Required reading:
Ch 13,14
Lecture 17:
Money and Banking
Econ 201, Autumn 2022
1
11/22/22
Money and Banking
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Monetary policy is shifting AD around by
manipulating the money supply
We need to understand the role money plays in
aggregate demand and aggregate expenditure
Need to understand the role banks play
Need to understand the Federal Reserve
The Meaning of Money
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Money is any asset that can easily be used to
purchase goods and services
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By definition, it is the most liquid asset
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Liquidity is how easily as asset can be turned into
cash without loss of value.
Checking account: very liquid.
A home: not very liquid
The Meaning of Money
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Currency in circulation is cash held by the
public.
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Currency sitting in bank vaults don’t count!
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Checkable bank deposits are bank accounts on
which people can write checks.
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The money supply is the total value of financial
assets in the economy that are considered money –
that is, that can easily be used to purchase goods
and services.
The Meaning of Money
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What is money for?
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We’ve talked about ‘sales’ when defining GDP
Money was needed to make all those sales
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A bunch of things.
Every dollar of goods was purchased with money
We somehow need 4 trillion dollars of money to buy all
our GDP
A medium of exchange is an asset that
individuals acquire for the purpose of trading
rather than for their own consumption.
Roles of Money
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People often hold cash as a way to save or insure
themselves against risk.
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A store of value is a means of holding
purchasing power over time.
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People compare prices using money
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A unit of account is a measure used to set
prices and make economic calculations.
The Role of Money
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Anything that is all three things
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Medium of Exchange
Store of Value
Unit of Account
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is money
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Lots of things have been money!
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Cigarettes in POW camps
Gold coinage
Little pieces of paper
The Role of Banks
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Banks transform liquid assets into illiquid assets
Take in cash, send out loans
Provide a place to store your cash, and provide
funds to finance investment for firms.
Banks profit by charge an interest rate on loans
they make that is larger than the interest rate
they pay out to people who deposited cash with
them.
Perform an information-processing role; instead of
lending out your money yourself, they find firms
and do it for you.
The Monetary Role of Banks
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A bank is a financial intermediary that uses liquid
assets in the form of bank deposits to finance the
illiquid investments of borrowers.
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Now we’re learning how the market for loanable funds
actually works
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A T-account is a tool for analyzing a business’s
financial position by showing, in a single table, the
business’s assets (on the left) and liabilities (on the
right).
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Bank reserves are the currency banks hold in their
vaults plus their deposits at the Federal Reserve.
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The reserve ratio is the fraction of bank deposits
that a bank holds as reserves.
Assets and Liabilities of First Street Bank
A T-account summarizes a bank’s financial position.
The bank’s assets, $900,000 in outstanding loans to
borrowers and reserves of $100,000, are entered on the
left side. Its liabilities, $1,000,000 in bank deposits
held for depositors, are entered on the right side.
Banks and the Money Supply
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Some checking accounts come from depositing
cash in a bank.
But others are created out of thin air by the banks
when they make a loan
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When bank makes a loan, it creates a checkable
deposit for the firm receiving it
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Now there is new money in the system that didn’t
exist before!
Determining the Money Supply
Effect on the money supply of a deposit at First Street
Bank
Initial effect before bank makes new loans:
Determining the Money Supply
Effect on the money supply of a deposit at First Street
Bank
Effect after bank makes new loans:
Determining the Money Supply
Effect on the money supply of a deposit at First Street
Bank
Effect after bank makes new loans:
Assets
Liabilities
Loans:900
1,000
Reserves:100
Reserves: 900
Deposits: 900
Determining the Money Supply
Effect on the money supply of a deposit at First Street
Bank
Effect after bank makes new loans:
Assets
Liabilities
Loans:900
1,000
Reserves:100
Loans: 810
Reserves:90
Deposits: 900
Determining the Money Supply
Effect on the money supply of a deposit at First Street
Bank
Effect after bank makes new loans:
Assets
Liabilities
Loans:900
1,000
Reserves:100
Loans: 810
900
Reserves:90
Reserves:810
Deposits: 810
Determining the Money Supply
Effect on the money supply of a deposit at First Street
Bank
Effect after bank makes new loans:
Assets
Liabilities
Loans:900
1,000
Reserves:100
Loans: 810
900
Reserves:90
Loans:729
Reserves: 81
Deposits: 810
Reserves, Bank Deposits, and the Money Multiplier
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Excess reserves are bank reserves over and
above the bank’s required reserves.
