MONEY, THE BANKING SYSTEM & THE FEDERAL RESERVE

MONEY, THE BANKING SYSTEM MONEY, THE BANKING SYSTEM & THE FEDERAL RESERVE& THE FEDERAL RESERVE

MONEY, THE BANKING SYSTEM MONEY, THE BANKING SYSTEM & THE FEDERAL RESERVE& THE FEDERAL RESERVE

Lecture 9Lecture 9

MONEYMONEYMONEYMONEY

Anything that is regularly Anything that is regularly used in economic used in economic transactions or exchanges.transactions or exchanges.

Anything that is regularly Anything that is regularly used in economic used in economic transactions or exchanges.transactions or exchanges.

THREE PROPERTIES OF THREE PROPERTIES OF MONEYMONEY

THREE PROPERTIES OF THREE PROPERTIES OF MONEYMONEY

1. Money serves as a medium 1. Money serves as a medium of exchangeof exchange

2. Money serves as a unit of 2. Money serves as a unit of accountaccount

3. Money serves as a store of 3. Money serves as a store of valuevalue

1. Money serves as a medium 1. Money serves as a medium of exchangeof exchange

2. Money serves as a unit of 2. Money serves as a unit of accountaccount

3. Money serves as a store of 3. Money serves as a store of valuevalue

MEDIUM OF EXCHANGEMEDIUM OF EXCHANGEMEDIUM OF EXCHANGEMEDIUM OF EXCHANGE

• Money is accepted in economic exchangesMoney is accepted in economic exchanges• Alternative to barter -- trading goods directly Alternative to barter -- trading goods directly

for goodsfor goods• For economic exchanges to occur using For economic exchanges to occur using

barter, barter, double coincidence of wants double coincidence of wants must must exist:exist:

-- unless you want to trade something another person -- unless you want to trade something another person wants, and you want what the other person has to wants, and you want what the other person has to trade, this economic exchange could not occurtrade, this economic exchange could not occur

• Money is accepted in economic exchangesMoney is accepted in economic exchanges• Alternative to barter -- trading goods directly Alternative to barter -- trading goods directly

for goodsfor goods• For economic exchanges to occur using For economic exchanges to occur using

barter, barter, double coincidence of wants double coincidence of wants must must exist:exist:

-- unless you want to trade something another person -- unless you want to trade something another person wants, and you want what the other person has to wants, and you want what the other person has to trade, this economic exchange could not occurtrade, this economic exchange could not occur

$$$$$$$$$$$$$$$

UNIT OF ACCOUNTUNIT OF ACCOUNTUNIT OF ACCOUNTUNIT OF ACCOUNT

• Money provides a convenient measuring Money provides a convenient measuring rod when prices for all goods are quoted in rod when prices for all goods are quoted in terms of moneyterms of money

• It makes it easier to conduct economic It makes it easier to conduct economic transactions since there is a standard unit transactions since there is a standard unit in which to do soin which to do so

• Money provides a convenient measuring Money provides a convenient measuring rod when prices for all goods are quoted in rod when prices for all goods are quoted in terms of moneyterms of money

• It makes it easier to conduct economic It makes it easier to conduct economic transactions since there is a standard unit transactions since there is a standard unit in which to do soin which to do so

STORE OF VALUESTORE OF VALUESTORE OF VALUESTORE OF VALUE

• During a period of time, the value of During a period of time, the value of money should not changemoney should not change

• Money is a somewhat imperfect store of Money is a somewhat imperfect store of value, thanks to inflationvalue, thanks to inflation

• During a period of time, the value of During a period of time, the value of money should not changemoney should not change

• Money is a somewhat imperfect store of Money is a somewhat imperfect store of value, thanks to inflationvalue, thanks to inflation

LIQUIDITY - 1LIQUIDITY - 1 LIQUIDITY - 1LIQUIDITY - 1• Refers to the ease with which an asset Refers to the ease with which an asset

can be converted into the economy's can be converted into the economy's medium of exchange. medium of exchange.

• Since money IS the economy's medium Since money IS the economy's medium of exchange, it must be the most liquid of exchange, it must be the most liquid store of value in the economy. store of value in the economy.

• Refers to the ease with which an asset Refers to the ease with which an asset can be converted into the economy's can be converted into the economy's medium of exchange. medium of exchange.

• Since money IS the economy's medium Since money IS the economy's medium of exchange, it must be the most liquid of exchange, it must be the most liquid store of value in the economy. store of value in the economy.

LIQUIDITY - 2LIQUIDITY - 2LIQUIDITY - 2LIQUIDITY - 2

• Other ways to store value include Other ways to store value include buying stocks, bonds, mutual funds, buying stocks, bonds, mutual funds, gold, silver, or owning a house or gold, silver, or owning a house or other valuable property. Since it other valuable property. Since it takes some time and effort to convert takes some time and effort to convert these assets into money, they are all these assets into money, they are all LESS liquid than money. LESS liquid than money.

• Other ways to store value include Other ways to store value include buying stocks, bonds, mutual funds, buying stocks, bonds, mutual funds, gold, silver, or owning a house or gold, silver, or owning a house or other valuable property. Since it other valuable property. Since it takes some time and effort to convert takes some time and effort to convert these assets into money, they are all these assets into money, they are all LESS liquid than money. LESS liquid than money.

HISTORY OF MONEYHISTORY OF MONEYHISTORY OF MONEYHISTORY OF MONEY

• Throughout history, money can be Throughout history, money can be divided into two general categories:divided into two general categories:

– commodity moneycommodity money

– fiat moneyfiat money

• Throughout history, money can be Throughout history, money can be divided into two general categories:divided into two general categories:

– commodity moneycommodity money

– fiat moneyfiat money

COMMODITY MONEYCOMMODITY MONEYCOMMODITY MONEYCOMMODITY MONEY

• Commodity money is money that takes the Commodity money is money that takes the form of a commodity with intrinsic value. form of a commodity with intrinsic value. Commodity money has value, in and of Commodity money has value, in and of itself, beyond its value as the medium of itself, beyond its value as the medium of exchange and the unit of account. The exchange and the unit of account. The classic example of commodity money is classic example of commodity money is gold and silver coins - you could always gold and silver coins - you could always melt the coins down and the gold and melt the coins down and the gold and silver would have its OWN valuesilver would have its OWN value.

