Chapter 8 - Money
CHAPTER 8. MONEY ...................................................................................................... 1
I. The U.S. Experience with Money ........................................................................... 2
I. The U.S. Experience with Money ............................................................................... 2
a medium of exchange ....................................................................................... 2
seigniorage, ........................................................................................................ 3
standard of value ............................................................................................... 3
store value .......................................................................................................... 4
2. The Definition of Money ..................................................................................... 4
M1 ....................................................................................................................... 5
M2 ....................................................................................................................... 5
M3 ....................................................................................................................... 5
Table 8-1. Different Definitions of Money ............................................................. 5
3. The Federal Reserve System .............................................................................. 6
Federal Reserve System ...................................................................................... 6
Clearinghouse for checks ............................................................................................ 6
Reserve accounts ......................................................................................................... 6
Loans of Reserves ....................................................................................................... 6
Cash............................................................................................................................. 6
Figure 8-1. How the Fed Works.......................................................................... 6
1. Setting the reserve requirement. ......................................................................... 7
2. Determining the Discount Rate ............................................................................. 7
3. Open Market Operations ....................................................................................... 7
4. Setting Up a Bank ............................................................................................ 7
Figure 8-3 ............................................................................................................... 9
Figure 8-4 ............................................................................................................. 10
5. Changing the Reserve Requirement ........................................................... 10
Figure 8-5. ............................................................................................................ 11
6. Open Market Operations .................................................................................. 12
Figure 8-6. ............................................................................................................ 12
7. Discounting ............................................................................................................. 13
Figure 8-7. ............................................................................................................ 14
8. Money Multiplier Through the Entire Banking System ........................ 15
Table 8-2. .............................................................................................................. 16
Figure 8-8. ............................................................................................................ 17
9. Conclusion .............................................................................................................. 17
\CHAPTER 8. MONEY
Very rarely do we have to stop to think about where the value for money comes
from. Yet we spend so much of our lives working extremely hard to gain enough of this
value so that our lives, families, and communities can be secure and enjoyable. However,
maintaining the value of money is an ongoing experiment that governments are
1
Chapter 8 - Money
continually trying to learn how to manage. Through history governments have come up
with new ways to manage money that provide important insights into the value of money.
I.
The U.S. Experience with Money
An understanding of the value and government management of money can be
illustrated by examining the history of the American experiment with money. Before the
European colonists came to America, there was a strong system of barter that carried
goods across the country. In barter arrangements there is no money. One item is
exchanged for another. However, when someone really needs something, it is
expensive to search for something that will be acceptable in a barter exchange.
It’s much easier to have something that everyone values and to keep it around so
that it is always available for exchange. Money can provide such a value if everyone
agrees to its value. If everyone seems to be willing to exchange items of value for
money, then people are continually reassured that it has value. Trust that others will
accept money as a medium of exchange is crucial. But who decides what is valuable?
Historically, certain scarce items have caught people’s attention and through
experience people find that others will accept these items as exchange. The items have
simply evolved into the role of money without any formal recognition. Certain items like
shells have migrated across the American continent and have similarly been found to play
the role of money in other cultures
(http://www.richmondfed.org/about_us/our_tours/money_museum/virtual_tour/monies/pr
imitive_money/index.cfm) Like other forms of early money shells facilitated exchange
because they had (1) high value per unit which meant little of it was needed, (2) low
weight which meant it was not too heavy to carry, (3) high durability which meant that it
preserved its value, and (4) wide utilization which meant that it was accepted by many
others. Money which had these properties greatly facilitated exchange.
When the European colonists arrived, they came from many different sea powers,
particularly Britain, France, and Spain. The currencies of these countries were used,
particularly “pieces of eight” from Spain
(http://www.richmondfed.org/about_us/our_tours/money_museum/virtual_tour/colonial_
coin_and_currency/index.cfm
). Even though Britain owned the American colonies, the Spanish currency was
adopted because the Spanish colonies were nearby, relatively rich and powerful, and
experiencing a great deal of commerce with the colonies which made their currency
accessible.
The colonies did not have enough of these currencies, and so they issued paper
money. Of course, the paper wasn’t worth anything in itself. So the colonies “backed”
the currency by making it exchangeable for the foreign currencies. Each state issued its
own currency. For example Georgia
(http://www.frbsf.org/currency/independence/show.html) had a paper note which was
based on the Spanish dollar, even though it had been a British colony. Even after being
2
Chapter 8 - Money
in rebellion against Britain other states issued notes that were backed by the English
shilling (http://www.frbsf.org/currency/independence/show.html). Strong governments
were an important source credibility for a currency, and the states had no illusion that
their governments were as strong as those of either Britain or Spain. A strong
government that can take necessary actions to back the value of money is essential if
people are to believe in the value of money.
