Week 7

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Week 7 Money and the Banking System pp.23
3 - 254
2
Money and the Banking System The financial syste
m channel savings into Investment. The Federal
Reserve exercises significant control over
aggregate demand by manipulation monetary
policy. Given the problem identification, adminis
trative, and implementation lags, and the
political problems associated with fiscal policy,
monetary policy is today viewed as a far more
important stabilization tool than fiscal policy.
To understand how monetary policy is conducted,
we need to understand money and the financial
system.
3

• The nature of money
• The most obvious way to trade commodities is by
  barter.
  
• The problem with barter double coincidence of
  wants is required before a transaction can take
  place.
  
• Money greases the wheels of exchange, and thus
  makes the whole economy more productive.
  
• Characteristics of money
• Medium of exchange
• Unit of account
• Store of value.

4

• Requirement for a good medium of exchange
• Divisible
• Uniform (readily identifiable)
• Storable (durable)
• Compact (high value per volume and weight)
• Scarce.
• Role of gold and silver for last 2,500 years.
  Because it has high value in non-monetary uses, a
  lot of purchasing power can be be carried without
  too much weight, it is also storable, divisible,
  and identifiable.

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Fiat money Fiat money is money that is decreed a
s a medium of exchange by the government. It has
little value as a commodity, but it maintains its
value as a medium of exchange because people have
faith that the issuer will stand behind it and
limit its production. Inscription on U.S. bank no
tes This note is legal tender for all debts,
public and private On U.S. bank notes there are
no promises, stated or implied, that the U.S.
government will exchange its banknotes for
anything else.
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Q Why do you accept worthless paper money in
return for your labor services?
A Because you know other people will accept it
in exchange for goods and services.
Greshams Law Bad money drives out good.
(Sir Thomas Gresham, treasurer for queen
Elizabeth 1, did not in fact thought up this law.
Kindelberger has traced it back to Nicholas
Oresme, bishop of Lisieuz, in 1360. (Martin
Mayer The Bankers The Next Generation.
Truman Talley Books/ Dutton, New York 1997) p.
49.
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The quantity of money is Measured on the basis of
liquidity. An assets liquidity refers to the
ease with which it can be converted into cash.
M1M2 M3 Near money liquid assets that are clo
se substitutes for money. The money supply which
can most directly be influenced by banks is M1
(Currency in Circulation plus Demand Deposits).
We will write it as M1 CC DD
Monetary aggregates, see PDF file for their
historic relevance.
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THE BANKING SYSTEM Goldsmith story Creating mo
ney Fractional reserve banking a system under w
hich bankers keep as reserves only a fraction of
the funds they hold on deposit.
When goldsmiths decided to keep only fractions of
their total deposits on reserve and lend out the
balance , they acquired the ability to create
money. P. 242-3.
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• Exposure to runs The danger of runs has induced
  bankers to keep prudent reserves and to lend
  money carefully.
  
• The profit / safety tradeoff
• Low reserves high profits High reserves
  low safety.
  
• Bank Regulation p244.
• Deposit insurance (FDIC 1933)
• Bank supervision (bank examinations, limits on
  the kinds and quantities of assets in which banks
  may invest)
  
• Reserve requirements (required reserves the
  minimum reserves, in cash or the equivalent).

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• Banks and money creation p246
• To understand how commercial banks create money,
  you have to understand Balance Sheet basics.
  
• A Balance Sheet is a statement of assets and
  claims
  
• A Balance Sheet must always balance, because
  every asset (something of economic value) will be
  claimed by someone.
  

