What Counts as Money
 Money has several 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
 Yet credit cards are not considered money, even though you
can use them to buy things
 Why is this?
 A more formal definition of money helps to answer questions
like this
 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

The right to borrow is not an asset - that is why credit limit on your
credit card, or your ability to go into a bank and borrow funds, is
not considered money
Only things that are widely acceptable as a means of payment are
regarded as money

Other assets—such as stocks and bonds or even gold bars—cannot
generally be used to pay for goods and services

They fail the acceptability test
Measuring the Money Supply
 Amount of money in circulation can affect
macroeconomy
 Money Supply
 Total amount of money held by the public
 In practice, measuring money supply is not as
straightforward as it might seem
 Governments have decided best way to deal with
them is to have different measures of the money
supply
 In effect, alternative ways of defining what is and
what is not money
 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

An illiquid asset can be converted to cash only after a
delay, or at considerable cost


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


Other checkable deposits


Catchall category for several types of checking accounts that work very
much like demand deposits - includes automatic transfers from saving
account
Travelers checks


Checking accounts held by households and business firms at commercial
banks
Specially printed checks that you can buy from banks or other private
companies, like American Express – can be easily spent at almost any hotel
or store
Savings-type accounts


At banks and other financial institutions
Are less liquid than checking-type accounts, since they do not allow you to
write checks
Assets and Their Liquidity
 Next on the list are deposits in retail money
market mutual funds – which use customer
deposits to buy a variety of financial assetsdepositors can withdraw their money by
writing checks.
 Time deposits (sometimes 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
Figure 1: Monetary Assets and
Their Liquidity (May 23, 2005)
Demand
Deposits
($332 billion)
+
Savings
Type
Other
Accounts
Checkable
Deposits ($3,512 billion)
($324 billion)
Cash in the
Hands of the
Public
($706 billion)
More Liquid
+
Travelers
Checks
($8 billion)
Money
Large
Small
Market
Time
Time
Mutual
Deposits
Deposits ($1189 billion)
Funds
($700 billion) ($886 billion)
Less Liquid
M1 And M2
 Standard measure of money stock 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
 Other official measures of money supply besides M1
and M2 that add in assets that are less liquid than
those in M2
 M1 and M2 have been most popular, and most
commonly watched, definitions
M1 And M2
 Important to understand that M1 and M2 money stock
measures exclude many things that people use
regularly as a means of payment
 Technological advances—now and in the future—will
continue trend toward new and more varied ways to
make payments
 For rest of our discussion, we will assume money
supply consists of just two components
 Cash in the hands of the public and demand deposits
 That is Money supply = Cash in the hands of public +
demand deposits
 You will see later that our definition of the money
supply corresponds closely to liquid assets that our
national monetary authority—the Federal Reserve—
can control
The Banking System: Financial
Intermediaries
 What are banks?
 Financial intermediaries—business firms that
specialize in
 Assembling 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
 An intermediary helps to solve problems by combining
a large number of small savers’ funds into customdesigned packages
 Then lending them to larger borrowers
 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
The Banking System: Financial
Intermediaries
 United States boasts a wide variety of financial
intermediaries, including






Commercial banks
Savings and loan associations
Mutual savings banks
Credit unions
Insurance companies
Some government agencies
 There are four types of financial intermediariesdepository institutions- that accept deposits from the
general public and lend the deposits to borrowers
 Savings and Loan associations – obtain funds through
their customers’ time, saving and checkable deposits
and use them primarily to make mortgage loans
 Mutual savings banks – accept deposits (shares)
and use them primarily to make mortgage loans
(differ from S&L because they are owned by
their depositors rather than outside investors)
 Credit unions – specialize in working with
particular group of people, acquire funds
through their member deposit – make consumer
and mortgage loans
 Commercial banks – largest group of depository
institutions, obtain funds mainly by accepting
checkable deposits, saving deposits and the time
deposits - make business, mortgage and
consumer loans
Commercial Banks


A commercial bank (or just “bank” for short) is a private
corporation that provides services to the public

Owned by its stockholders

Enables bank’s customers to pay bills and make purchases
without holding large amounts of cash that could be lost or
stolen
Every year, US households and businesses write trillions of
dollars’ worth of checks to pay their bills
For our purposes, most important service is to provide
checking accounts




Banks provide checking account services in order to earn a
profit
Where does a bank’s profit come from ??? Only by charging
check-printing fees and ATM-using fee??NO……then what is the most important source of profit?
What about interest rate differentials??
A Bank’s Balance Sheet