After winning Independence, the states organized under the Articles of
Confederation which preserved the autonomy of the different states. However, the states
were not strong enough to inspire much belief in a common currency or their own state
currencies. As a result there was a terrible inflation which wiped out the value of the
currencies and gave rise to the phrase “not worth a continental” which still today is used
to mean that something is worthless. Not until the states were organized under the
Constitution under one government would there be a possibility of a strong currency.
Particularly when money cases to be valued for its metal content, everyone looks to
government for accountability in maintaining the value of the money.
But the new government did not issue its own currency. It did not even have its
own bank. Private banks, utilities, churches, businesses and charities all issued their own
paper money. Bank Note reporters issued books which kept track of those notes which
were valuable and those which were “broken.” Continual breakdowns of the money
supply occurred and many of the frontier areas were poorly served. It was not until
Andrew Jackson’s attack on Biddle’s private bank which had served as the nation’s bank
did the United States finally set up its own bank. To discourage issuance of private
currencies a 10% surcharge was placed on the creation of notes- effectively creating the
first reserve requirement. But it took the civil war before both the Northern and Southern
governments issued their own national currencies. The 14th amendment to the
constitution would finally end the experiment with private currencies.
Why was a national currency so much stronger for the purpose of fighting a war?
One reason was seigniorage, the value of being the first to spend the newly created
money. But a far more important value of a single currency was the standardization of
value. With one currency it was easier for everyone to agree upon its worth, which is key
to one of the great values of money as a standard of value. Usability and
standardization for money have been the basis of experimentation right up to the present
day. Perhaps the greatest innovation was that of the Lydians in standardizing the weight
of metal in a coin which could be used for exchange
(http://www.richmondfed.org/about_us/our_tours/money_museum/virtual_tour/monies/c
oins_of_early_origin/croesus.cfm).
This innovation allowed the currency to be used throughout the Mediterranean by many
non-Greek states. Rome, Britain, and today United States have experienced the benefits
of being the international standardized currency. Today, many countries use the dollar as
their currency because it has a widely accepted value. In the face of standardization of a
strong international currency, countries have been willing to give up the seigniorage from
having their own currency in order to have the economic stability from sharing a
commonly valued single currency.
3
Chapter 8 - Money
During the Civil War the Union tried seven different experiments in the issuance
of money. It issued notes backed by gold, by silver, and by a certain promised interest
rate
(http://www.richmondfed.org/about_us/our_tours/money_museum/virtual_tour/us_curren
cy_1861-1865/index.cfm). But it also tried an experiment in issuing a currency, the
United States Note, that was simply backed by government debt. The United States Note
(http://www.richmondfed.org/about_us/our_tours/money_museum/virtual_tour/us_curren
cy_1861-1865/index.cfm
) would finally become part of the permanent money supply in 1878. It was successful
because it could be exchanged for risk-free government bonds which paid a fixed interest
rate. The availability of a risk-free bond in which people could store value and actually
have it appreciate in value through time was magic to people who were used to the
corrupted private system which periodically collapsed and destroyed savings. Long after
the gold backed and silver-backed currencies were abolished, the experiment, begun with
the United States Note, which was backed only by government debt, won. The Federal
Reserve Note that we use today is a direct descendant.
Once again the United States experienced a hyperinflation. As it was losing the
war, people began to realize that the southern currency would be no good. As always
happens with hyperinflation, price increases accelerated until the paper currency was
worthless. The failure or even the weakening of government undermines the value of its
currency.
2. The Definition of Money
The United States was experimenting with the kinds of money that it would use.
Economists identify several different types of money, each of which can be used as a
medium of exchange:
1. Money based on commodities. The value of such a money is entirely based on a
single commodity and that commodity is itself the money as in gold or shells.
2. Fiat money. Fiat money is required by law to be used for exchange purposes.
3. Fiduciary money. Backing money by another currency. This is what we saw the
colonies do in early American history when they backed their paper money with the
currencies of Spain or Britain. But this is also the idea behind a checking account at a
bank. The checking account is "backed" by the American currency.
While there are many different ways to exercise buying power, not all of them are
money. One of the best examples is the "line of credit" issued by banks. A line of credit
is an agreement that a borrower can buy up to a certain limit and the bank will make
good in paying for the purchases. Credit cards are a line of credit. But they are not
money. They are a loan, not a store of value in themselves, nor a medium of exchange in
themselves. The key distinction between a credit card and a debit card is that there is
4
Chapter 8 - Money
money already in an account to back the card up, while the credit card is a loan that is
backed by nothing but the bank's trust that you'll pay your monthly bill.