• Commodity money is money that takes the Commodity money is money that takes the form of a commodity with intrinsic value. form of a commodity with intrinsic value. Commodity money has value, in and of Commodity money has value, in and of itself, beyond its value as the medium of itself, beyond its value as the medium of exchange and the unit of account. The exchange and the unit of account. The classic example of commodity money is classic example of commodity money is gold and silver coins - you could always gold and silver coins - you could always melt the coins down and the gold and melt the coins down and the gold and silver would have its OWN valuesilver would have its OWN value.

FIAT MONEYFIAT MONEYFIAT MONEYFIAT MONEY• Fiat money is money without intrinsic value Fiat money is money without intrinsic value

that is used as money because of government that is used as money because of government decree.decree.

• The US $ is an example of fiat money because The US $ is an example of fiat money because the paper the $ is printed on has NO value the paper the $ is printed on has NO value outside of being the medium of exchange and outside of being the medium of exchange and the unit of account. the unit of account.

• Before moving from money to central banking, Before moving from money to central banking, we’ll first consider what the size of the US we’ll first consider what the size of the US money stock is and how it is measured.money stock is and how it is measured.

• Fiat money is money without intrinsic value Fiat money is money without intrinsic value that is used as money because of government that is used as money because of government decree.decree.

• The US $ is an example of fiat money because The US $ is an example of fiat money because the paper the $ is printed on has NO value the paper the $ is printed on has NO value outside of being the medium of exchange and outside of being the medium of exchange and the unit of account. the unit of account.

• Before moving from money to central banking, Before moving from money to central banking, we’ll first consider what the size of the US we’ll first consider what the size of the US money stock is and how it is measured.money stock is and how it is measured.

MONEY STOCKMONEY STOCKMONEY STOCKMONEY STOCK• The money stock is the quantity of The money stock is the quantity of

money circulating in the economy money circulating in the economy

Q: Suppose you want to know the size of Q: Suppose you want to know the size of the US money stock. What should you the US money stock. What should you count as money?count as money?

A: Currency and demand deposits, and a A: Currency and demand deposits, and a few other items (detailed in the following few other items (detailed in the following slides) but NOT credit cards. slides) but NOT credit cards.

• The money stock is the quantity of The money stock is the quantity of money circulating in the economy money circulating in the economy

Q: Suppose you want to know the size of Q: Suppose you want to know the size of the US money stock. What should you the US money stock. What should you count as money?count as money?

A: Currency and demand deposits, and a A: Currency and demand deposits, and a few other items (detailed in the following few other items (detailed in the following slides) but NOT credit cards. slides) but NOT credit cards.

WHAT COUNTS AS MONEYWHAT COUNTS AS MONEYWHAT COUNTS AS MONEYWHAT COUNTS AS MONEY

• Currency: the paper bills and coins in the hands of Currency: the paper bills and coins in the hands of the public.the public.

• Demand deposits: balances in bank accounts that Demand deposits: balances in bank accounts that depositors can access on demand by writing a depositors can access on demand by writing a check (or by using a debit card)check (or by using a debit card)

Q: How is the US money stock measured and Q: How is the US money stock measured and reported?reported?

A: Your textbook gives the two most important A: Your textbook gives the two most important measures - M1 and M2measures - M1 and M2

• Currency: the paper bills and coins in the hands of Currency: the paper bills and coins in the hands of the public.the public.

• Demand deposits: balances in bank accounts that Demand deposits: balances in bank accounts that depositors can access on demand by writing a depositors can access on demand by writing a check (or by using a debit card)check (or by using a debit card)

Q: How is the US money stock measured and Q: How is the US money stock measured and reported?reported?

A: Your textbook gives the two most important A: Your textbook gives the two most important measures - M1 and M2measures - M1 and M2

COMPONENTS OF M1COMPONENTS OF M1COMPONENTS OF M1COMPONENTS OF M1

Currency held by the publicCurrency held by the public $ 372 billion$ 372 billion

Demand depositsDemand deposits $ 389 billion$ 389 billion

Other checkable depositsOther checkable deposits $ 353 billion$ 353 billion

Travelers checksTravelers checks $ 9 billion$ 9 billion

Total of M1Total of M1 $1,123 billion$1,123 billionSource: Economic Report of the President, Washington, DC: U.S. Source: Economic Report of the President, Washington, DC: U.S.

Government Printing Office, 1996Government Printing Office, 1996

• Approximately two-thirds of M1 consists of checking Approximately two-thirds of M1 consists of checking account balancesaccount balances

• Approximately one-third consists of currencyApproximately one-third consists of currency

Currency held by the publicCurrency held by the public $ 372 billion$ 372 billion

Demand depositsDemand deposits $ 389 billion$ 389 billion

Other checkable depositsOther checkable deposits $ 353 billion$ 353 billion

Travelers checksTravelers checks $ 9 billion$ 9 billion

Total of M1Total of M1 $1,123 billion$1,123 billionSource: Economic Report of the President, Washington, DC: U.S. Source: Economic Report of the President, Washington, DC: U.S.

