Introduction to Money and Banking

1
Introduction to Money and Banking

• This chapter -- covers some basic fundamentals on
  Money and Banking. In this way, it helps us to
  become more familiar with how Monetary Policy
  works.
• Money -- Facilitator of Trade.

2
Specific Roles of Money as a
Facilitator of Trade

• Medium of Exchange -- Money is exchanged for
  goods and services
• Standard of Value -- Value is measured in dollars
  (the price tag)

3

• Standard of Deferred Payments -- Loans and
  financial instruments are denominated in terms of
  money.
• Store of Value -- People can use money when they
  wish.

4
Definitions of Money

• M1 Currency held by the public
• Travelers Checks
• Checkable Deposits
• M2 M1 Savings Deposits
• Small Time Deposits
• Money Market
• Mutual Funds

5
Definitions of Money Supply
Components

• Currency Held by the Public -- Paper money and
  coin held by consumers and firms.
• Checkable Deposits -- bank deposits which
  customers can write checks upon.

6
Other Bank Deposits

• Savings Deposits -- No checkable privileges, but
  customers can withdraw funds at any time without
  penalty.
• Time Deposits -- A contract specifying payment of
  principal and interest in an explicit way over a
  given interval. Withdrawal before maturity
  results in penalty.

7
Money Market Mutual Funds

• offered by private institutions (not banks)
• pools investor funds
• invests in short-term bonds
• pays interest based upon overall portfolio
• restricted checkability (based upon minimum size
  of check)

8
Quirks -- Defining Money

• M1 emphasizes medium of exchange function of
  money. M2 represents a broader measure.
• Checkable deposits, not checks, are included in
  the money supply definitions.
• Credit card purchases are not included in money
  supply definitions.

9
Liquidity of Financial Assets

• Liquidity -- how easily an asset can be converted
  into a medium of exchange.
• Ranking (most to least) based upon liquidity (1)
  Currency, (2) Checkable Deposits, (3) Savings
  Deposits, (4) Time Deposits.

10
The Role of Interest Rates

• The Interest Rate -- compensates financial
  investors for inconvenience due to holding asset
  (e.g. loss of liquidity).
• Ranking (most to least) based upon interest rate
  (1) Time Deposits, (2) Savings Deposits, (3)
  Checkable Deposits, (4) Currency.

11
Types of Banks

• Commercial Banks (full service)
• Savings and Loans (consumer mortgages)
• Savings Banks (consumer mortgages and consumer
  loans)
• Credit Unions (consumer loans)

12
Banks as Financial
Intermediaries

• Financial Intermediary -- An institution that
  borrows from lenders, then loans to borrowers.

13
The Role of Financial Intermediaries

• Takes advantage of institutional fact of life --
  lenders want to lend small, but borrowers want
  to borrow large.
• Pools small savers funds into large amount,
  available for private borrowers (e.g. mortgages,
  businesses).

14
The Banks Balance Sheet

• Assets Liabilities Equity
• Assets -- Market value of items in your
  possession.
• Liabilities -- Amounts owed to other parties.
• Equity Assets - Liabilities

15
Working With Assets, Liabilities, and Equity

• Note Definition of equity implies
• Assets Liabilities Equity
• (Balance sheets balance!).

16
A Balance Sheet Example

• Consider a house that you buy worth 120,000.
  You take out a mortgage of 100,000.
• Assets Liabilities Equity
• House 120,000 Mortgage 100,000
• Equity
  20,000

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The Banks Major Liabilities and Equity

• (1) Deposits (D) -- Checking,
• Savings, and Time Deposits of
• bank customers.
• (2) Borrowings (BORR) -- Funds
• borrowed by banks, usually for
• very short-term adjustments.
• (3) Equity (E) Total Assets
• - Total Liabilities

18
The Banks Major Assets

• (1) Reserves (R) -- vault cash of
• banks plus deposits at the
• Federal Reserve
• -- Non-interest earning
• -- Purpose to back up customer
• withdrawals from deposits

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Fundamental Balance Sheet Rule

• Any customer withdrawal from any of their
  deposits (checkable deposits or savings and time
  deposits) must be met with an equal decrease in
  reserves.

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An Example Customer Withdrawal

• Customer withdraws 200 from their savings
  deposit at Chase.
• Chase
• ?R - 200 ?D - 200

21
New Customer Deposits and the Acquisition of
Reserves

• Example Customer deposits 300 in their
  checkable deposit (D).
• Chase
• ?R 300 ?D 300

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Other Assets

• (2) Holdings of Bonds (B) -- source
• of revenue from interest.
• (3) Loans (L) -- revenue source
• preferred to bonds.
• -- less liquid
• ? higher interest rate
• -- more personal aspect

23
Inherent Instabilities in
Banking

• Loan Default -- borrower fails to repay loan,
  bank loses assets and equity.
• Profits Versus Safety -- tradeoff between having
  enough reserves to meet depositors withdrawal
  needs versus making sufficient profits from
  loaning the funds.

24
Bank Regulation -- Dealing With Banking
Instabilities

• Capital Requirements -- minimum equity-asset
  ratio to absorb loan defaults.
• Discount Window -- Federal Reserve serves as
  outlet for banks to borrow reserves for emergency
  withdrawal needs.

25

• Deposit Insurance (provided by the Federal
  Deposit Insurance Corporation, or FDIC) --
  guarantees reimbursement up to 100,000 per
  depositor if their bank fails.
• Reserve Requirements -- mandating a minimum
  safety Level of reserves.

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Reserve Requirements The Minimum Safety Level

• Federal Reserve issues a reserve ratio on
  customer deposits (rD) with the provision that,
  at any time
• R (rD)(D)

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Decomposition of Reserves

• Required Reserves (RR), RR (rD)(D)
• Excess Reserves (ER), ER R - RR
• Equivalent Ways to Express Reserve Requirement
  R ? RR, or ER ? 0

28
Bank Loaning -- Balance
Sheet Description

• Consider the following example.
• (rD 0.10)
• Chase
• R 4000 D 15000
• L 9000 E 1000
• B 3000

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Computing Required and Excess Reserves

• Chase rD
  0.10
• R 4000 D 15000
• L 9000 E 1000
• B 3000
• RR (rD)(D) (0.10)(15000) 1500
• ER R - RR 4000 - 1500 2500

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Chase Makes Loan of 2500 Step
1 -- Loan is Approved

• Chase
• R 4000 D 17500
• L 11500 E 1000
• Bonds 3000
• Borrower signs loan contract,
• receives check from bank.

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Step 2 -- Loan is Spent

• Chase
• R 1500 D 15000
• L 11500 E 1000
• B 3000
• Seller deposits check in her bank.
• Fleet
• ?R 2500 ?D 2500

32
Bank Loaning and the Money Supply

• Consider from previous example, Fleet gets new
  deposits (2500) while Chase has the same as
  before.
• Therefore M2 changes by 2500, the amount of the
  loan.
• Result bank loaning changes the money supply by
  the amount of the loan.

33
Loaning and the Banking System

• Seller deposits check in her bank.
• Fleet
• ?R 2500 ?D 2500
• Fleet now can make a loan.
• As funds from Fleets loan get deposited in
  another bank, the process continues