In the United States there are three basic definitions of money; M1, M2, and M3
and then a final comprehensive category, “L”. These definitions are distinguished on the
basis of the liquidity, return, and buying power of the items that are included within each
definition.
M1 is the most liquid and earns the least return. It includes cash or currency,
travelers checks, and transactions accounts. Transactions accounts are characterized by
the ability to make direct payments to another party. Each of these items is payable “on
demand.”
M2 includes M1 but also items which may receive some return. Savings accounts
and money market accounts have been increasingly popular over the last twenty years as
people have realized the importance of earning a return on money that they have
deposited. In some cases, banks or other financial institutions have the authority to
restrict the distribution of this form of money in time or in amount. Nevertheless it
represents huge amounts of buying power that is used like money.
M3 includes M2 but also large categories of buying power that are exercised by
institutions, some of which are outside of the country. For example, the Eudollar market
consists of dollar accounts in banks outside of the United States.
Money is continually being transformed to meet the needs of a changing
economy. Before examining the Federal Reserve System it is useful to examine just how
much change there has been during our life times in the last twenty years in the United
States. The following table shows how each of the items of M3 has changed over the last
20 years. Besides the increased use of money market funds and savings deposits it is
possible to see that the use of cash is increasing.
Table 8-1. Different Definitions of Money
1980 Percentages
2000 Percentages
Currency
115
5.76%
530
7.47%
plus travelers checks
3
0.15%
8
0.11%
plus Demand deposits
261
13.08%
313
4.41%
plus Other checkable deposits
28
1.40%
239
3.37%
Equals M1
407
20.40% 1090
15.37%
plus Money market funds, retail
64
3.21%
939
13.24%
plus savings deposits
400
20.05% 1872
26.40%
plus small time deposits
729
36.54% 1046
14.75%
Equals M2
1600
80.20% 4947
69.75%
plus large time deposits
260
13.03%
827
11.66%
plus repurchase agreements
58
2.91%
360
5.08%
plus Eurodollars
61
3.06%
191
2.69%
Money market funds- institutions only
16
0.80%
767
10.82%
Equals M3
1995
100.00% 7092
100.00%
*negotiable order of withdrawal (NOW) and automatic transfer service (ATS) accounts
as well as credit union share and thrift institution demand deposits
**less than $100,000 excluding retirement accounts
***$100,000 or more but excluding foreign
5
Chapter 8 - Money
3. The Federal Reserve System
Although the U.S. government had unified the currency there were still bank
panics, one of the most severe of which occurred in 1907. The Federal Reserve System
was created in 1914 to prevent such crises.
The Federal Reserve System is the bank for bankers. It is headed by the Board
of governors. Each member of that board is appointed to one and only one 14 year term.
There are 12 Reserve Banks (and Missouri is the only state with two of those banks) that
served different regions of the country. These banks provide the following services for
private banks:
1.
Clearinghouse for checks. Any bank’s check cashed or deposited at another bank
is canceled by the Federal Reserve Bank after transferring funds (reserves) from one bank
to the other. That saves banks having to go to each other to collect the money.
2.
Reserve accounts. Banks hold their reserves in accounts at the Fed just like we
might hold money in a checking account at a bank. In the diagram below, a household
might deposit money into a transaction account at Bank A. Then a check could be
written for goods and services to a business that has an account at Bank B. After the
business deposits the check to the transactions account at Bank B, Bank B sends the
check to the Federal Reserve Bank which processes the check by canceling it and
transferring reserves from Bank A’s account to Bank B’s account. The canceled check is
sent to Bank A who sends it back to the household. Hundreds of billions of dollars are
transferred this way each year through the Federal Reserve system.
3.
Loans of Reserves. Banks can go to the Fed for loans (“discounts”) of reserves
just like we might go to a bank for a loan of money.
4.
Cash. The Fed provides cash to the banks in exchange for reserves.
Figure 8-1. How the Fed Works
FEDERAL RESERVE BANK
Bank A
A Reserves Bank
Bank
BankBB
Account
Account
Account
Account
Canceled check
Check
BANK A
Household
account
Canceled
check
BANK B
Business
account
Money
Deposited
Check
Check
Household
Business
Real goods and services
6
Chapter 8 - Money
The most important role of the Fed is to control the overall money supply. It does
so through three policy instruments:
1.