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Claims can be 1) Claims by the owners (i.e. sto
ckholders of the firm) are called N
et Worth. 2) Claims by non-owners (e.g. amounts
deposited in a bank) are called Liabilities.
How money is created by a single bank as part of
a Multi-bank system. Step 1 Formation of a comm
ercial bank a) Secure a state or nationa
l charter i.e. obtain a license to operate a b
ank. b) Sell 250,000 worth of capital stock.The
owners of the shares will be the owners of the
bank.
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Balance Sheet 1
Assets Cash 250,000
Liabilities and Net Worth Capital Stock
250,000

• Step 2 Becoming a Going Concern.
• Acquire property and equipment
• Building 220,000
• Office equipment 20,000

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Balance Sheet 2
Assets Cash 10,000 Property
240,000
250,000

Liabilities and Net Worth Capital Stock
250,000 _______
250,000

• Step 3 Accepting Deposits
• Commercial banks have 2 important functions
• Accepting deposits
• and
• Making loans.

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• The bank receive its first deposit of 100,000
  from a Mr. Bradshaw.
  
• The received cash becomes an asset of the bank.
  
  
• Mr. Bradshaws claim of this asset of the bank,
  is a liability, listed as a checking Deposit.
  
• Balance Sheet 3

Assets Cash 110,000 Prop
erty 240,000
350,000
Liabilities and Net Worth Demand deposits 100
,000 Capital Stock 250,000
350,000
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• Step 4 Depositing Reserves in the Federal
  Reserve Bank
  
• All commercial banks and thrifts which provide
  checkable deposits must keep legal reserves with
  the Fed.
  
• Legal Reserves are specific percentages of the
  deposits made at the bank, and must be kept at
  the Federal Reserve.
  
• Vault cash is counted as reserves.
• Reserve Ratio (Banks Required Ress) / (Banks
  Dem. Deps Liabs)
  
• The Board of Governors of the Federal Reserve has
  the authority to change the reserve ratio.

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Assumptions and implications We assume the reser
ve ratio is 20 and that the RR applies only to
demand deposits (DD). Based on Mr. Bradshaws d
eposit, Our Bank must, therefore, deposit 20,000
as reserves. We suppose that the bank anticipat
es that it will receive more demand deposits.
Thus, instead of depositing 20,000 as reserves
with the Fed, the bank deposits a total of
110,000.
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Balance Sheet 4
Assets Cash 0 Reserves
110,000 Property 2
40,000
350,000
Liabilities and Net Worth Demand deposits 100,0
00 Capital Stock 250,000

350,000
Excess ReservesThe amount by which OUR Banks
actual reserves exceeds its required reserves
Actual reserves - Required Reserves Excess
Reserves 110,000 - 20,000
90,000
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• A commercial banks ability to make loans depends
  on the existence of excess reserves.
  
• Legal reserves permits the Feds Board of
  Governors to influence the lending ability of
  commercial banks.
  
• The Feds Board uses reserves to control the
  commercial banks and to facilitate the collection
  of checks.
  
• Reserves are assets to the depositing commercial
  bank and liabilities to the Federal Reserve bank
  receiving it.

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• Step 5 A Check is drawn against Our Bank.
• The client, Mr. Bradshaw, who made the 100,000
  deposit, now buys 50,000 worth of equipment from
  a supplier, Ajax, in Ardmore.
  
• Mr. Bradshaw, pays for the equipment by writing a
  50,000 check against his deposit.
  
• We want to know
• how this check is collected
• the effect of the collection of the check on the
  balance sheets of the banks involved 1) our
  bank, 2) Ajax's bank, and 3) the Federal Reserve
  bank of Philadelphia.