Government Printing Office, 1996Government Printing Office, 1996

• Approximately two-thirds of M1 consists of checking Approximately two-thirds of M1 consists of checking account balancesaccount balances

• Approximately one-third consists of currencyApproximately one-third consists of currency

COMPONENTS OF M1COMPONENTS OF M1COMPONENTS OF M1COMPONENTS OF M1• Currency held by publicCurrency held by public

-- All currency held outside of bank vaults-- All currency held outside of bank vaults

• Demand depositsDemand deposits

-- Deposits in checking accounts -- Deposits in checking accounts

• Other checkable depositsOther checkable deposits

-- Introduced in the early 1980s to describe -- Introduced in the early 1980s to describe checking accounts that paid interestchecking accounts that paid interest

• Travelers checksTravelers checks

-- included in M-- included in M11 since they are regularly since they are regularly used used

in economic exchangesin economic exchanges

• Currency held by publicCurrency held by public

-- All currency held outside of bank vaults-- All currency held outside of bank vaults

• Demand depositsDemand deposits

-- Deposits in checking accounts -- Deposits in checking accounts

• Other checkable depositsOther checkable deposits

-- Introduced in the early 1980s to describe -- Introduced in the early 1980s to describe checking accounts that paid interestchecking accounts that paid interest

• Travelers checksTravelers checks

-- included in M-- included in M11 since they are regularly since they are regularly used used

in economic exchangesin economic exchanges

CURRENCY IN THE ECONOMYCURRENCY IN THE ECONOMYCURRENCY IN THE ECONOMYCURRENCY IN THE ECONOMY $372 billion of currency amounts to over $1,430 $372 billion of currency amounts to over $1,430

for every man, woman and child in the U.S. for every man, woman and child in the U.S.

Most of the currency in the official statistics is Most of the currency in the official statistics is not used in ordinary commerce in the U.S.not used in ordinary commerce in the U.S.

• Much is held abroad by wealthy people Much is held abroad by wealthy people • Some circulates in other countries along with Some circulates in other countries along with

local currencieslocal currencies• Currency is also used in illegal transactionsCurrency is also used in illegal transactions

$372 billion of currency amounts to over $1,430 $372 billion of currency amounts to over $1,430 for every man, woman and child in the U.S. for every man, woman and child in the U.S.

Most of the currency in the official statistics is Most of the currency in the official statistics is not used in ordinary commerce in the U.S.not used in ordinary commerce in the U.S.

• Much is held abroad by wealthy people Much is held abroad by wealthy people • Some circulates in other countries along with Some circulates in other countries along with

local currencieslocal currencies• Currency is also used in illegal transactionsCurrency is also used in illegal transactions

M2M2M2M2• Broader definition of moneyBroader definition of money• Includes assets that are sometimes used in economic Includes assets that are sometimes used in economic

exchanges or can be readily turned into M1exchanges or can be readily turned into M1• Consists of all assets in M1 plus other assets such as Consists of all assets in M1 plus other assets such as

deposits in money market mutual funds deposits in money market mutual funds • These are funds in which individuals can invest, earn These are funds in which individuals can invest, earn

interest, and in some cases can be used to write checksinterest, and in some cases can be used to write checks• Deposits in savings accounts are also included in M2.Deposits in savings accounts are also included in M2.• M2 for 1996 was $3,657.4 billion. Dividing M1 by M2 M2 for 1996 was $3,657.4 billion. Dividing M1 by M2

shows that M1 was 29.4% of M2 during 1996.shows that M1 was 29.4% of M2 during 1996.

• Broader definition of moneyBroader definition of money• Includes assets that are sometimes used in economic Includes assets that are sometimes used in economic

exchanges or can be readily turned into M1exchanges or can be readily turned into M1• Consists of all assets in M1 plus other assets such as Consists of all assets in M1 plus other assets such as

deposits in money market mutual funds deposits in money market mutual funds • These are funds in which individuals can invest, earn These are funds in which individuals can invest, earn

interest, and in some cases can be used to write checksinterest, and in some cases can be used to write checks• Deposits in savings accounts are also included in M2.Deposits in savings accounts are also included in M2.• M2 for 1996 was $3,657.4 billion. Dividing M1 by M2 M2 for 1996 was $3,657.4 billion. Dividing M1 by M2

shows that M1 was 29.4% of M2 during 1996.shows that M1 was 29.4% of M2 during 1996.

WHY ARE THERE DIFFERENT WHY ARE THERE DIFFERENT MEASURES OF THE MONEY MEASURES OF THE MONEY

STOCK?STOCK?

WHY ARE THERE DIFFERENT WHY ARE THERE DIFFERENT MEASURES OF THE MONEY MEASURES OF THE MONEY

STOCK?STOCK?

• Because the assets that comprise M1 Because the assets that comprise M1 and M2 have varying degrees of liquidity. and M2 have varying degrees of liquidity. Notice that the assets included in M1 are Notice that the assets included in M1 are very liquid, while the assets that are very liquid, while the assets that are included in M2 are LESS liquid. You can included in M2 are LESS liquid. You can think of M1 as the most liquid measure of think of M1 as the most liquid measure of the money stock, while M2 is a less the money stock, while M2 is a less liquid measure.liquid measure.

• Because the assets that comprise M1 Because the assets that comprise M1 and M2 have varying degrees of liquidity. and M2 have varying degrees of liquidity. Notice that the assets included in M1 are Notice that the assets included in M1 are very liquid, while the assets that are very liquid, while the assets that are included in M2 are LESS liquid. You can included in M2 are LESS liquid. You can think of M1 as the most liquid measure of think of M1 as the most liquid measure of the money stock, while M2 is a less the money stock, while M2 is a less liquid measure.liquid measure.

BANKS AND THE MONEY BANKS AND THE MONEY SUPPLY - 1SUPPLY - 1

BANKS AND THE MONEY BANKS AND THE MONEY SUPPLY - 1SUPPLY - 1

Q:Q: How do banks operate?How do banks operate?

A: Banks accept money from people and A: Banks accept money from people and keep that money safe until the depositor keep that money safe until the depositor makes a withdrawal or writes a check on makes a withdrawal or writes a check on their account.their account.

Q:Q: How do banks operate?How do banks operate?

A: Banks accept money from people and A: Banks accept money from people and keep that money safe until the depositor keep that money safe until the depositor makes a withdrawal or writes a check on makes a withdrawal or writes a check on their account.their account.

