Chapter 14

Banking and the Money Supply

Narrow Definition of Money: M1

• M1: the most narrowly defined MS– Measures purchasing power– M1= currency held by the nonbanking public +

checkable deposits + traveler’s checks– What are checkable deposits?

• Bank deposits that allow the account owner to write checks to third parties.

– Is currency in bank vaults included?• NO!!! It is not being used as a medium of exchange

Broader Definition of Money: M2

• M2: adding near monies to M1– M2= M1 +near monies

• Near monies are easy to convert into currency or checkable deposits

– Savings deposits– Time deposits (CDs- certificates of deposit)– Money market mutual fund accounts

LO1

Measures of the Money Supply (February 2009)

Exhibit 1

Credit Cards and Debit Cards: What’s the Difference

• What do credit cards offer?– They offer an easy way to get a loan from the card

issuer.

• What do debit cards offer?– They reduce the balance of your checking

account; thus, they are part of M1.– It combines the functions of an ATM card and a

check.

Banks Are Financial Intermediaries

• By bringing together both sides of the money market, banks serve as financial intermediaries (go-betweens).

Coping with Asymmetric Information

• What borrowers do banks want?– Willing to pay interest and are able to repay the

loan.

• Asymmetric information: an inequality in what’s known by each party to the transaction.– The borrower knows more about their credit

history.

Reducing Risk Through Diversification

• They develop a diversified portfolio to reduce the risk to each individual saver.

Starting a Bank

• First, they must apply to the state banking authority in the case of a state bank or the U.S. Comptroller of the Currency for a national bank.– A charter

• The authority will decide to or not to approve the charter.

• If approved they are established.• Net Worth= Owners’ Equity

– Shares of Stock in the bank

Balance Sheet

• The balance sheet shows a balance between the two sides of the bank’s account.

• Left-hand side= Assets– Any physical property or financial claim owned by

the bank– Building and equipment– Stocks in the district Fed

• Right-hand side= Liabilities and Net Worth– An amount the bank owes

What if all excess reserves are gone?

LO2

Home Bank’s Balance Sheet

Exhibit 2

Reserve Accounts

• Now what??– They are required to hold a certain percentage of

the checkable deposits.– This amount is the required reserve, the dollar

amount that must be held as reserves.– The required reserve ratio dictates the minimum

proportion of deposits the bank must hold in reserve.

Required Reserves for Banks

• $0 to 10.7 million – 0%• $10.7 million to $55.2 million- 3%• Greater than $55.2 million- 10%

– They are held as cash in the bank’s vault with NO interest or as deposits at the Fed with some interest

Excess Reserves

• Excess Reserves: The amount of checkable deposits the bank holds over the required rate the Fed mandates– Starting in 2008, the Fed now gives interest on

excess reserves.– What can they do with them?

• Make loans • Buy government securities ( by law limited to this)

Liquidity vs. Profitability

• Liquidity is the ease with which an asset can be converted into cash without a significant loss of value.– Selling government bonds

• The objectives of liquidity and profitability are at odds.

Federal funds market

• The federal funds market provides for day-to-day lending and borrowing among banks of excess reserves on account at the Fed.

• They don’t leave the Fed, they shift among accounts.

• Federal funds rate: the interest rate banks charge one another for overnight borrowing- banks loaning to banks

Home Bank’s Balance Sheet After $1,000,000 Deposit Into Checking Account

LO2 Exhibit 3

Changes in Home Bank’s Balance Sheet After Fed Buys a $1,000 Bond from Securities

Dealer

LO3 Exhibit 4

How Banks Create Money

LO3

Creating money through excess reserves– Round two

• $900 loan• Money supply: +$900• Required reserves: +$90• Excess reserves: +$810

Changes in Home Bank’s Balance Sheet After Lending $900 to You

LO3 Exhibit 5

How Banks Create Money

LO3

Creating money through excess reserves– Round three

• $810 loan• Money supply: +$810• Required reserves: +$81• Excess reserves: +$729

Changes in Merchants Trust’s Balance Sheet After Lending $810 to English Major

LO3 Exhibit 6

How Banks Create Money

LO3

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

How Banks Create Money

LO3

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

Summary of the Money Creation Resulting from the Fed’s Purchase of

$1,000 U.S. Government Bond

LO3 Exhibit 7

Reserve Requirements and Money Expansion

• The multiple by which the money supply increases as a result of an increase in the banking system’s reserves is called the money multiplier.

The Money Multiplier

• Def: The money multiplier is equal to 1 divided by the required reserve ratio.

• In our case, it is 10

Ratioservequired ReRe11

The Real-World Money Multiplier

• It is much smaller than MM• It must be observed over time• What happens to it?

– Leakage• Banks could let excess reserves sit idle• Borrowers do something with the money• People may not choose to increase their cash holdings

The Fed’s Tools of Monetary Control

• Open-Market Operations and the Federal Funds Rate

• The Discount Rate• Reserve Requirements• Coping with Financial Crises• The Fed is a money machine

Open Market Operations and the Federal Funds Rate

• Buying and selling of U.S. Government bonds• FOMC meet every six weeks and during

emergencies to make these decisions.• To increase MS- the Fed directs the NY Fed to

buy U.S. bonds (open-market purchase).• To decrease MS- the Fed directs the NY Fed to

sell U.S. bonds (open-market sale).

Open Market Operations and the Federal Funds Rate

• The Federal Funds Rate is the interest rate banks charge one another for borrowing excess reserves at the Fed, typically just for a day or two.

• If the Fed is buying bonds the federal funds rate is lower because less demand for federal funds market.

• The lower federal funds rate prompt banks to lower short-term interest rates in general.

The Discount Rate

• The Discount Rate: the interest rate the Fed charges for loans it makes to banks.

• Two discount rates: – The primary discount rate is usually one

percentage point about the federal funds rate.– The secondary discount rate is usually about one-

half a percentage point higher than the primary discount rate.

• Banks that are less sound

Reserve Requirement

• The minimum amount of reserves that banks must hold to back up deposits.

• If the Fed increase the reserve requirement, then banks have less excess reserves to lend out– This reduces the banking system’s ability to create

money.

Coping with Financial Crises

• In 2001- the Fed bought all the government securities offered for sale, purchasing a record $150 billion worth in two days.

• In 2008- The Fed lowered the discount rate to nearly zero and encourage banks improve their balance sheets and a few other policies

The Fed is a money machine

• The Fed injected more that a trillion dollars of liquidity into the banking system in response to the 2008 meltdown.

• April 2009- 24% of Fed assets were U.S. government bonds, but in more normal times about 90% of assets.

Federal Reserve Bank Balance Sheet as of April 1, 2009 (Billions)

LO4 Exhibit 8