Setting the reserve requirement. The Fed determines the required reserve ratio
that each bank must meet. The required reserve ratio (RR) defines how much required
reserves (R) a bank must hold to cover its total deposits (transactions accounts (TA)).
Reserves include cash at the bank or reserves in the reserve account at the Fed. The
formula is:
Required Reserves = required reserve ratio
X Transactions Accounts
R
*
=
RR
TA
This formula is important because it determines the excess reserves (ER) which
determine how much a bank can lend. A bank examines its actual reserves (AR) against
its required reserves to determine excess reserves:
Excess Reserves = Actual Reserves – Required Reserves
ER
= AR
- R
A bank’s ability to make loans is equal to its excess reserves.
2. Determining the Discount Rate. The Fed decides what interest rate to charge banks
for borrowing reserves. This “discount rate” sets the floor to all other interest rates. The
“Federal Funds rate” is the rate charged by private banks to each other for lending
reserves to each other and closely tracks the discount rate.
3. Open Market Operations. The fed buys and sells government debt (bonds,
treasuries, etc.) and pays for them with reserves. By buying more government debt, the
Fed expands the money supply because the reserves it uses to pay for the bonds then
appear as excess reserves to banks which will then lend them out. By selling more
government debt, the Fed tightens the money supply. The banks that pay for the bonds
will be charged against their reserve accounts with the Fed.
With these three instruments the Fed is able to control the money supply.
4. Setting Up a Bank
To see how the Fed controls the money supply it is necessary to see how a bank
responds to actions by the fed. First we will pretend we are setting up a bank. Then we
will see what the bank does in response to different actions by the Fed.
7
Chapter 8 - Money
The steps for setting up a bank might include the following:
1.
If we were to set up a bank, we would need some equity. Suppose we put up
$100,000 (item 1a and we’ll drop three zeroes from now on to make it simpler) with
which to (1b) buy the building ($60,000) and (1c) all of the equipment ($40,000) that are
needed. The following “T-account” shows how this first action would be recorded in
terms of liabilities and equity. Notice that assets and liabilities always balance after
every step:
Figure 8-2.
SETTING UP A NEW BANK AND TAKING DEPOSITS
ASSETS
LIABILITIES
2b. Reserves at Fed 100
2a. Transactions Account 100
1b. Building
1c. Equipment
1a. Equity
TOTAL ASSETS
60
40
200
100
TOTAL LIABILITIES 200
2.
Also shown in the above diagram is the effect of advertising for deposits.
Everyone hears about our bank and deposits a total of $100,000 in transactions accounts
with us (2a). The checks they write on other banks in order to make these deposits cause
$100,000 to be transferred to the bank’s reserve account with the Fed (2b). Our accounts
now are in balance at $200,000 for both liabilities and assets.
3.
The bank must make money. It has three ways that it can invest its reserves. It
must leave some of the reserves at the Fed (or equivalently hold the money as cash in its
vaults). Here is where the required reserve ratio established by the Fed becomes
important. Suppose it is 10%. Then we use the following equation for required reserves
to find out how much must be kept in reserves:
R
= RR* TA
= .10 * $100
= $10
This means that the bank has excess reserves given by:
8
Chapter 8 - Money
ER
= AR - R
= 100 - 10
= $90
The bank can purchase securities or loan the money out. Government securities are very
safe and they provide a low return. Loans are more risky and provide a much greater
return. Suppose the bank decides to buy $40,000 in government bonds and to loan out
the rest. To buy the government bonds from the Fed, the bank writes a check on its
reserve account, just like we do with a checking account, for $40,000 which leaves
$60,000 in reserves (3a) and buys the securities (3b).
Then the bank uses the rest ($50,000 ) of its excess reserves to make $50,000 in
loans (3c). However, this time it does not have to draw down reserves. It effectively
creates MONEY by putting $50,000 into the borrowers’ transactions
accounts (3d). When we add the liabilities and assets, everything adds up to the same
amount ($250,000) on both sides and it reflects the creation of the new money.
Figure 8-3
INVESTING NEW RESERVES
ASSETS
LIABILITIES
3a. Reserves at Fed 60
3b. Securities
40
3c Loans
50
1b. Building
1c. Equipment
60
40
TOTAL ASSETS
250
2a. Transactions Account 100
3d. Loan adds purchasing
power to Transactions
Accounts
50
NEWLY CREATED MONEY
1a. Equity
100
TOTAL LIABILITIES 250
The bank has gone “long” by making the choices to buy securities and to make
loans. It is “tying up its money” because the money is less liquid even as it is earning
more money. Banks are taking on the key role of taking risk and being rewarded by the
returns for taking risks. But they are vulnerable to the collapse of the people to whom
they lend. They must be very careful about the willingness and ability of borrowers to
pay funds back and so they do careful credit checks and often make assessments of the
character of the people to whom they lend.
