Chapter 13 Money and Banking

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1 Chapter 13 Money and Banking After reading Chapter 13, MONEY AND BANKING, you should be able to: Explain the three functions of money: Medium of Exchange, Unit of Account, Store of Value. Understand the definition of Liquidity. Define the Narrow (M1) and Broad (M2) money-supply measures. Explain the role of a Financial Intermediary. Explain the main entries on a bank s balance sheet and how banks earn profits. Explain the meaning of a Fractional Reserve Banking System. Discuss the institutional structure of the Federal Reserve. Define the Monetary Base. Explain how the system of banks can create deposits in excess of its reserves. Explain how the Fed can control the money supply using Open Market Operations, Reserve Requirements, and Discount Rates. Outline I. Three Functions of Money A) Money is anything that serves the three functions of money: 1. Medium of Exchange: Money can be used to buy things and pay debts. 2. Unit of Value: Money is the unit in which prices are listed. 3. Store of Value: Money retains its purchasing powercan. B) Money is more efficient that barter since it eliminates the need for a Double Coincidence of Wants, which occurs where the buyer and the seller both want to obtain goods produced by the other. C) Liquidity refers to how quickly and with what risks an asset can be converted into money. The more liquid the asset the more closely it substitutes for money. D) The Narrow (M1) definition of money is the sum of currency, coins, checking account deposits held by the public, travelers checks, and other deposits upon which checks may be drawn. E) The Broad (M2) definition of money equals M1 plus savings deposits, small time deposits, money-market mutual-fund shares and a few other highly liquid assets.

2 Chapter 13 Money and Banking 131 II. Banks A) Banks are Financial Intermediaries that link lenders and borrowers. B) The main assets of a bank are its loans, investments, and securities. Reserves (reserves are held at the Fed and as vault cash) are somewhat less than 2 percent of all assets. C) Banks liabilities are the deposits it has accepted from the public, including transactions or demand deposits, savings and time deposits, and other debts. D) Banks earn a profit from the Interest Rates Spread, which is the difference between the interest that banks pay on deposits and the interest rates they receive on their loans and other investments. E) Banks hold only a small fraction of their total deposits as reserves. This is known as a Fractional-Reserve Banking System. This system can lead to bank failure when the public loses confidence in the banks ability to meet any withdrawals. III. The Federal Reserve A) The Federal Reserve (FED) is the central bank (a bank for banks) of the United States. 1. The Fed regulates and also assists the nation s banking system. 2. The Fed controls the nation s money supply. B) The seven-member Board of Governors, appointed by the President of the United States, directs the Fed. C) The Federal Open Market Committee (FOMC) consists of the seven Board members and presidents of five of the twelve regional Federal Reserve banks. The FOMC determines the amount of the nation s money supply. D) Open Market Operations are purchases and sales of federal government securities on the Fed s account. E) Reserve requirements are rules stating the amount of reserves banks must keep to back their deposits 1. The Fed sets Required Reserve Ratios, which tell the amount of reserves required for each dollar of deposits. 2. A bank s deposits at the Fed plus its vault cash are the bank s legal reserves. 3. Excess Reserves are reserves a bank holds beyond the quantity it is legally mandated to have. F) The Monetary Base is the sum of bank reserves on deposit at the Fed plus currency in circulation. 1. Whenever the Fed buys (sells) something, the monetary base expands (contracts). 2. The monetary base can be thought of as the Fed s currency liability.

3 132 Gregory Essentials of Economics, Sixth Edition G) Banks can create money when the Fed expands the monetary base. 1. When the Fed expands the monetary base, banks have excess reserves. 2. When any one bank has excess reserves, it loans the excess, which thereby winds up as deposits in another bank. 3. After the deposit is made at the second bank, it has some excess reserves. This bank loans these excess reserves, which will end up as deposits in a third bank. 4. The banking system, as a whole, increases its loans and deposits until it no longer has undesired excess reserves. By so doing, the banking system creates more deposits than the initial increase in base money. 5. The Deposit Multiplier is the ratio of the change in deposits to excess reserves. This equals the reciprocal of the reserve requirement. IV. How the Fed Controls the Money Supply The Fed has three instruments it can use to control the money supply: A) Open-Market Operations are buying and selling by the Federal Reserve of federal government securities. 1. When securities are purchased, the monetary base expands and the money supply increases; when they are sold, the monetary base shrinks and the money supply falls. 2. Open-market operations are the Fed s major tool of monetary control. B) When the Fed changes the Reserve Requirements imposed on banks, it alters the deposit multiplier. 1. If reserve requirements are increased (lowered), the deposit multiplier falls (rises), therefore shrinking (raising) the M1 money supply. 2. This tool is seldom used since it can create sudden shocks. C) The Discount Rate is the interest rate the Fed charges banks that borrow reserves. 1. If the Fed lowers (raises) the discount rate, banks borrow more (less), and the monetary base and money supply expands (contracts). 2. The Fed increases the discount rate to keep them in line with other interest rates. A change in the discount rate sends a signal to banks that credit will become tighter or looser. Review Questions True/False If the statement is correct, write true in the space provided; if it is wrong, write false. Below the question give a short statement that supports your answer. 1. Financial intermediaries borrow funds from ultimate lenders and lend it to ultimate borrowers. 2. One of the largest assets on banks balance sheets is demand deposits. 3. A bank keeps on hand as reserves all of the money entrusted to it as deposits. 4. The broad (M2) definition of money includes some assets excluded from the narrow (M1) definition.

