PART SIX
Money, Banking, and
Monetary Policy
Chapter 15: Money and
Banking
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
The Functions of Money
The three functions of money are:



medium of exchange
unit of account
store of value
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The Components
of the Money Supply


Two definitions of the U.S. money supply
are M1 and M2.
M1 is the narrowest definition of the
money supply, whereas M2 is a more
broadly defined money supply.
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Money Definition: M1
M1 money = currency + checkable deposits
Currency includes coins and paper money.
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All coins in circulation are token money.
Paper money, issued by the Federal Reserve
Banks, are known as Federal Reserve Notes.
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Money Definition: M1

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Checkable deposits (checkbook money)
are a large component of the stock of
money in the U.S..
These are deposits in commercial banks
and “thrifts” or savings institutions against
which checks may be written.
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Institutions That Offer
Checkable Deposits

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Commercial banks are the primary
deposit institutions in the U.S..
 These institutions accept deposits, offer
checking accounts and make loans.
Thrift institutions include savings and
loan associations (S&Ls), credit unions
and mutual savings banks.
 These “thrifts” offer savings and
checking accounts.
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
M1 Exception


Currency held at commercial banks and
other financial institutions is excluded from
M1 and other measures of the money
supply.
This prevents the error of double counting.
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Money Definition. M2
M2 money = M1 + near monies
Near monies are financial assets that do
not directly serve as a medium of exchange
but can be easily converted into M1.

Near monies include savings deposits
(including money market deposit accounts),
small time deposits (less than $100,000), and
money market mutual funds.
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What “Backs”
the Money Supply?
The U.S. money supply is guaranteed by
government’s ability to keep the value of
money relatively stable.
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Value of Money
Money has value because of its
acceptability, legal tender designation, and
relative scarcity.

Government has decreed currency as legal
tender; paper money is a valid and legal
means of payment of debt.
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Money and Prices


The purchasing power of money is the
amount of goods and services a unit of
money will buy.
The purchasing power of the dollar varies
inversely with the price level.

If the price level rises, the purchasing power of
the dollar falls, and vice versa.
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Money and Prices

Inflation may also affect the purchasing
power of money and its acceptability.
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When the government prints too much money,
the purchasing power of money declines.
Also, runaway inflation may significantly
reduce the purchasing power of the dollar and
may cause it to cease being used as a
medium of exchange.
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
The Federal Reserve System
and The Banking System


A key element of the U.S. banking system
is the Federal Reserve System (the “Fed”).
The Fed consists of the Board of
Governors of the Federal Reserve and 12
regional Federal Reserve Banks.
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
The Federal Reserve System
and The Banking System
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
The Federal Reserve System
and The Banking System
Board of Governors

The seven-member group that supervises and
controls the money and banking system of the
U.S..
The 12 Federal Reserve Banks


The 12 banks chartered by the U.S.
government to control the money supply and
perform other functions.
They collectively serve as the nation’s “central
bank” and also serve as bankers’ bank.
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
The Federal Reserve System
and The Banking System
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
The Federal Reserve System
and The Banking System
Federal Open Market Committee
(FOMC)


The FOMC is the 12 member Federal Reserve
group determines the purchase and sale
policies of the Federal Reserve Banks in the
market for U.S. securities.
The Federal Reserve Bank in New York City
conducts most of the Fed’s open market
operations.
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
The Federal Reserve System
and The Banking System
Commercial Banks and Thrifts


Of the approximately 7600 commercial banks,
three-fourths are state banks, while the
remaining one-fourth are national banks,
chartered by the Federal government to
operate nationally.
The 11,400 thrift institutions are regulated by
agencies separate and apart from the Board
of Governors and the Federal Reserve Banks.
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Fed Functions and
Responsibilities

The Fed performs the following functions.

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Issues currency
Sets reserve requirements and holds reserves
Lends money to banks and thrifts
Provides the banking system with a means for
collecting checks
Acts as a fiscal agent for the Federal government
Supervises the operation of banks
Controls the money supply
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Fed Reserve Independence


The Federal Reserve is an independent
agency of the government.
This protects the Fed from political pressure
so that it could effectively control the money
supply and interest rates to foster price-level
stability.
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The Fractional
Reserve System

The U.S. has a fractional reserve banking
system.


A fractional reserve banking system is one
in which banks and thrifts are required to hold
less than 100 percent of their checkabledeposit liabilities as cash reserves.
Only a portion of the total money supply is
held in reserve as currency.
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
A Single Commercial Bank


The fractional reserve banking system can
be better understood by analyzing a
commercial bank’s balance sheet.
A balance sheet is a statement of the
assets, liabilities, and net worth of a firm,
individual, or institution at some time.
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A Single Commercial Bank

We will analyze the following transactions.
1. Creating a Bank
2. Acquiring Property and Equipment
3. Accepting Deposits
4. Depositing Reserves in a Federal Reserve
Bank
5. Clearing a Check Drawn Against the Bank
6. Granting a Loan (Creating Money)
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Creating a Bank

To create a bank, an individual must
secure a state or national charter and sell
stock certificates to buyers. This creates
outstanding stock certificates and cash on
hand equal to the value of the certificates.
Balance Sheet 1
Assets
Liabilities and net worth
Cash $250,000
Stock shares
$250,000
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Acquiring Property
and Equipment

