MONEY, BANKS, AND THE FEDERAL RESERVE

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MONEY, BANKS, AND THE FEDERAL RESERVE
CHAPTER
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Objectives

• After studying this chapter, you will able to
• Define money and describe its functions
• Explain the economic functions of banks and other
  depository institutions and describe how they are
  regulated
• Explain how banks create money
• Describe the structure of the Federal Reserve
  System (the Fed), and the tools used by the Fed
  to conduct monetary policy
• Explain what an open market operation is, how it
  works, and how it changes the quantity of money

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Money makes the World Go Around

• Money has taken many forms what is money now?
• What do banks do, and can they create money?
• What is the Fed and what does it do?
• How does the Fed ensure that the economy has the
  right amount of money to function properly?

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What is Money?

• Money is any commodity or token that is generally
  acceptable as a means of payment.
• A means of payment is a method of settling a
  debt.
• Money has three other functions
• Medium of exchange
• Unit of account
• Store of value

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What is Money?

• Medium of Exchange
• A medium of exchange is an object that is
  generally accepted in exchange for goods and
  services.
• In the absence of money, people would need to
  exchange goods and services directly, which is
  called barter.
• Barter requires a double coincidence of wants,
  which is rare, so barter is costly.
• Unit of Account
• A unit of account is an agreed measure for
  stating the prices of goods and services.

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What is Money?

• Store of Value
• As a store of value, money can be held for a time
  and later exchanged for goods and services.
• Money in the United States Today
• Money in the United States consists of
• Currency
• Deposits at banks and other depository
  institutions
• Currency is the general term for bills and coins.

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What is Money?

• The two main official measures of money in the
  United States are M1 and M2.
• M1 consists of currency outside banks, travelers
  checks, and checking deposits owned by
  individuals and businesses.
• M2 consists of M1 plus time deposits, savings
  deposits, and money market mutual funds and other
  deposits.

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What is Money?

• Figure 26.1 illustrates the composition of these
  two measures in 2001 and shows the relative
  magnitudes of the components of money.

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What is Money?

• The items in M1 clearly meet the definition of
  money the items in M2 do not do so quite so
  clearly but still are quite liquid.
• Liquidity is the property of being instantly
  convertible into a means of payment with little
  loss of value.
• Checkable deposits are money, but checks are not
  checks are instructions to banks to transfer
  money.
• Credit cards are not money. Credit cards enable
  the holder to obtain a loan quickly, but the loan
  must be repaid with money.

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Depository Institutions

• A depository institution is a firm that accepts
  deposits from households and firms and uses the
  deposits to make loans to other households and
  firms.
• The deposits of three types of depository
  institution make up the nations money
• Commercial banks
• Thrift institutions
• Money market mutual funds

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Depository Institutions

• Commercial Banks
• A commercial bank is a private firm that is
  licensed to receive deposits and make loans.
• A commercial banks balance sheet summarizes its
  business and lists the banks assets,
  liabilities, and net worth.
• The objective of a commercial bank is to maximize
  the net worth of its stockholders.

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Depository Institutions

• To achieve its objective, a bank makes risky
  loans at an interest rate higher than that paid
  on deposits.
• But the banks must balance profit and prudence
  loans generate profit, but depositors must be
  able to obtain their funds when they want them.
• So banks divide their funds into two parts
  reserves and loans.
• Reserves are the cash in a banks vault and
  deposits at Federal Reserve Banks.
• Bank lending takes the form of liquid assets,
  investment securities, and loans.

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Depository Institutions

• Thrift Institutions
• The thrift institutions are
• Savings and loan associations
• Savings banks
• Credit unions.

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Depository Institutions

• A savings and loan association (SL) is a
  depository institution that accepts checking and
  savings deposits and that make personal,
  commercial, and home-purchase loans.
• A savings bank is a depository institution owned
  by its depositors that accepts savings deposits
  and makes mainly mortgage loans.
• A credit union is a depository institution owned
  by its depositors that accepts savings deposits
  and makes consumer loans.

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Depository Institutions

• Money Market Mutual Funds
• A money market fund is a fund operated by a
  financial institution that sells shares in the
  fund and uses the proceeds to buy liquid assets
  such as U.S. Treasury bills.

