Macro
McEachern
ECON
15
2010-2011
CHAPTER
Banking and the
Money Supply
Designed by
Amy McGuire, B-books, Ltd.
Chapter 15
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
1
Money Aggregates
LO1
Chapter 15
 Money aggregates
 Measure of money supply
 Defined by the Fed
 M1 = Narrow definition of money
 Currency (including coins)
 Nonbanking public
 Checkable deposits
 Bank deposits
 Write checks to third parties
 Traveler’s checks
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
2
Money Aggregates
 Currency = Fiat money
 Federal Reserve Notes
 U.S. Bureau of Engraving and
Printing
 Issued by & Liabilities of
 12 Federal Reserve Banks
 60% - abroad
 Coins
 U.S. Mint
LO1
Chapter 15
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
3
Money Aggregates
 M2 = Broader definition of money
 M1
 Savings deposits
 Earn interest; no specific maturity date
 Small-denomination time deposits
 Certificates of deposits, CDs
 Earn interest; specific maturity date
 Money market mutual fund accounts
 Restrictions
LO1
Chapter 15
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
4
Measures of the Money Supply
(February 2009)
Exhibit 1
LO1
Chapter 15
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
5
Money Aggregates
 Credit cards
 Loan from the card issuer
 Repay later
 Dispute a charge
 Not part of money supply
 Debit cards
 From checking account
 Part of M1
LO1
Chapter 15
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
6
LO2
How Banks Work
 Banks earn profit
 Attract deposits from savers
 Lend to borrowers
 Banks are financial intermediaries
 Reduce transaction costs
 Cope with asymmetric
information
 Reduce risk through
diversification
Chapter 15
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
7
LO2
Starting a Bank
 Home Bank – obtains a charter
 Net worth = Owner’s equity
 Shares of stock in the bank
 Balance sheet
 Assets = Liabilities + Net worth
 Asset – owned by bank
 Physical property
 Financial claim
 Stock in district Fed
 Liabilities – owned by bank
Chapter 15
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
8
LO2
Exhibit 2
Home Bank’s Balance Sheet
Chapter 15
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
9
LO2
Exhibit 3
Home Bank’s Balance Sheet After
$1,000,000 Deposit Into Checking Account
Chapter 15
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
10
LO2
Reserve Accounts
 Required reserve
 Dollar amount
 Must be held in reserve
 Required by Fed
 Required reserve ratio
 Percentage of checkable deposits (10%)
 Must be held in reserve
 Reserves (Earn no interest)
 Cash in bank’s vault
 Deposits at the Fed
 Excess reserves
Chapter 15
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
11
LO2
Liquidity vs. Profitability
 Liquidity
 Ease to convert assets into cash
 Safety
 Profitability
 Federal funds markets
 Day-to-day lending and
borrowing
 Among banks
 Excess reserves on account at
the Fed
 Interest: federal funds rate
Chapter 15
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
12
How Banks Create Money
 Creating money through excess
reserves
– Round one
• Fed buys $1,000 U.S.
government bond
– Creates reserves
• Money supply: +$1,000
• Required reserves: +$100
• Excess reserves: +$900
3
LO
Chapter 15
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
13
LO3
Exhibit 4
Changes in Home Bank’s Balance Sheet
After Fed Buys a $1,000 Bond from
Securities Dealer
Chapter 15
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
14
How Banks Create Money
 Creating money through excess reserves
– Round two
• $900 loan
• Money supply: +$900
• Required reserves: +$90
• Excess reserves: +$810
LO3
Chapter 15
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
15
LO3
Exhibit 5
Changes in Home Bank’s Balance Sheet
After Lending $900 to You
Chapter 15
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
16
How Banks Create Money
 Creating money through excess reserves
– Round three
• $810 loan
• Money supply: +$810
• Required reserves: +$81
• Excess reserves: +$729
LO3
Chapter 15
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
17
LO3
Exhibit 6
Changes in Merchants Trust’s Balance
Sheet After Lending $810 to English Major
Chapter 15
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
18
How Banks Create Money
 Creating money through excess reserves
– Round four and beyond
• Excess reserves – new loans
• Required reserves: +10% of new
checkable deposits
– Excess reserve – maximum amount
for loans
– Money supply expansion
LO3
Chapter 15
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
19
How Banks Create Money
 Creating money through excess reserves
 A summary of rounds
– Fed: $1,000 injection in fresh reserves
– Increased excess reserves
– Money supply increase: Up to $10,000
• Checkable deposits
– Banking system
• Eliminates excess reserves
– Expand money supply
LO3
Chapter 15
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
20
LO3
Exhibit 7
Summary of the Money Creation
Resulting from the Fed’s Purchase of
$1,000 U.S. Government Bond
Chapter 15
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
21
Reserve Requirements
& Money Expansion
 Assumptions
– No bank holds excess
reserves
– Borrowed funds don’t
sit idle
– People don’t want to
hold more cash
LO3
Chapter 15
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
22
Reserve Requirements
& Money Expansion




Required reserve ratio = r
Money multiplier
Simple money multiplier = 1/r
Change in the money supply = Change in
fresh reserves × 1/r
LO3
Chapter 15
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
23
Limitations of Money
Expansion
 Leakages from expansion
– Smaller money multiplier
– Cash – preferred to checking accounts
• People hold money
• Fewer excess reserves
LO3
Chapter 15
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
24
Multiple Contraction of
Money Supply
 The Fed sells a $1,000 bond
– Money supply: -$1,000
– Required reserves: -$900
– Recall loans
– Money supply: -$900
– Required reserves: -$810
– Maximum effect
• Decrease money supply =
Original decrease in reserve
LO3
requirements × 1/r
Chapter 15
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
25
The Fed’s Tools of
Monetary Control
 Open-market operations
– Buy/sell U.S. government bonds
 The discount rate
– Interest rate, the Fed
– For loans made to banks
 The required reserve ratio
– Minimum fraction of reserves
LO4
Chapter 15
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
26
Open-Market Operations
 Increase money supply
– The Fed buys U.S. bonds
• Open-market purchase
 Reduce money supply
– The Fed sells U.S. bonds
• Open-market sale
LO4
Chapter 15
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
27
Open-Market Operations
 Tool of choice for the Fed
 Influences bank reserves
 Influences federal funds rate
– Interest rate
– Borrowing among banks
– Of excess reserves at the
Fed
LO4
Chapter 15
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
28
The Discount Rate
 Discount rate
– Interest rate charged by the Fed
– Loans to banks
 Bank borrow ‘Discount window’
– Satisfy reserve requirements
 The Fed
– Lender of last resort
LO4
Chapter 15
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
29
The Discount Rate
 Primary discount rate
 Secondary discount rate
 Signal to financial markets
– Monetary policy
 Emergency tool
– Injecting liquidity
LO4
Chapter 15
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
30
Reserve Requirements
 Required reserve ratio
 Money creation for each dollar of
fresh reserves
 Disruptive
– Banking system
LO4
Chapter 15
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
31
Coping with Financial Crisis
 Regulation of financial markets
 Prevents major disruptions and
financial panics
 Sufficient liquidity
– Financial system
LO4
Chapter 15
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
32
The Fed Is a Money Machine
 Assets
– U.S. government bonds, 24%
– Earns interest
 Liabilities
– Federal Reserve notes, 43%
– Fed pays no interest
 The Fed is a money machine
– Supplies Federal Reserve notes
– Main asset: earns interest
LO4 – Main liability: no interest payment
Chapter 15
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
33
LO4
Exhibit 8
Federal Reserve Bank Balance Sheet as of
April 1, 2009 (Billions)
Chapter 15
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
34