{ Banking: Basic Operation and Money Modules 25 & 26

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Banking: Basic Operation and Money

Modules 25 & 26

Banks are a financial intermediary Two jobs

Take deposits Provide loans (liquidity) to finance

illiquid investments by borrowers Role of the Federal Reserve is

different “Dual Mandate” – full employment,

low inflation Banks cannot lend ALL their money

Banking

Banks must keep substantial quantities of liquid reserves on hand (post Depression) Currency or deposits in the Federal

Reserve Money in the bank vault

Banks must have sufficient assets to cover their financial liabilities PLUS depositor withdraws

Banking

T-accounts Summarize a business’s financial position

STANDARD BUSINESS>

BANK>

Banks are different from standard businesses in T-accounts Must have some money set aside with the

Fed by law (assets column) Required Reserve Ratio – required

amount of deposits a bank must hold (usually 10%) Bank runs and subsequent bank failure “Fractional Reserve Banking” – when central

banks require reserves

Banking

Money creation Through their activity, banks actual CREATE money

Banking

Paper money is obsolete and should be removed from circulation all together.

Four-Corner Debate

Just a reminder:

M1 = measures money in circulation and demand deposits (checking)

Monetary Base Sum of currency in circulation AND

reserves held by banks. DIFFERENT- Bank reserves are NOT

considered part of the money supply, but ARE part of the monetary base!

Checkable bank deposits, part of money supply aren’t part of

monetary base

Money multiplier Ratio of money supply to the monetary

base Tells us the total number of dollars

created in the banking system by each $1 addition to the monetary base Simple money multiplier:

$1/rr**** rr = Reserve rate

Banking

SO: If the reserve rate is 10% and the

Fed adds $100 to the monetary base, then the money supply will increase BY:

1/.10 = 1010x$100 = $1000

Assume money lent out is spent and will end up back in another bank Some may keep cash in our wallet

(leakage) Assumptions

Not worried about leakage Banks lend out ALL their money (save Req.

Reserve Rate) What if a bank keeps too much in reserves?

– excess reserves What happens if rr falls?

Banking Regulations Deposit Insurance Capital Requirements Reserve Requirements Discount Window

The Federal Reserve One of the most important,

controversial elements of the US economy Many conspiracy theories about the

founding of the bank, the role of the bank, and its propensity to create debt burdens.

Little government oversight, but not a private entity Oversight through appointment

The Federal Reserve

Historic Analysis Various “national banks” in our history Panic of 1907

JP Morgan’s role VERY similar to today (8% unemp)

Trusts speculating on the stock market (Knickerbocker Trust)

United Copper Company’s stock Currency supply issues, credit markets

frozen Progressives feared Morgan’s power, and

tried to limit his influence

Jekyll Island gathering Wealthiest men in America, politicians

gathered in secret to plan and organize a new national bank.

1913- Federal Reserve Act instituted a new national bank,

regulated, and set basic requirements for lending and currency involvement.

Unanimously passed in Congress

Dual mandate of the Fed Keep unemployment low and keep

prices (inflation) stable This is achieved through open market

operations Effectiveness?

1930s issues Crisis in the 1980s 2008 Recession

The Fed

The Federal Reserve System and Function Two parts to the Fed

Board of Governors (US Gov, appointed) 12 Regional Fed Banks (Private)

Functions Provide Financial Services

“bank for banks” Supervise and Regulate Banks Maintain stability of financial system Conduct monetary policyThe Fed: Banking

Functions

Fed Functions and Market Performances What if a bank has insufficient funds?

Federal funds market Borrow reserves from banks with excess! Overnight loan, w/interest Federal funds rate

Fed can adjust RR to alter money supply (last time: 1992)

The Fed: Banking Functions

Discount Rate Banks in need of RR funds can borrow

directly from the fed using the “discount window” Discount rate- usually 1% above the FFR

to encourage banks to borrow from each other

Fed can adjust to also alter money supply (ex- 2008 it was 0.25% interest!!) Cost of being short reserves falls,

encouraging banks to lend!The Fed: Banking Functions

Open-Market operations Mainly short-term (1 year) US

Treasury bill purchases Purchased through commercial banks

(financial market banks) BAD idea to buy directly from government

(historically terrible) Pays banks for bills by crediting

reserve accounts of commercial banks

The Fed: Banking Functions

Fed creates the money to purchase the bills “Click of the mouse,” created at the

Fed’s own discretion Does not directly enter the money

supply, BUT, sets the money multiplier in motion Increases reserves, commercial banks

then lend out excess reserves easier, which increases money supply.The Fed: Banking

Functions

The Federal Reserve should be ended because it has too much

control over the economy.

Four-Corner Debate