BANKS AND THE MONEY BANKS AND THE MONEY SUPPLY - 2 SUPPLY - 2

BANKS AND THE MONEY BANKS AND THE MONEY SUPPLY - 2 SUPPLY - 2

Q: Do banks keep all of our money in their Q: Do banks keep all of our money in their vault?vault?

A: No. The US banking system is called A: No. The US banking system is called fractional reserve banking. Bankers fractional reserve banking. Bankers understand that it is not necessary to understand that it is not necessary to keep 100% of a depositors money on keep 100% of a depositors money on hand at all times. As a result, bankers hand at all times. As a result, bankers take some of our money and loan it out take some of our money and loan it out to other people. to other people.

Q: Do banks keep all of our money in their Q: Do banks keep all of our money in their vault?vault?

A: No. The US banking system is called A: No. The US banking system is called fractional reserve banking. Bankers fractional reserve banking. Bankers understand that it is not necessary to understand that it is not necessary to keep 100% of a depositors money on keep 100% of a depositors money on hand at all times. As a result, bankers hand at all times. As a result, bankers take some of our money and loan it out take some of our money and loan it out to other people. to other people.

FRACTIONAL RESERVE FRACTIONAL RESERVE BANKINGBANKING

FRACTIONAL RESERVE FRACTIONAL RESERVE BANKINGBANKING

• Fractional Reserve Banking is a Fractional Reserve Banking is a banking system in which banks hold banking system in which banks hold only a fraction of deposits as only a fraction of deposits as reserves reserves

• The reserve ratio is the fraction of The reserve ratio is the fraction of deposits that banks hold as reserves. deposits that banks hold as reserves. Minimum reserve ratios are set by Minimum reserve ratios are set by the Fed. the Fed.

• Fractional Reserve Banking is a Fractional Reserve Banking is a banking system in which banks hold banking system in which banks hold only a fraction of deposits as only a fraction of deposits as reserves reserves

• The reserve ratio is the fraction of The reserve ratio is the fraction of deposits that banks hold as reserves. deposits that banks hold as reserves. Minimum reserve ratios are set by Minimum reserve ratios are set by the Fed. the Fed.

BANKS AS FINANCIAL BANKS AS FINANCIAL INTERMEDIARIESINTERMEDIARIES

BANKS AS FINANCIAL BANKS AS FINANCIAL INTERMEDIARIESINTERMEDIARIES

• Help bring savers and investors together.Help bring savers and investors together.• By using expertise and powers of By using expertise and powers of

diversification, financial intermediaries reduce diversification, financial intermediaries reduce risk to savers and allow investors to obtain risk to savers and allow investors to obtain funds on better terms.funds on better terms.

• A typical commercial bank accepts funds from A typical commercial bank accepts funds from savers in the form of deposits.savers in the form of deposits.

• The bank then turns the money around and The bank then turns the money around and makes loans to businesses.makes loans to businesses.

• Help bring savers and investors together.Help bring savers and investors together.• By using expertise and powers of By using expertise and powers of

diversification, financial intermediaries reduce diversification, financial intermediaries reduce risk to savers and allow investors to obtain risk to savers and allow investors to obtain funds on better terms.funds on better terms.

• A typical commercial bank accepts funds from A typical commercial bank accepts funds from savers in the form of deposits.savers in the form of deposits.

• The bank then turns the money around and The bank then turns the money around and makes loans to businesses.makes loans to businesses.

BALANCE SHEETBALANCE SHEETBALANCE SHEETBALANCE SHEET• Has two sides -- assets and liabilitiesHas two sides -- assets and liabilities

• Liabilities are the source of funds for the bankLiabilities are the source of funds for the bank

-- Your deposits to a current account are -- Your deposits to a current account are an an example of liabilitiesexample of liabilities

• Assets are the uses of the fundsAssets are the uses of the funds

-- Loans are an example of a bank’s assets-- Loans are an example of a bank’s assets

• The difference between assets and liabilities is The difference between assets and liabilities is call its call its net worthnet worth

Net Worth = Assets - LiabilitiesNet Worth = Assets - Liabilities

• Has two sides -- assets and liabilitiesHas two sides -- assets and liabilities

• Liabilities are the source of funds for the bankLiabilities are the source of funds for the bank

-- Your deposits to a current account are -- Your deposits to a current account are an an example of liabilitiesexample of liabilities

• Assets are the uses of the fundsAssets are the uses of the funds

-- Loans are an example of a bank’s assets-- Loans are an example of a bank’s assets

• The difference between assets and liabilities is The difference between assets and liabilities is call its call its net worthnet worth

Net Worth = Assets - LiabilitiesNet Worth = Assets - Liabilities

RESERVESRESERVESRESERVESRESERVES• Assets which are not lent outAssets which are not lent out• Banks used to be required by law to hold a fraction of Banks used to be required by law to hold a fraction of

their deposits as reserves and not make loans with this their deposits as reserves and not make loans with this fraction of deposits. It was called fraction of deposits. It was called required reservesrequired reserves

• Banks often chose to hold additional reserves beyond Banks often chose to hold additional reserves beyond what was required; these were called what was required; these were called excess reservesexcess reserves

• A bank’s reserves are the sum of its required and excess A bank’s reserves are the sum of its required and excess reservesreserves

• Reserves can either be cash kept in a bank’s vaults or Reserves can either be cash kept in a bank’s vaults or deposits with the Federal Reserve.deposits with the Federal Reserve.

• Banks do not earn any interest on these reservesBanks do not earn any interest on these reserves

• Assets which are not lent outAssets which are not lent out• Banks used to be required by law to hold a fraction of Banks used to be required by law to hold a fraction of

their deposits as reserves and not make loans with this their deposits as reserves and not make loans with this fraction of deposits. It was called fraction of deposits. It was called required reservesrequired reserves

• Banks often chose to hold additional reserves beyond Banks often chose to hold additional reserves beyond what was required; these were called what was required; these were called excess reservesexcess reserves

• A bank’s reserves are the sum of its required and excess A bank’s reserves are the sum of its required and excess reservesreserves

• Reserves can either be cash kept in a bank’s vaults or Reserves can either be cash kept in a bank’s vaults or deposits with the Federal Reserve.deposits with the Federal Reserve.

