CHAPTER 10: MONEY, BANKS AND THE FEDERAL RESERVE

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1 CHAPTER 10: MONEY, BANKS AND THE FEDERAL RESERVE Learning Goals To know what is money To know how banks create money To know the structure of the Federal Reserve System To know how the Fed controls the money supply using its monetary policy tools I. What is Money? A. Money is any commodity or token that is generally acceptable as a means of payment. 1. A means of payment is a method of settling a debt. 2. Money has three other functions: a) Medium of exchange b) Unit of account c) Store of value B. Medium of Exchange 1. A medium of exchange is an object that is generally accepted in exchange for goods and services. 2. In the absence of money, people would need to exchange goods and services directly, which is called barter. 3. Barter requires a double coincidence of wants, whereby each person in the barter transaction has what the other wants. This situation is rare, so barter is costly. C. Unit of Account 1. A unit of account is an agreed measure for stating the prices of goods and services. Page 1 of 15

2 D. Store of Value As a store of value, money can be held for a time and later exchanged for goods and services. E. Money in the United States is currency and deposits held at banks and other financial institutions. F. The two official measures of money (defined by the Federal Reserve) in the United States are M1, which includes currency outside banks, traveler s checks, and checking deposits owned by individuals and businesses; and M2, which includes M1 plus savings deposits and time deposits. 1. The items in M1 clearly meet the definition of money; the items in M2 do not do so quite so clearly but still are quite liquid. Liquidity measures the ease with which an asset may be converted into money at a known price. 2. Checkable deposits are money, but checks are not; checks merely are the means by which the money is transferred among people. 3. Credit cards are not money. Credit cards enable the holder to obtain a loan quickly, but ultimately the loan must be repaid with money. II. Depository Institutions A. A depository institution s a firm that is licensed by the Comptroller of the Currency or by a state agency to receive deposits and make loans. The three types of financial intermediaries are Commercial banks Thrift institutions Money market mutual funds. Page 2 of 15

3 B. Commercial banks are private firms that receive deposits and make loans. The best way to understand the operations of commercial banks is by examining the balance sheet of the commercial banking sector. 1. A balance sheet is a statement listing what a firm owns (its assets) and what it owes (its liabilities). The fundamental equation is that Liabilities + Net Worth = Assets. a) The major liabilities of a commercial bank are the deposits it has accepted. b) The major assets of a bank are its reserves, liquid assets, investment securities, and loans. c) Reserves consist of cash in the bank s vault and deposits held at the Fed. Example of a balance sheet: Assets Liabilities + Net worth Reserves $200,000 Checking Deposits $1,000,000 Securities $450,000 Saving Accounts $360,000 Loans $800,000 Net Worth $240,000 Property $150,000 Total Assets $1,600,000 Total Liabilities + Net Worth $1,600,000 C. Thrift institutions include savings and loan associations, savings banks, and credit unions. 1. Savings and loan associations are depository institutions that accept checking and savings deposits and that make personal, commercial, and home-purchase loans. 2. A savings bank is a depository institution owned by its depositors that accepts savings deposits and makes mainly mortgage loans. 3. A credit union is a depository institution owned by its depositors that accepts savings deposits and makes consumer loans. Page 3 of 15

4 D. A money market fund is a fund operated by a financial institution that sells shares in the fund and holds liquid assets such as U.S. Treasury bills or short-term commercial paper. E. The Economic Functions of Depository Institutions Depository institutions make a profit from the difference between the interest rate they pay on their deposits and the interest rate they charge on their loans. This spread exists because intermediaries provide four services: 1. Financial intermediaries create liquidity by accepting deposits that can be withdrawn instantly and using these deposits to make long-term loans. 2. Financial intermediaries minimize the cost of obtaining funds by pooling many people s relatively small deposits into large sums that can be loaned to many borrowers. 3. Financial intermediaries minimize the cost of monitoring borrowers by specializing in this activity. 4. By loaning to many different borrowers, financial intermediaries pool risk so that if one borrower is unable to pay back the loan the lender loses only a small fraction of total deposits. III. Financial Regulation, Deregulation, and Innovation A. Depository institutions face two types of regulation: deposit insurance and balance sheet rules. B. Deposits at banks, S&Ls, savings banks, and credit unions are insured by the Federal Deposit Insurance Corporation (FDIC). a) This insurance guarantees deposits of up to $100,000. b) Banks benefit from deposit insurance because the risk of a bank run is minimized. Page 4 of 15

5 c) This guarantee gives depository institutions the incentive to make risky loans because the depositors believe their funds to be perfectly safe; because of this incentive balance sheet regulations have been established. C. There are four main balance sheet regulations: 1. Capital requirements regulations setting the minimum amount of the owners financial wealth that must be at stake in the financial intermediary. 2. Reserve requirements rules listing the minimum percentages of deposits that must be held as currency or as other safe assets. 3. Deposit rules restrictions on the type of deposits that an intermediary may accept. 4. Lending rules restrictions on the type and size of loans that can be made by a financial intermediary. D. Deregulation in the 1980s and 1990s 1. The 1980s were marked by considerable financial deregulation, when federal legislation and rule changes lifted many of the restrictions on depository institutions, removing many of the distinctions between banks and others, and strengthening the control of the Federal Reserve over the system. 2. In 1994 the Riegle-Neal Interstate Banking and Branching Efficiency Act was passed, which permits U.S. banks to establish branches in any state. It led to a wave of mergers. E. Financial Innovation 1. The 1980s and 1990s have been marked by financial innovation the development of new financial products aimed at lowering the cost of making loans or at raising the return on lending. 2. Financial innovation occurred for three reasons: Page 5 of 15

