Money, Banking, and the Federal Reserve System

1
Money, Banking, and the Federal Reserve System

• Keys Issues
• What is money and why does money make economies
  more efficient?
• Define money and describe its functions
• What determines the amount of money in the
  economy?
• 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
• How do changes in the quantity of money influence
  the macroeconomy? (Later)

2
What is Money?

• Money is any commodity or token that is generally
  acceptable as a medium of exchange.
• Money has three other functions
• Means of Payment
• Unit of account
• Store of value

3
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.

4
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.
• Means of Payment
• A means of payment is a method of settling a
  debt.

5
What is Money?

• 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.

6
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.

7
What is Money?

• Figure 10.1 illustrates the composition of these
  two measures in 2001 and shows the relative
  magnitudes of the components of money.

8
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.

9
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

10
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.

11
Depository Institutions

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

12
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.

13
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.

14
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

15
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.

16
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.

17
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.

18
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.

19
How Banks Create Money

• The process continues and keeps repeating with
  smaller and smaller loans at each round.
• Figure 10.2 illustrates the money creation
  process.