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The bank wants to lend these out. Lending out
excess reserves is how the bank makes money.
Increase in bank deposits from $1,000 in excess
reserves =
$1,000 + ($1,000 × (1 − rr)) + ($1,000 × (1 − rr)2)
+
($1,000 × (1 − rr)3) + . . .
This can be simplified to:
Increase in bank deposits from $1,000 in excess
reserves = $1,000/rr
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A Multiplier effect!
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Firm gets a loan, spends money
That money goes into someone else’s bank account
Some of money gets lent out
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The reserve ratio fraction gets kept
Firms gets a loan, spends money
…
So 1 dollar in new excess reserves means (1/rr)
dollars in new money
That original dollar in cash means many dollars in
new money
The Money supply grows!
Cash In
Circulation
Demand
Deposits
100
0
0
100
0
100
100
100
I made a Deposit
90
100
10
190
0
190
100
190
Bank loaned out 90
The person who got the loan
deposited it
81
190
19
271
The bank mad a loan
Reserves Money Supply
Action
Determining the Money Supply
Effect on the money supply of a deposit at First Street
Bank
Effect after bank makes new loans:
Assets
Liabilities
Loans:800
1,000
Reserves:200
Reserves: 800
Deposits: 800
Determining the Money Supply
Effect on the money supply of a deposit at First Street
Bank
Effect after bank makes new loans:
Assets
Liabilities
Loans:800
1,000
Reserves:200
Loans: 640
Reserves:160
Deposits: 800
The Money Multiplier in Reality
§ The monetary base is the sum of currency in
circulation and bank reserves.
§ The money multiplier is the ratio of the money
supply to the monetary base.
The Federal Reserve System
§ A central bank is an institution that oversees and
regulates the banking system and controls the
monetary base.
§ The Federal Reserve is a central bank—an
institution that oversees and regulates the banking
system, and controls the monetary base.
§ The Federal Reserve system consists of the Board of
Governors in Washington, D.C., plus 12 regional
Federal Reserve Banks.
The Federal Reserve System
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In charge of oversight and regulation of Banks
Control the Monetary Base
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Semi-autonomous
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Local districts are confederations of private banks,
elect local Fed Presidents
Board of Governors in Washington
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Members of the Board of Governors serve a 14 year term
Chairman of the Board of Governors serves a 4 year term
The Federal Reserve System
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The Fed makes policy decisions in the Federal
Open Market Committee
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The Board of Governors + five of the Regional
Presidents
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FOMC
The 5 Rotate
Always includes New York President
Current Chair: Jerome Powell
The Federal Reserve System
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Current Board of Governors
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Jerome Powell, Chairman. Chair term ends 2026, membership ends 2028
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Lael Brainard, Vice Chair, term ends 2026
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Michael BArr, Vice Chair for supervision term ends 2032
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Lisa Cook Term ends 2024
Miki Bowman: Term ends 2034
Philip Jefferson, Term ends 2036
Chris Waller, Term Ends2030
Current Bank Presidents
John C. Williams, Pres NY
Susan Collins, Boston
Loretta Mester, Cleveland
Helen Mucciolo, 1st Pres NY
James Bullard, St. Louis
Charles Evans, Chicago
Mary Daly, San Francisco
Neel Kashkari, Minneapolis
Raphael Bostic, Atlanta
Lorie Logan, Dallas
Esther George, Kansas City
Thomas Barkin, Richmond
Patrick Harker, Philadelphia
The Federal Reserve System
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Created 1913 in response to a financial panic in
1907
No central bank at the time
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No “Lender of Last Resort”
JP Morgan took on that role during the crisis. Need for
a permanent public institution to do it.
The Fed has three major policy tools
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The Reserve Requirement
The Discount Rate
Open Market Operations
The Federal Reserve System
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The FOMC meets every 5-8 weeks
Decides the course of Monetary Policy, which open
market operations to carry out
The New York Fed executes the actual trades on
the New York Markets
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That’s why they are always on the FOMC
Banks used to be paired
Now the rest are in groups of 3, besides Chicago and
Cleveland, which are still paired.
