Money and Banks

1
Money and Banks

• Chapter 13

2
What Is Money?

• Without money, you would have to use barter to
  get items you want.
• Barter is the direct exchange of one good for
  another, without the use of money.
• Money solves the double coincidence of wants.

3
The Money Supply

• Anything that serves all of the following
  purposes can be thought of as mey
• Medium of exchange
• Unit of account
• Store of value

4
Modern Concepts

• Money is anything generally accepted as a medium
  of exchange.
• The currency (greenbacks) we carry around today
  are not the only form of money we use.
• Checking accounts can and do perform the same
  market functions as cash.
• Credit cards are another popular medium of
  exchange but are not money.
• They are only a payment service with no store of
  value in and of themselves.

5
Diversity of Bank Accounts

• There are many forms of bank accounts.
• Some bank accounts are better substitutes for
  cash than others.
• How much money is available affects consumers
  ability to purchase goods and services and
  affects aggregate demand.

6
M1 Cash and Transactions Accounts

• M1 money supply includes currency in circulation,
  transaction-account balances, and travelers
  checks.
• A transactions account is a bank account that
  permits direct payment to a third party, for
  example, with a check or debit card.

7
M2 M1 Savings Accounts, etc.

• M2 money supply M1 plus balances in most
  savings accounts and money market mutual funds.
• Savings-account balances are almost as good a
  substitute for cash as transaction-account
  balances.

8
Composition of the Money Supply
A Question of Liquidity
M2 (6,293 billion)
9
Bank Regulation

• The deposit-creation activities of banks are
  regulated by the government.
• The central bank influences the amount of bank
  lending, thereby affecting the basic money
  supply.
• Bank reserves are assets held by a bank to
  fulfill its deposit obligations.

10
Fractional Reserves

• The central bank requires banks to maintain some
  minimum reserve ratio.
• Bank reserves are only a fraction of total
  transaction deposits.
• The reserve ratio is the ratio of a bank's
  reserves to its total deposits.

11
Creation of Money

• Currency is printed.
• Coins are minted.

12
Deposit Creation

• When a bank lends someone money, it simply
  credits that individuals bank account.
• Deposit creation is the creation of transactions
  deposits by bank lending.
• When a bank makes a loan, it effectively creates
  money because transactions-account balances are
  counted as part of the money supply.

13
Deposit Creation

• There are two basic principles of the money
  supply

• Transactions-account balances are a large portion
  of our money supply.
• Banks can create transactions-account balances by
  making loans.

14
Deposit Creation

• When someone deposits cash or coins in a bank,
  they are changing the composition of the money
  supply, not its size.
• Assume a student deposits SK1000 from their piggy
  bank into the University Bank and receives a new
  checking account.

15
Deposit Creation

• The University Bank loans SK1000 to the
  University Bookstore by crediting its checking
  account.
• Money has been created because checking accounts
  are money.
• Total bank reserves have remained unchanged.

16
Secondary Deposits

• If there is only one bank, when Campus Bookstore
  uses the loan, the proceeds of the loan are
  re-deposited in the University Bank.

17
The T-account of the Bank

• The books of a bank must always balance, because
  all of the assets of the bank must belong to
  someone (its depositors or its owners).

18
Money Creation
19
Money Creation
20
Required Reserves

• A minimum reserve requirement directly limits
  deposit-creation possibilities.
• Required reserves are the minimum amount of
  reserves a bank is required to hold by government
  regulation
• Equals required reserve ratio times transactions
  deposits.

Required reserves minimum reserve ratio X
total deposits
21
A Multibank World

• In reality, there is more than one bank.
• The ability of banks to make loans depends on
  access to excess reserves.
• Example If a bank is required to hold 20 in
  reserves and has 100 in deposits, then it must
  keep 20 in reserves and can lend out the 80
  excess.

Excess reserves Total reserves Required
reserves
22
Changes in the Money Supply

• As the excess reserves are loaned out again, more
  transaction deposits are created and thus more
  money is created.

23
Deposit Creation
24
Deposit Creation
25
Deposit Creation
26
Deposit Creation
27
Deposit Creation
28
The Money Multiplier

• In a multi-bank system, deposits created by one
  bank invariably end up as reserves in another
  bank.
• Required reserves represent leakage from the flow
  of money, since they cannot be used to create new
  loans.
• Excess reserve can be used for new loans.
• This process can theoretically continue until all
  banks have zero excess reserves (no more loans
  can be made).

29
The Money Multiplier

• The money multiplier is the number of deposit
  (loan) dollars that the banking system can create
  from 1 of excess reserves.

30
The Money Multiplier

• The money supply can be increased through the
  process of deposit creation to this limit

Potential deposit creation Excess reserves of
banking system X Money multiplier
31
The Money Multiplier Process
32
Excess Reserves as Lending Power

• Each bank may lend an amount equal to its excess
  reserves and no more.
• The banking system can increase the volume of
  loans by the amount of excess reserves multiplied
  by the money multiplier.

