Chapter 25

1. Chapter 25 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—things of value that people own—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 two useful functions • Provides a unit of account • Standardized way of measuring value of things that are traded. • Serves as store of value • One of several ways in which households can hold their wealth.

3. 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.

4. 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. • Demand deposits (Checking accounts) • Other checkable 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 deposits in retail money market mutual funds. • 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

5. Figure 1: Monetary Assets and Their Liquidity (July 14, 2003)

6. M1 And M2 • Standard measure of money stock (supply) is M1 • Sum of the first four assets in our list • M1 = cash in the hands of the public + demand deposits + other checking account 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 + retail MMMF balances + small denomination time deposits

7. M1 And M2 • We will assume money supply consists of just two components. • Cash in the hands of the public and demand deposits • Our definition of the money supply corresponds closely to liquid assets that our national monetary authority—the Federal Reserve—can control.

8. The Banking System: Financial Intermediaries • What are banks? • Financial intermediaries—business 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 the rate they pay to depositors.

9. A Bank’s 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 bank’s assets are listed • Everything of value that it owns • Bonds • Loans • Vault cash • Account with the Federal Reserve • On the other side, the bank’s liabilities are listed • Amounts it owes • Deposits • Net worth = Total assets – Total liabilities

10. A Bank’s Balance Sheet • Explanations for vault cash and accounts with Federal Reserve • On any given day, some of the bank’s 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

11. Figure 2: The Geography of the Federal Reserve System

12. Figure 3: The Structure of the Federal Reserve System

13. 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 nation’s money supply by buying and selling bonds in public (“open”) bond market.

14. The Fed and the Money Supply • Suppose Fed wants to change nation’s money supply • It buys or sells government bonds to bond dealers, banks, or other financial institutions. • Actions are called open market operations • We’ll 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.

15. 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.

16. 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 • ΔDD = 10 x reserve injection

17. 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 • ΔDD = (1 / RRR) x ΔReserves • 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 • ΔMoney Supply = (1 / RRR) x ΔReserves

18. 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 multiplier—1/(RRR), we can calculate the decrease in money supply with the same formula. • ΔDD = (1/RRR) x Δreserves • This time, the change in reserve is negative.

19. Some Important Provisos About the Demand Deposit Multiplier • Although process of money creation and destruction as we’ve described it illustrates the basic ideas, formula for demand deposit multiplier—1/RRR—is oversimplified. • In reality, multiplier is likely to be smaller than formula suggests, for two reasons: • We’ve assumed that as money supply changes, public does not change its holdings of cash. • We’ve assumed that banks will always lend out all of their excess reserves.

20. 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.