• Banks do not earn any interest on these reservesBanks do not earn any interest on these reserves

THE PROCESS OF MONEY THE PROCESS OF MONEY CREATIONCREATION

THE PROCESS OF MONEY THE PROCESS OF MONEY CREATIONCREATIONAN EXAMPLEAN EXAMPLE

• A bank has deposits of $1,000A bank has deposits of $1,000

• Banks are required to keep 10% of deposits Banks are required to keep 10% of deposits as reserves and hold no excess reservesas reserves and hold no excess reserves

• The reserve ratio, in this case, is 0.1The reserve ratio, in this case, is 0.1

• The bank in this example will keep $100 in The bank in this example will keep $100 in reserves and make loans totaling $900reserves and make loans totaling $900

AN EXAMPLEAN EXAMPLE

• A bank has deposits of $1,000A bank has deposits of $1,000

• Banks are required to keep 10% of deposits Banks are required to keep 10% of deposits as reserves and hold no excess reservesas reserves and hold no excess reserves

• The reserve ratio, in this case, is 0.1The reserve ratio, in this case, is 0.1

• The bank in this example will keep $100 in The bank in this example will keep $100 in reserves and make loans totaling $900reserves and make loans totaling $900

THE PROCESS OF DEPOSIT CREATION:THE PROCESS OF DEPOSIT CREATION:CHANGES IN BALANCE SHEETSCHANGES IN BALANCE SHEETS


First Bank of HollywoodAssets Liabilities

$100 reserves $1,000 deposit$900 loans





Second Bank of BurbankAssets Liabilities

$90 reserves $900 deposit$810 loans







Third Bank of VeniceAssets Liabilities










Fourth Bank of Pasadena









Fourth Bank of PasadenaFifth bank of Compton

MONEY MULTIPLIER - 1MONEY MULTIPLIER - 1MONEY MULTIPLIER - 1MONEY MULTIPLIER - 1• It tells what the total increase in checking It tells what the total increase in checking

account deposits would be for any initial cash account deposits would be for any initial cash depositdeposit

• = 1 / reserve ratio= 1 / reserve ratio

• In the banking system, an initial cash deposit In the banking system, an initial cash deposit triggers additional rounds of deposits and triggers additional rounds of deposits and lending by bankslending by banks

• This leads to a multiple expansion of depositsThis leads to a multiple expansion of deposits

• The money creation process and the money The money creation process and the money multiplier also works in reversemultiplier also works in reverse

• It tells what the total increase in checking It tells what the total increase in checking account deposits would be for any initial cash account deposits would be for any initial cash depositdeposit

• = 1 / reserve ratio= 1 / reserve ratio

• In the banking system, an initial cash deposit In the banking system, an initial cash deposit triggers additional rounds of deposits and triggers additional rounds of deposits and lending by bankslending by banks

• This leads to a multiple expansion of depositsThis leads to a multiple expansion of deposits

• The money creation process and the money The money creation process and the money multiplier also works in reversemultiplier also works in reverse

MONEY MULTIPLIER - 2MONEY MULTIPLIER - 2MONEY MULTIPLIER - 2MONEY MULTIPLIER - 2

• In our example, the original deposit In our example, the original deposit created $1,000 in reserves at the created $1,000 in reserves at the bank. The money multiplier is equal bank. The money multiplier is equal to 10 (1/0.1). Therefore, the original to 10 (1/0.1). Therefore, the original $1,000 deposit will eventually turn $1,000 deposit will eventually turn into $10,000 of deposits.into $10,000 of deposits.

• In our example, the original deposit In our example, the original deposit created $1,000 in reserves at the created $1,000 in reserves at the bank. The money multiplier is equal bank. The money multiplier is equal to 10 (1/0.1). Therefore, the original to 10 (1/0.1). Therefore, the original $1,000 deposit will eventually turn $1,000 deposit will eventually turn into $10,000 of deposits.into $10,000 of deposits.

MONEY MULTIPLIER - 3MONEY MULTIPLIER - 3MONEY MULTIPLIER - 3MONEY MULTIPLIER - 3

• The change in the money supply, M1, The change in the money supply, M1, will be the change in deposits plus will be the change in deposits plus the change in currency held by the the change in currency held by the publicpublic

• In example, the money supply, M1, In example, the money supply, M1, increased by $9,000 ( $10,000 - increased by $9,000 ( $10,000 - $1,000$1,000

• The change in the money supply, M1, The change in the money supply, M1, will be the change in deposits plus will be the change in deposits plus the change in currency held by the the change in currency held by the publicpublic

• In example, the money supply, M1, In example, the money supply, M1, increased by $9,000 ( $10,000 - increased by $9,000 ( $10,000 - $1,000$1,000

MONEY MULTIPLIERMONEY MULTIPLIERMONEY MULTIPLIERMONEY MULTIPLIER• As of 1995, in the United States, were required to hold As of 1995, in the United States, were required to hold

10% on all checkable deposits exceeding $54 million10% on all checkable deposits exceeding $54 million• Since large banks would face a 10% reserve Since large banks would face a 10% reserve

requirement on any new deposits, a money multiplier requirement on any new deposits, a money multiplier of 10 would be expectedof 10 would be expected

• The money multiplier in the United States is actually The money multiplier in the United States is actually between 2 and 3, howeverbetween 2 and 3, however

• This reduced multiplier is because people hold part of This reduced multiplier is because people hold part of their loans in cash, the funds are not available for the their loans in cash, the funds are not available for the banking system to lend out banking system to lend out

• The money multiplier would also be less if banks held The money multiplier would also be less if banks held excess reserves excess reserves