33
The Money Multiplier at Work
34
Banks and the Circular Flow

• Banks perform two essential functions for the
  macro economy
• Banks transfer money from savers to borrowers by
  lending funds (excess reserves) held on deposit.
• The banking system creates additional money by
  making loans in excess of total reserves.
• This financial intermediation helps maintain any
  desired rate of aggregate demand.

35
Financing Injections

• Consumer saving is a leakage.
• A substantial portion of consumer saving is
  deposited in banks.
• Bank deposits can be used to make loans, which
  returns purchasing power to the circular flow.

36
Banks in the Circular Flow
Domestic consumption
Income
Sales receipts
Business firms
Investment expenditures
Wages, dividends, etc.
37
Constraints on Deposit Creation

• There are three major constraints on deposit
  creation
• Deposits Consumers must be willing to use and
  accept checks rather than cash.
• Borrowers Borrowers must be willing to borrow
  the money that banks provide.
• Regulation The central bank sets the ceiling on
  deposit creation.

38
When Banks Fail

• In the past, runs of depositors rushing to
  withdraw their funds have created panics.
• Bank closed, wiping out customer deposits,
  curtailing lending, and often pushing the economy
  into recession.
• In the early part of the Great Depression
  (1930-1933), 9000 banks failed.

39
Deposit Insurance

• The FDIC and FSLIC were created by Congress in
  1933-34, to ensure depositors that their money
  would be safe -- thus eliminating the motivation
  for deposit runs.

40
Monetary Policy

• Chapter 15

41
Policy Tools

• Monetary Policy
• Changes in the supply of money used to try to
  influence the levels of output, employment, and
  prices.
• GDP C I G (Ex-Im)

42
Money Balances

• Most of the money in the money supply (M1 and M2)
  is in the form of bank balances.
• Money Supply (M1) Currency held by the public,
  plus balances in transactions accounts.
• Money Supply (M2) - M1 plus balances in most
  savings accounts and money market mutual funds.

43
The Money Market

• The price of money is determined by the supply
  and demand of money.
• The interest rate is the price paid for the use
  of money.
• Foregone interest is the opportunity cost of
  money and affects why people choose to hold money.

44
The Demand for Money

• The demand for money reflects the quantity of
  money people are willing and able to hold at
  alternative interest rates, ceteris paribus.
• A portfolio decision is the choice of how to hold
  idle funds.

45
The Demand for Money

• Although holding money provides little or no
  interest, there are reasons for doing so.
• Transactions demand
• Money held for the purpose of making everyday
  market purchases.
• Precautionary demand
• Money held for unexpected market transactions or
  for emergencies.
• Speculative demand
• Money held for later financial opportunities.

46
Demand and Supply in the Money Market

• The quantity of money that people are willing and
  able to hold (demand) increases as interest rates
  fall (ceteris paribus).
• The money supply is determined by the central
  bank and does not respond to interest rates.
• The equilibrium rate of interest is the interest
  rate at which the quantity of money demanded in a
  given time period equals the quantity of money
  supplied.

47
Money Market Equilibrium
Money supply
The amount of money demanded (held) depends on
interest rates
E1
Interest Rate (percent per year)
7
Money demand
g1
0
Quantity Of Money (billions of dollars)
48
Changing Interest Rates

• To increase the equilibrium rate of interest, the
  central bank decreases the money supply.
• To lower the equilibrium rate of interest, the
  central bank increases the money supply.
• People are willing to hold larger money balances
  only at lower interest rates.

49
Changing Interest Rates
Money supply
The amount of money demanded (held) depends on
interest rates
E1
Interest Rate (percent per year)
7
Money demand
g1
0
Quantity Of Money (billions of dollars)
50
Changing Interest Rates
E1
Interest Rate(percent per year)
7
E3
Demand for money
6
g1
g3
0
Quantity Of Money (billions of dollars)
51
Inter-Bank Rate

• When the central bank injects or withdraws
  reserves from the banking system, the inter-bank
  rate is most directly affected.
• The inter-bank rate reflects the cost of funds
  for banks.
• Federal Funds Rate The interest rate for
  inter-bank reserve loans.

52
Consumption and Investment

• Changes in interest rates affect consumer,
  investor, and net export spending.
• Lowering interest rates lowers the cost of
  borrowing which encourages investment.
• Increased investment injects new spending into
  the circular flow.
• The multiplier effect results in an even larger
  increase in aggregate demand.

53
Increasing Aggregate Demand

• To lower unemployment pressures, the central bank
  will apply a policy of monetary stimulus.
• The central banks objective of stimulating the
  economy is achieved in three steps
• An increase in the money supply.
• A reduction in interest rates.
• An increase in aggregate demand.

54
Monetary Stimulus
55
Decreasing Aggregate Demand

• To lower inflationary pressures, the central bank
  will apply a policy of monetary restraint.
• Monetary restraint is achieved with
• A decrease in the money supply.
• An increase in interest rates.
• A decrease in aggregate demand.

56
Monetary Restraint
An increase in the rate of interest lowers
investment
Less investment decreases aggregate demand
(including multiplier effects)
AS
Investment demand
7
Interest Rate
Price Level
6
AD1
AD2
0
I2
I1
Rate Of Investment
Income (Output)