Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 1...

Designed byAmy McGuire, B-books, Ltd.

McEachern 2010-2011

CHAPTERBanking and the Money Supply

Money Aggregates

Money aggregates Measure of money supply Defined by the Fed

M1 = Narrow definition of money Currency (including coins)

Nonbanking public Checkable deposits

Bank deposits Write checks to third parties

Traveler’s checks

Money Aggregates

Currency = Fiat money Federal Reserve Notes

U.S. Bureau of Engraving and Printing

Issued by & Liabilities of 12 Federal Reserve Banks

60% - abroad Coins

U.S. Mint

Money Aggregates

M2 = Broader definition of money M1 Savings deposits

Earn interest; no specific maturity date Small-denomination time deposits

Certificates of deposits, CDs Earn interest; specific maturity date

Money market mutual fund accounts Restrictions

Measures of the Money Supply (February 2009)

Exhibit 1

Money Aggregates

Credit cards Loan from the card issuer Repay later Dispute a charge Not part of money supply

Debit cards From checking account Part of M1

How Banks Work

Banks earn profit Attract deposits from savers Lend to borrowers

Banks are financial intermediaries Reduce transaction costs Cope with asymmetric

information Reduce risk through

diversification

Starting a Bank

Home Bank – obtains a charter Net worth = Owner’s equity

Shares of stock in the bank Balance sheet

Assets = Liabilities + Net worth Asset – owned by bank

Physical property Financial claim Stock in district Fed

Liabilities – owned by bank

Home Bank’s Balance Sheet

Exhibit 2

Home Bank’s Balance Sheet After $1,000,000 Deposit Into Checking Account

LO2 Exhibit 3

Reserve Accounts

Required reserve Dollar amount

Must be held in reserve Required by Fed

Required reserve ratio Percentage of checkable deposits (10%)

Must be held in reserve Reserves (Earn no interest)

Cash in bank’s vault Deposits at the Fed

Excess reserves

Liquidity vs. Profitability

Liquidity Ease to convert assets into cash Safety

Profitability Federal funds markets

Day-to-day lending and borrowing

Among banks Excess reserves on account at

the Fed Interest: federal funds rate

How Banks Create Money

Creating money through excess reserves– Round one

• Fed buys $1,000 U.S. government bond

– Creates reserves• Money supply: +$1,000• Required reserves: +$100• Excess reserves: +$900

Changes in Home Bank’s Balance Sheet After Fed Buys a $1,000 Bond from Securities

Dealer

LO3 Exhibit 4

Creating money through excess reserves– Round two

• $900 loan• Money supply: +$900• Required reserves: +$90• Excess reserves: +$810

Changes in Home Bank’s Balance Sheet After Lending $900 to You

LO3 Exhibit 5

Creating money through excess reserves– Round three

• $810 loan• Money supply: +$810• Required reserves: +$81• Excess reserves: +$729

Changes in Merchants Trust’s Balance Sheet After Lending $810 to English Major

LO3 Exhibit 6

Creating money through excess reserves– Round four and beyond

• Excess reserves – new loans• Required reserves: +10% of new

checkable deposits– Excess reserve – maximum amount

for loans– Money supply expansion

Creating money through excess reserves A summary of rounds

– Fed: $1,000 injection in fresh reserves– Increased excess reserves– Money supply increase: Up to $10,000

• Checkable deposits– Banking system

• Eliminates excess reserves– Expand money supply

Summary of the Money Creation Resulting from the Fed’s Purchase of

$1,000 U.S. Government Bond

LO3 Exhibit 7

Reserve Requirements & Money Expansion

Assumptions– No bank holds excess

reserves– Borrowed funds don’t

sit idle– People don’t want to

hold more cash

Reserve Requirements & Money Expansion

Required reserve ratio = r Money multiplier Simple money multiplier = 1/r Change in the money supply = Change in

fresh reserves × 1/r

Limitations of Money Expansion

Leakages from expansion– Smaller money multiplier– Cash – preferred to checking accounts

• People hold money• Fewer excess reserves

Multiple Contraction ofMoney Supply

The Fed sells a $1,000 bond– Money supply: -$1,000– Required reserves: -$900– Recall loans– Money supply: -$900– Required reserves: -$810– Maximum effect

• Decrease money supply = Original decrease in reserve requirements × 1/r

The Fed’s Tools of Monetary Control

Open-market operations– Buy/sell U.S. government bonds

The discount rate– Interest rate, the Fed– For loans made to banks

The required reserve ratio– Minimum fraction of reserves

Open-Market Operations

Increase money supply– The Fed buys U.S. bonds

• Open-market purchase Reduce money supply

– The Fed sells U.S. bonds• Open-market sale

Open-Market Operations

Tool of choice for the Fed Influences bank reserves Influences federal funds rate

– Interest rate– Borrowing among banks– Of excess reserves at the

The Discount Rate

Discount rate– Interest rate charged by the Fed– Loans to banks

Bank borrow ‘Discount window’– Satisfy reserve requirements

The Fed– Lender of last resort

The Discount Rate

Primary discount rate Secondary discount rate Signal to financial markets

– Monetary policy Emergency tool

– Injecting liquidity

Reserve Requirements

Required reserve ratio Money creation for each dollar of

fresh reserves Disruptive

– Banking system

Coping with Financial Crisis

Regulation of financial markets Prevents major disruptions and

financial panics Sufficient liquidity

– Financial system

The Fed Is a Money Machine

Assets– U.S. government bonds, 24%

– Earns interest Liabilities

– Federal Reserve notes, 43%– Fed pays no interest

The Fed is a money machine– Supplies Federal Reserve notes– Main asset: earns interest– Main liability: no interest payment

Federal Reserve Bank Balance Sheet as of April 1, 2009 (Billions)

LO4 Exhibit 8

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