• As of 1995, in the United States, were required to hold As of 1995, in the United States, were required to hold 10% on all checkable deposits exceeding $54 million10% on all checkable deposits exceeding $54 million

• Since large banks would face a 10% reserve Since large banks would face a 10% reserve requirement on any new deposits, a money multiplier requirement on any new deposits, a money multiplier of 10 would be expectedof 10 would be expected

• The money multiplier in the United States is actually The money multiplier in the United States is actually between 2 and 3, howeverbetween 2 and 3, however

• This reduced multiplier is because people hold part of This reduced multiplier is because people hold part of their loans in cash, the funds are not available for the their loans in cash, the funds are not available for the banking system to lend out banking system to lend out

• The money multiplier would also be less if banks held The money multiplier would also be less if banks held excess reserves excess reserves

FED TOOLS FOR CONTROLLING FED TOOLS FOR CONTROLLING THE MONEY SUPPLYTHE MONEY SUPPLY

FED TOOLS FOR CONTROLLING FED TOOLS FOR CONTROLLING THE MONEY SUPPLYTHE MONEY SUPPLY

• The Fed has 3 main tools for controlling The Fed has 3 main tools for controlling the size of the money supply:the size of the money supply:– Open Market Operations– Reserve Requirements– The Discount Rate

• The Fed has 3 main tools for controlling The Fed has 3 main tools for controlling the size of the money supply:the size of the money supply:– Open Market Operations– Reserve Requirements– The Discount Rate

OPEN MARKET OPEN MARKET OPERATIONS - 1OPERATIONS - 1OPEN MARKET OPEN MARKET

OPERATIONS - 1OPERATIONS - 1• The Fed can buy or sell government bonds to The Fed can buy or sell government bonds to

increase or decrease the money supply.increase or decrease the money supply.• When the Fed BUYS bonds, the money supply When the Fed BUYS bonds, the money supply

is INCREASED. is INCREASED. • Here is why: The Fed pays for the bonds it buys Here is why: The Fed pays for the bonds it buys

with money that was not currently a part of the with money that was not currently a part of the money supply - hence, when the Fed buys money supply - hence, when the Fed buys bonds it simply increases the total amount of bonds it simply increases the total amount of money in circulation.money in circulation.

• The Fed can buy or sell government bonds to The Fed can buy or sell government bonds to increase or decrease the money supply.increase or decrease the money supply.

• When the Fed BUYS bonds, the money supply When the Fed BUYS bonds, the money supply is INCREASED. is INCREASED.

• Here is why: The Fed pays for the bonds it buys Here is why: The Fed pays for the bonds it buys with money that was not currently a part of the with money that was not currently a part of the money supply - hence, when the Fed buys money supply - hence, when the Fed buys bonds it simply increases the total amount of bonds it simply increases the total amount of money in circulation.money in circulation.

OPEN MARKET OPEN MARKET OPERATIONS - 2OPERATIONS - 2OPEN MARKET OPEN MARKET

OPERATIONS - 2OPERATIONS - 2• When the Fed SELLS bonds, the money When the Fed SELLS bonds, the money

supply is DECREASED. supply is DECREASED. • Here is why: The Fed sells bonds in the Here is why: The Fed sells bonds in the

market and receives cash in return for the market and receives cash in return for the bonds it sells. Once the Fed receives the bonds it sells. Once the Fed receives the cash, this cash is taken OUT of circulation cash, this cash is taken OUT of circulation - therefore, the size of the money supply is - therefore, the size of the money supply is decreased.decreased.

• When the Fed SELLS bonds, the money When the Fed SELLS bonds, the money supply is DECREASED. supply is DECREASED.

• Here is why: The Fed sells bonds in the Here is why: The Fed sells bonds in the market and receives cash in return for the market and receives cash in return for the bonds it sells. Once the Fed receives the bonds it sells. Once the Fed receives the cash, this cash is taken OUT of circulation cash, this cash is taken OUT of circulation - therefore, the size of the money supply is - therefore, the size of the money supply is decreased.decreased.

RESERVE REQUIREMENTSRESERVE REQUIREMENTSRESERVE REQUIREMENTSRESERVE REQUIREMENTS

• By controlling reserve ratios that banks must By controlling reserve ratios that banks must keep, the Fed also controls the amount of money keep, the Fed also controls the amount of money that banks can lend out. that banks can lend out.

• In the previous slide, we showed how bank In the previous slide, we showed how bank lending increases the money supply. However, lending increases the money supply. However, when the Fed increases reserve ratios, they when the Fed increases reserve ratios, they reduce the amount of money banks can lend and reduce the amount of money banks can lend and also reduce the size of the money supply.also reduce the size of the money supply.

• When the Fed lowers reserve ratios, they increase When the Fed lowers reserve ratios, they increase the amount of money banks can lend out and also the amount of money banks can lend out and also increase the size of the money supply.increase the size of the money supply.

• By controlling reserve ratios that banks must By controlling reserve ratios that banks must keep, the Fed also controls the amount of money keep, the Fed also controls the amount of money that banks can lend out. that banks can lend out.

• In the previous slide, we showed how bank In the previous slide, we showed how bank lending increases the money supply. However, lending increases the money supply. However, when the Fed increases reserve ratios, they when the Fed increases reserve ratios, they reduce the amount of money banks can lend and reduce the amount of money banks can lend and also reduce the size of the money supply.also reduce the size of the money supply.

• When the Fed lowers reserve ratios, they increase When the Fed lowers reserve ratios, they increase the amount of money banks can lend out and also the amount of money banks can lend out and also increase the size of the money supply.increase the size of the money supply.

THE DISCOUNT RATE - 1THE DISCOUNT RATE - 1THE DISCOUNT RATE - 1THE DISCOUNT RATE - 1

• Another function of the Fed is to loan money to Another function of the Fed is to loan money to banks in the economy. Banks may need these banks in the economy. Banks may need these loans for several reasons:loans for several reasons:– Emergency borrowing is one reason - banks that are Emergency borrowing is one reason - banks that are

in trouble have the Fed as the lender of last resort - in trouble have the Fed as the lender of last resort - this Fed function serves to calm depositors at this Fed function serves to calm depositors at troubled banks. troubled banks.