A balance sheet is a two-column list that provides information
about financial condition of a bank at a particular point in time




Amounts bank owes
On the other side, the bank’s liabilities are listed
A promise to pay back borrowed funds, issued by a corporation or
government agency
An agreement to pay back borrowed funds, signed by a household
or noncorporate business –examples?
Next come two categories that might seem curious




Everything of value that it owns
Loan



Bond


In one column, bank’s assets are listed
“Vault cash” – coin and currency that bank has stored in its vault
“Account with the Federal Reserve” – banks maintain their own
accounts with the Fed reserve – they add and subtract to these
accounts when they make transaction with other banks
Neither vault cash nor accounts with the Fed pay interest
Then why does the bank hold them?
Commercial Bank’s Balance Sheet
Liabilities and Net
Worth
Assets
Property and buildings
$5 million
Demand deposit liabilities
$100
million
Government and corporate
bonds
$25 million
Net Worth
$5 million
Loans
$65 million
`
Cash in vault
$2 million
In accounts with the Federal
Reserve
$8 million
Total Assets
$105
million
Total Liabilities plus Net
Worth
$105
million
The Federal Reserve System
 Every large nation controls its money supply with a central
bank
 A nation’s principal monetary authority
 Most developed countries established central banks long
ago
 England’s central bank—Bank of England—was created in
1694
 France established Banque de France in 1800
 United States established Federal Reserve System in 1913
 U.S. waited such a long time to establish a central
authority because of
 Suspicion of central authority that has always been part of
U.S. politics and culture
 Large size and extreme diversity of our country
 Fear that a powerful central bank might be dominated by
the interests of one region to the detriment of others
The Federal Reserve System
 Our central bank is different in form from its European
counterparts
 One major difference is indicated in the very name of
the institution
 Does not have the word “central” or “bank” anywhere
in its title
 Another difference is the way the system is organized
 Another interesting feature of Federal Reserve System
is its peculiar status within government
 Strictly speaking, it is not even a part of any branch
of government
 Both President and Congress exert some influence on
Fed through their appointments of key officials
Figure 2: The Geography of the
Federal Reserve System
1
9
Minneapolis
12
San Francisco
2
7
Boston
New York
Philadelphia
10
Cleveland
Washington
Kansas City
4 Richmond
St. Louis
5
8
3
Chicago
Atlanta
11
6
Dallas
Note: Both Alaska and Hawaii are in the Twelfth District
District boundaries
State boundaries
Reserve Bank cities
Board of Governors of the Federal Reserve System
Figure 3: The Structure of the
Federal Reserve System
President
appoints
Senate
confirms
Chair of Board of Governors
Board of Governors
(7 members, including chair)
• Supervises and regulates
member banks
• Supervises 12 Federal
Reserve District Banks
• Sets reserve requirements
and approves discount rate
Federal Open Market
Committee
(7 Governors + 5 Reserve
Bank Presidents)
• Conducts open market
operations to control the
money supply
Appoints 3 directors of each
Federal Reserve Bank
12 Federal Reserve
District Banks
• Lend reserves
• Clear checks
• Provide currency
Elect 6 directors
of each
Federal Reserve
Bank
3,500 Member Banks
The Structure of the Fed

Board of Governors


Consists of seven members who are appointed by President
and confirmed by Senate for a 14-year term
In order to keep any President or Congress from having too
much influence over Fed


Each of 12 Federal Reserve Banks is supervised by nine
directors




Four-year term of the chair is not coterminous with four-year
term of the President
Three of whom are appointed by Board of Governors
Other six are elected by private commercial banks—the official
stockholders of the system
Directors of each Federal Reserve Bank choose a president of
that bank, who manages its day-to-day operations
Only about 3,500 of the 8,000 or so commercial banks in
United States are members of Federal Reserve System


But they include all national banks and state banks
All of the largest banks in United States are nationally
chartered banks and therefore member banks as well
The Federal Open Market
Committee
 Federal Open Market Committee (FOMC)
 A committee of Federal Reserve officials that
establishes U.S. monetary policy
 Most economists regard FOMC as most
important part of Fed
 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
 Committee exerts control over nation’s money
supply by buying and selling bonds in public
(“open”) bond market
The Functions of the Federal
Reserve
 Federal Reserve, as overseer of the
nation’s monetary system, has a
variety of important responsibilities
including





