Topic 6
The Banking System and the Money Supply
1
What Counts as Money
• Definition of Money
Money is an asset that is widely accepted as a means of payment
• Only assets—things of value that people own—can be considered as
money
– Can credit cards be considered as money?
• Only things that are widely acceptable as a means of payment are
regarded as money
– Can stocks or bonds be considered as money?
• Money has two useful functions
– Provides a unit of account
• Standardized way of measuring value of things that are traded
– Serves as store of value
• One of several ways in which households can hold their wealth
2
Measuring the Money Supply
• Money Supply
– Total amount of money held by the public
• Governments use different measures of the money supply
– Each measure includes a selection of assets that are widely
acceptable as a means of payment and are relatively liquid
• An asset is considered liquid if it can be converted to cash quickly and
at little cost
– So, an illiquid asset can be converted to cash only after a delay, or at
considerable cost
3
Assets and Their Liquidity
• Most liquid asset is cash in the hands of the public
• Next in line are asset categories of about equal liquidity
– Demand deposits (Checking accounts)
– Other checkable deposits
– Travelers checks
• Then, savings-type accounts
– less liquid than checking-type accounts, since they do not allow
you to write checks
• Next on the list are deposits in retail money market mutual
funds
– Time deposits (called certificates of deposit, or CDs)
• Require you to keep your money in the bank for a specified period of
time (usually six months or longer)
– Impose an interest penalty if you withdraw early
4
Figure 1: Monetary Assets and Their
Liquidity (July 14, 2003)
5
M1 And M2
• Standard measure of money stock (supply) is M1
– Sum of the first four assets in our list
• M1 = cash in the hands of the public + demand deposits +
other checking account deposits + travelers checks
– When economists or government officials speak about
“money supply,” they usually mean M1
• Another common measure of money supply, M2,
adds some other types of assets to M1
– M2 = M1 + savings-type accounts + retail MMMF
balances + small denomination time deposits
6
M1 And M2
Money Supply
• We will assume money supply consists of just two
components
– Cash in the hands of the public and demand deposits
• Our definition of the money supply corresponds closely to
liquid assets that our national monetary authority—the
Federal Reserve—can control
8
The Banking System: Financial
Intermediaries
• What are banks?
– Financial intermediaries—business firms that specialize in
• Collecting loanable funds from households and firms whose revenues
exceed their expenditures
• Channeling those funds to households and firms (and sometimes the
government) whose expenditures exceed revenues
• Intermediaries must earn a profit for providing brokering
services
– By charging a higher interest rate on funds they lend than rate they
pay to depositors
9
A Bank’s Balance Sheet
• A balance sheet is a financial statement that provides information
about financial conditions of a bank at a particular point in time
– On one side, a bank’s assets are listed
• Everything of value that it owns
–
–
–
–
–
Property and buildings
Bonds
Loans
Vault cash
Account with the Federal Reserve
– On the other side, the bank’s liabilities are listed
• Amounts it owes
– Deposits
– Net worth = Total assets – Total liabilities
• What bank would owe to its owners if it went out of business
– A balance sheet always balances
10
A Bank’s Balance Sheet
• Explanations for vault cash and accounts with Federal
Reserve
– On any given day, some of the bank’s customers might want to
withdraw more cash than other customers are depositing
– Banks are required by law to hold reserves
• Sum of cash in vault and accounts with Federal Reserve
• Required reserve ratio tells banks the fraction of their
checking accounts that they must hold as required
reserves
– Set by Federal Reserve
11
Figure 2: The Geography of the
Federal Reserve System
12
Figure 3: The Structure of the
Federal Reserve System
13
Federal Reserve Functions
•
•
•
•
•
•
•
Issue currency
Set reserve requirements
Lend money to banks
Collect checks
Act as a fiscal agent for U.S. government
Supervise banks
Control the money supply
Federal Reserve Independence
• Established by Congress as an
•
•
independent agency
Protects the Fed from political pressures
Enables the Fed to take actions to
increase interest rates in order to stem
inflation as needed
The Federal Open Market Committee
• Federal Open Market Committee (FOMC)
– A committee of Federal Reserve officials that establishes U.S.
