Macroeconomics Lecture 13

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MacroeconomicsLecture 13

• Chapter 13
• Money Banking

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Money

• Money plays an important role in EVERY sector of
  the economy.
• In this chapter we examine
• What money is
• How the quantity of money in an economy is
  determined
• The role of banks in regards to the money supply

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What is Money?

• Money is anything that is generally accepted by
  sellers in exchange for goods and services.
• Most common form of money Cash
• Why is it easier to use cash to buy goods and
  services than other items?

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Liquidity

• Money is the most liquid asset it can be easily
  exchanged for goods and services without losing
  principal.
• Example Cash vs. Car for buying goods.
• How liquid must an asset be before it is
  considered money?
• Must evaluate the functions of money to answer
  this question.

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Functions of Money

• Money serves four basic functions
• Medium of exchange
• Unit of account
• Store of value
• Standard of deferred payment

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1. Medium of Exchange

• Used in exchange for goods and services.
• Sellers willingly accept it.
• Without it, we would barter.
• Double coincidence of wants must occur.
• Raises transaction costs.
• Should be portable divisible.

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2. Unit of Account

• Assigns price to goods and services.
• Allows for comparison in relative terms.
• Relative values make it easy to compare.
• Reduces costs of gathering information on what
  items are worth.

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3. Store of Value

• Retains purchasing power.
• Durability ability to retain value over time.
• Inflation affects the durability of money.
• If inflation is very high, cash will lose its
  value consumers will start using something else
  as their form of money.
• Currency Substitution this occurs when domestic
  currency loses its value due to inflation, thus,
  foreign currency is used instead.

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4. Standard of Deferred Payment

• Debt obligations are written in terms of money
  values.
• We use money to establish debt pay debt.
• Money credit are not the same thing.
• Credit is available savings that is loaned to
  borrowers to spend (credit is a debt, whereas
  money is an asset).

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Review

• Why would cigarettes emerge as money among
  inmates in a state prison?

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The U.S. Money Supply

• The quantity of money in the economy is an
  important determinant of many key macroeconomic
  factors including
• Interest rates
• Inflation
• Thus, the money supply affects the overall
  economic health of an economy.

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U.S. Money Supply

• Economists measure spendable assets when
  measuring the money supply. This has caused 3
  definitions of money to emerge
• M1
• M2
• M3

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M1 Money Supply

• The M1 money supply is the most liquid measure of
  money.
• Ready for immediate spending
• It includes
• Currency
• Travelers Checks
• Demand Deposits (checking accts at bank)
• Other checkable deposits (OCD)

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M2 Money Supply

• M2 is a broader definition of money than M1. It
  includes all spendable assets in M1 plus some
  other less liquid assets
• Savings Deposits
• Earns interest w/no check-writing privileges
• Small denomination time deposits (CODs)
• Must be less than 100,000
• Retail money market mutual fund balances
• Investment accounts (combined deposits of
  individual customers) may or may not provide
  check writing privileges

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M3 Money Supply

• The M3 money supply includes all assets in M1
  M2 plus additional spendable assets that are less
  liquid than both M1 M2 assets including
• Large Time Deposits (more than 100,000)
• Repurchase Agreements (RP)
• Eurodollar Deposits
• Institution-only money market mutual funds

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The U.S. M1 Money Supply in Billions
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The U.S. M2 Money Supply in Billions
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The U.S. M3 Money Supply in Billions
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International Reserve Currencies

• Governments use international reserve assets to
  settle debts amongst each other.
• Gold used to be the primary international reserve
  asset, but now national currencies are the
  primary asset used to settle debts.
• A currency held by a government to settle
  international debts is known as an international
  reserve currency.

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Banking

• Commercial banks are financial institutions that
  offer deposits on which checks can be written.
• Examples?
• In the U.S. (and most countries) commercial banks
  are privately owned.
• In 1999, Congress passed the Gramm-Leach-Bliley
  Act that allowed banks to expand their financial
  activities to include insurance selling
  securities.

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Banking

• Historically, thrift institutions offered just
  savings accounts.
• Examples?
• In 1980, Congress passed the Depository
  Institutions Deregulation and Monetary Control
  Act (allowed for more than just savings accts to
  be offered). The objective was to promote and
  stimulate competition.
• Now, commercial banks thrift institutions offer
  many of the same services.

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Financial Intermediaries

• Both commercial banks and thrift institutions are
  considered financial intermediaries.
• Middleman between savers and borrowers.
• Banks are willing to be the intermediary in the
  expectation of a profit.
• In other words, they will usually pay out a lower
  interest rate on deposits than they charge on
  loans.