Supervising and regulating banks
Acting as a “bank for banks”
Issuing paper currency
Check clearing
Controlling money supply
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
How the Fed Increases the Money
Supply
 To increase money supply, Fed will buy government
bonds
 Called an open market purchase
 Suppose 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
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
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 lent 90% of deposit it received
 Whatever the injection of reserves, demand deposits
will increase by a factor of 10, so we can write
 ΔDD = 10 x reserve injection
 Demand deposit multiplier is number by which we
must multiply injection of reserves to get total change
in demand deposits
 Size of demand deposit multiplier depends on value of
required reserve ratio set by Fed
Cumulative Increases in Demand
Deposits After a $1,000 Cash Deposit
Round
Additional Demand Deposits
Created by Each Bank
Additional Demand Deposits
Created by All Banks
Bank 1
$1,000
$1,000
Bank 2
$900
$1,900
Bank 3
$810
$2,710
Bank 4
$729
$3,439
Bank 5
$656
$4,095
Bank 6
$590
$4,685
…
…
…
Bank 10
$387
$6,511
…
…
…
Bank 20
$135
$8,784
…
…
…
Bank 50
very close to zero
very close to $10,000
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
 Since we’ve been assuming 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
The Fed’s Influence on the Banking
System as a Whole
 Can also look at what happened to total
demand deposits and money supply from
another perspective
 Where did additional $1,000 in reserves end up?
 In the end, additional $1,000 in reserves will be
distributed among different banks in system as
required reserves
 After an injection of reserves, demand deposit
multiplier stops working—and the money supply
stops increasing—only when all reserves
injected are being held by banks as required
reserves
 In the end, total reserves in system have
increased by $1,000
 Amount of open market purchase
How the Fed Decreases the Money
Supply
 Just as Fed can increase money supply by purchasing
government bonds
 Can also decrease money supply by selling
government bonds
 An open market sale
 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
 Keeping in mind that a withdrawal of reserves is a
negative change in reserves
 Can still use our demand deposit multiplier—1/(RRR)—
and our general formula
 ΔDD = (1/RRR) x ΔReserves
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
Other Tools for Controlling the
Money Supply
 While other tools can affect the money
supply, open market operations have two
advantages over them
 Precision and secrecy
 This is why open market operations remain Fed’s
primary means of changing money supply
 Fed’s ability to conduct its policies in
secret—and its independent status in
general—is controversial
 In recent years, because Fed has been so
successful in guiding economy, controversy has
largely subsided
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
Using the Theory: Bank Failures
and Banking Panics
 A bank failure occurs when a bank cannot meet its
obligations to those who have claims on the bank
 Includes those who have lent money to the bank, as
well as those who deposited their money there
 Historically, many bank failures have occurred when
depositors began to worry about a bank’s financial
health
 Run on the bank
 An attempt by many of a bank’s depositors to
withdraw their funds
 Ironically, a bank can fail even if it is in good financial
health, with more than enough assets to cover its
liabilities
 Just because people think bank is in trouble
 Banking panic occurs when many banks fail
simultaneously
Using the Theory: Bank Failures
and Banking Panics
 Banking panics can cause serious problems for the
nation
 Hardship suffered by people who lose their accounts
when their bank fails
 Even when banks do not fail, withdrawal of cash
decreases banking system’s reserves
 Money supply can decrease suddenly and severely,
causing a serious recession
 Banking panic of 1907 convinced Congress to
establish Federal Reserve System
 But creation of Fed did not, in itself, solve problem
 Great Depression is a good example of this problem
 Officials of Federal Reserve System, not quite
grasping seriousness of the problem, stood by and let
it happen
Using the Theory: Bank Failures
and Banking Panics
 For five-year period ending in Dec 2004, a total of 29
banks failed—an average of about 6 per year
 Why the dramatic improvement?
 Federal Reserve learned an important lesson from Great
Depression

It now stands ready to inject reserves into system more quickly in
a crisis
 In 1933 Congress created Federal Deposit Insurance
Corporation (FDIC) to reimburse those who lose their deposits
 FDIC has had a major impact on the psychology of banking
public
 FDIC protection for bank accounts has not been costless
 To many observers, experience of late 1980s and early
1990s was a reminder of the need for a sound insurance
system and close monitoring of banking system
Figure 4: Bank Failures in the United
States, 1921-2004
Number of Bank Failures
4,000
3,500
3,000
2,500
2,000
1,500
1,000
500