monetary policy
• Consists of all 7 governors of Fed, along with 5 of the 12
district bank presidents
• Not even President of United States knows details behind
the decisions, or what FOMC actually discussed at its
meeting, until summary of meeting is finally released
– The FOMC exerts control over nation’s money supply by buying
and selling bonds in public (“open”) bond market
16
The Fed and the Money Supply
• Suppose Fed wants to change nation’s money supply
– It buys or sells government bonds to bond dealers, banks, or other
financial institutions
• Actions are called open market operations
• We’ll make two special assumptions to keep our analysis
of open market operations simple for now
– Households and business are satisfied holding the amount of cash
they are currently holding
• Any additional funds they might acquire are deposited in their
checking accounts
• Any decrease in their funds comes from their checking accounts
– Banks never hold reserves in excess of those legally required by
law
17
How the Fed Increases the Money
Supply
• To increase money supply, Fed will buy government
bonds
– Called an open market purchase
• Suppose, by writing a check, Fed buys $1,000 bond from
Lehman Brothers, which deposits the total into its checking
account
– Two important things have happened
• Fed has injected reserve into banking system
• Money supply has increased
– Demand deposits have increased by $1,000 and demand deposits are
part of money supply (for instance, M1)
– Lehman Brothers’ bank now has excess reserves
» Reserves in excess of required reserves
» If required reserve ratio is 10% bank has excess reserves of $900 to
lend
» Demand deposits increase each time a bank lends out excess
reserves
18
The Demand Deposit Multiplier
• How much will demand deposits increase in total?
– Each bank creates less in demand deposits than the bank before
– In each round, a bank lends 90% of deposit it received
– So, the total increase in demand deposits is
DD  1000  900  810  729       
So, DD  1000  1000  0.9  1000  0.9 2  1000  0.9 3       
 1000  1  0.9  0.9 2  0.9 3      
1
1000
 1000 

1  0.9 Required Reserve Ratio
 1000 10
 10000
• Whatever the injection of reserves, demand deposits will increase by a
factor of 10, so we can write
– ΔDD = 10 x reserve injection
19
The Demand Deposit Multiplier
• For any value of required reserve ratio (RRR), formula for
demand deposit multiplier is 1/RRR
• Using general formula for demand deposit multiplier, can
restate what happens when Fed injects reserves into
banking system as follows
– ΔDD = (1 / RRR) x ΔReserves
• With the assumption that the amount of cash in the hands
of the public (the other component of the money supply)
does not change, we can also write
– ΔMoney Supply = (1 / RRR) x ΔReserves
20
How the Fed Decreases the Money
Supply
• Just as Fed can decrease money supply by selling
government bonds
• An open market sale
• Banks have to call in loans in order to meet the required
reserve amount with Fed
• Process of calling in loans will involve many banks
– Each time a bank calls in a loan, demand deposits are destroyed
– Total decline in demand deposits will be a multiple of initial
withdrawal of reserves
– Using demand deposit multiplier—1/(RRR), we can calculate the
decrease in money supply with the same formula
• ΔDD = (1/RRR) x Δreserves
• This time, the change in reserve is negative
21
Some Important Provisos About the
Demand Deposit Multiplier
• Although process of money creation and destruction as
we’ve described it illustrates the basic ideas, formula for
demand deposit multiplier—1/RRR—is oversimplified
– In reality, multiplier is likely to be smaller than formula suggests, for
two reasons
• We’ve assumed that as money supply changes, public does
not change its holdings of cash
• We’ve assumed that banks will always lend out all of their
excess reserves
22
Other Tools for Controlling the
Money Supply
• There are two other tools Fed can use to increase or
decrease money supply
– Changes in required reserve ratio
– Changes in discount rate
• Changes in either required reserve ratio or discount rate
could set off the process of deposit creation or deposit
destruction in much the same way outlined in this chapter
– In reality, neither of these policy tools is used very often
• Why are these other tools used so seldom?
– Partly because they can have unpredictable effects
23
The Financial Crisis of 2007 and 2008
• Mortgage Default Crisis
• Many causes
–Government programs that
encouraged home ownership
–Declining real estate values
–Bad incentives provided by
mortgage-backed bonds
The Financial Crisis of 2007 and 2008
• Securitization- the process of slicing up
•
•
and bundling groups of loans into new
securities
As loans defaulted, the system collapsed
“Underwater” homeowners abandoned
homes and mortgages