9
Chapter 8 - Money
4
But the bank doesn’t hold onto the new money for long. The borrowers have
not spent the money they have borrowed. When they write a check for
$50,000 it must be subtracted from the transactions account (4a) and the Fed
will transfer $50,000 of the bank’s reserves to some other bank leaving only
$10,000 in reserves (4b). Now total assets and liabilities are exactly where
they were before the loan and the purchase of securities. However, the
created money has not disappeared. It has now gone to another bank where it
will provide the basis for a new loan.
Figure 8-4
THE BORROWER DRAWS DOWN THE LOAN
ASSETS
LIABILITIES
3a. Reserves at Fed 60
4b. Subtracted when
Fed transfers reserves
to another bank -50
3b. Securities
40
3c Loans
50
2a. Transactions Account 100
3d. added by loan
50
4a. Subtracted when
borrower spends
-50
1b. Building
1c. Equipment
1a. Equity
TOTAL ASSETS
60
40
200
100
TOTAL LIABILITIES 200
.
Now that we have set up a bank, let’s see how the Fed can alter the money supply
5.
Changing the Reserve Requirement
The Fed can change the required reserve ratio (RR). Suppose the Fed lowers the
ratio. Let’s work through what our new bank will do, assuming that it will lend all new
excess reserves that it receives. Following is where we left our new bank. We can
follow the effect of cutting the reserve ratio from 10% to 5%.
1. The bank computes its required reserves:
R
= RR* TA
= .05 * $100
= $5
This means that the bank has excess reserves given by:
10
Chapter 8 - Money
ER
= AR - R
= 10 - 5
= $5
The bank uses the $5,000 of its excess reserves to make $5,000 in loans (1a). It
effectively creates MONEY by putting $5,000 into the borrowers’
transactions accounts (1b). When we add the liabilities and assets, everything adds
up to the same amount ($205,000) on both sides and it reflects the creation of the new
money.
2
Once again the bank doesn’t hold onto the new money for long. The
borrowers have not spent the money they have borrowed. When they write a check for
$5,000 it must be subtracted from the transactions account (2a) and the Fed will transfer
$5,000 of the bank’s reserves to some other bank leaving only $5,000 in reserves (2b).
Now total assets and liabilities are exactly where they were before the loan and the
purchase of securities. However, the created money has not disappeared. It has now
gone to another bank where it will provide the basis for a new loan.
Figure 8-5.
CHANGING THE RESERVE REQUIREMENT
ASSETS
LIABILITIES
Reserves at Fed 10
2a. Reserve drawn
down
-5
Securities
40
Loans
1a new loans
50
5
Building
Equipment
60
40
TOTAL ASSETS
200
Transactions Account 100
1b loan adds money
to transactions
accounts
5
2b. Borrower writes check
on account
-5
Equity
100
TOTAL LIABILITIES 200
The above example involves "loosening" the money supply. When the fed
tightens the money supply, banks suddenly find themselves out of compliance with the
reserve requirement. They can get back into compliance with the required reserves by
allowing borrowers to pay off loans. The effect of paying off a loan is to lower loans by
the same amount as reserves are increased. In effect letting people pay off loans rather
than making new loans means that the bank is “going short.” Because this mechanism is
11
Chapter 8 - Money
so powerful in creating and destroying money Congress is very reluctant to let the Fed
use this instrument, and historically it has been used very infrequently.
6. Open Market Operations
By far the most commonly used mechanism for controlling the money supply is
the use of open market operations. For this purpose, the Fed buys or sells government
securities to a bank. Let’s see what happens to our new bank where we left it in the
previous section. Suppose the Fed buys $10,000 worth of government securities from the
bank. The following steps occur:
Figure 8-6.
OPEN MARKET OPERATIONS
ASSETS
1b.
3b.
1a.
2a.
LIABILITIES
Reserves at Fed 5
FED pays reserves +10
FED transfers
reserves to another
bank
-10
Securities
40
Bank sells
securities
-10
Loans
55
Bank makes loans 10
Building
Equipment
TOTAL ASSETS
60
40
200
Transactions Account 100
2b. Bank adds money
to transactions
account
10
3a. Borrower draws down
loan
-10
Equity
100
TOTAL LIABILITIES 200
1. The bank sells $10,000 worth of government securities (1a) and the Fed pays $10,000
worth of reserves (1b).
