The Banking System and the Money Supply

1

• The Banking System and the Money Supply

2
What Counts as Money

• Definition of Money
• Money is an asset that is widely accepted
  as a means of payment
• Only assets can be considered as money
• Can credit cards be considered as money?
• Only things that are widely acceptable as a means
  of payment are regarded as money
• Can stocks or bonds be considered as money?
• Money has three useful functions
• Serves as a medium of exchange
• accepted in exchange for goods and services
• Provides a unit of account
• Standardized way of measuring value of things
  that are traded
• Serves as a store of value
• One of several ways in which households can hold
  their wealth

3
History of Currency

• In a barter economy, where there is no commonly
  accepted currency cows, sheep, fish
• Commodity money (with intrinsic value) like
  precious metals gold, silver, copper,etc.
• Paper currency
• used to be backed by physical commodity
• Now, we have fiat money, i.e. a means of
  payment by government declaration.
• Legal tender payment that cannot be refused
  in settlement of a debt denominated in the same
  currency by virtue of law.

4
Measuring the Money Supply

• Money Supply
• Total amount of money held by the public
• Governments use different measures of the money
  supply
• Each measure includes a selection of assets that
  are widely acceptable as a means of payment and
  are relatively liquid
• An asset is considered liquid if it can be
  converted to cash quickly and at little cost
• So, an illiquid asset can be converted to cash
  only after a delay, or at considerable cost

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Assets and Their Liquidity

• Most liquid asset is cash in the hands of the
  public
• Next in line are asset categories of about equal
  liquidity
• Checkable deposits (demand deposits and other
  checking accounts)
• Travelers checks
• Then, savings-type accounts
• less liquid than checking-type accounts, since
  they do not allow you to write checks
• Next on the list are time deposits
• Time deposits (called certificates of deposit, or
  CDs)
• Require you to keep your money in the bank for a
  specified period of time (usually six months or
  longer)
• Impose an interest penalty if you withdraw early

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M1 And M2

• Standard measure of money stock (supply) is M1
• M1 cash in the hands of the public checkable
  deposits travelers checks
• When economists or government officials speak
  about money supply, they usually mean M1
• Another common measure of money supply, M2, adds
  some other types of assets to M1
• M2 M1 savings-type accounts small
  denomination time deposits
• M3M2large denomination time deposits

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The Banking System Financial Intermediaries

• What are banks?
• Financial intermediariesbusiness firms that
  specialize in
• Collecting loanable funds from households and
  firms whose revenues exceed their expenditures
• Channeling those funds to households and firms
  (and sometimes the government) whose expenditures
  exceed revenues
• Intermediaries must earn a profit for providing
  brokering services
• By charging a higher interest rate on funds they
  lend than rate they pay to depositors

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Figure 1 The Geography of the Federal Reserve
System
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Figure 2 The Structure of the Federal Reserve
System
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The Federal Open Market Committee

• Federal Open Market Committee (FOMC)
• A committee of Federal Reserve officials that
  establishes U.S. monetary policy
• Consists of all 7 governors of Fed, along with 5
  of the 12 district bank presidents
• Not even President of United States knows details
  behind the decisions, or what FOMC actually
  discussed at its meeting, until summary of
  meeting is finally released
• The FOMC exerts control over nations money
  supply by buying and selling bonds in public
  (open) bond market

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A Banks Balance Sheet

• A balance sheet is a financial statement that
  provides information about financial conditions
  of a bank at a particular point in time
• On one side, a banks assets are listed
• Everything of value that it owns
• Property and buildings
• Bonds
• Loans
• Vault cash
• Account with the Federal Reserve
• On the other side, the banks liabilities are
  listed
• Amounts it owes
• Deposits
• Net worth Total assets Total liabilities
• What bank would owe to its owners if it went out
  of business
• A balance sheet always balances

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A Banks Balance Sheet

• Explanations for vault cash and accounts with
  Federal Reserve
• On any given day, some of the banks customers
  might want to withdraw more cash than other
  customers are depositing
• Banks are required by law to hold reserves
• Sum of cash in vault and accounts with Federal
  Reserve
• Required reserve ratio tells banks the fraction
  of their checking accounts that they must hold as
  required reserves
• Set by Federal Reserve

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The Fed and the Money Supply

• Suppose Fed wants to change nations money supply
• It buys or sells government bonds to bond
  dealers, banks, or other financial institutions
• Actions are called open market operations
• Well make two special assumptions to keep our
  analysis of open market operations simple for now
• Households and business are satisfied holding the
  amount of cash they are currently holding
• Any additional funds they might acquire are
  deposited in their checking accounts
• Any decrease in their funds comes from their
  checking accounts
• Banks never hold reserves in excess of those
  legally required by law

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How the Fed Increases the Money Supply

• To increase money supply, Fed will buy government
  bonds
• Called an open market purchase
• Suppose, by writing a check, Fed buys 1,000 bond
  from Lehman Brothers, which deposits the total
  into its checking account
• Two important things have happened
• Fed has injected reserve into banking system
• Money supply has increased
• Demand deposits have increased by 1,000 and
  demand deposits are part of money supply (for
  instance, M1)
• Lehman Brothers bank now has excess reserves
• Reserves in excess of required reserves
• If required reserve ratio is 10 bank has excess
  reserves of 900 to lend
• Demand deposits increase each time a bank lends
  out excess reserves

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The Demand Deposit Multiplier

• How much will demand deposits increase in total?
• Each bank creates less in demand deposits than
  the bank before
• In each round, a bank lends 90 of deposit it
  received
• So, the total increase in demand deposits is
• Whatever the injection of reserves, demand
  deposits will increase by a factor of 10, so we
  can write
• ?DD 10 x reserve injection

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The Demand Deposit Multiplier

• For any value of required reserve ratio (RRR),
  formula for demand deposit multiplier is 1/RRR
• Using general formula for demand deposit
  multiplier, can restate what happens when Fed
  injects reserves into banking system as follows
• ?DD (1 / RRR) x ?Reserves
• With the assumption that the amount of cash in
  the hands of the public (the other component of
  the money supply) does not change, we can also
  write
• ?Money Supply (1 / RRR) x ?Reserves

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How the Fed Decreases the Money Supply

• Just as Fed can decrease money supply by selling
  government bonds
• An open market sale
• Banks have to call in loans in order to meet the
  required reserve amount with Fed
• Process of calling in loans will involve many
  banks
• Each time a bank calls in a loan, demand deposits
  are destroyed
• Total decline in demand deposits will be a
  multiple of initial withdrawal of reserves
• Using demand deposit multiplier1/(RRR), we can
  calculate the decrease in money supply with the
  same formula
• ?DD (1/RRR) x ?reserves
• This time, the change in reserve is negative

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Some Important Provisos About the Demand Deposit
Multiplier

• Although process of money creation and
  destruction as weve described it illustrates the
  basic ideas, formula for demand deposit
  multiplier1/RRRis oversimplified
• In reality, multiplier is likely to be smaller
  than formula suggests, for two reasons
• Weve assumed that as money supply changes,
  public does not change its holdings of cash
• Weve assumed that banks will always lend out all
  of their excess reserves

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Other Tools for Controlling the Money Supply

• There are two other tools Fed can use to increase
  or decrease money supply
• Changes in required reserve ratio
• Changes in discount rate
• Changes in either required reserve ratio or
  discount rate could set off the process of
  deposit creation or deposit destruction in much
  the same way outlined in this chapter
• In reality, neither of these policy tools is used
  very often
• Why are these other tools used so seldom?
• Partly because they can have unpredictable effects