12 Money and the Banking System [Money] is a machine for doing quickly and commodiously what would be done, though less quickly and commodiously, without

12

Money and the Banking System

[Money] is a machine for doing quickly and

commodiously what would be done, though less quickly and commodiously, without it.

JOHN STUART MILL

● The Nature of Money● How the Quantity of Money is Measured● The Banking System● The Origins of the Money Supply● Banks and Money Creation● Why the Deposit Creation Formula Is

Oversimplified● The Need for Monetary Policy

● The Nature of Money● How the Quantity of Money is Measured● The Banking System● The Origins of the Money Supply● Banks and Money Creation● Why the Deposit Creation Formula Is

Oversimplified● The Need for Monetary Policy

ContentsContents

Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

● Barter versus Monetary Exchange♦ A barter system (with no money) would be

awkward and extremely inefficient.

♦ Money greases the wheels of exchange and, thus, makes the whole economy more productive.

● Barter versus Monetary Exchange♦ A barter system (with no money) would be

awkward and extremely inefficient.

♦ Money greases the wheels of exchange and, thus, makes the whole economy more productive.

The Nature of MoneyThe Nature of Money



● The Conceptual Definition of Money♦ The functions of money:

■Medium of exchange■Unit of account■Store of value

♦ Money = whatever serves as the medium of exchange

● The Conceptual Definition of Money♦ The functions of money:

■Medium of exchange■Unit of account■Store of value

♦ Money = whatever serves as the medium of exchange


● What Serves as Money?♦ Societies have gradually moved from the use

of commodity monies to the use of money that has no commodity backing at all.

● What Serves as Money?♦ Societies have gradually moved from the use

of commodity monies to the use of money that has no commodity backing at all.



● There is no single, obvious place to draw the line between “money” and “near money.”

● M1 = coins and paper money in circulation, plus checkable deposits

● M2 = M1 + money market deposit accounts, money market mutual funds, and savings accounts

● There is no single, obvious place to draw the line between “money” and “near money.”

● M1 = coins and paper money in circulation, plus checkable deposits

● M2 = M1 + money market deposit accounts, money market mutual funds, and savings accounts

How the Quantity of Money is MeasuredHow the Quantity of Money is Measured

FIGURE 2: Two Definitions of the Money Supply, January 2005

FIGURE 2: Two Definitions of the Money Supply, January 2005


M1 = $1361 billion

CurrencyOutside banks$710 billion

Othercheckabledeposits$321 billions

Checking depositsIn commercialBanks $330 billion

M2 = $6443 billion

Money marketmutual funds$704 billion

M1$1361 billion

Savingsdeposits

$4378 billion


● How Banking Began♦ Fractional reserve banking began when

goldsmiths realized they could profitably lend out a portion of the gold that had been deposited with them for safekeeping.

● How Banking Began♦ Fractional reserve banking began when

goldsmiths realized they could profitably lend out a portion of the gold that had been deposited with them for safekeeping.

The Banking SystemThe Banking System



● How Banking Began♦ Three important features of the fractional

reserve banking system: ■Bank profitability■Banks discretion over the money supply■Exposure to bank runs

● How Banking Began♦ Three important features of the fractional

reserve banking system: ■Bank profitability■Banks discretion over the money supply■Exposure to bank runs



● Principles of Bank Management: Profits versus Safety♦ To make a profit, a banker must take risks.

♦ But because the business is risky, the same banker must also emphasize safety.

♦ The heart of banking is to be torn between the two principles.

● Principles of Bank Management: Profits versus Safety♦ To make a profit, a banker must take risks.

♦ But because the business is risky, the same banker must also emphasize safety.

♦ The heart of banking is to be torn between the two principles.

FIGURE 1: Bank Failures in the United States, 1915-2003

FIGURE 1: Bank Failures in the United States, 1915-2003


1915 1920 1925 1930 1935 1940 19450

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

2,200

Year(a)

FDIC established

Great Depressionbegins

0

200

160

120

80

40

1945 1955 1965 1975 1985 1995 '03(b)



● Bank Regulation♦ Deposit insurance (FDIC)

■Eliminates the motive for customers to withdraw funds because of bad news regarding the bank’s finances

♦ Moral hazard■When an individual is insured against risk, he/she

puts forth little effort to avoid risk■FDIC could make the banking system less safe

● Bank Regulation♦ Deposit insurance (FDIC)

■Eliminates the motive for customers to withdraw funds because of bad news regarding the bank’s finances

♦ Moral hazard■When an individual is insured against risk, he/she

puts forth little effort to avoid risk■FDIC could make the banking system less safe



● Bank Regulation♦ Bank Supervision

■Needed to reduce moral hazard problem■Ensures banks take only sensible, defensible risks ■Controls the money supply

♦ Reserve Requirements ■Helps control the money supply

● Bank Regulation♦ Bank Supervision

■Needed to reduce moral hazard problem■Ensures banks take only sensible, defensible risks ■Controls the money supply

♦ Reserve Requirements ■Helps control the money supply


● How Bankers Keep Books♦ Banks keep balance sheets

■Assets = liabilities + net worth

♦ Assets include: ■Reserves■Loans

♦ Liabilities include: ■Deposits owed to customers.

