Banking and the Money supply

1. Banking and the Money supply • Monetary aggregates • Checkable deposits • Balance sheets • Money creation • Money multiplier • Tools of the Fed

2. Monetary aggregates These are measures of the money supply. We add together all assets that are liquid enough to be classified as money

3. M1 The narrow measure of the money supply; includes only the most liquid assets M1 equals Currency and coin in circulation Plus: Checkable depositsPlus: Travelers’ checks

4. About 60 percent of Federal Reserve notes now circulate abroad

5. M2 A broader measure of the money supply favored by many economists. M2 equals M1Plus: Miscellaneous near moniesPlus: Small denomination time depositsPlus: Savings depositsPlus: Money market deposit accounts

6. Measures of the money supply (July 2007)

7. How banks Work By bringing together both sides of the money market , banks serve as intermediaries or go-betweens. Banks reduce the transactions costs of channeling saving to creditworthy borrowers. • Coping with asymmetric information. • Reducing risk through diversification.

8. Starting a bank To start a bank we must obtain a charter from a state government or from the Federal Reserve

9. Note that: Assets = Liabilities + Net Worth Home Bank’s balance sheet

10. Remember that deposits are an asset for depositors but a liability for the bank. Home Bank’s balance sheet after $1,000,000 deposit into checking account

11. Reserve requirements Banks must maintain a reserve account at the regional Federal Reserve bank • Required reserves: The dollar amount of reserves a bank is required to hold as cash in vault or on account at the Fed. • Required reserve ratio: The ratio of reserves to deposits that banks by regulation are obligated to hold. • Excess reserves: Bank reserves exceeding required reserves

12. Liquidity versus profitability Banks must be ready for customers’ withdrawals, so liquid bank assets are desirable. At the same time, less liquid assets such as commercial and real estate loans are more profitable.

13. Banks create money!! • Banks create money when they make loans and credit the accounts of loan recipients. • Money creation (lending) is limited by banks’ holdings of excess reserves. • Reserve do not earn interest; hence banks seek to minimize reserve holdings

14. Illustrating the effects of fed Open market operations Suppose the Fed pays $1,000 to a securities dealer for a bond. The transaction is handled by the dealer’s bank—Home Bank

15. The Fed credits home Bank’s reserve account by $1,000. • Home Banks’ liabilities increase by $1,000. Changes in Home Bank’s balance sheet after Fed buys a $1,000 bond from Securities dealer

16. Let’s make a loan! Assume the legal reserve ratio is .10 or 10 percent. The preceding transaction will create a $900 excess reserve for Home Bank. Loans and deposits can be expanded by that amount.

17. Thus the money supply initially increases by $900 as a result of this loan. Round 2: Changes in Home Bank’s balance sheet after lending $900 to you

18. Checking away the loan Suppose you write a $900 check to your university to pay fees. Your university deposits the check into its account at Merchants Trust bank. When the check clears, the Fed debits Home Banks’ reserve account for $900 and credits Merchant Bank’s reserve account for $900. Thus the transaction creates a $810 excess reserve for MerchantsTrust.

19. Merchants Trust makes a loan Merchants Trust makes a $810 loan to an English major starting an online note-taking service called “Note This.”

20. Note that as a result of this loan the money supply has increased by $810. Round 3: Changes in Merchants Trust’s balance sheet after lending $810 to English Major

21. Checking away the loan: Part 2 The English major writes an $810 check to the college bookstore. The college bookstore deposits the $810 check into its account at Fidelity Bank When the check clears, the Fed debits Merchant Trust’s reserve account for $810 and credits Fidelity Bank’s reserve account for $810. Thus the transaction creates a $729 excess reserve for Fidelity Bank.

22. Fidelity Bank is now positioned to make loans totaling $729

23. Summary of money creation resulting from Fed’s purchase of $1,000 US Government Bond

24. Simple Money multiplier The multiple by which the money supply changes as a result of a fresh change in fresh reserves of the banking system. Change in the money supply = change in fresh reserves x 1/r Where r is the required reserve ratio Simple money multiplier In our case: Change in the money supply = $900 x 1/.10 = (4900)(10)= 9,000

25. Fed Open market operationshave powerful effects It should be clear now that when Fed buys government securities in large quantities, there are strong effects in terms of bank excess reserves and lending capacity.

26. Federal Reserve Bank balance sheet as of August 22, 2007 (billions)