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Print slide 20, with three Balance Sheets sepa
rately.
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Bringing all the assets and liabilities of Our
Bank in consideration (after slide 20).
Balance Sheet 5
Assets Reserves 60,000 Propert
y 240,000
300,000
Liabilities and Net Worth Demand Deposits 50,0
00 Capital Stock 250,000
300,000
What is the excess reserves position now?
Actual Reserves - Required Res. Excess Res.
60,000 - 10,000
50,000
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The next three transactions show
1) how money is created by a commercial ban
k when a loan is granted 2) how money is dest
royed when loans are repaid and
3) how banks create money when they buy bonds fr
om the public.
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1. Granting a loan Coke Bottling CO of Chester,
wants to expand. The company needs a loan of
50,000. Coke submits its proposal to Our Bank
for consideration. Our Bank approves the loan,
and asks Coke for a promissory note, and
increases Cokes demand deposits by 50,000.
(Book entry only!) From Our Banks point of vie
w, it received a promissory note (i. e. an
interest bearing asset) Coke has exchanged an IOU
, (not part of M1) for a checkable deposit (part
of M1).
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Balance Sheet 6
Assets Reserves 60,000 Loans
50,000 Property 240,000
350,000
Liabilities and Net Worth Dem. Deps. 100,000
Capital Stock 250,000
350,000
When the bank grants a loan it creates money.
Coke went to Our Bank with an IOU (not money) and
walked out with something (demand deposit) which
is part of the nations money supply.
M1 CC DD
The IOU was monetized
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Coke hires Construction Inc. to do the expansion
work. Construction Inc. is paid by Coke with a
check drawn on Our Bank. Construction Inc. deposi
t the check in Mellon bank in Havertown.
The check is collected, as before.
Our Bank looses both reserves and demand
deposits.
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Balance Sheet 7
Assets Reserves 10,000 Loans
50,000 Property 250,000
300,000

Liabs and Net Worth Dem. Deps. 50,000 Cap
ital Stock 250,000 3
00,000

Compute the Excess Reserves Actual Res. - Requ
ired Res. Excess Res. 10,000 -
10,000 0
Our Bank could not have lent an amount greater t
han 50,000 and still have met its reserve
requirement.
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The total amount of the loans of a single bank
must never exceed its initial pre-loan reserves.
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2. Repaying a loan When a loan is repaid, money
is destroyed. Suppose Coke repays the loan 2 year
s later. (Ignore interest payments and other
transactions in the interim period.)
To repay, Coke writes a check for 50,000 against
its demands deposits. As a result, our banks
demand deposits. decline by 50,000. The bank
gives Coke its IOU the supply of money has been
reduced, the banks required reserves and Excess
Reserves were both reduced. M1 CC DD
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Balance Sheet 8
Assets Reserves 10,000 Loans
0 Property 240,000
250,000
Liabs. And Net Worth Dem Deps 0 Cap
ital Stock 250,000
250,000

Act. Res. - Req. Res. Excess Res.
10,000 - 0 10,000

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3. Buying Government Securities
When a commercial bank buys government bonds from
the public, it creates money. Assume Our Banks b
alance sheet, before the securities transaction,
looks as in balance sheet 9, Balance Sheet 9
Assets Reserves 60,000 Property
240,000
300,000
Liabs and Net Worth Dem. Deps. 50,000 Capt
. Stock 250,000 300,0
00

Act. Res. - Req. Res. Excess Res.
60,000 - 10,000 50,000
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Now the bank buys 50,000 worth of government
bonds from the public. The bank receives the
interest bearing bonds, and gives the member of
the public an increase in his / her demand
deposits.Balance Sheet 10
Assets Reserves 60,000 Securities
50,000 Property 240,000
350,000
Liabs and Net Worth Dem. Deps. 100,000 Capt.
Stock 250,000
350,000
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When buying a bond the bank creates money.
M1 CC DD
When selling a bond the bank destroys money.
M1 CC DD (if the buyer pays
cash) or, M1 CC DD (if th
e buyer pays with a check) When a member of th
e public pays cash over to a bank, the cash
ceases to be CC, it becomes part of the banks
vault cash, thus part of its reserves.
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Commercial banks seek profits. They buy
securities and make loans. A banks safety lies
in its liquidity. Banks sometimes, lend exces
s reserves to other banks (which can not meet the
required reserve ratio at the end of a business
day) on an over-night basis, at the Fed.
Determined Federal Funds rate.
34
The Banking System(Multiple Deposit Expansion)
A commercial banking system can lend, i.e. creat
e money up to a multiple of its excess reserves.
This multiple lending is accomplished even though
each bank in the system can only lend an amount
equal to its excess reserves. To prove this, we m
ake three simplifying assumptions
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• Three simplifying assumptions
• The reserve ratio for all commercial banks is
  20.
  
