MONEY, THE BANKING SYSTEM & THE FEDERAL RESERVE

Lecture 9 MONEY, THE BANKING SYSTEM & THE FEDERAL RESERVE

MONEY Anything that is regularly used in economic transactions or exchanges.

THREE PROPERTIES OF MONEY 1. Money serves as a medium of exchange 2. Money serves as a unit of account 3. Money serves as a store of value

MEDIUM OF EXCHANGE $$$$$$$$$$$$$$$ • Money is accepted in economic exchanges • Alternative to barter -- trading goods directly for goods • For economic exchanges to occur using barter, double coincidence of wants must exist: -- unless you want to trade something another person wants, and you want what the other person has to trade, this economic exchange could not occur

UNIT OF ACCOUNT • Money provides a convenient measuring rod when prices for all goods are quoted in terms of money • It makes it easier to conduct economic transactions since there is a standard unit in which to do so

STORE OF VALUE • During a period of time, the value of money should not change • Money is a somewhat imperfect store of value, thanks to inflation

LIQUIDITY - 1 • Refers to the ease with which an asset can be converted into the economy's medium of exchange. • Since money IS the economy's medium of exchange, it must be the most liquid store of value in the economy.

LIQUIDITY - 2 • Other ways to store value include buying stocks, bonds, mutual funds, gold, silver, or owning a house or other valuable property. Since it takes some time and effort to convert these assets into money, they are all LESS liquid than money.

HISTORY OF MONEY • Throughout history, money can be divided into two general categories: • commodity money • fiat money

COMMODITY MONEY • Commodity money is money that takes the form of a commodity with intrinsic value. Commodity money has value, in and of itself, beyond its value as the medium of exchange and the unit of account. The classic example of commodity money is gold and silver coins - you could always melt the coins down and the gold and silver would have its OWN value.

FIAT MONEY • Fiat money is money without intrinsic value that is used as money because of government decree. • The US $ is an example of fiat money because the paper the $ is printed on has NO value outside of being the medium of exchange and the unit of account. • Before moving from money to central banking, we’ll first consider what the size of the US money stock is and how it is measured.

MONEY STOCK • The money stock is the quantity of money circulating in the economy Q: Suppose you want to know the size of the US money stock. What should you count as money? A: Currency and demand deposits, and a few other items (detailed in the following slides) but NOT credit cards.

WHAT COUNTS AS MONEY • Currency: the paper bills and coins in the hands of the public. • Demand deposits: balances in bank accounts that depositors can access on demand by writing a check (or by using a debit card) Q: How is the US money stock measured and reported? A: Your textbook gives the two most important measures - M1 and M2

COMPONENTS OF M1 Currency held by the public $ 372 billion Demand deposits $ 389 billion Other checkable deposits $ 353 billion Travelers checks $ 9 billion Total of M1 $1,123 billion Source: Economic Report of the President, Washington, DC: U.S. Government Printing Office, 1996 • Approximately two-thirds of M1 consists of checking account balances • Approximately one-third consists of currency

COMPONENTS OF M1 • Currency held by public -- All currency held outside of bank vaults • Demand deposits -- Deposits in checking accounts • Other checkable deposits -- Introduced in the early 1980s to describe checking accounts that paid interest • Travelers checks -- included in M1 since they are regularly used in economic exchanges

CURRENCY IN THE ECONOMY $372 billion of currency amounts to over $1,430 for every man, woman and child in the U.S. Most of the currency in the official statistics is not used in ordinary commerce in the U.S. • Much is held abroad by wealthy people • Some circulates in other countries along with local currencies • Currency is also used in illegal transactions

M2 • Broader definition of money • Includes assets that are sometimes used in economic exchanges or can be readily turned into M1 • Consists of all assets in M1 plus other assets such as deposits in money market mutual funds • These are funds in which individuals can invest, earn interest, and in some cases can be used to write checks • Deposits in savings accounts are also included in M2. • M2 for 1996 was $3,657.4 billion. Dividing M1 by M2 shows that M1 was 29.4% of M2 during 1996.

WHY ARE THERE DIFFERENT MEASURES OF THE MONEY STOCK? • Because the assets that comprise M1 and M2 have varying degrees of liquidity. Notice that the assets included in M1 are very liquid, while the assets that are included in M2 are LESS liquid. You can think of M1 as the most liquid measure of the money stock, while M2 is a less liquid measure.

BANKS AND THE MONEY SUPPLY - 1 Q: How do banks operate? A: Banks accept money from people and keep that money safe until the depositor makes a withdrawal or writes a check on their account.