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Depository Institutions

• The Economic Functions of Depository Institutions
• Depository institutions make a profit from the
  spread between the interest rate they pay on
  their deposits and the interest rate they charge
  on their loans.
• This spread exists because depository
  institutions
• Create liquidity
• Minimize the cost of obtaining funds
• Minimize the cost of monitoring borrowers
• Pool risk

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Financial Regulation, Deregulation, and Innovation

• Financial Regulation
• Depository institutions face two types of
  regulations
• Deposit insurance
• Balance sheet rules

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Financial Regulation, Deregulation, and Innovation

• Deposits at banks, SLs, savings banks, and
  credit unions are insured by the Federal Deposit
  Insurance Corporation (FDIC).
• This insurance guarantees deposits in amounts of
  up to 100,000 per depositor.
• This guarantee gives depository institutions the
  incentive to make risky loans because the
  depositors believe their funds to be perfectly
  safe because of this incentive balance sheet
  regulations have been established.

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Financial Regulation, Deregulation, and Innovation

• There are four main balance sheet rules
• Capital requirements
• Reserve requirements
• Deposit rules
• Lending rules

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Financial Regulation, Deregulation, and Innovation

• Deregulation in the 1980s and 1990s
• During the 1980s many restrictions on depository
  institutions were lifted and distinctions between
  banks and others depository institutions ended.
• In 1994 the Riegle-Neal Interstate Banking and
  Branching Efficiency Act was passed, which
  permits U.S. banks to establish branches in any
  state.
• This change in the law led to a wave of bank
  mergers.

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Financial Regulation, Deregulation, and Innovation

• Financial Innovation
• The 1980s and 1990s have been marked by financial
  innovationthe development of new financial
  products aimed at lowering the cost of making
  loans or at raising the return on lending.
• Financial innovation occurred for three reasons
• The economic environment--high inflation
• Massive technological change
• Avoid regulation

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Financial Regulation, Deregulation, and Innovation

• Deregulation, Innovation, and Money
• The combination of deregulation and innovation
  has produced large changes in the composition of
  money, both M1 and M2.

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How Banks Create Money

• Reserves Actual and Required
• The fraction of a banks total deposits held as
  reserves is the reserve ratio.
• The required reserve ratio is the fraction that
  banks are required, by regulation, to keep as
  reserves. Required reserves are the total amount
  of reserves that banks are required to keep.
• Excess reserves equal actual reserves minus
  required reserves.

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How Banks Create Money

• Creating Deposits by Making Loans
• To see how banks create deposits by making loans,
  suppose the required reserve ratio is 25 percent.
• A new deposit of 100,000 is made.
• The bank keeps 25,000 in reserve and lends
  75,000.
• This loan is credited to someones bank deposit.
• The person spends the deposit and another bank
  now has 75,000 of extra deposits.
• This bank keeps 18,750 on reserve and lends
  56,250.

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How Banks Create Money

• The process continues and keeps repeating with
  smaller and smaller loans at each round.
• Figure 26.2 illustrates the money creation
  process.

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The Federal Reserve System

• The Federal Reserve System, or the Fed, is the
  central bank of the United States.
• A central bank is the public authority that
  regulates a nations depository institutions and
  controls the quantity of money.

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The Federal Reserve System

• The Feds Goals and Targets
• The Fed conducts the nations monetary policy,
  which means that it adjusts the quantity of money
  in circulation.
• The Feds goals are to keep inflation in check,
  maintain full employment, moderate the business
  cycle, and contribute toward achieving long-term
  growth.
• In pursuit of its goals, the Fed pays close
  attention to interest rates and sets a target
  that is consistent with its goals for the federal
  funds rate, which is the interest rate that the
  banks charge each other on overnight loans of
  reserves.

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The Federal Reserve System

• The Structure of the Fed
• The key elements in the structure of the Fed are
• The Board of Governors
• The regional Federal Reserve banks
• The Federal Open Market Committee.

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The Federal Reserve System

• The Board of Governors has seven members
  appointed by the president of the United States
  and confirmed by the Senate.
• Board terms are for 14 years and overlap so that
  one position becomes vacant every 2 years.
• The president appoints one member to a
  (renewable) four-year term as chairman.
• Each of the 12 Federal Reserve Regional Banks has
  a nine-person board of directors and a president.

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The Federal Reserve System

• Figure 26.3 shows the regions of the Federal
  Reserve System.

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The Federal Reserve System

• The Federal Open Market Committee (FOMC) is the
  main policy-making group in the Federal Reserve
  System.
• It consists of the members of the Board of
  Governors, the president of the Federal Reserve
  Bank of New York, and the 11 presidents of other
  regional Federal Reserve banks of whom, on a
  rotating basis, 4 are voting members.
• The FOMC meets every six weeks to formulate
  monetary policy.

