Chapter 29
Banking and the Money
Supply
© 2006 Thomson/South-Western
1
Definitions of the Money Supply: M1
Money aggregates: measures of the
economy’s money supply – M1, M2, M3
M1: the narrowest measure of money
supply: currency, including coins, held by
 Non-banking
public
 Checkable deposits:
 Deposits
in financial institutions against which checks
can be written and ATM or debit cards can be applied
 Travelers
checks
2
Definitions of the Money Supply: M2
Includes M1, plus
Savings deposits
Earn interest, but have no specific maturity date
Time deposits
called certificates of deposit, or CDs, specific
maturity date
Money market mutual funds
carry additional restrictions
3
Definitions of the Money Supply: M3
Includes M2, plus
 large-denomination
time deposits ($100,000
or more)
M3 is less liquid than M2,
Which is less liquid than M1
4
Exhibit 1: Alternative Measures of the
Money Supply
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Credit Cards
Definitions of money include debit cards
but not credit cards
Credit cards offer an easy way to get a
loan from the card issuer
Money isn’t needed until the credit car
holder must repay the credit card issuer
The credit card has not eliminated the
use of money, merely delayed it
6
Debit Cards
Debit Card
 Check
card
 Combines the functions of an ATM and
check
 Safer than credit cards
Disadvantages
 Draw
down checking account immediately
 Cannot dispute bill or withhold or stop
payment
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Financial Intermediaries
Banks serve as financial intermediaries, or as
go-betweens by bringing together the two sides
of the money market
Banks reduce the transaction costs of
channeling savings to credit worthy borrowers
Coping with asymmetric information
Reducing risk through diversification
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Asymmetric Information
As lenders, banks try to identify borrowers who
are willing to pay interest and are able to repay
the loans
However, borrowers have more reliable
information about their own credit history and
financial plans than do lenders: in the market
for loans there is asymmetric information – an
inequality in what’s known by each party to the
transaction
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Asymmetric Information
Because they have experience in
evaluating applicants, banks have a
greater ability to cope with asymmetric
information and draw up and enforce
contracts than would an individual saver
 Savers
are better off dealing with banks
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Reducing Risk
By developing a diversified portfolio of assets
rather than lending funds to a single borrower,
banks reduce the risk to each individual saver
A bank, in effect, lends a tiny fraction of each
saver’s deposits to each of its many borrowers
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Starting a Bank
Founders obtain a charter, or the right to
operate, by appling to the state banking
authority (for a state bank) or to the U.S.
Comptroller of the Currency (for a national
bank)
The founders invest $500,000 for shares which
become the owner’s equity or the net worth of
the bank
Part of this goes to the Fed to buy shares in
their district bank, leaving $450,000
12
Exhibit 2: Home Bank’s Balance Sheet
Balance sheet shows a balance between the two sides of the bank’s
accounts:
The left side lists the bank’s assets (any physical property or financial
claim owned by the bank)
The right side lists the bank’s liabilities (an amount the bank owes) and
net worth
Reflects the basic equality that Assets = Liabilities + Net Worth
13
Exhibit 3: Home Bank’s Balance Sheet
after $1,000,000 Deposit
Suppose a customer deposits $1,000,000 into a new checking account.
In accepting this, the bank promises to repay the depositor that amount – it is a
liability to the bank: bank’s assets and liabilities both increase by $1,000,000
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Reserve Accounts
Recall that banks are required by the Fed to set
aside, or to hold in reserve, a percentage of
their checkable deposits
The dollar amount that must be held in reserve
is called required reserves: checkable deposits
multiplied by the required reserve ratio
The required reserve ratio dictates the
minimum proportion of deposits the bank must
hold in reserve
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Reserve Accounts
The current reserve requirement is 10%
on checkable deposits, held either as cash
in the bank’s vault or as deposits at the
Fed, but neither earns the bank any
interest
In our example, Home Bank must
therefore hold $100,000 as reserves
($1,000,000 * .10)
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Reserve Accounts
If Home Bank deposits their required
reserves with the FED, they now have
$900,000 in excess reserves held as cash
in the vault
Excess reserves have two additional uses
They can be used to make loans, or
To purchase interest-bearing assets, such as
government bonds
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Liquidity versus Profitability
Management of a bank must structure the
portfolio of assets with an eye towards
Liquidity
Profitability
Liquidity is the ease with which an asset can be
converted into cash without a significant loss of
value – if all of its cash held is as reserves, it
forgoes profits
At the other extreme, if the bank uses all its
excess reserves to acquire high-yielding but
illiquid assets, it will run into problems whenever
withdrawals exceed new deposits
18
Federal Funds Market
Federal funds market: a market for
overnight lending and borrowing of
reserves among banks; the market for
reserves on account at the Fed
The interest rate paid on these loans is
called the federal funds rate, the rate that
the Fed targets as a tool of monetary
policy
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How Banks Create Money
Notice the pattern of deposits and loans in the
money creation process:
Each time a bank gets a fresh deposit, 10% goes to
required reserves
The rest becomes excess reserves, which fuel new
loans or other asset acquisitions
An individual bank can lend no more than its
excess reserves
When the borrower spends the amount loaned,
reserves at one bank usually fall, but total
reserves in the banking system do not
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How Banks Create Money
The recipient bank uses most of the new
deposit to extend more loan, more
checkable deposits
The potential expansion of checkable
deposits in the banking system equals
some multiple of the initial increase in
reserves
21
Exhibit 7: Summary
During each round, the increase in checkable deposits (1) minus the increase in
required reserves (2) equals the potential increase in loans (3). Checkable deposits
in this example can potentially increase by as much as $10,000.
