Lecture 10

1. Lecture 10 Money and the Banking System & Monetary Policy

2. Why are Banks so Heavily Regulated? Nature of Money How Quantity of Money is Measured Banking System Origins of the Money Supply Banks & Money Creation Why the Money Creation Multiplier is Oversimplified Need for Monetary Policy Overview

3. Why are Banks so Heavily Regulated? • Major “output” of banking industry is the nation’s MS --important determinant of AD. • 1. Bank managers are paid to max shareholder value & not what is in the best interests of the economy. • Gov does not allow banks to determine MS & interest rates strictly on profit considerations. • 2. Concern for the safety of depositors • If banks are allowed to fail, then depositors would lose their money whenever one went bankrupt. • “Run on a bank:” if depositors get nervous, they may all rush to cash their accounts which causes the bank to fail. This is highly contagious!

4. Figure 1 (a) Bank failures in the United States, 1915–2009 Bank failures have been less common since 1930s –until recently.

5. Figure 1 (b) Bank failures in the United States, 1915–2009 ‘09

6. The Nature of Money • Barter • System of exchange where people directly trade goods for goods without using money as an intermediate step • Requires: “double coincidence of wants” • Money • Greases the wheels of exchange & makes the whole economy more productive • Dramatically reduces search costs under a barter system

7. The Nature of Money • What is Money? • Medium of exchange • Standard object used in exchanging goods & services • Unit of account • Standard unit used for quoting prices • Store of value • Store wealth from one point in time to another • Money is not a good hedge against inflation!

8. The Nature of Money • What Serves as Money? • Commodity money • An object (like cattle, stones, cigarettes, gold) used as a medium of exchange that also has substantial value in alternative uses • Paper money = Fiat money • Decreed as money by gov & has little value as a commodity • Maintains its value as a medium of exchange because people have faith that the issuer will back the paper & limit its production

9. How Quantity of Money is Measured • One measure of MS: M1 • Narrowly defined • Includes coins, paper money, traveler’s checks, conventional checking accounts, & certain other checkable deposits in banks & savings institutions • M1 = $1,693 billion in 2009

10. How Quantity of Money is Measured • Another measure of MS: M2 • Broadly defined • Includes M1 plus money market deposit accounts, money market mutual funds, & savings accounts • M2 = $8,524 billion in 2009 • Everything in M1 is completely “liquid.” • Liquidity refers to the ease with which an asset can be converted into cash.

11. How Quantity of Money is Measured • Credit cards are not included in MS • How much money does your credit card represent? • Should we count what you owe or your available credit? • We will stick with a conventional definition of money • Coins, paper money, & checkable deposits

12. The Banking System • Fractional reserve banking • is a system under which bankers keep as reserves only a fraction of the funds they hold on deposit • Features • Bank profitability • Banks get deposits at zero interest & lend some of them out at positive interest rates.

13. The Banking System Features (cont.) Bank discretion over money supply Create money by keeping only a fraction of their total deposits on reserve & lending out the balance Bankers’ decisions on how much to hold in reserves influence the supply of money Exposure to bank runs Danger of a run on the bank has induced bankers to keep prudent reserves & lend out money carefully

14. The Banking System • Banking is an inherently risky business • Safe only by cautious & prudent management • Recent events (e.g., subprime mortgage meltdown) showed that bank managers were neither cautious nor prudent. Why? • Caution is not the road to high profits • Max profits by keeping low reserves & earning high interest rates on risky borrowers • Banks need to strike a balance between the lure of profits & the need for safety

15. The Banking System • Bank regulations • Deposit insurance - guarantees the safety of bank deposits • FDIC • Established in 1933 –reduced the # of bank failures • Your account is insured up to $250,000 • Prevents bank runs • Moral hazard problem • If depositors are freed from risk of loss from a failing bank, then they will not shop around for safer banks. • People who are insured against the consequences of risk will engage in riskier behaviors.

16. The Banking System Bank regulations (cont.) Bank supervision Various regulatory authorities conduct periodic bank examinations Laws & regulations limit the kinds & qualities of assets in which banks may invest Reserve requirements Minimum amount of reserves Proportional to volume of deposits Not really for safety but to control the MS

17. The Origins of the Money Supply • Asset of a bank: item of value that is owned by the bank (e.g., bank building or loan) • Liability of a bank: item of value that the bank owes (e.g., your bank balance) • Balance sheet: is an accounting statement • Left side: lists values of all assets • Right side: values of all liabilities & net worth • Net worth = value of assets – value of liabilities • Assets = Liabilities + Net worth

18. Table 1 Balance sheet of Bank-a-mythica, December 31, 2007 Example of a balance sheet. Bank has only two kinds of assets: $1M in cash reserves & $4.5M in outstanding loans. One kind of liability: $5M in checking deposits. Net worth = total assets – total liabilities = $500,000.