6 a) The economic environment, especially of the 1980s, featured high inflation and high interest rates, which created risk for intermediaries. Some innovations, such as variable rate mortgages, were aimed at lowering this risk. b) Massive technological change, especially reductions in the cost of computing and long-distance communication, brought other innovations. c) Much innovation was directed at avoiding regulation. F. Deregulation, Innovation, and Money The combination of deregulation and innovation has produced large changes in the composition of money, both M1 and M2. IV. How Banks Create Money A. Terminology Deposits (D) are the checking accounts of private individuals and firms. Reserves (R) consist of cash in the bank s vault and deposits held at the Fed. The required reserve ratio (rr) is the fraction of total deposits that banks are required, by regulation, to keep as reserves. Required reserves (RR) are the total amount of reserves that banks are required to keep. RR = rr x D Excess reserves (ER) equal actual reserves minus required reserves. ER = R -RR B. A bank s ability to create money is based on the fractional reserve principle, i.e., a bank needs to keep only a fraction of each dollar of its deposits in reserve. The rest of the money (the excess reserves) can be loaned out. Page 6 of 15

7 C. Creating Deposits by Making Loans Principles of Macroeconomics 1. When a bank receives a deposit of currency, its reserves increase by the amount deposited, but its required reserves increase by only a fraction (determined by the required reserve ratio) of the amount deposited. 2. The bank has excess reserves, which it loans. These loans can end up as deposits in another bank in the banking system. The new bank behaves the same as the previous bank (loaning the excess reserves) but has a smaller amount of excess reserves. 3. The process continues until the banking system has created enough deposits to eliminate its excess reserves. D. Example: How does a single bank create money? Assume the reserve ratio is 20 percent. Step 1: Bank A accepts a deposit (John deposits $1000 in his demand deposit account at Bank A) Assets Reserves (Required reserves ) (Excess reserves ) Liabilities Demand deposit Step 2: Bank A makes a loan and the borrower uses the loan to make a purchase. Assets Reserves (Required reserves ) (Excess reserves ) Loans Liabilities Demand deposit New money created by Bank A = $800. Page 7 of 15

8 E. How does the banking system create money? Principles of Macroeconomics The money created by bank A (=$800) gets transferred to bank B. Bank B s reserves will increase by $800. RR = 0.2 x $800 = $160 ER = R - RR = =$640 Bank B can loan out $640. Deposit creation will expand in the banking system as follows: Bank Newly Acquired Deposits and Reserves Required Reserves Potential for new loans (creating money) A $ $ $ B C D All other banks $ $ $ Total amount of loans created by the banking system is $4000. In the above example, $5000 is the maximum amount of money that could be supported by the banking system, given a required reserve ratio of 20% (rr = 0.2) and Reserves= $1000. F. The deposit multiplier (d) is the amount by which an increase in bank reserves is multiplied to calculate the increase in bank deposits. 1 Deposit multiplier = 1/(required reserve ratio) or d = rr G. Total deposits in the banking system = Deposit Multiplier x Initial Deposit Total loans made by the banking system = Deposit multiplier x Excess reserves of the banking system. Page 8 of 15

9 (Note that the total loans made by the banking system are equivalent to the new deposits created by the banking system. Example 1: John Doe deposits $1200 in Bank Q, which has a reserve ratio of 10 percent and holds no excess reserves. a) How much can this bank loan out? b) Calculate the amount lent and the amount of deposits created if all the funds lent in (a) are returned to the banking system in the form of deposits. c) By how much has the quantity of money increased after two rounds of loans? d) What is the total increase in bank loans, bank deposits and the quantity of money, when the process comes to an end? Example 2: If Bank Luvecon receives a deposit of $50,000 and the required reserve ratio is 25 percent for all banks, what is the maximum amount of money Luvecon can loan out? What is the deposit multiplier? How much additional money could be created by the entire banking system from the $50,000 deposit? Page 9 of 15

10 V. The Federal Reserve System BOARD OF GOVERNORS OPEN MARKET COMMITTEE TWELVE FEDERAL RESERVE REGIONAL BANKS DEPOSITORY INSTITUTIONS THE PRIVATE SECTOR: FIRMS AND HOUSEHOLDS A. The Federal Reserve System, or the Fed, is the central bank of the United States. A central bank is a bank s bank and a public authority that regulates a nation s depository institutions and controls the quantity of money. B. The Fed s Goals and Targets 1. The Fed conducts the nation s monetary policy, which means that it adjusts the quantity of money in circulation. 2. The Fed s goals are to keep inflation in check, maintain full employment, moderate the business cycle, and contribute toward achieving long-term growth. Page 10 of 15