● How Bankers Keep Books♦ Banks keep balance sheets

■Assets = liabilities + net worth

♦ Assets include: ■Reserves■Loans

♦ Liabilities include: ■Deposits owed to customers.

The Origins of the Money SupplyThe Origins of the Money Supply

TABLE 1: Balance Sheet of Bank-a-mythica, Dec. 31, 2004

TABLE 1: Balance Sheet of Bank-a-mythica, Dec. 31, 2004



Banks and Money CreationBanks and Money Creation

● The Limits to Money Creation by a Single Bank♦ Banks can lend money in their vault that is

above the minimum required reserve ratio.

♦ In doing so, they create new money.

● The Limits to Money Creation by a Single Bank♦ Banks can lend money in their vault that is

above the minimum required reserve ratio.

♦ In doing so, they create new money.

TABLE 2: Bank-a-mythica’s Balance Sheet, Jan. 2, 2005

TABLE 2: Bank-a-mythica’s Balance Sheet, Jan. 2, 2005


TABLE 3: Bank-a-mythica’s Balance Sheet, Jan. 3-6, 2005








● Multiple Money Creation by a Series of Banks♦ When all banks make loans with funds they

have that are above the required reserve ratio, the society’s money supply expands.

● Multiple Money Creation by a Series of Banks♦ When all banks make loans with funds they

have that are above the required reserve ratio, the society’s money supply expands.



● Multiple Money Creation by a Series of Banks deposits = (1/m) x reserves

■Assumes banks keep the minimum reserve ratio, m■Assumes all new money held in the form of

deposits■Oversimplified deposit multiplier formula

● Multiple Money Creation by a Series of Banks deposits = (1/m) x reserves

■Assumes banks keep the minimum reserve ratio, m■Assumes all new money held in the form of

deposits■Oversimplified deposit multiplier formula

TABLE 5: Changes in First National Bank’s Balance Sheet

TABLE 5: Changes in First National Bank’s Balance Sheet


TABLE 6: Changes in Second National Bank’s Balance Sheet

TABLE 6: Changes in Second National Bank’s Balance Sheet


FIGURE 3: The Chain of Multiple Deposit Creation

FIGURE 3: The Chain of Multiple Deposit Creation


•

•

•

$400,000

$268,928

$236,160

$195,200

$144,000

(3)

$80,000

Loans

•

•

•

$100,000

•

•

•

$500,000

$336,160

$295,200

$244,000

$180,000

Running Sums

(2)

$100,000

Deposits

$67,232

$59,040

$48,800

$36,000

(1)

$20,000

Reserves

And so on . . .

$40,960 deposit

$32,768 lent out $8,192 on reserve

$51,200 deposit


$64,000 deposit


$80,000 deposit


$100,000 deposit




● The Process in Reverse: Multiple Contractions of the Money Supply♦ Deposits, and with them the money supply,

contract when reserves are reduced.■Banks reduce their loan commitments.■Calculation of the contraction in the money supply

utilizes the same formula as for money expansion.

● The Process in Reverse: Multiple Contractions of the Money Supply♦ Deposits, and with them the money supply,

contract when reserves are reduced.■Banks reduce their loan commitments.■Calculation of the contraction in the money supply

utilizes the same formula as for money expansion.

TABLE 7: Changes in Balance Sheet of Bank-a-mythica

TABLE 7: Changes in Balance Sheet of Bank-a-mythica


TABLE 8: Changes, Balance Sheet of First National Bank

TABLE 8: Changes, Balance Sheet of First National Bank



● Individuals hold some portion of additions to their money in the form of cash.

● Banks sometimes hold reserves above the required minimum.

● Individuals hold some portion of additions to their money in the form of cash.

● Banks sometimes hold reserves above the required minimum.

Why the Deposit Creation Formula Is OversimplifiedWhy the Deposit Creation Formula Is Oversimplified


The Need for Monetary PolicyThe Need for Monetary Policy

● Left uncontrolled, banks would: ♦ Reduce the money supply in a recession♦ Increase the money supply during boom

periods

● Changes in the money supply would exacerbate the business cycle.

● One reason for monetary policy, therefore, is to prevent this behavior on the part of banks.

● Left uncontrolled, banks would: ♦ Reduce the money supply in a recession♦ Increase the money supply during boom

periods

● Changes in the money supply would exacerbate the business cycle.

● One reason for monetary policy, therefore, is to prevent this behavior on the part of banks.

Documents

12 Money and the Banking System [Money] is a machine for doing quickly and commodiously what would be done, though less quickly and commodiously, without