19. Banks and Money Creation • Our goal is to understand the process of deposit creation. • Fractional reserve banking system can turn $1 of bank reserves into several dollars of bank deposits • Excess reserves • Any reserves held in excess of the legal minimum • Earn no interest so banks typically want to keep excess reserves at zero

20. Table 2 Changes in Bank-a-mythica’s balance sheet, January 2, 2008 Eccentric widower deposits $100,000 in cash into a checking deposit. The bank has $100,000 more in cash reserves & in checking deposits. Assuming the required reserve ratio is 20%, the bank now has excess reserves of $80,000.

21. Table 3 Changes in Bank-a-mythica’s balance sheet, January 3–6, 2008 Bank earns 0% interest on the excess reserves, so it will make a loan of $80,000 to Hard-Pressed Construction Co. Loans rise by $80,000 & cash reserves fall by $80,000.

22. Table 4 Changes in Bank-a-mythica’s balance sheet, January 2–6, 2008 Combine Tables 2 & 3 to show the bank’s transactions. Checking deposits are up by $100,000, reserves are up by $20,000, loans are up by $80,000. Money creation has begun! $100,000 in cash deposits has turned into $100,000 in checking deposits + $80,000 loan (which was probably deposited in another bank by Hard-Pressed). So the original $100,000 deposit is now $180,000.

23. Table 5 Changes in First National Bank’s balance sheet Hard-Pressed banks at First National & deposits the $80,000 loan from BAM. First National’s reserves rise by $80,000 & it loans out the excess reserves of $64,000 to Al’s Auto Shop. Now $244,000 worth of money is circulating = $100,000 initial deposit + $80,000 (loan & deposit of Hard-Pressed) + $64,000 (loan & presumed deposit of Al).

24. Table 6 Changes in Second National Bank’s balance sheet Al deposits the $64,000 loan from FN to his bank, Second National. Second National now has $51,200 in excess reserves which it will loan out. And the money creation process continues…

25. Banks and Money Creation • Assumptions of our money creation process • Each bank holds exactly 20% required reserves • Each loan recipient re-deposits proceeds in the next bank • Sum of infinite geometric progression where R = 0.80 $100,000 + $80,000 + $64,000 + $51,200 + … = $100,000 X 1/(1 – 0.80) = $100,000/(0.20) = $500,000

26. Figure 2. Chain of Multiple Deposit Creation The initial deposit of $100,000 in cash is eventually absorbed in bank reserves (col. 1), leading to a total of $500,000 in new deposits (col. 2), & $400,000 in new loans (col. 3). Money supply rises by $400,000 because the nonbank public holds $100,000 less in currency & $500,000 more in checking deposits.

27. Banks and Money Creation • Reserve ratio = m • R = 1-m • Deposits expand by 1/m of each $1 of new reserves that are injected into the system • Oversimplified money multiplier formula • ∆MS= (1/m) x ∆reserves • Our example: ∆reserves = $100,000 x 1/0.20 = $500,000 but $500,000 is not the ∆MS because money includes both checking deposits & cash –which increases by only $400,000. There are $500,000 in new deposits but $100,000 less in cash.

28. Banks and Money Creation • Multiple contractions of MS • Deposit destruction shown in Tables 7 & 8 • Now the eccentric widower withdrawals $100,000 from his checking deposit at BAM & places it under his mattress. • Decrease BAM’s reserves by $100,000 • BAM needs $80,000 to meet its reserve requirement • As outstanding loans are paid off it would cease granting new loans until the $80,000 is acquired • Where did the borrowers get this $80,000? • Probably by making withdrawals from other banks

29. Banks and Money Creation Assume funds came from FNB which now loses $80,000 in deposits & $80,000 in reserves. It is now short $64,000 in reserves & must reduce its loan commitments by $64,000 as shown in Table 8. This reaction causes some other bank to suffer a loss of reserves & deposits of $64,000 & the whole process repeats. Overall, process looks like Figure 2 but with minus signs. Deposits shrink by $500,000; loans fall by $400,000; bank reserves fall by $100,000; & M1 falls by $400,000.

30. Table 7 Changes in the balance sheet of Bank-a-mythica

31. Table 8 Changes in the balance sheet of First National Bank

32. Money-Creation Formula Is Oversimplified • Oversimplified money multiplier is only accurate under very particular circumstances: • Every recipient of cash must redeposit the cash into another bank rather than hold it. • Every bank must hold reserves no larger than the legal minimum.

33. Money-Creation Formula Is Oversimplified • If individuals & firms hold more cash, the multiple expansion of bank deposits is curtailed because fewer dollars of cash will be available for use as reserves to support checking deposits. So the MS will be smaller. • If banks wish to keep excess reserves, the multiple expansion of bank deposits will be limited. A given amount of cash will support a smaller MS than would be the case if banks held no excess reserves.