4 Chapter 13 Money and Banking The major component of M1 is checking accounts and other checkable deposits. 6. The Federal Reserve is overseen by the seven-member Board of Governors. 7. Open-market operations are the purchase or sale of government securities by commercial banks. 8. Anytime the Fed buys something, it removes money from the economy. 9. Commercial banks are completely free to determine the amount of reserves they keep on hand to back their deposits. 10. The monetary base is changed whenever a bank customer withdraws funds from his or her checking account. 11. Each bank can create additional demand deposits equal in amount to its excess reserves. 12. A bank s excess reserves equal its total reserves minus its required reserves. 13. An increase in the required reserve ratio increases the deposit multiplier. 14. If people decide they want to hold more currency and fewer demand deposits, the M1 money supply eventually falls. 15. Open-market purchases of government bonds by the Federal Reserve increase the nation s money supply. 16. The discount rate is the interest rate the Federal Reserve pays on the reserves banks keep at the Federal Reserve. Multiple Choice Questions Circle the letter corresponding to the correct answer. 1. Which of the following assets is most liquid? (a) Shares of stock in IBM (b) US government securities (c) Land (d) Gold (e) Currency

5 134 Gregory Essentials of Economics, Sixth Edition 2. Money must fulfill all of the following functions except (a) be a medium of exchange. (b) serve as the unit of value. (c) be a store of value. (d) be generally accepted as a means of purchasing commodities (e) The above are all functions of money. 3. The M1 money supply equals (a) the sum of coins and currency. (b) the sum of coins, currency, travelers checks, checking accounts at banks, and other accounts upon which checks may be drawn. (c) the sum of coins, currency, travelers checks, checking accounts at banks, other accounts upon which checks may be drawn, and savings and time deposits. (d) the sum of all accounts upon which checks may be drawn. (e) the sum of currency in circulation and bank reserves held at the Federal Reserve. 4. M1 increases when the Fed (a) raises the discount rate. (b) sells a government security. (c) raises the required reserve ratio. (d) buys a government security. (e) All of these actions lower the money supply. 5. Which of the following statements about the Federal Reserve is false? (a) The Federal Reserve sets required reserve ratios that commercial banks must meet. (b) The Federal Reserve is overseen by the seven-member Board of Governors. (c) Federal Reserve actions can change the amount of the nation s money supply. (d) The Federal reserve can increase or decrease the monetary base. (e) None of the above; that is, they are all true statements. Essay Questions Write a short essay or otherwise answer each question. 1. Why isn t the line of credit on credit cards counted as part of the nation s money supply? 2. Suppose the First Federal Bank has demand deposits of $100 million. If the required reserve ratio is 15 percent, what amount of reserves is First Federal required to keep? What if the required reserve ratio is 10 percent?