• 2) Initially, all banks are exactly loaned up
  (i.e.is just meeting the 20 reserve requirement
  no excess reserves exist, and no loans can be
  made).
• 3) If any bank acquire excess reserves, an
  amount equal to the excess reserves will be
  loaned to 1 borrower, who will write a check for
  the entire amount of the loan, and give it to
  some-one else who will deposit the entire amount
  in another bank.

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Lending Potential DemonstratedSuppose a junk
yard operator find a 100 bill on her lot. She
deposits the 100 bill in Bank A.
Bank A.
Assets Reserves 100
-80 Loan
80
Liabs and Net Worth Dem. Deps. 100 De
m Dep 80
-80
Act Res (100) - Req Res (20) Excess Res (80)
This bank now give a loan of 80 to 1 borrower.
The borrower writes a check for 80, which ends
up deposited in Bank B. Bank B collects the
check, in the process bank As Demand deps, and
its reserves are reduced by 80. Now Bank A is
once more, Loaned up
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Bank B Balance Sheet
Assets Reserves 80
-64
Loan 64
Liabs and Net Worth Dem Deps 80
64
-64

Act Res (80) Req. Res (16) Excess Res (64) This
bank now give a loan of 64 to 1 borrower.
The borrower writes a check for 64, which ends
up deposited in Bank c, Bank C collects the
check, in the process bank Bs Demand deps, and
reserves are reduced by 64. Now Bank B is once
more, Loaned up
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Multiple Deposit Expansion Process
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Reserves lost by a single bank is not lost to the
system as a whole.
1
The Money Multiplier
Required Reserve Ratio
1/R
Under the simplifying assumptions, the maximum
deposit expansion that can take place is equal to
the initial pre-loan excess reserves of Bank A,
times the money multiplier. In our example
Max Dem. Dep. Expansion 80 X ( 1 / .20)
80 X 5
400
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The increase in the Demand Deposits, and
therefore in the money supply, will not always be
the Maximum because 1) Currency Drains If the
full amount of each banks loan is not deposited
at the next bank 2) If any bank is conservativ
e and prefers to keep some excess reserves, that
is, lend less than its full excess reserves.
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• The Need for Monetary Policy 252
• The money supply has an important influence on
  the Aggregate Demand. Banks trying to maximize
  profits will
  
• During a recession, decline loans to less credit
  worthy clients, thus keep the aggregate demand
  from moving outward. This will aggravate the
  recession.
• During a boom, aggravate the situation by
  expanding the money supply.
  
• Without monetary policy business cycles
  fluctuations will be more severe.

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Recent Developments in US Commercial banking
In his authoritative Bankers, The Next
Generation, Martin Meyer notes that since 1980,
banks get their funds primarily by selling jumbo
(more than 100,00) certificates of deposit on
the primary bond market. Congress eliminated
interest rate controls in the early 1980s. These
two facts now make it impossible for the Fed to
create a credit crunch.
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Banks now package their outstanding loans
(illiquid assets) as securities that are sold on
the primary bond market. (This process is called
securitization, and now includes outstanding
balances on mortgage loans, credit cards, etc.)
When the banks borrowers pay off their loans,
they pay the owner of the security. The banks
buy and inexpensive insurance policy to protect
buyers of such securities against default by bank
customers, This enable the banks to issue
guarantees with the securitized loans. When such
securitized loans are sold, (for slightly less
than the loans face value) the banks receive
cash (that can serve as reserves) this increases
their excess reserves and ability to make loans.
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When the Fed is trying to influence what banks
do, it may buy or sell as much as 3 Billions
worth of US government bonds on the secondary
bond market. Any big bank inconvenienced by the
Feds action could borrow over night, from a
foreign bank, at a rate lower than the Federal
Funds Rate, some of the more than 1.3 trillion
per day, handled via the Clearing House Interbank
Payments Company (CHIPCo). (See CHIPS.org)
Think thru the implications of these recent
developments.
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END WEEK 8 MONETARY POLICY AND THE NATION
AL ECONOMY