This might be changed, soon!
Reserve Requirements and the Discount Rate
§ The federal funds market allows banks that fall
short of the reserve requirement to borrow funds
from banks with excess reserves.
§ Allows them to meet their overnight reserve
requirements
§ The federal funds rate is the interest rate
determined in the federal funds market.
§ Not under direct Fed Control, but
§ The discount rate is the rate of interest the Fed
charges on loans to banks.
§ The Fed funds rate tracks this closely.
Reserve Requirements and the Discount Rate
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The discount rate is for borrowing directly from
Fed
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Historically, a bad sign for a bank to need the Fed’s
money.
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Historically, set to FFR + .01
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Set to FFR + .0025 curing crisis
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“Opening the Discount Window”
Lower FFR and Discount Rate can encourage more
lending by banks
Open Market Operations by the Fed
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Open Market Operations are simply the Fed
buying and selling assets in the open market, like
any other trader.
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Typical Trade: Fed buys US treasury Bills, pays
with cash
Open Market Operations by the Fed
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Why is it different when the Fed buys an asset, instead
of a regular trader?
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You buy, the person you buy from gets new cash in
their account
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But your account has less money
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Money Multiplier effect
Money Multiplier effect in opposite direction
They Cancel
But when the Fed buys, they pay with brand new
money that didn’t exist before!
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Electronic Money, not cash, but is the same thing.
Open-Market Operations
Open-market operations by the Fed are the
principal tool of monetary policy: the Fed can increase
or reduce the monetary base by buying government
debt from banks or selling government debt to banks.
The Federal Reserve’s Assets and Liabilities:
Open-Market Operations by the Federal Reserve
An Open-Market Purchase of $100 Million
Open-Market Operations by the Federal Reserve
An Open-Market Sale of $100 Million
Money Creation in Detail
Action My
Account
100
I Buy a 0
bond
My
Bank’s
Reserves
Trader’s Trader’s
Account Banks
Reserves
Fed’s
Assets
Fed’s
Liabilities
10
0
0
10
10
+100
=+10 + 90
10
10
10-100=-90 +100
Now, my bank must borrow to meet it’s reserve requirements, and the
trader’s bank has 90 in excess reserves it can lend out. These cancel.
Money Creation in Detail
Action
Fed
Buys
Bond
My
Account
My
Bank’s
Reserves
Trader’s Trader’s
Account Banks
Reserves
Fed’s
Assets
Fed’s
Liabilities
100
10
0
0
10
10
100
10
100
100
110
110
Now, my bank doesn’t have to do anything. The trader’s bank has 90 in
excess reserves to lend out. The Money supply increased.
Open-Market Operations by the Federal
Reserve
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When the Fed buys assets, it increases the money
supply
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Pays with new money à new loans, increases M1
When the fed sells assets, it decreases the money
supply
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Takes in money, reducing lending, makes no new loans
à decreases M1
Open Market Operations
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What assets does the Fed Have?
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Lots!
Fed is largest holder of US Government Debt
First built up assets during WWII
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Realized it was creating money almost accidentally
Fed earns a lot of interest!
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Only profitable branch of government
Returns extra income to Congress
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After it spends as much as it wants
Another reason it is autonomous
The Fed Balance Sheet
21-Jul-2015
21-Jul-2012
21-Jul-2009
21-Jul-2006
21-Jul-2003
21-Jul-2000
21-Jul-1997
21-Jul-1994
21-Jul-1991
21-Jul-1988
21-Jul-1985
21-Jul-1982
21-Jul-1979
21-Jul-1976
21-Jul-1973
21-Jul-1970
21-Jul-1967
21-Jul-1964
21-Jul-1961
21-Jul-1958
21-Jul-1955
21-Jul-1952
21-Jul-1949
21-Jul-1946
21-Jul-1943
21-Jul-1940
21-Jul-1937
21-Jul-1934
21-Jul-1931
21-Jul-1928
21-Jul-1925
21-Jul-1922
21-Jul-1919
21-Jul-1916
Fed Balance Sheet since 1916
as a share of GDP\GNP
0.3
0.25
0.2
0.15
0.1
0.05
0
Next Class:
Money and the Federal Reserve
47
9/6/2011