– Another reason banks borrow from the Fed is to Another reason banks borrow from the Fed is to meet reserve requirements. In the course of meet reserve requirements. In the course of business, banks may make too many loans, or have business, banks may make too many loans, or have unusually large withdrawals by their depositors.unusually large withdrawals by their depositors.

• Another function of the Fed is to loan money to Another function of the Fed is to loan money to banks in the economy. Banks may need these banks in the economy. Banks may need these loans for several reasons:loans for several reasons:– Emergency borrowing is one reason - banks that are Emergency borrowing is one reason - banks that are

in trouble have the Fed as the lender of last resort - in trouble have the Fed as the lender of last resort - this Fed function serves to calm depositors at this Fed function serves to calm depositors at troubled banks. troubled banks.

– Another reason banks borrow from the Fed is to Another reason banks borrow from the Fed is to meet reserve requirements. In the course of meet reserve requirements. In the course of business, banks may make too many loans, or have business, banks may make too many loans, or have unusually large withdrawals by their depositors.unusually large withdrawals by their depositors.


• The result of either (or both) of these situations The result of either (or both) of these situations is that the bank will NOT have met its reserve is that the bank will NOT have met its reserve requirements.requirements.

• Regardless of the reason prompting a bank to Regardless of the reason prompting a bank to borrow from the Fed, the loan from the Fed to borrow from the Fed, the loan from the Fed to the bank increases the bank's reserves. As we the bank increases the bank's reserves. As we now know, the new reserves allow the banking now know, the new reserves allow the banking system to generate more money.system to generate more money.

• The result of either (or both) of these situations The result of either (or both) of these situations is that the bank will NOT have met its reserve is that the bank will NOT have met its reserve requirements.requirements.

• Regardless of the reason prompting a bank to Regardless of the reason prompting a bank to borrow from the Fed, the loan from the Fed to borrow from the Fed, the loan from the Fed to the bank increases the bank's reserves. As we the bank increases the bank's reserves. As we now know, the new reserves allow the banking now know, the new reserves allow the banking system to generate more money.system to generate more money.


• The discount rate is a tool for controlling The discount rate is a tool for controlling the money supply because it represents the money supply because it represents the cost to banks of borrowing from the the cost to banks of borrowing from the Fed (banks pay interest to the Fed on the Fed (banks pay interest to the Fed on the loan). A higher discount rate will loan). A higher discount rate will discourage banks from borrowing discourage banks from borrowing reserves from the Fed. A lower discount reserves from the Fed. A lower discount rate encourages borrowing.rate encourages borrowing.

• The discount rate is a tool for controlling The discount rate is a tool for controlling the money supply because it represents the money supply because it represents the cost to banks of borrowing from the the cost to banks of borrowing from the Fed (banks pay interest to the Fed on the Fed (banks pay interest to the Fed on the loan). A higher discount rate will loan). A higher discount rate will discourage banks from borrowing discourage banks from borrowing reserves from the Fed. A lower discount reserves from the Fed. A lower discount rate encourages borrowing.rate encourages borrowing.

• Created in 1913 following a series of financial Created in 1913 following a series of financial panicspanics

• Congress created the Federal Reserve System Congress created the Federal Reserve System to be a banker’s bank or to be a banker’s bank or central bankcentral bank

• As a As a lender of last resortlender of last resort, the Federal Reserve , the Federal Reserve would be there to lend funds to banks, would be there to lend funds to banks, reducing some of the adverse consequences reducing some of the adverse consequences of a panicof a panic

• Created in 1913 following a series of financial Created in 1913 following a series of financial panicspanics

• Congress created the Federal Reserve System Congress created the Federal Reserve System to be a banker’s bank or to be a banker’s bank or central bankcentral bank

• As a As a lender of last resortlender of last resort, the Federal Reserve , the Federal Reserve would be there to lend funds to banks, would be there to lend funds to banks, reducing some of the adverse consequences reducing some of the adverse consequences of a panicof a panic

THE STRUCTURE OF THE THE STRUCTURE OF THE FEDERAL RESERVEFEDERAL RESERVE

THE STRUCTURE OF THE THE STRUCTURE OF THE FEDERAL RESERVEFEDERAL RESERVE

THE STRUCTURE OF THE THE STRUCTURE OF THE FEDERAL RESERVE FEDERAL RESERVE

THE STRUCTURE OF THE THE STRUCTURE OF THE FEDERAL RESERVE FEDERAL RESERVE

There are three distinct subgroups:There are three distinct subgroups:

• Federal Reserve BanksFederal Reserve Banks

• The Board of GovernorsThe Board of Governors

• The Federal Open Market The Federal Open Market CommitteeCommittee

There are three distinct subgroups:There are three distinct subgroups:

• Federal Reserve BanksFederal Reserve Banks

• The Board of GovernorsThe Board of Governors

• The Federal Open Market The Federal Open Market CommitteeCommittee

FEDERAL RESERVE BANKSFEDERAL RESERVE BANKSFEDERAL RESERVE BANKSFEDERAL RESERVE BANKS• The United States is divided into 12 Federal The United States is divided into 12 Federal

Reserve districts, each of which has a Reserve districts, each of which has a Federal Reserve BankFederal Reserve Bank

• Provide advice on monetary policyProvide advice on monetary policy

• Take part in decision making on monetary Take part in decision making on monetary policypolicy

• Provide liaison between the Fed and the Provide liaison between the Fed and the banks in their districtbanks in their district

• The United States is divided into 12 Federal The United States is divided into 12 Federal Reserve districts, each of which has a Reserve districts, each of which has a Federal Reserve BankFederal Reserve Bank