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U.S. Banking Structure

• U.S. Banking used to be conducted on a primarily
  local level.
• The banking industry has evolved, thus in the
  future it is likely most banking will be done on
  a national scale.

According the graph, commercial banks greatly
outnumber thrift institutions in the U.S.
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FDIC

• The FDIC (Federal Deposit Insurance Corporation)
  was created in 1933 to insure bank deposits so
  depositors do not lose their deposits in the
  event that a bank fails.
• The FDIC is a federal agency.

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Banks Reserve Requirements

• Banks take in money (deposits)
• Banks are only required to keep a portion of
  their deposits on hand for withdrawals.
• A system which allows banks to keep less then
  100 of their deposits on hand for withdrawals is
  called a fractional reserve banking system.
• The required reserves set by the Federal Reserve
  Board varies (we will say its 10 in our examples
  to simplify).
• Any additional reserves held by a bank over their
  required reserve requirement are called excess
  reserves.

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Bank Loans

• Banks lend money (loans)
• Every time a bank makes a loan they are creating
  money or increasing the money supply in the
  economy.
• A bank can loan all of its deposits that are in
  excess of its required reserves.
• Example If a bank has deposits equaling 100,
  it must have reserves equivalent to 10, thus it
  can loan out 90 of its deposits
• 100 - 10 90

Bank Deposits
Required Reserves
Available for Loans
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Bank Balance Sheet (Simplified)

• The bank balance sheet indicates what the bank
  owns (assets) and what it owes (liabilities).
• Assets
• Cash on hand (reserves)
• Loans
• Liabilities
• Deposits
• Total assets always equal total liabilities.

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Example 1st National Bank
When a bank maintains no excess reserves they
are said to be loaned up.
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Additional Deposits

• Every time a bank receives additional deposits,
  this changes the amount of reserve requirements,
  excess reserves, and money available for loans.

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Example 1st National Bank
An additional deposit of 100,000 changed the
reserve requirement for the bank and also gave
the bank excess reserves which can be used for
more loans.
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Loans Increase the Money Supply

• Lets say 1st Natl. Bank loans out their excess
  reserves of 90,000.
• They have now increased the money supply by
  90,000.
• That 90,000 will now be spent in the economy and
  ultimately end up back in a bank. (2nd Natl.)
• Now, another bank has 90,000 which it can use
  for loaning out (less its reserve requirement).

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Example 1st 2nd Natl. Banks
2nd National bank now has excess reserves of
81,000 that are available for loans. Assuming
2nd Natl. Bank loans out these funds, it will
increase the money supply by another 81,000, be
deposited in another bank, and be loaned out
again (less the reserve requirement). We see
that ultimately bank deposits multiply in the
economy.
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Deposit Expansion Multiplier

• We can use the deposit expansion multiplier to
  find the maximum increase in deposits that an
  initial deposit can cause
• 1
• Reserve Requirement
• So in our example the reserve requirement is 10,
  so the deposit expansion multiplier would be
  1/.10 10. Thus, the maximum increase in
  deposits would be 100,000 (initial deposit) x 10
  (multiplier) 1,000,000.

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Deposit Expansion Multiplier

• If banks receives no new deposits, the bank
  system can only increase the money supply by
• Deposit expansion multiplier x excess reserves
• Remember, this is the maximum possible change in
  total deposits. In order for the maximum change
  in the money supply to occur, banks must loan all
  their excess reserves and all of the money
  deposited must stay in the banking system.

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Limits on Multiplier Effect

• If banks hold reserves in excess of the required
  reserve, this reduces the effect of the deposit
  expansion multiplier.
• Ex. If bank holds 20 reserves instead of 10,
  this means they loan out less money.
• If money is withdrawn from banking system and
  kept as cash, this also reduces the effect of the
  deposit expansion multiplier.
• This is called currency drain.

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Ch 13 Worksheet

• 1. What is the value of M1 in the table?
• 2. What is the value of M2 in the table?
• 3. What is the value of M3 in the table?

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Ch 13 Worksheet

• 4. 1st Bank has cash reserves of 100,000, loans
  of 400,000, and deposits of 500,000.
• a. Prepare a balance sheet for this bank.
• b. If the bank maintains a reserve requirement
  of 10, what is the largest additional loan it
  can make?
• c. What is the maximum amount the money supply
  can be increased as a result of 1st Banks
  additional loan?