquid
• An asset is considered liquid if it 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

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Assets and Their Liquidity

• Most liquid asset is cash in the hands of the
  public
• Next in line are asset categories of about equal
  liquidity
• Demand deposits
• Checking accounts held by households and business
  firms at commercial banks
• Other checkable deposits
• Catchall category for several types of checking
  accounts that work very much like demand deposits
• Travelers checks
• Specially printed checks that you can buy from
  banks or other private companies, like American
  Express
• Savings-type accounts
• At banks and other financial institutions
• Are less liquid than checking-type accounts,
  since they do not allow you to write checks
• Next on the list are deposits in retail money
  market mutual funds (MMMF)
• 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)

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Figure 1 Monetary Assets and Their Liquidity
(July 14, 2003)
Demand Deposits (314 billion) Other Checkable D
eposits (298 billion) Travelers Checks (8
billion)
Less Liquid
More Liquid
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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 common measure of money supply, M2, adds
  some other types of assets to M1
• M2 M1 savings-type accounts retail MMMF
  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 have been most popular, and most
  commonly watched, definitions

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M1 And M2

• Important to understand that M1 and M2 money
  stock measures exclude many things that people
  use regularly as a means of payment
• Technological advancesnow and in the futurewill
  continue trend toward new and more varied ways to
  make payments
• 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

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The Banking System Financial Intermediaries

• What are banks?
• Financial intermediariesbusiness 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 helps to solve problems by
  combining a large number of small savers funds
  into custom-designed packages
• Then lending them to larger borrowers
• Intermediaries must earn a profit for providing
  brokering services
• By charging a higher interest rate on funds they
  lend than rate they pay to depositors

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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

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A Banks Balance Sheet

• A balance sheet is a two-column list that
  provides information about financial condition of
  a bank at a particular point in time
• In one column, banks assets are listed
• Everything of value that it owns
• On the other side, the banks liabilities are
  listed
• Amounts bank owes
• Bond
• A promise to pay back borrowed funds, issued by a
  corporation or government agency
• Loan
• An agreement to pay back borrowed funds, signed
  by a household or noncorporate business
• Next come two categories that might seem curious
• Vault cash
• Account with the Federal Reserve
• Why does the bank hold them?

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A Banks Balance Sheet

• Explanations for 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

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The Federal Reserve System

• Every large nation controls its money supply with
  a central bank
• Englands central bankBank of Englandwas
  created in 1694
• France established Banque de France in 1800
• United States established Federal Reserve System
  in 1913
• U.S. waited such a long time to establish a
  central authority because of
• Suspicion of central authority that has always
  been part of U.S. politics and culture
• Large size and extreme diversity of our country
• Fear that a powerful central bank might be
  dominated by the interests of one region to the
  detriment of others

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Figure 2 The Geography of the Federal Reserve
System
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Figure 3 The Structure of the Federal Reserve
System
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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
• Consists of all 7 governors of Fed, along with 5
  of the 12 district bank presidents
• 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

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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

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The Fed and the Money Supply

• Suppose Fed wants to change nations money supply
• It buys or sells government bonds to bond
  dealers, banks, or other financial institutions
• Actions are called open market operations
• Well make two special assumptions to keep our
  analysis of open market operations simple for now
• 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

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How the Fed Increases the Money Supply

• To increase money supply, Fed will buy government
  bonds
• Called an open market purchase
• Suppose Fed buys 1,000 bond from Lehman
  Brothers, which deposits the total into its
  checking account
• Two important things have happened
• Fed has injected reserve into banking system
• Money supply has increased
• Demand deposits have increased by 1,000 and
  demand deposits are part of money supply
• Lehman Brothers bank now has excess reserves
• Reserves in excess of required reserves
• If required reserve ratio is 10 bank has excess
  reserves of 900 to lend
• Demand deposits increase each time a bank lends
  out excess reserves

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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
• Whatever the injection of reserves, demand
  deposits will increase by a factor of 10, so we
  can write
• ?DD 10 x reserve injection
• 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

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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

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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

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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

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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

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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

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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

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Figure 4 Bank Failures in the United States,
1921-1999