34. The Need for Monetary Policy • During a recession • Banks would reduce MS by increasing their excess reserves & refusing to lend to less creditworthy applicants • Tight credit deepens a recession • Need government intervention • During Great Depression, MS contracted violently because banks held excess reserves rather than making loans that might not be repaid.

35. The Need for Monetary Policy • During an economic boom • Banks would expand MS by keeping reserves at a minimum & lending to firms when AD and profits are high • Adds undesirable momentum to the economy & paves the way for inflation • Need government intervention

36. Managing Aggregate Demand: Monetary Policy

37. Money & Income Federal Reserve System Open Market Operations Other Methods of Monetary Control How Monetary Policy Works Money & the Price Level Overview

38. Money and Income: Difference Money • At one point in time • How much money do you have right now? • E.g., money stock (M1) Income • Over a period of time • What is your income? (per month or per year) • E.g., nominal GDP per year Examine how interest rates and stock of money influence rate at which people earn income –or how monetary policy affects GDP 38

39. The Federal Reserve System Federal Reserve System “The Fed” • U.S. central bank • Bank for banks • Created in 1907 • After four severe banking panics (1873-1907) • 12 central banks • Each is a corporation whose stockholders are member banks • Immense profits go to U.S. Treasury 39

40. The Federal Reserve System (7 member) Board of Governors • Appointed by U.S. President • Chairman serves a 4-year term • Most powerful central banker in the world • Advice & consent of Senate The Fed • Independent • Makes decisions without political interference • Sets monetary policy 40

41. The Federal Reserve System Federal Open Market Committee (FOMC) • Determines short-term interest rates & size of U.S. MS • 12 voting members • 7 governors of the Fed • President of the NY Fed • 4 (of remaining 11) district bank presidents • Meets 8 times a year in Washington • Very limited access to meetings; no press • Decisions are announced at the meeting’s end 41

42. Implementing Monetary Policy Fed normally relies on open-market operations to control interest rates • Fed’s purchase or sale of gov securities Open market operations either give banks more reserves or take reserves away from them, thereby triggering a multiple expansion in MS To see how open-market operations affect interest rates, we need to understand the market for bank reserves 42

43. Implementing Monetary Policy Market for bank reserves • (upward-sloping) Supply curve • Fed decides how many dollars of reserves to supply • ∆Fed policy shifts the S curve • (downward-sloping) Demand curve • Banks are required to hold reserves • Required reserve ratio (m) = 0.10 in U.S. • Reflects the demand for bank deposits • People hold bank deposits to conduct transactions • GDP reflects the number of transactions & P level reflects the average price per transaction • ∆GDP or ∆P level will shift the D curve 43

44. Figure 1 S ∆Fed policy will shift the S curve ∆GDP or ∆P level will shift the D curve D For given Fed policy E Interest Rate For given Y and P D S Quantity of Bank Reserves The market for bank reserves 44

45. Implementing Monetary Policy Market for bank reserves • Interest rate in Fig. 1 is the federal funds rate • Interest rate that banks pay/receive when they borrow reserves from one another • Banks lend or borrow from one another to maintain a desired level of reserves • D (S) for reserves slopes downward (upward) because as interest rates rise borrowing (lending) becomes more expensive (attractive) 45

46. Figure 2 S0 S1 If Fed wants to lower federal funds rate, it provides additional reserves by purchasing T-Bills from banks. This shifts S curve outward. D E A Interest Rate D S1 S0 Quantity of Bank Reserves The effects of an open-market purchase 46

47. Implementing Monetary Policy Table 1 shows the bookkeeping behind the Fed’s open-market purchase of $100m worth of T-Bills. Fed makes payment by giving banks $100m in new reserves. • These reserves are liabilities of Fed & assets of banks. • Bank deposits have not increased so required reserves are unchanged but actual reserves are $100m higher. • Now banks have $100m in excess reserves. 47

48. Table 1 Reserves +$100 million Bank Reserves +$100 million U.S. government securities +$100 million U.S. government securities -$100 million Bank gets Reserves Addendum: Changes in Reserves Actual Reserves +$100 million Required Reserves No Change Excess Reserves +$100 million Fed gets securities Effects of an open-market purchase of gov securities on the balance sheets of banks and the Fed 48

49. Implementing Monetary Policy Additional bank reserves can support a multiple expansion of MS. • Banks lend to rid themselves of excess reserves. • Estimate ultimate ↑MS = $100m ∕ “m” = $500m • If m = 0.20 Difficult to estimate ultimate ↑MS because • People may want to hold more cash • Banks may want to hold excess reserves • Oversimplified money multiplier assumes that neither is true. 49

50. Implementing Monetary Policy Fed controls the federal funds rate directly by buying just the right volume of securities. Consider the case when Fed wants to increase interest rates (contractionary monetary policy) • Fed sells T-Bills in the open market • Banks pay with reserves • They draw down on their deposits at the Fed • Banks acquire reserves by curtailing their lending • Multiple contraction process ensues 50