The Banking System and the Money Supply

1. 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 deposits • 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

8. Money Supply • 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

9. 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 rate they pay to depositors

10. 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 • Property and buildings • 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 • What bank would owe to its owners if it went out of business • A balance sheet always balances

11. 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

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

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

14. Federal Reserve Functions • Issue currency • Set reserve requirements • Lend money to banks • Collect checks • Act as a fiscal agent for U.S. government • Supervise banks • Control the money supply

15. Federal Reserve Independence • Established by Congress as an independent agency • Protects the Fed from political pressures • Enables the Fed to take actions to increase interest rates in order to stem inflation as needed

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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 • Why are these other tools used so seldom? • Partly because they can have unpredictable effects

24. The Financial Crisis of 2007 and 2008 • Mortgage Default Crisis • Many causes • Government programs that encouraged home ownership • Declining real estate values • Bad incentives provided by mortgage-backed bonds

25. The Financial Crisis of 2007 and 2008 • Securitization- the process of slicing up and bundling groups of loans into new securities • As loans defaulted, the system collapsed • “Underwater” homeowners abandoned homes and mortgages