Money, Banking, and
the Federal Reserve
System
Chapter 14
The Meaning of Money

Money is an asset that can easily be used to purchase
goods and services.

Currency in circulation is cash held by the public.

Checkable bank deposits are bank accounts on which
people can write checks.

The money supply is the total value of financial assets in
the economy that are considered money.


Narrowest: currency in circulation, traveler’s checks, and
checkable bank deposits (M1)
Broader: currency in circulation, traveler’s checks, and
checkable bank deposits PLUS “almost” checkable—savings
accounts. (M2)
Global Comparison: Currency
Roles of Money
1.
Medium of exchange
2.
Store of value
3.
Unit of Account
Money of Medium of Exchange

A medium of exchange is an asset that
individuals acquire for the purpose of
trading rather than for their own
consumption.

Money makes the transactions easier.

The alternative is barter.
Money as Store of Value

A store of value is a means of holding
purchasing power over time.

Money keeps its value over time.

What can threaten the “store of value” of
money?
Money as Unit of Account

A unit of account is a measure used to set
prices and make economic calculations.

Money as a unit of account allows one to
compare the values of goods and
services.
Types of Money

Commodity Money



Representative Money



Good that is used as a medium of exchange that has value in its
own right.
Examples are gold and silver.
Commodity-backed money is a medium of exchange with no
intrinsic value whose ultimate value is guaranteed by a promise
that it can be converted into valuable goods.
An example is a bank note redeemable for a commodity like gold
or silver.
Fiat Money

Something that has value because government says that it has
value—US $.
Measuring the Money Supply

Monetary Aggregates
 An overall measure of the money supply
 Federal Reserve calculates the size of two
monetary
aggregates

M1: currency in circulation, traveler’s checks,
and checkable bank deposits

M2: currency in circulation, traveler’s checks,
and checkable bank deposits PLUS “almost”
checkable—savings accounts—example of
near-moneys.
Monetary Aggregates, Sept. 2011
Monetary Role of Banks

A bank is a financial intermediary that uses liquid assets
in the form of banks deposits to finance the illiquid
investments of borrowers.

Bank reserves are the currency banks hold in their vaults
plus their deposits at the Federal Reserve.

The reserve ratio is the fraction of bank deposits that a
bank holds as reserves.

T-account summarizes a bank’s financial position


Bank’s assets include its reserves as well as loans
Bank’s liabilities include the deposits it holds.
Bank Regulation

A bank run is a phenomenon in which many of a bank’s depositors try to
withdraw their funds due to fears of a bank failure.

Deposit insurance guarantees that a bank’s depositors will be paid even if
the bank does not have the funds, up to a maximum per account.

Federal Deposit Insurance Corporation (FDIC) currently guarantees the first
$250,000 held in each account at a bank.

Capital requirements are requirements by the Federal Reserve that bank
owners hold substantially more assets than the value of bank deposits.

Reserve requirements are rules set by the Federal Reserve that determine
the minimum reserve ratio for a bank. (10%)

The Federal Reserve lends money to banks through an arrangement known
as the discount window.
Reserves, Bank Deposits, and the
Money Multiplier

Excess reserves are a bank’s reserves over and above
its required reserves.

Money is created when a bank loans any excess
reserves it holds.

Banks lending leads to new deposits in the banking
system and a multiplier effect on the money supply.

In a checkable-deposits-only system, the money supply
equals bank reserves divided by the reserve ratio.
Determining the Money Supply
How Banks Create Money
Practice:
1.
The A&Z Bank has $250,000 in deposits. If the
reserve ratios is 10%, how much of these
deposits must the bank hold in reserve?
2.
How much in loans can the A&B Bank issue in
the given situation?
3.
What does the T-Account for A&B Bank look
like?
ASSETS
Loans
$225,000
Reserves $25,000
LIABILITIES
Deposits $250,000
Practice:
4.
Steve deposits his $15,000 Christmas bonus
into his savings account at the New Market
Bank. If the required reserve ratio is 15%, how
much must the bank hold in required reserves?
5.
Sam deposits $5,000 in cash into his checking
account at the First Bank of Macroland. If the
required reserve ratio is 20% what are the
bank’s excess reserves?
Money Multiplier in Reality

Federal Reserve controls the sum of bank reserves and
currency in circulation, monetary base.

The money multiplier is the ratio of the money supply to
the monetary base.

The size of the money
multiplier is reduced when
funds are held as cash rather
than as checkable deposits.

In reality, the money multiplier is
smaller than the bank reserves
divided by the reserve ratio.
Money Multiplier
Monetary
multiplier


=
1
required reserve ratio
Assume reserve requirement = 20%
$100 put in bank
Graphic
Example
1. = 1 =
rr
.2
=
1
rr
5
New Reserves
$100
$80
Excess
Reserves
$400
Bank System Lending
$20
Required
Reserves
$100
Initial
Deposit
Money Created
32-18
Think, Pair, Share

What is the difference between the
monetary base and the money supply?

