The Banking System and the Money Supply South-Western/Thomson Learning

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1 The Banking System and the Money Supply 2003 South-Western/Thomson Learning

2 What Counts as Money MONEY Anything that is widely accepted as a means of payment

3 What Counts as Money MONEY Anything that is widely accepted as a means of payment cash

4 What Counts as Money MONEY Anything that is widely accepted as a means of payment cash checks (demand deposits)

5 What Counts as Money MONEY Are credit cards money?

6 What Counts as Money NEAR MONEYS Assets that are close substitutes for money

7 What Counts as Money Liquidity The property of being easily converted into cash (currency)

8 Liquid Assets An asset is considered liquid if it can be converted into cash quickly at little cost

9 Illiquid Assets An asset is illiquid if it can be converted into cash only: after a delay, or at considerable cost

10 Assets in Order of Liquidity #1 - Cash in the Hands of the Public #2 - Demand Deposits #3 - Other Checkable Deposits #4 - Travelers Checks #5 - Savings-type Accounts #6 - Money Market Mutual Funds #7 - Time Deposits

11 Assets and Their Liquidity #1 - Cash in the Hands of the Public Currency and coins held outside of banks #2 - Demand Deposits Checking accounts that do not pay interest

12 Assets and Their Liquidity Savings Type Accounts ($2,312 billion) Cash in the Hands of the Public ($586 billion) Demand Deposits ($330 billion) + Other Checkable Deposits ($260 billion) + Travelers Checks ($8 billion) Money Market Mutual Funds ($984 billion) Small Time Deposits ($962 billion) Large Time Deposits ($797 billion) More Liquid Less Liquid

13 M1 and M2 M1 A standard measure of the money supply, including cash in the hands of the public, demand and other checking account deposits, and travelers checks

14 M1 and M2 M2 M1 plus savings account balances, noninstitutional money market mutual fund balances, and small denomination time deposits

15 M1 and M2 Money supply = cash in the hands of the public + demand deposits

16 The Banking System Financial Intermediaries Commercial Banks A A Bank s Balance Sheet

17 Financial Intermediaries Financial Intermediary A business firm that specializes in brokering between savers and borrowers

18 Financial Intermediaries Savings and Loan Associations Mutual Savings Banks Credit Unions Commercial Banks Insurance Companies Mutual Funds

19 Commercial Banks A commercial bank is a private corporation, owned by its stockholders, that provides services to the public.

20 Commercial Banks The most important service is to provide checking accounts. The public holds about as much money in the form of demand deposits and other checking-type accounts as it holds in cash.

21 Commercial Banks A bank s profit comes mostly from lending out the funds that people deposit and charging interest on the loans.

22 A Bank s Balance Sheet Balance Sheet A financial statement showing assets, liabilities, and net worth at a point in time

23 A Bank s Balance Sheet Assets Liabilities + Net Worth Cash Deposits with Fed (Reserves) Loans Investments (Bonds) Plant & Equip Demand Deposits Time Deposits Loans from Fed Borrowings Net Worth

24 A Bank s Balance Sheet How a Bank Makes its Profits Bond An IOU issued by a corporation or government agency when it borrows funds Loan An IOU issued by a household or noncorporate business when it borrows funds Financial Services Check clearing, credit cards, investment banking

25 A Bank s Balance Sheet Assets Liabilities + Net Worth Cash Deposits with Fed (Reserves) Loans Investments (Bonds) Plant & Equip Demand Deposits Time Deposits Loans from Fed Borrowings Net Worth

26 A Bank s Balance Sheet Reserves Vault cash plus balances held at the Fed Required Reserves The minimum amount of reserves a bank must hold, depending on the amount of its deposit liabilities

27 A Bank s Balance Sheet Assets Liabilities + Net Worth Cash Deposits with Fed (Reserves) Loans Investments (Bonds) Plant & Equip Demand Deposits Time Deposits Loans from Fed Borrowings Net Worth

28 A Bank s Balance Sheet Required Reserve Ratio The minimum fraction of checking account balances that banks must hold as reserves

29 A Bank s Balance Sheet Net Worth The difference between assets and liabilities Net worth = Total assets Total Liabilities

30 A Bank s Balance Sheet Assets Liabilities + Net Worth Cash Deposits with Fed (Reserves) Loans Investments (Bonds) Plant & Equip Demand Deposits Time Deposits Loans from Fed Borrowings Net Worth

