Lecture 9
MONEY, THE BANKING SYSTEM
& THE FEDERAL RESERVE
MONEY
Anything that is regularly
used in economic
transactions or exchanges.
THREE PROPERTIES OF
MONEY
1. Money serves as a medium
of exchange
2. Money serves as a unit of
account
3. Money serves as a store of
value
MEDIUM OF EXCHANGE
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• Money is accepted in economic exchanges
• Alternative to barter -- trading goods
directly for goods
• For economic exchanges to occur using
barter, double coincidence of wants must
exist:
-- unless you want to trade something another
person wants, and you want what the other
person has to trade, this economic exchange
could not occur
UNIT OF ACCOUNT
• Money provides a convenient measuring
rod when prices for all goods are quoted in
terms of money
• It makes it easier to conduct economic
transactions since there is a standard unit
in which to do so
STORE OF VALUE
• During a period of time, the value of
money should not change
• Money is a somewhat imperfect store of
value, thanks to inflation
LIQUIDITY - 1
• Refers to the ease with which an asset
can be converted into the economy's
medium of exchange.
• Since money IS the economy's medium
of exchange, it must be the most liquid
store of value in the economy.
LIQUIDITY - 2
• Other ways to store value include
buying stocks, bonds, mutual funds,
gold, silver, or owning a house or
other valuable property. Since it
takes some time and effort to convert
these assets into money, they are all
LESS liquid than money.
HISTORY OF MONEY
• Throughout history, money can be
divided into two general categories:
– commodity money
– fiat money
COMMODITY MONEY
• Commodity money is money that
takes the form of a commodity with
intrinsic value. Commodity money
has value, in and of itself, beyond its
value as the medium of exchange
and the unit of account. The classic
example of commodity money is gold
and silver coins - you could always
melt the coins down and the gold
and silver would have its OWN value.
FIAT MONEY
• Fiat money is money without intrinsic value
that is used as money because of government
decree.
• The US $ is an example of fiat money because
the paper the $ is printed on has NO value
outside of being the medium of exchange and
the unit of account.
• Before moving from money to central banking,
we’ll first consider what the size of the US
money stock is and how it is measured.
MONEY STOCK
• The money stock is the quantity of
money circulating in the economy
Q: Suppose you want to know the size of
the US money stock. What should you
count as money?
A: Currency and demand deposits, and a
few other items (detailed in the following
slides) but NOT credit cards.
WHAT COUNTS AS MONEY
• Currency: the paper bills and coins in the
hands of the public.
• Demand deposits: balances in bank accounts
that depositors can access on demand by
writing a check (or by using a debit card)
Q: How is the US money stock measured and
reported?
A: Your textbook gives the two most important
measures - M1 and M2
COMPONENTS OF M1
Currency held by the public
Demand deposits
Other checkable deposits
Travelers checks
Total of M1
$ 372 billion
$ 389 billion
$ 353 billion
$ 9 billion
$1,123 billion
Source: Economic Report of the President, Washington, DC: U.S.
Government Printing Office, 1996
• Approximately two-thirds of M1 consists of
checking account balances
• Approximately one-third consists of currency
COMPONENTS OF M1
• Currency held by public
-- All currency held outside of bank vaults
• Demand deposits
-- Deposits in checking accounts
• Other checkable deposits
-- Introduced in the early 1980s to describe
checking accounts that paid interest
• Travelers checks
-- included in M1 since they are regularly
used in economic exchanges
CURRENCY IN THE ECONOMY
$372 billion of currency amounts to over
$1,430 for every man, woman and child in
the U.S.
Most of the currency in the official statistics
is not used in ordinary commerce in the
U.S.
• Much is held abroad by wealthy people
• Some circulates in other countries along
with local currencies
• Currency is also used in illegal transactions
M2
• Broader definition of money
• Includes assets that are sometimes used in
economic exchanges or can be readily turned into
M1
• Consists of all assets in M1 plus other assets such
as deposits in money market mutual funds
• These are funds in which individuals can invest,
earn interest, and in some cases can be used to
write checks
• Deposits in savings accounts are also included in
M2.
• M2 for 1996 was $3,657.4 billion. Dividing M1 by M2
shows that M1 was 29.4% of M2 during 1996.
WHY ARE THERE DIFFERENT
MEASURES OF THE MONEY
STOCK?
• Because the assets that comprise M1
and M2 have varying degrees of liquidity.
Notice that the assets included in M1 are
very liquid, while the assets that are
included in M2 are LESS liquid. You can
think of M1 as the most liquid measure of
the money stock, while M2 is a less liquid
measure.
BANKS AND THE MONEY
SUPPLY - 1
Q: How do banks operate?
A: Banks accept money from people and
keep that money safe until the depositor
makes a withdrawal or writes a check on
their account.
BANKS AND THE MONEY
SUPPLY - 2
Q: Do banks keep all of our money in their
vault?