The bank’s owners must then acquire
property (a building) and equipment. It
uses cash on hand to make these
purchases.
Balance Sheet 2
Assets
Liabilities and net worth
Cash
$10,000 Stock shares
$250,000
Property $240,000
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Accepting Deposits

Once the bank is operating, suppose
businesses and citizens open up accounts
and deposit $100,000 in the bank.
Balance Sheet 2
Assets
Liabilities and net worth
Cash
$110,000 Checkable
Property $240,000
deposits
$100,000
Stock shares
$250,000
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Depositing Reserves in
a Federal Reserve Bank


All commercial banks and thrifts that
provide checkable deposits must by law
keep required reserves.
Required reserves are an amount of
funds equal to a specified percentage of
the bank’s own deposit liabilities.

Required reserves must be kept on deposit
with the Federal Reserve Bank or held as
cash in the bank’s vault.
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Depositing Reserves in
a Federal Reserve Bank

The “specified percentage” of checkable
deposit liabilities that a commercial bank
must be keep as reserves is known as the
reserve ratio.
Reserve
bank’s required reserves
=
ratio
bank’s checkable-deposit liabilities
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Depositing Reserves in
a Federal Reserve Bank

If the Fed sets a reserve ratio of 20
percent, the bank must hold $20,000 in
required reserves ($100,000 x .2 =
$20,000)
Balance Sheet 3
Assets
Liabilities and net worth
Cash
$108,000 Checkable
Reserves $2,000
deposits
$100,000
Property $240,000 Stock shares
$250,000
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Depositing Reserves in
a Federal Reserve Bank

If the bank decides to hold all its cash in
reserves with the Fed, then its cash
amount will be zero.
Balance Sheet 4
Assets
Liabilities and net worth
Cash
$0 Checkable
Reserves $110,000 deposits
$100,000
Property $240,000 Stock shares
$250,000
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Depositing Reserves in
a Federal Reserve Bank



When a bank holds more in reserves then
is required, it holds excess reserves.
Excess reserves are actual bank or thrift
reserves minus legally required reserves.
Actual reserves are the funds that a bank
or thrift has on deposit at the Federal
Reserve Bank or is holding as vault cash.

Our bank has $90,000 (=$110,000 - $20,000)
in excess reserves.
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Clearing a Check
Drawn against the Bank

Suppose a bank customer writes a
$50,000 check against her deposit
account. As the check clears through the
Federal Reserve Bank, it reduces our
bank’s reserves by $50,000. The bank
also reduces its customer’s deposit
account by $50,000.
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Clearing a Check
Drawn against the Bank
Balance Sheet 5
Assets
Liabilities and net worth
Reserves $60,000 Checkable
Property $240,000
deposits
$50,000
Stock shares
$250,000
 Whenever a check is drawn against one bank
and deposited in another bank, collection of
that check will reduce both the reserves and
the checkable deposit of the bank on which
the check is drawn.
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Granting a Loan
(Creating Money)


Suppose a bank customer desire a loan
from our bank of $50,000. When the loan
is approved, the customer signs a
promissory note to repay the loan plus
some amount of interest in the future.
The customer’s deposit account increases
by $50,000 and the bank’s loans increase
by $50,000.
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Granting a Loan
(Creating Money)

When a bank makes loans, it creates
money.
Balance Sheet 6
Assets
Liabilities and net worth
Reserves $60,000 Checkable
Loans
$50,000
deposits
$100,000
Property $240,000 Stock shares
$250,000
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Granting a Loan
(Creating Money)


If the borrower turns around and writes a
check for $50,000 to another individual,
this changes the balance sheet.
When the individual deposits the check
into his account somewhere else, the
check is collected and clears in the same
manner described in balance sheet 5.
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Granting a Loan
(Creating Money)

The bank’s assets and liabilities are both
reduced by $50,000.
Balance Sheet 7
Assets
Liabilities and net worth
Reserves $10,000 Checkable
Loans
$50,000
deposits
$50,000
Property $240,000 Stock shares
$250,000
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The Banking System:
Multiple-Deposit Expansion


An individual bank can only lend an
amount equal to its excess reserves, but
the commercial banking system can lend
by a multiple of its excess reserves.
The banking system magnifies any original
excess reserves into a larger amount of
newly created checkable-deposit money.
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The Monetary Multiplier
The monetary multiplier, m, is the
multiple of its excess reserves by which
the banking system can expand checkable
deposits and thus the money supply by
making new loans.
1
Money
=
Multiplier required reserve ratio
or, m = 1/R
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The Monetary Multiplier


The maximum checkable-deposit creation,
D, is equal to total excess reserves, E,
times the monetary multiplier, or, in
symbols,
D=Exm
For example, if R = .20, m = 5 (1/.20).
If excess reserves is $80, then D = $80 x 5
= $400.
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Reversibility: The Multiple
Destruction of Money


Just as banks can create money through
loans, money is destroyed when loans are
paid off.
Loan repayment sets off a process of
multiple destruction of money akin to the
multiple creation process.
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.