2. The bank recomputes its required reserves:
R
= RR* TA
= .05 * $100
= $5
This means that the bank has excess reserves given by:
12
Chapter 8 - Money
ER
= AR - R
= 15 - 5
= $10
The bank uses the $10,000 of its excess reserves to make $10,000 in loans (2a). It
effectively creates MONEY by putting $10,000 into the borrowers’
transactions accounts (2b). When we add the liabilities and assets, everything adds
up to the same amount ($210,000) on both sides and it reflects the creation of the new
money.
3
Once again the bank doesn’t hold onto the new money for long. The borrowers
have not spent the money they have borrowed. When they write a check for $10,000 it
must be subtracted from the transactions account (3a) and the Fed will transfer $10,000
of the bank’s reserves to some other bank leaving only $5,000 in reserves (3b). Now
total assets and liabilities are exactly where they were before the loan and the purchase of
securities. However, the created money has not disappeared. It has now gone to another
bank where it will provide the basis for a new loan.
The open market operations of the Fed work in reverse when monetary policy is
tightened. Then the Fed sells government securities to banks and the banks use their
reserves to pay for the securities. An example of a bank buying securities was provided
when we first set up the bank.
7. Discounting
Occasionally banks have a shortage of reserves. They can make up the reserve
shortage by selling securities, borrowing funds from other banks through a market
referred to as the "federal funds market," or they can borrow reserves from the Fed at
the "discount" window. Discounts are the Fed's loans of reserves to banks and those
loans are made at the discount rate. When the Fed wants to discourage expansion of the
money supply, it can raise the discount rate and make it more expensive for banks to
borrow reserves from the Fed. And if the banks then try to go to the Federal Funds
market to borrow from other banks they will find that the "federal funds rate" has
followed the discount rate upward. So, even if the Fed doesn't lend much reserves itself,
it has a big impact on overall lending of reserves.
We can follow our bank from the end of last section as it borrows reserves from
the Fed in order to make new loans:
1.
Suppose the bank wants to borrow $15 worth of reserves. The discounts from the
Fed are payable back to the Fed and must be shown on the liability side of a bank's ledger
(1a). The borrowed reserves are added to total reserves (1b).
2. The bank recomputes its required reserves:
13
Chapter 8 - Money
R
= RR* TA
= .05 * $100
= $5
This means that the bank has excess reserves given by:
ER
= AR - R
= 20 - 5
= $15
The bank uses the $15,000 of its excess reserves to make $15,000 in loans (2a). It
effectively creates MONEY by putting $15,000 into the borrowers’
transactions accounts (2b). When we add the liabilities and assets, everything adds
up to the same amount ($230,000) on both sides and it reflects the creation of the new
money.
Figure 8-7.
DISCOUNTING
ASSETS
LIABILITIES
Reserves at Fed 5
1b. Reserves from Fed 15
3b. FED transfers
reserves to another
bank
-15
Securities
30
Loans
65
2a. Bank makes loans 15
Building
Equipment
TOTAL ASSETS
Transactions Account 100
2b. Bank adds money
to transactions
account
15
3a. Borrower draws down
loan
-15
1a. Discounts
15
Equity
100
60
40
215
TOTAL LIABILITIES 215
3
Once again the bank doesn’t hold onto the new money for long. The borrowers
have not spent the money they have borrowed. When they write a check for $15,000 it
must be subtracted from the transactions account (3a) and the Fed will transfer $15,000
of the bank’s reserves to some other bank leaving only $5,000 in reserves (3b). Now
total assets and liabilities are larger by the amount of reserves lent by the Fed. $15,000
of the newly created money has now gone to another bank where it will provide the basis
for a new loan.
14
Chapter 8 - Money
As in the previous two instruments used by the Fed, much of the effect of Fed
actions is repetitive. And the overall impact on the economy of the Fed's action on any
given bank is similarly repetitive.
8. Money Multiplier Through the Entire Banking System
Each of the actions that the Fed took above can be analyzed from the point of
view of the entire Federal Reserve System of Banks. If we step back and look at the Taccounts of the entire banking system it operates quite similarly to the individual bank.
However the entire system never loses any reserves. If every transaction stays within a
system it is called a monopoly banking system. The reserves never are transferred
outside of such system. That means that when a check is written the reserves always stay
the same for the entire banking system. The multiplying effects of each successive bank
receiving higher transactions deposits from the original infusion (or contraction) of
reserves leads to an expansion of loans.