6 Chapter 13 Money and Banking 135 For the next 5 questions, assume the required reserve ratio is 10 percent. 3. Suppose the balance sheet of Mellon bank is initially given by Vault Cash $80 Transactions deposits $900 Reserves at Fed $70 Loans $750 What are Mellon s total reserves? Its required reserves? Its excess reserves? If Mellon decided it wanted to increase its loans by the maximum possible, how much can Mellon increase its loans? 4. Continuing from Question 3, suppose Mellon made the maximum loan possible to U.S. Steel. After Mellon made the loan, but before U.S. Steel has spent the loan, what is Mellon s balance sheet? 5. From Question 4, suppose U.S. Steel withdraws its loan by taking cash. After U.S. Steel withdraws its loan, what is Mellon s balance sheet? What are Mellon s total reserves? Its required reserves? Its excess reserves? 6. Suppose U.S. Steel uses the proceeds of its loan to pay its electric bill (in cash) to its electric company, Duquesne Light. If Duquesne Light deposits this in its checking account with Pittsburgh National Bank, what will be the bank s balance sheet after the deposit if its balance sheet before the deposit is Vault Cash $40 Transactions deposits $700 Reserves at Fed $30 Loans $ Using the balance sheet in Question 6, before Duquesne Light deposited its funds in Pittsburgh National Bank, what were the bank s total reserves? Required reserves? Excess reserves? By how much could the bank increase its loans? After the funds are deposited, what are the bank s total reserves? Required reserves? Excess reserves? By how much can Pittsburgh National increase its loans? 8. If the required reserve ratio is 10 percent, what is the deposit multiplier? If the Fed raises the monetary base and excess reserves by $1000, by how much can the money supply ultimately change? If the required reserve ratio is 20 percent, what can be the increase in the money supply from the $1000 change? 9. The boxed example in this chapter uses the concept of moral hazard to explain the Asian Crisis of 1997 and Write an essay explaining how the belief in an ultimate lender of last resort, such as the International Monetary Fund, helped create the Asian Crisis.

7 136 Gregory Essentials of Economics, Sixth Edition Answers to Review Questions True/False 1. True. A bank is a good example of an intermediary: it borrows from people (the ultimate lenders) by accepting their deposits and then loans to other individuals or firms (the ultimate borrowers). 2. False. Transactions (demand) deposits are a liability not an asset to the bank because the deposits are owned by others. The bank must pay them back to their owners upon request. 3. False. Banks keep on hand as reserves only about 2 percent of the total deposits. 4. True. These assets include time deposits, savings deposits, and shares in money-market mutual-funds. 5. True. Checkable deposits, including demand deposits, comprise about 70 percent of M1. 6. True. Members of the board are appointed for fourteen-year terms by the President of the United States. 7. False. Open market operations are the purchase or sale of government securities by the Federal Reserve. 8. False. Anytime the Fed buys something, it injects money into the economy. 9. False. The Fed sets legally required reserve ratios that constrain banks to hold at least a certain level of reserves. 10. False. The monetary base is changed only when the Federal Reserve injects or withdraws currency or bank reserves. 11. True. Each bank is free to create additional demand deposits by loaning the amount of its excess reserves to a customer. 12. True. This is the definition of excess reserves. 13. False. The deposit multiplier equals the reciprocal of the required reserve ratio, so an increase in the required reserve ratio lowers the deposit multiplier. 14. True. When people withdraw more currency from banks, banks reserves fall. In order to maintain their required level of reserves, banks must reduce the loans they grant. This reduction sets off a multiple contraction of the M1 money supply. 15. True. The Fed pays for its purchases by either increasing the amount of currency (thereby raising M1 directly) or by increasing the reserves accounts banks maintain at the Fed. This latter action raises banks excess reserves, thereby leading to a multiple expansion of the M1 money supply. 16. False. The discount rate is the interest rate the Federal Reserve charges banks when the banks borrow reserves from it.

8 Chapter 13 Money and Banking 137 Multiple Choice Questions 1. (e) Currency is the most liquid of any asset. 2. (e) If an asset meets these functions, it is considered money. 3. (b) This is the definition of M1. 4. (d) Purchasing a government security is an open-market operation that raises the base money supply and banks excess reserves. This leads to a multiple expansion of the money supply. 5. (e) All of the statements about the Federal Reserve are correct and, because the Federal Reserve plays a significant role in the nation s economy, all of the statements are important. Essay Questions 1. Credit cards merely allow their owners very easy and convenient access to a loan. Ultimately the loan must be repaid using money, either currency or checking account money. Thus the credit limit on credit cards is a loan limit and not part of the money supply. 2. When the required reserve ratio is 15 percent, $15 million in reserves is required [($100 million) (.15)]. When the reserve ratio is 10 percent, $10 million must be kept as reserves. Lowering the reserve requirement reduces the legally required amount of reserves. Such a decrease gives banks more excess reserves that they may use to loan out, thereby creating more money. 3. Total reserves are $150 (the sum of vault cash plus reserves at the Fed). Required reserves are $90 (the required reserve ratio,.10, times the total amount of transactions [demand] deposits, $900). Excess reserves are $60 (the difference between total reserves and required reserves). Mellon may increase its loans by $60. A bank may increase its loans by the amount of its excess reserves. 4. Vault Cash $80 Transactions deposits $960 Reserves at Fed $70 Loans $810 The new balance sheet is given above. Mellon has loaned $60 to U.S. Steel by opening a checking account for U.S. Steel in the amount of the loan. Thus total transactions deposits (checking accounts) rise by $60 and total loans rise by $ Vault Cash $20 Transactions deposits $900 Reserves at Fed $70 Loans $810 As shown above, U.S. Steel withdraws its loan by reducing its checking account by $60, so transactions deposits fall by $60. Since U.S. Steel takes its funds in the form of currency, vault cash falls by $60. Mellon s total reserves are $90 (the sum of vault cash plus reserves at Fed). Required reserves are $90 (the required reserve ratio times the total deposits). Its excess reserves are $0 (the difference between actual and required reserves). Mellon now has no excess reserves with which to make loans.

