Banking: Basic
Operation and
Money
{
Modules 25 & 26

Banks are a financial intermediary
Two jobs
 Take deposits
 Provide loans (liquidity) to finance illiquid
investments by borrowers
 Role of the Federal Reserve is different
 “Dual Mandate” – full employment, low
inflation
 Banks cannot lend ALL their money

Banking

Banks must keep substantial quantities of
liquid reserves on hand (post Depression)
 Currency or deposits in the Federal Reserve
 Money in the bank vault

Banks must have sufficient assets to cover their
financial liabilities PLUS depositor withdraws
Banking
T-accounts


Summarize a business’s financial
position
STANDARD BUSINESS>
BANK>

Banks are different from standard
businesses in T-accounts
Must have some money set aside with the Fed
by law (assets column)
 Required Reserve Ratio – required amount of
deposits a bank must hold (usually 10%)

Bank runs and subsequent bank failure
 “Fractional Reserve Banking” – when central banks
require reserves

Banking

Money creation

Through their activity, banks actual
CREATE money
Banking
Paper money is obsolete and should be
removed from circulation all together.
Four-Corner Debate

Just a reminder:
M1 = measures money in
circulation and demand deposits
(checking)

Monetary Base



Sum of currency in circulation AND reserves held
by banks.
DIFFERENT- Bank reserves are NOT considered
part of the money supply, but ARE part of the
monetary base!
Checkable bank deposits, part of money supply
aren’t part of
monetary base

Money multiplier
Ratio of money supply to the monetary base
 Tells us the total number of dollars created in
the banking system by each $1 addition to
the monetary base


Simple money multiplier:
 $1/rr**
** rr = Reserve rate
Banking
SO:

If the reserve rate is 10% and the Fed
adds $100 to the monetary base, then the
money supply will increase BY:
1/.10 = 10
10x$100 = $1000

Assume money lent out is spent and will end up
back in another bank
 Some may keep cash in our wallet (leakage)
 Assumptions



Not worried about leakage
Banks lend out ALL their money (save Req.
Reserve Rate)
What if a bank keeps too much in reserves? –
excess reserves

What happens if rr falls?

Banking Regulations




Deposit Insurance
Capital Requirements
Reserve Requirements
Discount Window

The Federal Reserve

One of the most important, controversial
elements of the US economy


Many conspiracy theories about the founding of
the bank, the role of the bank, and its propensity
to create debt burdens.
Little government oversight, but not a private
entity
 Oversight through appointment
The Federal Reserve

Historic Analysis


Various “national banks” in our history
Panic of 1907



JP Morgan’s role
VERY similar to today (8% unemp)
 Trusts speculating on the stock market
(Knickerbocker Trust)
 United Copper Company’s stock
 Currency supply issues, credit markets frozen
Progressives feared Morgan’s power, and tried to
limit his influence

Jekyll Island gathering


Wealthiest men in America, politicians
gathered in secret to plan and organize a new
national bank.
1913- Federal Reserve Act instituted a new
national bank,
regulated, and
set basic
requirements for
lending and
currency
involvement.

Unanimously passed in Congress

Dual mandate of the Fed

Keep unemployment low and keep prices
(inflation) stable


This is achieved through open market
operations
Effectiveness?
 1930s issues
 Crisis in the 1980s
 2008 Recession
The Fed

The Federal Reserve System and
Function

Two parts to the Fed



Board of Governors (US Gov, appointed)
12 Regional Fed Banks (Private)
Functions




Provide Financial Services
 “bank for banks”
Supervise and Regulate Banks
Maintain stability of financial system
Conduct monetary policy
The Fed: Banking Functions

Fed Functions and Market
Performances

What if a bank has insufficient funds?
 Federal funds market




Borrow reserves from banks with excess!
Overnight loan, w/interest
Federal funds rate
Fed can adjust RR to alter money supply (last
time: 1992)
The Fed: Banking Functions

Discount Rate

Banks in need of RR funds can borrow
directly from the fed using the “discount
window”


Discount rate- usually 1% above the FFR to
encourage banks to borrow from each other
Fed can adjust to also alter money supply (ex2008 it was 0.25% interest!!)
 Cost of being short reserves falls,
encouraging banks to lend!
The Fed: Banking Functions

Open-Market operations

Mainly short-term (1 year) US Treasury bill
purchases



Purchased through commercial banks (financial
market banks)
BAD idea to buy directly from government
(historically terrible)
Pays banks for bills by crediting reserve
accounts of commercial banks
The Fed: Banking Functions

Fed creates the money to purchase the
bills


“Click of the mouse,” created at the Fed’s
own discretion
Does not directly enter the money
supply, BUT, sets the money multiplier in
motion

Increases reserves, commercial banks then
lend out excess reserves easier, which
increases money supply.
The Fed: Banking Functions
The Federal Reserve should be ended
because it has too much control over the
economy.
Four-Corner Debate