To see how this occurs let's reexamine the case of the changing reserve
requirement on the bank that was created in section 5. That bank lent $5,000 as a result
of the changing reserve requirement which added the same amount to its transaction
deposits. When those deposits were drawn down by the borrower, they went to someone
else who then deposited the $5,000 at another bank. That other bank, call it "bank B"
also had a required reserve ratio of .05. So out of its $5000 of new deposits its required
reserves would be:
R
= RR* TA
= .05 * $5
= $.25
This means that the bank has excess reserves given by:
ER
= AR - R
= 5 - .25
= 4.75
When Bank B lends $4.75, the money ends up as greater deposits in a bank C, which then
computes its required and excess reserves. The result can be summarized by an EXCEL
program as follows:
15
Chapter 8 - Money
Table 8-2.
1
2
3
4
5
6
7
A
Bank
Initial Bank
Bank B
Bank C
Bank D
Bank E
Bank F
B
New Deposit
C
|D
Excess Reserves | RR=
5 0.05
5
4.75
4.75
4.5125
4.5125
4.286875
4.286875
4.07253125
4.07253125
3.868904688
…
…
Total
is new created money
100
|
NOTE: In this program, the new “$5” deposit of bank B (shown in B3) equals the excess
reserves of the initial bank (shown in C2). New deposits of bank B are then multiplied by
(1- RR) where RR, the reserve requirement, is posted at the upper right hand corner in
D2. In other words, C3 =B3*(1-D2). Dragging down both formulas (from B3 and then
from C3) shows in the third column how much money is created by each bank. The
total, if dragged on forever would approach 100.
In a monopoly system, the existence of excess reserves anywhere is multiplied by
the money multiplier to find the total expansion of loans that will occur throughout the
system. The arm waving of the previous paragraph is summarized by the formula:
New money created
= (Initial excess reserves)/RR
=
5/.05
= 100
To illustrate how a monopoly banking system is different from a single bank, we will use
exactly the same numbers as we did in section 5 and pretend that they represent a trillion
dollars rather than only a thousand dollars. Here is the way the overall system looks and
the step by step procedure for analyzing the effect of cutting the reserve requirement from
.10 to .05.
1. The monopoly bank computes its required reserves, just like an individual bank
would:
R
= RR* TA
= .05 * $100
= $5
This means that the bank has excess reserves given by:
ER
= AR - R
= 10 - 5
= $5
16
Chapter 8 - Money
But the monopoly bank uses the $5 trillion of its excess reserves to make loans in the
amount of the excess reserves times the money multiplier, 1/.05. That's the same thing
as dividing the excess reserves by the required reserve ratio:
Loans = ER * (1/.05) = 5/.05 =100
After all multiplying effects the banking system has added $100 trillion to loans(1a). It
effectively creates MONEY by putting $100 trillion into the borrowers’
transactions accounts (1b). When we add the liabilities and assets, everything adds
up to the original total plus the amount of the new loans.
2
Since the reserves stay within the system, we don't have a second step- unlike
an individual bank. Unlike the inidividual bank we can see the complete
multiplying effect of the money multiplier in the T-account of a monopoly
banking system.
Figure 8-8.
CHANGING THE RESERVE REQUIREMENT
FOR A MONOPOLY BANKING SYSTEM
ASSETS
LIABILITIES
Reserves at Fed 10
Securities
40
Loans
1a new loans
50
100
Building
Equipment
60
40
TOTAL ASSETS
300
Transactions Account 100
1b loan adds money
to transactions
accounts
100
Equity
100
TOTAL LIABILITIES 300
9. Conclusion
Like real goods, money has a multiplier. While the flow of goods and services is
amplified by a multiplier that depends upon the marginal propensity to consume, the flow
of money is amplified by a multiplier that depends upon the required reserve ratio which
tells banks how much money they must keep on hand. Both the flow of real goods and
the flow of money are regulated by how much of the flow is siphoned off, either by
government requirement or people's behavior in saving.
17
Chapter 8 - Money
From a management point of view, the two multipliers must be kept in
synchronization with each other. A fundamental identity, called the quantity theory of
money, connects money (M) and the real goods (real GDP) through the price level (P)
and the velocity of money (V):
M*V= P*(real GDP)
In effect, the equation shows that prices and the velocity of money must always change to
maintain the identity. The government must manage (or avoid overmanaging) the money
supply in order to prevent hyperinflations or deflations (either of which cause P to spin
out of control) as well as to prevent shut downs or overheating of the economy (where
real GDP spins out of control). With the lags in our information about real GDP, finding
the right balance is a continual experiment with dire consequences when there is failure.