A: No. The US banking system is called
fractional reserve banking. Bankers
understand that it is not necessary to
keep 100% of a depositors money on
hand at all times. As a result, bankers
take some of our money and loan it out
to other people.
FRACTIONAL RESERVE
BANKING
• Fractional Reserve Banking is a
banking system in which banks hold
only a fraction of deposits as
reserves
• The reserve ratio is the fraction of
deposits that banks hold as reserves.
Minimum reserve ratios are set by
the Fed.
BANKS AS FINANCIAL
INTERMEDIARIES
• Help bring savers and investors together.
• By using expertise and powers of
diversification, financial intermediaries
reduce risk to savers and allow investors to
obtain funds on better terms.
• A typical commercial bank accepts funds
from savers in the form of deposits.
• The bank then turns the money around and
makes loans to businesses.
BALANCE SHEET
• Has two sides -- assets and liabilities
• Liabilities are the source of funds for the
bank
-- Your deposits to a current account are
an example of liabilities
• Assets are the uses of the funds
-- Loans are an example of a bank’s assets
• The difference between assets and
liabilities is call its net worth
Net Worth = Assets - Liabilities
RESERVES
• Assets which are not lent out
• Banks used to be required by law to hold a
fraction of their deposits as reserves and not
make loans with this fraction of deposits. It was
called required reserves
• Banks often chose to hold additional reserves
beyond what was required; these were called
excess reserves
• A bank’s reserves are the sum of its required and
excess reserves
• Reserves can either be cash kept in a bank’s
vaults or deposits with the Federal Reserve.
• Banks do not earn any interest on these reserves
THE PROCESS OF MONEY
CREATION
•
•
•
•
AN EXAMPLE
A bank has deposits of $1,000
Banks are required to keep 10% of deposits
as reserves and hold no excess reserves
The reserve ratio, in this case, is 0.1
The bank in this example will keep $100 in
reserves and make loans totaling $900
THE PROCESS OF DEPOSIT CREATION:
CHANGES IN BALANCE SHEETS
First Bank of Hollywood
Assets
Liabilities
$100 reserves
$1,000 deposit
$900 loans
THE PROCESS OF DEPOSIT CREATION:
CHANGES IN BALANCE SHEETS
First Bank of Hollywood
Assets
Liabilities
$100 reserves
$1,000 deposit
$900 loans
Second Bank of Burbank
Assets
Liabilities
$90 reserves
$900 deposit
$810 loans
THE PROCESS OF DEPOSIT CREATION:
CHANGES IN BALANCE SHEETS
First Bank of Hollywood
Assets
Liabilities
$100 reserves
$1,000 deposit
$900 loans
Second Bank of Burbank
Assets
Liabilities
$90 reserves
$900 deposit
$810 loans
Third Bank of Venice
Assets
Liabilities
$81 reserves
$810 deposit
$729 loans
THE PROCESS OF DEPOSIT CREATION:
CHANGES IN BALANCE SHEETS
First Bank of Hollywood
Assets
Liabilities
$100 reserves
$1,000 deposit
$900 loans
Second Bank of Burbank
Assets
Liabilities
$90 reserves
$900 deposit
$810 loans
Third Bank of Venice
Assets
Liabilities
$81 reserves
$810 deposit
$729 loans
Fourth Bank of Pasadena
THE PROCESS OF DEPOSIT CREATION:
CHANGES IN BALANCE SHEETS
First Bank of Hollywood
Assets
Liabilities
$100 reserves
$1,000 deposit
$900 loans
Second Bank of Burbank
Assets
Liabilities
$90 reserves
$900 deposit
$810 loans
Third Bank of Venice
Assets
Liabilities
$81 reserves
$810 deposit
$729 loans
Fourth Bank of Pasadena
Fifth bank of Compton
MONEY MULTIPLIER - 1
• It tells what the total increase in checking
account deposits would be for any initial
cash deposit
• = 1 / reserve ratio
• In the banking system, an initial cash
deposit triggers additional rounds of
deposits and lending by banks
• This leads to a multiple expansion of
deposits
• The money creation process and the money
multiplier also works in reverse
MONEY MULTIPLIER - 2
• In our example, the original deposit
created $1,000 in reserves at the
bank. The money multiplier is equal
to 10 (1/0.1). Therefore, the original
$1,000 deposit will eventually turn
into $10,000 of deposits.
MONEY MULTIPLIER - 3
• The change in the money supply, M1,
will be the change in deposits plus
the change in currency held by the
public
• In example, the money supply, M1,
increased by $9,000 ( $10,000 $1,000
MONEY MULTIPLIER
• As of 1995, in the United States, were required to
hold 10% on all checkable deposits exceeding
$54 million
• Since large banks would face a 10% reserve
requirement on any new deposits, a money
multiplier of 10 would be expected
• The money multiplier in the United States is
actually between 2 and 3, however
• This reduced multiplier is because people hold
part of their loans in cash, the funds are not
available for the banking system to lend out
• The money multiplier would also be less if banks
held excess reserves
FED TOOLS FOR CONTROLLING
THE MONEY SUPPLY
• The Fed has 3 main tools for controlling
the size of the money supply:
– Open Market Operations
– Reserve Requirements
– The Discount Rate
OPEN MARKET
OPERATIONS - 1
• The Fed can buy or sell government bonds to
increase or decrease the money supply.