BANKS AND THE MONEY SUPPLY - 2 Q: Do banks keep all of our money in their vault? A: No. The US banking system is called fractional reserve banking. Bankers understand that it is not necessary to keep 100% of a depositors money on hand at all times. As a result, bankers take some of our money and loan it out to other people.

FRACTIONAL RESERVE BANKING • Fractional Reserve Banking is a banking system in which banks hold only a fraction of deposits as reserves • The reserve ratio is the fraction of deposits that banks hold as reserves. Minimum reserve ratios are set by the Fed.

BANKS AS FINANCIAL INTERMEDIARIES • Help bring savers and investors together. • By using expertise and powers of diversification, financial intermediaries reduce risk to savers and allow investors to obtain funds on better terms. • A typical commercial bank accepts funds from savers in the form of deposits. • The bank then turns the money around and makes loans to businesses.

BALANCE SHEET • Has two sides -- assets and liabilities • Liabilities are the source of funds for the bank -- Your deposits to a current account are an example of liabilities • Assets are the uses of the funds -- Loans are an example of a bank’s assets • The difference between assets and liabilities is call its net worth Net Worth = Assets - Liabilities

RESERVES • Assets which are not lent out • Banks used to be required by law to hold a fraction of their deposits as reserves and not make loans with this fraction of deposits. It was called required reserves • Banks often chose to hold additional reserves beyond what was required; these were called excess reserves • A bank’s reserves are the sum of its required and excess reserves • Reserves can either be cash kept in a bank’s vaults or deposits with the Federal Reserve. • Banks do not earn any interest on these reserves

THE PROCESS OF MONEY CREATION AN EXAMPLE • A bank has deposits of $1,000 • Banks are required to keep 10% of deposits as reserves and hold no excess reserves • The reserve ratio, in this case, is 0.1 • The bank in this example will keep $100 in reserves and make loans totaling $900

THE PROCESS OF DEPOSIT CREATION: CHANGES IN BALANCE SHEETS First Bank of Hollywood Assets Liabilities $100 reserves $1,000 deposit $900 loans

THE PROCESS OF DEPOSIT CREATION: CHANGES IN BALANCE SHEETS First Bank of Hollywood Assets Liabilities $100 reserves $1,000 deposit $900 loans Second Bank of Burbank Assets Liabilities $90 reserves $900 deposit $810 loans

THE PROCESS OF DEPOSIT CREATION: CHANGES IN BALANCE SHEETS First Bank of Hollywood Assets Liabilities $100 reserves $1,000 deposit $900 loans Second Bank of Burbank Assets Liabilities $90 reserves $900 deposit $810 loans Third Bank of Venice Assets Liabilities $81 reserves $810 deposit $729 loans

THE PROCESS OF DEPOSIT CREATION: CHANGES IN BALANCE SHEETS First Bank of Hollywood Assets Liabilities $100 reserves $1,000 deposit $900 loans Second Bank of Burbank Assets Liabilities $90 reserves $900 deposit $810 loans Third Bank of Venice Assets Liabilities $81 reserves $810 deposit $729 loans Fourth Bank of Pasadena

THE PROCESS OF DEPOSIT CREATION: CHANGES IN BALANCE SHEETS First Bank of Hollywood Assets Liabilities $100 reserves $1,000 deposit $900 loans Second Bank of Burbank Assets Liabilities $90 reserves $900 deposit $810 loans Third Bank of Venice Assets Liabilities $81 reserves $810 deposit $729 loans Fourth Bank of Pasadena Fifth bank of Compton

MONEY MULTIPLIER - 1 • It tells what the total increase in checking account deposits would be for any initial cash deposit • = 1 / reserve ratio • In the banking system, an initial cash deposit triggers additional rounds of deposits and lending by banks • This leads to a multiple expansion of deposits • The money creation process and the money multiplier also works in reverse

MONEY MULTIPLIER - 2 In our example, the original deposit created $1,000 in reserves at the bank. The money multiplier is equal to 10 (1/0.1). Therefore, the original $1,000 deposit will eventually turn into $10,000 of deposits.

MONEY MULTIPLIER - 3 The change in the money supply, M1, will be the change in deposits plus the change in currency held by the public In example, the money supply, M1, increased by $9,000 ( $10,000 - $1,000

MONEY MULTIPLIER • As of 1995, in the United States, were required to hold 10% on all checkable deposits exceeding $54 million • Since large banks would face a 10% reserve requirement on any new deposits, a money multiplier of 10 would be expected • The money multiplier in the United States is actually between 2 and 3, however • This reduced multiplier is because people hold part of their loans in cash, the funds are not available for the banking system to lend out • The money multiplier would also be less if banks held excess reserves

FED TOOLS FOR CONTROLLING THE MONEY SUPPLY • The Fed has 3 main tools for controlling the size of the money supply: • Open Market Operations • Reserve Requirements • The Discount Rate

OPEN MARKET OPERATIONS - 1 • The Fed can buy or sell government bonds to increase or decrease the money supply. • When the Fed BUYS bonds, the money supply is INCREASED. • Here is why: The Fed pays for the bonds it buys with money that was not currently a part of the money supply - hence, when the Fed buys bonds it simply increases the total amount of money in circulation.