Crucial to the working of the monetary system is the role of the Banks in creating
money. While the government can print cash, the real buying power comes from the
bankers' roles in lending money. They will only lend money if they trust people will pay
it back with interest. When such trust is violated, bankers cease making loans. Without
loans businesses begin to shut down. Without such trust money, you have now learned
how to use the T-accounts to see how money simply evaporates- no one steals it. Every
loan that is created is a vote of faith in a sustained economy and is itself sustaining of the
economy.
Case Study: China’s Central Bank.
The following article from the New York Times shows that China is trying to use
its monetary policy to control growth, much as the Federal Reserve System does in the
United States. However, with only recent experience in making loans, China’s banks
have a likelihood of making many bad loans as the following article shows:
China's Soft Landing
Published: June 11, 2004
It's not all up to Alan Greenspan. When it comes to the global economy, Zhou
Xiaochuan and Liu Mingkang may be as influential, even if most Americans have never
heard of them. Mr. Zhou, the governor of China's central bank, and Mr. Liu, its top
banking regulator, are central to the country's efforts to cool its overheated economy.
China, the world's most populous nation, has been growing at a torrid pace for some time,
and there is a gold-rush aspect to its boom that Beijing needs to address. The aim is to
achieve what economists call a soft landing, turning that headlong rush into continued,
sustainable growth.
The alternative is a hard landing, also known as a crash.
More than the recent dot-com bubble, China's boom resembles America's feverish
industrialization of the late 19th century. Much as the United States did then, China has a
dynamic economy that lacks a developed financial system. If it's serious about its
18
Chapter 8 - Money
ambitions, the Communist government will need to foster the creation of mature and
independent capital markets, even though it would mean relinquishing more control.
China has averaged 10 percent annual growth in recent years, lifting millions out of
poverty. The arithmetic of the boom is staggering. Ten million Chinese enter the work
force each year, and some 350 million people are expected to migrate from the
countryside to cities in the next quarter-century. China's exports have doubled in less than
five years, though the country's growing appetite for commodities to fuel its
industrialization means that it has an American-size trade deficit. The market for
mortgage loans grew by a staggering 40 percent last year. Spending on new steel mills
tripled from 2002 to 2003, and China now consumes nearly 30 percent of the world's
steel products.
Much of the exuberance is rational, but plenty is not. In a frothy environment
where money is in ample supply, and where assessing credit risks remains a sketchy
concept, the banking system may have to write off more than a third of its outstanding
loans. Part of the soft-landing strategy of Mr. Liu and Mr. Zhou is to make the banks
more parsimonious.
Beijing was hoping to push its growth rate down near the 7 percent mark this
year, but the economy still grew at an annual rate of 9.7 percent in the first quarter…,
China is now one of the world's twin economic engines, alongside the United States.
China's growing appetite for everything from soybeans to iron ore is responsible for an
across-the-board surge in commodity prices. And not only is the Chinese market helping
to perk up Japan and South Korea, but it has also become important to such faraway
nations as Brazil. The whole world, in other words, is anxiously watching to see whether
China remains the next big thing or becomes the next big bust.
accessed on June 11, 2004 from the New York Times at:
http://www.nytimes.com/2004/06/11/opinion/11FRI3.html?th
If Chinese banks experience large defaults on loans, what will happen to their money
supply? Based on the model of the banking system in this chapter you should be able to
see that there will be a collapse in the ability of the banks to make loans. With fewer
loans, by definition the money supply must contract. There will be lower output and
fewer jobs.
"discount" window .... 14
Fiat money .................. 4
Discount Rate .............. 8
Discounting ............... 14
Discounts................... 14
excess reserves .......... 11
federal funds market . 14
federal funds rate....... 14
Federal Reserve System
................................. 6
Fiduciary money ......... 4
going short ................ 12
gone “long” ............... 10
Copyright
loosening" the money
supply .................... 12
M*V= P*(real GDP) . 18
M1 ............................... 5
M2 ............................... 5
M3 ............................... 5
medium of exchange ... 2
money multiplier ....... 17
Money Multiplier ...... 15
monopoly banking
system ................... 15
Open Market Operations
................................. 8
required reserves ....... 13
reserve requirement ..... 7
Reserve Requirement 11
seigniorage .................. 3
shortage of reserves... 14
standard of value ......... 3
store value ................... 4
T-account .................. 17
the quantity theory of
money.................... 18
transactions accounts 9
velocity of money ..... 18
19