Econ 101H
Michael K. Salemi
Class 27: Money, Prices and the Financial System
1.
Financial intermediaries are firms, such as banks, that channel funds from savers to
investor s and other borrowers.
a. Direct and Indirect Finance
i. Some financial transactions occur directly--without the intervention of financial firms.
ii. Most financial transactions involve a financial intermediary such as a commercial bank,
thrift institution, or investment bank.
iii. The following flow chart compares direct and indirect finance.
b. Financial intermediaries “repackage” IOUs. Many lenders prefer owning repackaged to
owning IOUs of specific borrowers.
i.
Lenders prefer to hold a diversified portfolio of IOUs.
ii. Borrowers and lenders have different time horizons.
iii. Lenders may be more willing to lend if they know that they can quickly and without loss
re-covert the IOUs that they own to cash.
c. Commercial banks are financial intermediaries that issue deposit liabilities which are part of
the money supply.
i.
A balance sheet is a list of the assets, liabilities and net worth of a firm or individual.
ii. Balance sheets balance by construction because “net worth” is defined to be the value of
the firm’s assets minus the value of its liabilities.
Balance Sheet
Assets
iii.
Liabilities
Net Worth
The following T-account depicts the consolidated balance sheet of commercial
banks in the United States at the end of December, 2005, a time when both the
US and world economies were in the midst of an expansion.
Consolidated Balance Sheet of Commercial Banks in the United States
December 2005
Billions of Dollars
o
o
o
2.
Assets
Treasury and Agency Securities
Other Securities
Commercial and Industrial Loans
Real Estate Loans
Consumer Loans
Security Loans
Other Loans
Interbank Loans
Cash Assets
Other Assets
1,134
907
1,045
2,904
705
262
525
278
311
636
Total Assets
8707
Liabilities
Transaction Deposits
Large Time Deposits
Other Non-transaction Deposits
Borrowings from US Banks
Borrowing from Others
Other Liabilities
656
1,418
3,657
361
1,360
568
Total Liabilities
8,020
Net Worth
687
From what sources does the bank get the funds that it uses to acquire its assets?
What types of assets do banks hold?
How well capitalized were banks in December, 2005?
What is money and what is the connection between the money supply in the United States
and Financial Intermediaries?
a.
Money, in a modern economy, is properly viewed as a social contract. That is, the money
supply in an economy is properly thought of as money if and only if the members of that
economy willingly exchange goods and services for that money.
b.
Operational Definitions of Money
i.
M1, the narrowest definition of money, equals currency held by the public plus
travelers checks of non-bank issuers plus demand deposits at commercial banks
plus other checkable deposits.
ii.
M2, a less narrow definition of money and the one favored by economists when
they study the relationship between the quantity of money and economic
behavior, equals M1 plus (1) savings deposits including money market deposit
accounts plus (2) small-denomination time deposits at depository institutions
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(except for IRA and Keogh balances) plus (3) balances in retail money market
deposit accounts (except for IRA and Keogh balances).
iii.
c.
M3, the broadest definition of money, equals M2 plus (1) balances in institutional
money market mutual funds plus (2) large-denomination time deposits plus (3)
large repurchase agreements of depository institutions on US government and
federal agency securities plus (4) Eurodollars held by US addressees.
The following table provides data on the quantity of money in the US in December 2005.
Money Stock Measures for the U.S.
December 2005
Billions of Dollars
Fraction of
2005:IV GDP
(12,901 B)
Components of M1
Currency
Travelers Checks
Demand Deposits
Other Checkable Deposits
M1
M2
M3
d.
3.
724
7
321
317
1,369
6,676
10,154
0.11
0.53
0.79
Commercial banks create money when they make loans to customers.
Cash
XYZ Bank-Cash Deposit
Change in Assets
Change in Liabilities
$1,000 Deposits
$1,000
Loans
XYZ Bank-New Lending
Change in Assets
Change in Liabilities
$9,000 Deposits
$9,000
Cash
Loans
XYZ Bank-Total Picture
Change in Assets
Change in Liabilities
$1,000 Deposits
$10,000
$9,000
What is a central bank and what does it do?
a.