• Provide advice on monetary policyProvide advice on monetary policy

• Take part in decision making on monetary Take part in decision making on monetary policypolicy

• Provide liaison between the Fed and the Provide liaison between the Fed and the banks in their districtbanks in their district

THE FEDERAL RESERVE BANKS OF THE CONTINENTALTHE FEDERAL RESERVE BANKS OF THE CONTINENTALUNITED STATESUNITED STATES

BostonBoston

New YorkNew York

PhiladelphiaPhiladelphia

RichmondRichmond

AtlantaAtlanta

ClevelandClevelandChicagoChicago

St. LouisSt. Louis

DallasDallas

MinneapolisMinneapolis

KansasKansasCityCity

San FranciscoSan Francisco

THE BOARD OF GOVERNORSTHE BOARD OF GOVERNORSTHE BOARD OF GOVERNORSTHE BOARD OF GOVERNORS• The true seat of power over the monetary The true seat of power over the monetary

systemsystem• Headquartered in Washington, DCHeadquartered in Washington, DC• Seven members of the board are appointed Seven members of the board are appointed

for staggered 14-year terms by the President for staggered 14-year terms by the President and must be confirmed by the Senateand must be confirmed by the Senate

• The Chairman of the Board of Governors, the The Chairman of the Board of Governors, the principal spokesman for monetary policy in principal spokesman for monetary policy in the country, serves a four-year term as the country, serves a four-year term as chairmanchairman

• The true seat of power over the monetary The true seat of power over the monetary systemsystem

• Headquartered in Washington, DCHeadquartered in Washington, DC• Seven members of the board are appointed Seven members of the board are appointed

for staggered 14-year terms by the President for staggered 14-year terms by the President and must be confirmed by the Senateand must be confirmed by the Senate

• The Chairman of the Board of Governors, the The Chairman of the Board of Governors, the principal spokesman for monetary policy in principal spokesman for monetary policy in the country, serves a four-year term as the country, serves a four-year term as chairmanchairman

FEDERAL OPEN MARKET COMMITTEE ( FOMC )FEDERAL OPEN MARKET COMMITTEE ( FOMC )FEDERAL OPEN MARKET COMMITTEE ( FOMC )FEDERAL OPEN MARKET COMMITTEE ( FOMC )

• Decisions on monetary policy made by the FOMCDecisions on monetary policy made by the FOMC• A 12-person board consisting of seven members of the Board of A 12-person board consisting of seven members of the Board of

Governors, the president of the New York Federal Reserve, plus Governors, the president of the New York Federal Reserve, plus presidents of four other regional Federal Reserve Bankspresidents of four other regional Federal Reserve Banks

• Presidents of the regional banks other than New York serve on a Presidents of the regional banks other than New York serve on a rotating basisrotating basis

• Seven non-voting bank presidents attend meetings and provide Seven non-voting bank presidents attend meetings and provide their viewstheir views

• The chairman of the Board of Governors also serves as chairman The chairman of the Board of Governors also serves as chairman of the FOMCof the FOMC

• The FOMC makes the actual decisions on changes in the money The FOMC makes the actual decisions on changes in the money supply supply

• Decisions on monetary policy made by the FOMCDecisions on monetary policy made by the FOMC• A 12-person board consisting of seven members of the Board of A 12-person board consisting of seven members of the Board of

Governors, the president of the New York Federal Reserve, plus Governors, the president of the New York Federal Reserve, plus presidents of four other regional Federal Reserve Bankspresidents of four other regional Federal Reserve Banks

• Presidents of the regional banks other than New York serve on a Presidents of the regional banks other than New York serve on a rotating basisrotating basis

• Seven non-voting bank presidents attend meetings and provide Seven non-voting bank presidents attend meetings and provide their viewstheir views

• The chairman of the Board of Governors also serves as chairman The chairman of the Board of Governors also serves as chairman of the FOMCof the FOMC

• The FOMC makes the actual decisions on changes in the money The FOMC makes the actual decisions on changes in the money supply supply

THE STRUCTURE OF THE FEDERAL RESERVETHE STRUCTURE OF THE FEDERAL RESERVE

CHAIRCHAIR

Board of GovernorsBoard of Governors7 members7 members

Federal Reserve BanksFederal Reserve Banks

12 presidents12 presidents

Federal Open Market CommitteeFederal Open Market Committee( FOMC )( FOMC )

Board of GovernorsBoard of Governorsplus 5 bank presidentsplus 5 bank presidents

Decisions about Decisions about monetary policymonetary policy

$$$$$$$$$$

INDEPENDENCE OF THE INDEPENDENCE OF THE FEDERAL RESERVEFEDERAL RESERVE

INDEPENDENCE OF THE INDEPENDENCE OF THE FEDERAL RESERVEFEDERAL RESERVE

• The chairman of the Federal Reserve is required The chairman of the Federal Reserve is required to report to Congress on a regular basisto report to Congress on a regular basis

• Although the Federal Reserve operates with Although the Federal Reserve operates with independence, it is a creation of Congressindependence, it is a creation of Congress

• The U.S. Constitution gives Congress the power The U.S. Constitution gives Congress the power to ‘coin money and regulate the value thereof”to ‘coin money and regulate the value thereof”

• In practice, the Fed takes its actions first and In practice, the Fed takes its actions first and reports to Congress after the factreports to Congress after the fact

• The chairman of the Federal Reserve is required The chairman of the Federal Reserve is required to report to Congress on a regular basisto report to Congress on a regular basis

• Although the Federal Reserve operates with Although the Federal Reserve operates with independence, it is a creation of Congressindependence, it is a creation of Congress

• The U.S. Constitution gives Congress the power The U.S. Constitution gives Congress the power to ‘coin money and regulate the value thereof”to ‘coin money and regulate the value thereof”

• In practice, the Fed takes its actions first and In practice, the Fed takes its actions first and reports to Congress after the factreports to Congress after the fact

Documents

MONEY, THE BANKING SYSTEM & THE FEDERAL RESERVE