11 3. In pursuit of its goals, the Fed pays close attention to interest rates and sets a target that is consistent with its goals for the federal funds rate, which is the interest rate that the banks charge each other on overnight loans of reserves. C. The Structure of the Fed 1. The key elements in the structure of the Fed are the Board of Governors, the regional Federal Reserve banks, and the Federal Open Market Committee. 2. The Board of Governors has seven members appointed by the president of the United States and confirmed by the Senate. Board terms are for 14 years and overlap so that one position becomes vacant every 2 years. The president appoints one member to a (renewable) four-year term as chairman. 3. Each of the 12 Federal Reserve Regional Banks has a nine-person board of directors and a president. Figure 10.3 shows the regions of the Federal Reserve System. 4. The Federal Open Market Committee (FOMC) is the main policy-making group of the Federal Reserve System. It consists of the members of the Board of Governors, the president of the Federal Reserve Bank of New York, and the 11 presidents of other regional Federal Reserve banks of whom, on a rotating basis, 4 are voting members. The FOMC meets every six weeks to formulate monetary policy. D. The Fed s Power Center 1. In practice, the chairman of the Board of Governors (since 1987 Alan Greenspan) is the center of power in the Fed. 2. The chairman controls the agenda of the Board, has better contact with the Fed s staff, and is the Fed s spokesperson and point of contact with the federal government and with foreign central banks and governments. E. The Fed s Policy Tools 1. The Fed uses three monetary policy tools: the required reserve ratio, the discount rate, and open market operations. Page 11 of 15

12 a) The Fed sets required reserve ratios, which are the minimum percentages of deposits that depository institutions must hold as reserves. b) The discount rate is the interest rate at which the Fed stands ready to lend reserves to depository institutions. c) An open market operation is the purchase or sale of government securities U.S. Treasury bills and bonds by the Federal Reserve System in the open market. F. The Fed s Balance Sheet 1. On the Fed s balance sheet, the largest and most important asset is U.S. government securities. The most important liabilities are Federal Reserve notes in circulation and banks deposits. Table 10.3 shows the Fed s balance sheet for February The sum of Federal Reserve notes, coins, and banks deposits at the Fed is the monetary base. Page 12 of 15

13 V. Controlling the Quantity of Money A. How Required Reserve Ratios Work An increase in the required reserve ratio boosts the reserves that banks must hold, decreases their lending, and decreases the quantity of money. B. How the Discount Rate Works An increase in the discount rate raises the cost of borrowing reserves from the Fed, thereby decreasing banks reserves, which decreases their lending and decreases the quantity of money. C. How an Open Market Operation Works 1. When the Fed conducts an open market operation by buying a government security, it increases banks reserves. Banks loan the excess reserves. By making loans, they create money. The reverse occurs when the Fed sells a government security. 2. Although the initial accounting details differ, the ultimate process of how an open market operation changes the money supply is the same regardless of whether the Fed conducts its open market transactions with a commercial bank or with a member of the public. Figure 10.5 illustrates both situations. 3. An open market operation that increases banks reserves also increases the monetary base. D. The Monetary Base, The Quantity of Money, and the Money Multiplier 1. The money multiplier determines the change in the quantity of money that results from a given change in the monetary base. The money multiplier is the amount by which a change in the monetary base is multiplied to calculate the final change in the quantity of money (see E.1.(b) on the next page). Page 13 of 15

14 2. An increase in currency held outside the banks is called a currency drain. A currency drain decreases the amount of money that banks can create from a given increase in the monetary base. 3. Banks use excess reserves from the open market operation to make loans so that the banks where the loans are deposited acquire excess reserves which they, in turn, then loan. Because the initial loans are re-loaned, when the Fed conducts an open market operation, the ultimate change in the quantity of money is larger than the initiating open market operation. 4. Figure 10.6 and Figure 10.7 illustrate the multiplier effect of an open market purchase. E. The Size of the Money Multiplier 1. The size of the money multiplier depends on the magnitudes of the required reserve ratio and the ratio of currency to deposits. Let mm be the money multiplier, cc be the ratio of currency to deposits, rr be the required reserve ratio, M be the quantity of money and B be the monetary base. Note that the quantity of money, M, equals the sum of currency, C, and deposits, D. (M=C+D). a) The formula for the money multiplier is mm = (1 + c) (rr + c) b) The relationship between money, the monetary base and the money multiplier is given by the formula M = mm x B 2. The magnitude of the U.S. money multiplier depends on the definition of money that is used. For M1, the money multiplier is 1.8. For M2, the money multiplier is 8.6. Page 14 of 15

15 Example 1. You are given the following information about the economy of Fredzone. The people and businesses in Fredzone have bank deposits of $500 billion and hold $100 billion in notes and coins. The banks hold deposits at the Fredzone Fed of $5 billion, and they keep $5 billion in notes and coins in their vaults and machines. Calculate a. The monetary base. b. The quantity of money. c. The banks reserve ratio. d. The currency drain as a percentage of the quantity of money. Page 15 of 15