A central bank is a bank that accepts deposits from commercial banks, oversees
commercial bank operations, and is charged with controlling the money supply of a
nation. The Federal Reserve is the Central Bank of the United States.
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b.
c.
A central bank requires commercial banks to hold reserves for each dollar of deposits it
accepts (10 percent in the United States). Those reserves can be held in the form of cash
or deposits at the central bank.
The balance sheet of the Federal Reserve reflects important facts about money and the
history of money in the United States.
Balance Sheet of the Federal Reserve
December 28, 2005
Billions of Dollars
c.
Assets
Gold Certificates
Special Drawing Rights
Coin
US Treasury Securities
Federal Agency Securities
Repurchase Agreements
Loans
Items in the Process of Collection
Bank Premises
Other Assets
11.0
2.2
0.7
744.2
0.0
45.3
0.1
7.8
1.8
37.3
Total Assets
850.4
Liabilities
Federal Reserve Notes
Reverse Repurchase Agreements
Depository Institution Deposits
US Treasury Deposits
Foreign Official Deposits
Other Deposits
Deferred Availability of Cash Items
Other Liabilities
Total Liabilities
Net Worth
759.2
30.4
17.1
4.2
0.09
0.3
6.7
4.4
822.4
28.0
Central banks can increase and decrease the supply of money by buying and selling
government bonds in the open market.
Federal Reserve
Change in Assets
Change in Liabilities
1 Government Bonds $1B
Fed Check
$1B
3
Net Government Bonds
+ $1B
Fed Check
XYZ Deposit
- $1B
+ $1B
XYZ Deposit
+ $1B
Bond Dealer
Change in Liabilities
Change in Assets
1 Government Bonds -$1B
Fed Check
+ $1B
2 Fed Check
Deposit in XYZ Bank
- $1B
+ $1B
Net Government Bonds
Bank Deposit
- $1B
+ $1B
XYZ Commercial Bank
Change in Assets
Change in Liabilities
2 Fed Check
+ $1B
Dealer Deposit + $1B
3 Fed Check
Deposit at Fed
- $1B
+ $1B
Net Deposit at Fed
+ $1B
Dealer Deposit + $1B
The bottom line is that an open market purchase of government bonds increases the bank reserves
of commercial banks and makes additional lending possible.
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d.
4.
Through open market operations, a central bank is able to control short term interest rates
Federal Reserve Policy
a.
By law, the Federal Reserve is required to maintain price stability and promote full
employment of resources.
b.
The Fed is responsible for managing growth in the US money supply.
i.
ii.
iii.
When the Fed grows the money supply at an appropriate rate, it helps the economy
grow by providing the new dollars necessary to support the transactions associated
with growth.
When the Fed allows the money supply to grow too rapidly, inflation results and
the value of money decreases.
The following table illustrates that the Fed has done a better job of controlling the
money supply in some periods and a worse job in others.
Period
1955-65
1965-75
1975-85
1985-95
1995-2005
Excessive Money Growth Results in Inflation
Ten Year Growth Rates in Annual Terms
Money Base Growth
Real GDP Growth
Inflation
3.0
3.9
1.8
6.8
2.9
5.5
8.1
3.4
6.1
8.0
2.8
2.8
6.0
3.3
2.1
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c.
The following diagram provides evidence for Milton Friedman’s famous claim that
inflation is “always and everywhere a monetary phenomenon.”
From Dwyer, Gerald and R. W. Hafer, “Are Money Growth and Inflation Still Related?”
Federal Reserve Bank of Atlanta Economic Review, Second Quarter, 1999
d.
During the Great Recession, the normal relationship between money growth and inflation
broke down because commercial banks were unwilling to lend.
i.
Normally, banks hold very small amounts of excess reserves because they
respond to increases in their reserves by increasing loans to private sector
borrowers.
ii.
During the Financial Market Crisis, banks perceived that loans were risky. When
the Fed increased banking system reserves (through open market bond purchases)
banks chose to hold excess reserves.
iii.
In order to provide banks additional revenue and lower the probability of bank
failures, the Fed began paying interest on reserve balances which also gave banks
an incentive to hold excess reserves.
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