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The Federal Reserve System
Figure 26.4 summarizes the Feds structure and
policy tools.
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The Federal Reserve System

• The Feds Power Center
• In practice, the chairman of the Board of
  Governors (since 1987 Alan Greenspan) is the
  center of power in the Fed.
• He controls the agenda of the Board, has better
  contact with the Feds staff, and is the Feds
  spokesperson and point of contact with the
  federal government and with foreign central banks
  and governments.

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The Federal Reserve System

• The Feds Policy Tools
• The Fed uses three monetary policy tools
• Required reserve ratios
• The discount rate
• Open market operations

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The Federal Reserve System

• The Fed sets required reserve ratios, which are
  the minimum percentages of deposits that
  depository institutions must hold as reserves.
• The Fed does not change these ratios very often.
• The discount rate is the interest rate at which
  the Fed stands ready to lend reserves to
  depository institutions.
• An open market operation is the purchase or sale
  of government securitiesU.S. Treasury bills and
  bondsby the Federal Reserve System in the open
  market.

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The Federal Reserve System

• The Feds Balance Sheet
• On the Feds balance sheet, the largest and most
  important asset is U.S. government securities.
• The most important liabilities are Federal
  Reserve notes in circulation and banks deposits.
• The sum of Federal Reserve notes, coins, and
  banks deposits at the Fed is the monetary base.

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Controlling the Quantity of Money

• How Required Reserve Ratios Work
• An increase in the required reserve ratio boosts
  the reserves that banks must hold, decreases
  their lending, and decreases the quantity of
  money.
• How the Discount Rate Works
• An increase in the discount rate raises the cost
  of borrowing reserves from the Fed, decreases
  banks reserves, which decreases their lending
  and decreases the quantity of money.

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Controlling the Quantity of Money

• How an Open Market Operation Works
• When the Fed conducts an open market operation by
  buying a government security, it increases banks
  reserves.
• Banks loan the excess reserves.
• By making loans, they create money.
• The reverse occurs when the Fed sells a
  government security.

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Controlling the Quantity of Money

• Although the details differ, the ultimate process
  of how an open market operation changes the money
  supply is the same regardless of whether the Fed
  conducts its transactions with a commercial bank
  or a member of the public.
• An open market operation that increases banks
  reserves also increases the monetary base.

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Controlling theQuantity of Money

• Figure 26.5 illustrates both types of open market
  operation.

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Controlling the Quantity of Money

• Bank Reserves, the Monetary Base, and the Money
  Multiplier
• The money multiplier is the amount by which a
  change in the monetary base is multiplied to
  calculate the final change in the money supply.
• An increase in currency held outside the banks is
  called a currency drain.
• Such a drain reduces the amount of banks
  reserves, thereby decreasing the amount that
  banks can loan and reducing the money multiplier.

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Controlling the Quantity of Money

• The money multiplier differs from the deposit
  multiplier.
• The deposit multiplier shows how much a change in
  reserves affects deposits.
• The money multiplier shows how much a change in
  the monetary base affects the money supply.

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Controlling the Quantity of Money

• The Multiplier Effect of an Open Market Operation
• When the Fed conducts an open market operation,
  the ultimate change in the money supply is larger
  than the initiating open market operation.
• Banks use excess reserves from the open market
  operation to make loans so that the banks where
  the loans are deposited acquire excess reserves
  which they, in turn, then loan.

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Controlling the Quantity of Money

• Figure 26.6 illustrates a round in the multiplier
  process following an open market operation.

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Controlling the Quantity of Money

• Figure 26.7 illustrates the multiplier effect of
  an open market operation.

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Controlling the Quantity of Money

• The Size of the Multiplier
• To calculate the size of the money multiplier,
  first define
• R reserves
• C currency in circulation
• D deposits
• M quantity of money
• B monetary base
• c ratio of currency to deposits
• r required reserve ratio

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Controlling the Quantity of Money

• The quantity of money, M, is
• M C D (1 c) ? D
• The monetary base, B, is
• B R C (r c) ? D
• Divide the first equation above by the second one
  to get
• M/B (1 c)/(r c)
• or
• M (1 c)/(c r) ? B

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Controlling the Quantity of Money

• The money multiplier is (1 c)/(c r)the
  amount by which a change in B is multiplied to
  determine the resulting change in M.
• With c 0.5 and r 0.1, the money multiplier is
• 1.5/0.6 2.5.

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THE END