Bank reserves are in the monetary base
and not in the money supply.
Structure of the Federal Reserve

A central bank is an institution that oversees and
regulates the banking system and controls the monetary
base.

Federal Reserve, established in 1913, is the central bank
of the US.

Federal Reserve system consists of:


Board of Governors
12 regional Federal Reserve banks that provide various banking
and supervisory services to commercial banks.
Federal Reserve Regions
Federal Reserve System

Seven members of the Board of Governors are appointed by the
president with Senate approval.



Serve 14-year terms
Terms staggered so one member is replaced every two years. (above
political pressure)
The chairman of the Fed is appointed by the president with Senate
approval and serves a four-year term with possible reappointment.
Ben Bernake (2006 to Present)
Alan Greenspan (1987 to 2006)
Role of Federal Reserve

A bank to banks and to the Federal government

Regulate the banks in their district

Provide a safe and stable financial system

Implement Monetary Policy
Policy Tools of Fed

Reserve requirements


Increase or decrease the amount that banks must hold in reserve.
Discount rate

The federal funds market allows banks that fall short of the reserve
requirement to borrow funds from banks with excess reserves.
 Interest rate the Fed charges banks to borrow for reserves
 Rate is normally 1% above the federal funds rates although reduced in
2007 with financial crisis.

Open-market operations

An open-market operation is a purchase or sale of government debt by
the Fed.
 The Federal Reserve’s assets include government debt, mainly in the
form of US Treasury bills.
 The Fed’s liabilities include the currency in circulation plus bank
reserves which comprise the monetary base.
Open-Market Operations

Federal Open Market Committee comprised of


Board of Governors
President of the New York Federal Reserve Bank + five other regional
Federal Reserve Bank presidents

Federal Open Market Committee makes decisions regarding
monetary policy.|

An open-market purchase of Treasury bills increases the monetary
base and the money supply.
An open-market sale of Treasury bills decreases the monetary
base and money supply.

European Central Bank

Created in January 1999 when 11 European
nations decided to adopt the euro as their
common currency.

Equivalent to the Fed’s Board of Governors
Overview of 21st Century American
Banking System

Crisis at turn of century



1907 panic originated in less regulated institutions known as trusts
The Fed was created in response to panic to centralize holding of reserves,
inspect banks’ books and make the money supply sufficiently responsive to
varying economic situations.
Responding to bank crises


Widespread banks runs in the early 1930s
Emergency measures were adopted that gave RFC powers to stabilize and
restructure banking industry
 Glass-Steagall Act (1933) separated banks into 2 categories:




Commercial bank accepts deposits and is covered by deposit insurance
Investment bank trades in financial assets (stocks and corporate bonds) and is not
covered by deposit insurance.
Adoption of federal deposit insurance was most important to stop bank runs.
Regulation Q prevented commercial banks from paying interest on checking
accounts.
 With a long period of financial and banking stability, regulation Q was eliminated
in 1980 and Glass-Steagall Act significantly weakened by 1999.
Overview of 21st Century American
Banking System

Savings and Loan Crisis of 1980s
A
savings and loan (thrift) is a type of deposit-taking
bank, usually specialized in home loans.
 Crisis
of 1980s caused sharp losses in the financial
and real estate sectors, resulting in an early 1990s
recession.
Overview of 21st Century American
Banking System

Financial Crisis of 2008

Long-term Capital Management (LTCM) was a hedge fund
created in 1994.




A financial institution engages in leverage when it finances its
investments with borrowed funds.
Balance sheet effect is when sales of assets depress asset prices
all over the world and other firms see the value of their balance
sheets fall.
When asset prices falling from the balance sheet effect go below a
critical threshold, creditors call in loans--leading to more asset sales
as borrowers try to get cash to repay loans-leading to more
defaults-leading to more declines in asset prices-leading to more
loans called in and thus a vicious cycle of deleveraging.
Federal Reserve Bank of New York arranged a $3.625 billion
bailout of LCTM in 1998 and revived world credit markets.
Overview of 21st Century American
Banking System

Financial Crisis of 2008

Subprime lending and the housing bubble




Subprime lending involves loans to people who don’t meet the usual
criteria for borrowing and for being unable to afford their payments.
Securitization is the process of assembling pools of loans and
selling shares in the income from these pools.
Housing boom turned out to be a bubble. When it burst, banks and
nonbank financial instructions led to widespread collapse in the
financial system.
Crisis and Response


Collapse of trust in the financial system, combined with large losses
suffered by financial firms, led to a severe cycle of deleveraging and
a credit crunch for the economy.
As the crisis originated in nontraditional banks institutions, the crisis
of 2008 indicated a wider safety net and broader regulation are
needed in the financial sector.