OPEN MARKET OPERATIONS - 2 • When the Fed SELLS bonds, the money supply is DECREASED. • Here is why: The Fed sells bonds in the market and receives cash in return for the bonds it sells. Once the Fed receives the cash, this cash is taken OUT of circulation - therefore, the size of the money supply is decreased.

RESERVE REQUIREMENTS • By controlling reserve ratios that banks must keep, the Fed also controls the amount of money that banks can lend out. • In the previous slide, we showed how bank lending increases the money supply. However, when the Fed increases reserve ratios, they reduce the amount of money banks can lend and also reduce the size of the money supply. • When the Fed lowers reserve ratios, they increase the amount of money banks can lend out and also increase the size of the money supply.

THE DISCOUNT RATE - 1 • Another function of the Fed is to loan money to banks in the economy. Banks may need these loans for several reasons: • Emergency borrowing is one reason - banks that are in trouble have the Fed as the lender of last resort - this Fed function serves to calm depositors at troubled banks. • Another reason banks borrow from the Fed is to meet reserve requirements. In the course of business, banks may make too many loans, or have unusually large withdrawals by their depositors.

THE DISCOUNT RATE - 2 • The result of either (or both) of these situations is that the bank will NOT have met its reserve requirements. • Regardless of the reason prompting a bank to borrow from the Fed, the loan from the Fed to the bank increases the bank's reserves. As we now know, the new reserves allow the banking system to generate more money.

THE DISCOUNT RATE - 3 • The discount rate is a tool for controlling the money supply because it represents the cost to banks of borrowing from the Fed (banks pay interest to the Fed on the loan). A higher discount rate will discourage banks from borrowing reserves from the Fed. A lower discount rate encourages borrowing.

THE STRUCTURE OF THE FEDERAL RESERVE • Created in 1913 following a series of financial panics • Congress created the Federal Reserve System to be a banker’s bank or central bank • As a lender of last resort, the Federal Reserve would be there to lend funds to banks, reducing some of the adverse consequences of a panic

THE STRUCTURE OF THE FEDERAL RESERVE There are three distinct subgroups: • Federal Reserve Banks • The Board of Governors • The Federal Open Market Committee

FEDERAL RESERVE BANKS • The United States is divided into 12 Federal Reserve districts, each of which has a Federal Reserve Bank • Provide advice on monetary policy • Take part in decision making on monetary policy • Provide liaison between the Fed and the banks in their district

THE FEDERAL RESERVE BANKS OF THE CONTINENTAL UNITED STATES Minneapolis Boston New York San Francisco Chicago Cleveland Kansas City Philadelphia Richmond St. Louis Atlanta Dallas

THE BOARD OF GOVERNORS • The true seat of power over the monetary system • Headquartered in Washington, DC • Seven members of the board are appointed for staggered 14-year terms by the President and must be confirmed by the Senate • The Chairman of the Board of Governors, the principal spokesman for monetary policy in the country, serves a four-year term as chairman

FEDERAL OPEN MARKET COMMITTEE ( FOMC ) • Decisions on monetary policy made by the FOMC • A 12-person board consisting of seven members of the Board of Governors, the president of the New York Federal Reserve, plus presidents of four other regional Federal Reserve Banks • Presidents of the regional banks other than New York serve on a rotating basis • Seven non-voting bank presidents attend meetings and provide their views • The chairman of the Board of Governors also serves as chairman of the FOMC • The FOMC makes the actual decisions on changes in the money supply

THE STRUCTURE OF THE FEDERAL RESERVE CHAIR Federal Reserve Banks Board of Governors 7 members 12 presidents Federal Open Market Committee ( FOMC ) Board of Governors plus 5 bank presidents Decisions about monetary policy $$$$$

INDEPENDENCE OF THE FEDERAL RESERVE • The chairman of the Federal Reserve is required to report to Congress on a regular basis • Although the Federal Reserve operates with independence, it is a creation of Congress • The U.S. Constitution gives Congress the power to ‘coin money and regulate the value thereof” • In practice, the Fed takes its actions first and reports to Congress after the fact

MONEY, THE BANKING SYSTEM & THE FEDERAL RESERVE