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Reserve Requirements and Money Expansion
Money multiplier: the multiple by which
the money supply increases as a result of an
increase fresh reserves in the banking
system
The simple money multiplier equals the
reciprocal of the required reserve ratio, or
1 / r, where r is the reserve ratio
 It
is the maximum multiple of fresh reserves
by which the money supply can increase
23
Checkable Deposits / Money Supply
The formula for the multiple expansion of
the money supply can be written as
Change in the money supply = Change in
reserves x 1/r
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Money Multiplier
The higher the reserve requirement, the greater
the fraction of deposits that must be held as
reserves and the smaller the money multiplier
Reserve requirement of 20% = money
multiplier of 5
Reserve requirement of 5% = money multiplier
of 20
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Limitations on Money Expansion
Various leakages from the multiple
expansion process reduce the size of the
money multiplier. Assume that
Banks do not let excess reserves sit idle
Borrowers do something with the money
People do not choose to increase their cash
holdings
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Contraction of the Money Supply
Fed’s sale of government bonds reduces
bank reserves, forcing banks to recall
loans or to somehow replenish reserves
and the same multiple contraction would
work
For example, with a reserve requirement
of 10%, a $1,000 sale of bonds would
reduce the checkable deposits and the
money supply by a maximum of $10,000
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Tools for Controlling Reserves
The Fed has three tools for controlling
reserves
 Conducting
open market operations, buying
and selling of U.S. government bonds
Setting the discount rate, the interest rate
the Fed charges for loans it makes to banks
Setting the required reserve ratio, the
minimum fraction of reserves that banks
must hold against deposits
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Open Market Operations
Open market operations refers to the buying
and selling of U.S. government bonds in the
open market
To increase the money supply, the Fed buys U.S.
bonds: open-market purchase
To reduce the money supply, the Fed sells U.S.
bonds: open-market sale
Advantage of open-market operations
Relatively easy to carry out
Require no change in laws or regulations
Can be executed in any amount
The tool of choice by the Fed
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Federal Funds Market
Through open-market operations, the Fed
influences bank reserves and the federal funds
rate
Recall that the federal funds rate is the interest
rate banks charge one another for borrowing
excess reserves at the Fed, typically overnight
Banks that are unable to meet their legal
reserve requirements can borrow in the federal
funds market
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Federal Funds Market
The federal funds rate serves as a good
indicator of the tightness of monetary policy
For example, suppose the Fed buys bonds in
the open market and thereby increases reserves
in the banking system
 banks
have more excess reserves
 demand for excess reserves falls while the supply
increases
 the federal funds rate declines
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Discount Rate
Discount rate is the interest rate the Fed
charges on loans it makes to banks
Banks can borrow from the Fed when they
need reserves to satisfy their reserve
requirements
By lowering or raising the discount rate, the
Fed encourages or discourages banks from
borrowing, which alters reserves and affects the
money supply
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Discount Rate
A lower discount rate reduces the cost of
borrowing, encouraging banks to borrow
reserves from the Fed
 more
bank lending leads to an increase in the money
supply
Higher discount rate increases the cost of
borrowing reserves from the Fed
 less
bank lending leads to reduced money supply
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Reserve Requirements
Reserve requirements are the regulations
regarding the minimum amount of
reserves that banks must hold to back up
deposits
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Reserve Requirements
If the Fed increases the reserve
requirement, banks must hold more
reserves
a
reduction in the fraction of each dollar that
can be lent out
 reduces the banking system’s ability to
create money
35
Reserve Requirements
Conversely, a decrease in the reserve
requirement increases the fraction of each
dollar on deposit that can be lent out, which
increases the banking system’s ability to create
money
Reserve requirements can be changed by a
simple majority vote by the Board of
Governors
Since even a small change in the reserve
requirement can be disruptive, the Fed seldom
employs this tool
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Exhibit 8: Federal Reserve Bank Balance Sheet
as of December 31, 2003 (millions of dollars)
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