31 The Federal Reserve System The Structure of the Fed The Federal Open Market Committee The Functions of the Federal Reserve

32 The Federal Reserve System Central Bank A nation s principal monetary authority

33 The Structure of the Fed Chair of Board of Governors Board of Governors Federal Open Market Committee 12 Federal Reserve District Banks Member Banks

34 The Structure of the Fed President appoints Senate confirms Chair of Board of Governors Board of Governors (7 members, including chair) Supervises and regulates member banks Supervises 12 Federal Reserve District Banks Sets reserve requirements and approves discount rate Federal Open Market Committee (7 Governors + 5 Reserve Bank Presidents) Conducts open market operations to control the money supply Appoints 3 directors of each Federal Reserve Bank 12 Federal Reserve District Banks Lend reserves Provide currency Clear checks Elect 6 directors of each Federal Reserve Bank 3,500 Member Banks

35 The FOMC Federal Open Market Committee (FOMC) A committee of Federal Reserve officials that establishes U.S. monetary policy

36 Functions of the Federal Reserve Supervising and Regulating Banks Acting as a Bank for Banks Issuing Paper Currency Check Clearing Controlling the Money Supply

37 Functions of the Fed Discount Rate The interest rate the Fed charges on loans to banks

38 The Fed and the Money Supply How the Fed Increases the Money Supply The Demand Deposit Multiplier The Fed s Influence on the Banking System as a Whole How the Fed Decreases the Money Supply Some Important Provisos About the Demand Deposit Multiplier Other Tools for Controlling the Money Supply

39 The Fed and the Money Supply Open Market Operations When the Fed wants to increase or decrease the money supply, it buys ro sells government bonds to bond dealers, banks, or other financial institutions, a process called open market operations.

40 Feds Balance Sheet Assets Liabilities + Net Worth Loans to Member Banks Government Bonds Gold Plant & Equip Member Bank Reserves Currency Net Worth

41 How the Fed Increases the Money Supply Excess Reserves Reserves in excess of required reserves

42 How the Fed Increases the Money Supply Demand deposits increase each time a bank lends out excess reserves. In the end, demand deposits will increase by a multiple of the original dollars in reserves injected into the banking system by the open market purchase.

43 OPEN MARKET PURCHASE Banks Reserves +100 Deposits +100 Fed Bonds +100 Reserves +100 Public Bonds -100 Deposits +100

44 OPEN MARKET PURCHASE (required reserve 20%) Reserves +100 Loans +400 Banks Deposits +500 Fed Bonds +100 Reserves +100 Bonds -100 Deposits +500 Public Loans +400

45 Banks OPEN MARKET SALE Fed Reserves -100 Deposits -100 Bonds -100 Reserves -100 Public Bonds +100 Deposits -100

46 Banks OPEN MARKET SALE Fed Reserves -100 Loans -400 Deposits -500 Bonds -100 Reserves -100 Bonds +100 Deposits -500 Public Loans -400

47 BANK BORROWS FROM FED (DISCOUNT WINDOW) Banks Reserves +100 Fed Loan +100 Bank Loan +100 Fed Reserves +100 Public

48 BANK BORROWS FROM FED (DISCOUNT WINDOW) Banks Fed Reserves +100 Loans +500 Deposits +500 Fed Loan +100 Bank Loan +100 Reserves +100 Deposits +500 Public Loans +500

49 The Demand Deposit Multiplier Demand Deposit Multiplier The number by which a change in reserves is multiplied to determine the resulting change in demand deposits For any value of the required reserve ratio (RRR), the formula is 1/RRR.

50 The Fed s Influence on the Banking System After an injection of reserves, the demand deposit multiplier stops working - and the money supply stops increasing - only when all the reserves injected are being held by banks as required reserves.

51 How the Fed Decreases the Money Supply Just as the Fed can increase the money supply by purchasing government bonds, it can also decrease the money supply by selling government bonds - an open market sale.

52 Demand Deposit Multiplier In reality, banks often want to hold excess reserves, for a variety of reasons.

53 Other Tools for Controlling the Money Supply Changes in the Required Reserve Ratio Changes in the Discount Rate

54 Other Tools for Controlling the Money Supply While other tools can affect the money supply, open market operations have two advantages: precision and accuracy. This is why open market operations remain the Fed s primary means of changing the money supply.

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