Terms relating to Money and Banking
Draft ©Dohan 2012
central bank = Federal Reserve Banking System in the USA (often called the “Fed”)
financial intermediary: financial institutions which receive money for various purposes and lend it
out.(commercial banks take in demand deposits and lend money, savings banks and credit unions,
investment banks usually borrow money or use their own capital to lend money to large companies,
insurance companies receive premiums for insurance or annuities and purchase liabilities (or lend money)
banks or commercial banks: function is to accept demand deposits and to lend money (i.e., lend money to
people (car loans, mortgages, home equity loans, etc) and businesses or to buy liabilities such as bonds, T-bill,
short-term commercial paper, credit card charges, etc). Unlike European banks they can not buy ownership in
companies, e.g., shares of stock. US commercial banks are subject to strict regulations about reserves (
RR=rrr*DD), capital (net equity), etc.
investment banks: function as a financial intermediary on a much large scale between where it borrows (or
uses its own capital) and lends money to large businesses, manages initial public offerings (IPO), arranges
mergers and acquisitions of firms by other firms, creates and markets securities such as mortgage-backed
securities (MBS), participates bond offerings for corporations, etc.
savings banks
Money supply: there are many definitions of money supply depending on what we are analyzing.
M1 = currency, demand deposits
M2 = M1 + savings accounts, small time deposits at banks, and retail money market funds.
demand deposits (DD) = which you know as “checking accounts” = the biggest components of our M1 (our
narrow definition of money supply)
money market fund is a mutual fund which buys up short term commercial loans (paper) maturing in less than
360 days and pay interest. The use money deposited in their fund by depositors who can write checks against
their balances just like a check in a commercial bank.
currency (coins and currency) in the hands of the public outside the banking system. (outside the Federal
Reserve and the commercial banks). The Fed adjusts this according to seasonal demand, e.g. Christmas season.
CD’s = certificates of deposit = type of time deposit with a date of maturity, a face value, and a fixed interest rate
Reserves (R) = deposits held in the Fed or till cash (currency) held in the bank itself
Required reserve ratio = rrr = 10% on most demand deposits in the US
Required reserves (RR) = rrr*DD (Other types of deposit, e.g., savings accounts, have lower reserve requirements
Excess Reserves ExR = R – RR = R – rrr * DD
Money Multiplier (or coefficient of monetary expansion) = (1/rrr). DO NOT CONFUSE IT WITH THE GDP MULTIPLIER
Terms relating to Money and Banking
Draft ©Dohan 2012
VERY IMPORTANT CONCEPTS FOR SOLVING PROBLEMS OF MONETARY POLICY.
Changes in the money supply
Ms = R * (1/rrr) + currency = DD + currency
So ignoring currency
∆Ms = ∆R * (1/rrr)
If banks don’t hold excess reserves and no money leaks into hand-to-hand circulation (that is, into people’s
pockets), then an increase in Reserves ∆R leads to an increase demand deposits of ∆DD= (1/rrr) * ∆R.
For example if ∆R = + 30 and rrr = 0.10, ∆Ms = +300.
If you want to increase the Ms for economy policy, you usually increase Reserves by
Open Market Policy of Buying Treasury Bills, Notes and Bonds
Discount Rate Policy: Lending Commercial Banks Reserves through the discount window by
lowering the discount rate paid by commercial banks to borrow reserves.
The Fed rarely changes the required reserve ratio = rrr.
The rrr is set at 10% (0.10) of DD so help control the money supply without wide swings.