• When the Fed BUYS bonds, the money supply
is INCREASED.
• Here is why: The Fed pays for the bonds it buys
with money that was not currently a part of the
money supply - hence, when the Fed buys
bonds it simply increases the total amount of
money in circulation.
OPEN MARKET
OPERATIONS - 2
• When the Fed SELLS bonds, the money
supply is DECREASED.
• Here is why: The Fed sells bonds in the
market and receives cash in return for the
bonds it sells. Once the Fed receives the
cash, this cash is taken OUT of circulation
- therefore, the size of the money supply is
decreased.
RESERVE REQUIREMENTS
• By controlling reserve ratios that banks must
keep, the Fed also controls the amount of
money that banks can lend out.
• In the previous slide, we showed how bank
lending increases the money supply. However,
when the Fed increases reserve ratios, they
reduce the amount of money banks can lend
and also reduce the size of the money supply.
• When the Fed lowers reserve ratios, they
increase the amount of money banks can lend
out and also increase the size of the money
supply.
THE DISCOUNT RATE - 1
• Another function of the Fed is to loan money
to banks in the economy. Banks may need
these loans for several reasons:
– Emergency borrowing is one reason - banks that are
in trouble have the Fed as the lender of last resort this Fed function serves to calm depositors at
troubled banks.
– Another reason banks borrow from the Fed is to
meet reserve requirements. In the course of
business, banks may make too many loans, or have
unusually large withdrawals by their depositors.
THE DISCOUNT RATE - 2
• The result of either (or both) of these
situations is that the bank will NOT have met
its reserve requirements.
• Regardless of the reason prompting a bank to
borrow from the Fed, the loan from the Fed to
the bank increases the bank's reserves. As we
now know, the new reserves allow the banking
system to generate more money.
THE DISCOUNT RATE - 3
• The discount rate is a tool for controlling
the money supply because it represents
the cost to banks of borrowing from the
Fed (banks pay interest to the Fed on the
loan). A higher discount rate will
discourage
banks
from
borrowing
reserves from the Fed. A lower discount
rate encourages borrowing.
THE STRUCTURE OF THE
FEDERAL RESERVE
• Created in 1913 following a series of
financial panics
• Congress created the Federal Reserve
System to be a banker’s bank or central
bank
• As a lender of last resort, the Federal
Reserve would be there to lend funds to
banks, reducing some of the adverse
consequences of a panic
THE STRUCTURE OF THE
FEDERAL RESERVE
There are three distinct
subgroups:
• Federal Reserve Banks
• The Board of Governors
• The Federal Open Market
Committee
FEDERAL RESERVE BANKS
• The United States is divided into 12 Federal
Reserve districts, each of which has a
Federal Reserve Bank
• Provide advice on monetary policy
• Take part in decision making on monetary
policy
• Provide liaison between the Fed and the
banks in their district
THE FEDERAL RESERVE BANKS OF THE CONTINENTAL
UNITED STATES
Minneapolis
Boston
San Francisco
Chicago Cleveland
Kansas
City
New York
Philadelphia
Richmond
St. Louis
Atlanta
Dallas
THE BOARD OF GOVERNORS
• The true seat of power over the monetary
system
• Headquartered in Washington, DC
• Seven members of the board are appointed
for staggered 14-year terms by the
President and must be confirmed by the
Senate
• The Chairman of the Board of Governors,
the principal spokesman for monetary
policy in the country, serves a four-year
term as chairman
FEDERAL OPEN MARKET COMMITTEE ( FOMC )
• Decisions on monetary policy made by the FOMC
• A 12-person board consisting of seven members
of the Board of Governors, the president of the
New York Federal Reserve, plus presidents of four
other regional Federal Reserve Banks
• Presidents of the regional banks other than New
York serve on a rotating basis
• Seven non-voting bank presidents attend
meetings and provide their views
• The chairman of the Board of Governors also
serves as chairman of the FOMC
• The FOMC makes the actual decisions on
changes in the money supply
THE STRUCTURE OF THE FEDERAL RESERVE
CHAIR
Federal Reserve Banks
Board of Governors
7 members
12 presidents
Federal Open Market Committee
( FOMC )
Board of Governors
plus 5 bank presidents
Decisions about
monetary policy
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INDEPENDENCE OF THE
FEDERAL RESERVE
• The chairman of the Federal Reserve is required
to report to Congress on a regular basis
• Although the Federal Reserve operates with
independence, it is a creation of Congress
• The U.S. Constitution gives Congress the power
to ‘coin money and regulate the value thereof”
• In practice, the Fed takes its actions first and
reports to Congress after the fact