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The Money Supply and the BANKING System. CHAPTER OUTLINE. An Overview of Money What Is Money? Commodity and Fiat Monies Measuring the Supply of Money The Private Banking System How Banks Create Money The Modern Banking System The Creation of Money The Money Multiplier
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The Money Supply and the BANKING System CHAPTEROUTLINE An Overview of Money What Is Money? Commodity and Fiat Monies Measuring the Supply of Money The Private Banking System How Banks Create Money The Modern Banking System The Creation of Money The Money Multiplier How the Central BankControls the Money Supply 25
An Overview of Money • Money • anything that is generally accepted in payment for goods or services or in the repayment of debts • For economists: • Money is the set of assets in the economy that people regularly use • to buy goods and services from each other. • Money is anything that can perform the functions: • Medium of exchange (used to pay for goods and services) • Unit of account (used to measure value in the economy) • Store of value (used as a repository of purchasing power over time)
Functions of Money The three basic functions of money are: medium of exchangeor means of payment What sellers generally accept and buyers generally use to pay for goods and services. store of value An asset that can be used to transport purchasing power from one time period to another. unit of account A standard unit that provides a consistent way of quoting prices.
Barter - the direct exchange of goods and services for other goods and services. Liquidity Property Of Money The property of money that makes it a good medium of exchange as well as a store of value: It is portable and readily accepted and thus easily exchanged for goods.
THE KINDS OF MONEY Commodity monies Items used as money that also have intrinsic value in some other use. Fiat, or token, money Items designated as money that are intrinsically worthless.
legal tender Money that a government has required to be accepted in settlement of debts. currency are the paper bills and coins in the hands of the public. currency debasement The decrease in the value of money that occurs when its supply is increased rapidly.
Discussion question: Which of these are money? • Currency • Checks • Deposits in checking accounts (called demand deposits) • Credit cards
Measuring the Supply of Money Central Bank an institution designed to oversee the banking system and regulate the quantity of money in the economy. The two most common measures of money are : transactions money, alsocalled M1, and broad money, also called M2. Exact classifications of M1 and M2 depend on the country.
Measuring the Supply of Money M1- Money that can be directly used for transactions. M2 - M1 plus savings accounts, money market accounts, and other near monies. near monies Close substitutes for transactions money, such as savings accounts and money market accounts. M1 ≡ currency held outside banks + demand deposits + traveler’s checks + other checkable deposits M2 ≡ M1 + savings accounts + money market accounts +other near monies
Turkey: M1=Currency in circulation + Demand deposits M2= M1 + Time deposits
The Private Banking System financial intermediaries Banks and other institutions that act as a link between those who have money to lend and those who want to borrow money. The main types of financial intermediaries are commercial banks, followed by savings and loan associations, life insurance companies, and pension funds.
The modernBanking System A Brief Review of Accounting Central to accounting practices is the statement that “the books always balance” Assets − Liabilities ≡ Net Worth or Assets ≡ Liabilities + Net Worth Assets Any item of economic value owned by an individual or corporation, especially that which could be converted to cash. Liabilities Obligations of a company or organization. Net Worth Difference between what it owns and what it owes.
T-Account for a Typical Bank (millions of dollars) The balance sheet of a bank must always balance, so that the sum of assets (reserves and loans) equals the sum of liabilities (deposits and net worth). reserves The deposits that a bank has at the Central bank plus its cash on hand. required reserve ratio The percentage of its total deposits that a bank must keep as reserves at the Central bank.
The Creation of Money excess reserves ≡ actual reserves − required reserves Excess reserves bank reserves in excess of the reserve requirement. Required reserves the amount of reserves that banks are required to hold, determined by the central bank as a function of a bank's deposit liabilities.
The Creation of Money When There Are Many Banks In panel 1, there is an initial deposit of $100 in bank 1. In panel 2, bank 1 makes a loan of $80 by creating a deposit of $80. A check for $80 by the borrower is then written on bank 1 (panel 3) and deposited in bank 2 (panel 1). The process continues with bank 2 making loans and so on.In the end, loans of $400 have been made and the total level of deposits is $500.
Balance Sheets of a Bank in a Single-Bank Economy In panel 2, there is an initial deposit of $100. In panel 3, the bank has made loans of $400.
The Money Multiplier An increase in bank reserves leads to a greater than one-for-one increase in the money supply. Economists call the relationship between the final change in deposits and the change in reserves that caused this change the money multiplier. money multiplier The multiple by which deposits can increase for every dollar increase in reserves; equal to 1 divided by the required reserve ratio.
How the central banks (CB) Controls the money supply • Central banks in different countries (Fed in USA) control the money supply (M1): If the Fed wants to increase the supply of money, it creates more reserves, thereby freeing banks to create additional deposits by making more loans. If it wants to decrease the money supply, it reduces reserves. • Three tools are available to the Fed for changing the money supply: • Changing the required reserve ratio. • Changing the discount rate. • Engaging in open market operations.
The Required Reserve Ratio Decreases in the required reserve ratio allow banks to have more deposits with the existing volume of reserves. As banks create more deposits by making loans, the supply of money (currency + deposits) increases. The reverse is also true: If the Central bankwants to restrict the supply of money, it can raise the required reserve ratio, in which case banks will find that they have insufficient reserves and must therefore reduce their deposits by “calling in” some of their loans. The result is a decrease in the money supply.
The Discount Rate discount rate The interest rate that banks pay to the Central bank to borrow from it. moral suasion The pressure that in the past the Fed exerted on member banks to discourage them from borrowing heavily from the Fed.
Open Market Operations • open market operations • The purchase and sale by the Central bank of government securities in the open market; • a tool used to expand or contract the amount of reserves in the system • and thus the money supply. • Two Branches of Government Deal in Government Securities • The Treasury Department is responsible for collecting taxes and paying the federal government’s bills. • The Mechanics of Open Market Operations • We can sum up the effect of these open market operations this way: • An open market purchase of securities by the Fed results in an increase in reserves and an increase in the supply of money by an amount equal to the money multiplier times the change in reserves. • An open market sale of securities by the Fed results in a decrease in reserves and a decrease in the supply of money by an amount equal to the money multiplier times the change in reserves.