9 138 Gregory Essentials of Economics, Sixth Edition 6. Vault Cash $100 Transactions deposits $760 Reserves at Fed $30 Loans $630 The balance after the deposit is shown above. Duquesne Light deposits the $60 in its checking account, so transactions deposits, as well as cash, rise by $ Before the Deposit After the Deposit Total reserves $70 Total reserves $130 Required reserves $70 Required reserves $76 Excess reserves $0 Excess reserves $54 Maximum loan $0 Maximum loan $54 As shown above, notice that Pittsburgh National Bank is now in a position to increase its loans. Were it to do so, the money supply would continue to grow. 8. The deposit multiplier is 10. It equals 1/(required reserve ratio) or 1 / (0.1) = 10. If the monetary base is increased, the money supply can ultimately change by the deposit multiplier (10) times the change in the monetary base ($1,000) or by $10,000. If the required reserve ratio is 20 percent, the deposit multiplier is 5. Thus, if the monetary base is raised by $1,000, the money supply ultimately can change by $5,000. As the required reserve ratio is increased, banks are forced to retain more of any additional deposit as reserves. Hence they loan out less, so the money supply does not increase by as much as when the required reserve ratio is smaller. 9. When lenders believe that there is a lender-of-last-resort, such as the International Monetary Fund, they will be willing to grant risky loans without much research on the underlying solvency of borrowers because they can rely on being automatically bailed out by the lender-of-last-resort. This tendency to make risky loans in this situation has been termed a moral hazard problem. Additional Questions 1. Explain what happens to M1 and M2 as a result of the following: (a) Heather takes money out of her checking account and puts it into her savings account. (b) Rick sells a corporate bond and uses the proceeds to buy a CD (a small time deposit) (c) Nicole writes a check to buy a US government bond.

10 Chapter 13 Money and Banking Consider the following bank statement: Reserves $400 Demand Deposits $2,000 Loans $3,500 Time Deposits $4,000 Securities $2,000 Other $500 Net Worth (a) If the required reserve ratio on demand deposits is 10% how much are required reserves? (b) How much excess reserves is the bank holding? (c) What is the bank net worth? (d) By how much can this bank increase the money supply? Explain. 3. Assume the required reserve ratio is 5%. By how much could the money supply increase by if the Federal Reserve made an open market purchase of $5 billion? What would happen to the money supply if they sold $3 billion of government securities? 4. In the discussion in your textbook it was assumed that banks hold no excess reserves and all money is redeposited back into the bank. In essence people are holding no currency. What would happen to the magnitude of the multiplier if banks held some excess reserves and the public held some currency? What would you think would happen to the multiplier at Christmas time? Why? Answers 1. (a) M1 will fall but M2 will remain the same. Remember that M1 is part of M2. (b) M1 stays the same but M2 will increase since small time deposits are part of M2. (c) M1 and M2 falls. Government bonds are not included in M1 or M2. M1 falls since she pays for the bond out of her checking account and M2 falls because M1 is part of M2. 2. (a) Required reserves are 10% of the $2,000 in demand deposits or $200. (b) The bank holds $200 in excess reserves: $400 total minus $200 required. (c) The bank s net worth is equal to $400: the $6,400 in assets minus the $6,000 in liabilities. (d) The bank can make $200 worth of loans. Thus, the money supply would increase by $ In both cases the multiplier, which is equal to 1/required reserve ratio, is 20. Therefore, if the Fed makes an open market purchase of $5 billion, the money supply could increase by $100 billion. If they made an open market sale of $3 billion, the money supply could fall by $60 billion. 4. If banks hold on to excess reserves rather than lend out the money, the money creation process will generate less than if they held no excess reserves. Therefore, the multiplier would be smaller. Also, if the public holds onto some currency rather than depositing in the bank, the banks ability to make new loans would decrease and therefore, the multiplier will be smaller. During Christmas time the multiplier could fall since people increase the amount of currency they hold relative to the amount of demand deposits.

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