34 Money, Banking, and Financial Institutions McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Money, Banking, and Financial Institutions • Learning objectives – After reading this chapter students should be able to: • Identify and explain the functions of money and the components of the money supply. • Describe what “backs” the money supply, making us willing to accept it as payment. • Identify and explain the main factors that contributed to the financial crisis of 2007-2008. • Explain the basics of a bank’s balance sheet and discuss why the U.S. banking system is called a “fractional reserve” system. • Explain the distinction between a bank’s actual reserves and its required reserves. • . LO2 Money, Banking, and Financial Institutions • Describe how a bank can create money • Describe the multiple expansion of loans and money by the entire banking system. • Define the monetary multiplier, explain how to calculate it, and demonstrate its relevance • Discuss how the equilibrium interest rate is determined in the market for money. • List and explain the goals and tools of monetary policy. • Identify the mechanisms by which monetary policy affects GDP and the price level. LO2 Money, Banking, and Financial Institutions • Functions of Money • Medium of exchange: Money can be used for buying and selling goods and services. • Unit of account: Prices are the U.S. are quoted in dollars and cents. • Store of value: Money allows us to transfer purchasing power from present to future. It is the most liquid (spendable) of all assets, a convenient way to store wealth. LO2 Money, Banking, and Financial Institutions • Components of the Money Supply • 1. Narrow definition of money: M1 includes currency and checkable deposits (see Figure 34.1a). • Currency (coins + paper money) held by public. (51% of M1) • a. It is “token” money, which means its intrinsic value is less than actual value. The metal in a dime is worth less than 10¢. • B. All paper currency consists of Federal Reserve Notes issued by the Federal Reserve. • 2. Checkable deposits are included in M1, since they can be spent almost as readily as currency and can easily be changed into currency. (49% of M1) • a. Commercial banks are a main source of checkable deposits for households and businesses. LO2 Money, Banking, and Financial Institutions • b. Thrift institutions (savings & loans, credit unions, mutual savings banks) also have checkable deposits. • Money Definition: M2 = M1 + some near-monies which include: (See Figure 34.1b) • Savings deposits and money market deposit accounts. • Small-denominated time deposits (certificates of deposit) less than $100,000. • Money market mutual fund balances, which can be redeemed by phone calls, checks, or through the Internet. LO2 Money, Banking, and Financial Institutions • C. CONSIDER THIS … Are Credit Cards Money? • Credit cards are not money, but their use involves short-term loans; their convenience allows you to keep M1 balances low because you need less for daily purchases. LO2 Money, Banking, and Financial Institutions • What “backs” the money supply? • A. The government’s ability to keep its value stable provides the backing. • B. Money is debt; paper money is a debt of Federal Reserve Banks and checkable deposits are liabilities of banks and thrifts because depositors own them. • C. Value of money arises not from its intrinsic value, but its value in exchange for goods and services. • 1. It is acceptable as a medium of exchange. • 2. Currency is legal tender or fiat money. • 3. The relative scarcity of money compared to goods and services will allow money to retain its purchasing power. • LO2 Money’s purchasing power determines its value. Higher prices mean less purchasing power. Money, Banking, and Financial Institutions • Excessive inflation may make money worthless and unacceptable. An extreme example of this was German hyperinflation after World War I, which made the mark worth less than 1 billionth of its former value within a four-year period. 1. Worthless money leads to use of other currencies that are more stable. 2. Worthless money may lead to barter exchange system. • Maintaining the value of money 1. The government tries to keep supply stable with appropriate fiscal policy. 2. Monetary policy tries to keep money relatively scarce to maintain its purchasing power, while expanding enough to allow the economy to grow. LO2 Money, Banking, and Financial Institutions • The Financial Crisis of 2007 and 2008 • In 2007 and 2008 the malfunctioning U.S. financial system experienced the worst financial crisis since the Great Depression which led to problems in the credits markets and spread to the rest of the economy resulting in a recession. • The Mortgage Default Crisis: In 2007 there were a huge number of defaults on home mortgages in the United States, mostly subprime loans which previously the Federal government had encouraged banks to make. When banks wrote-off these loans it reduced their reserves and their ability to loan out other funds. • Banks and mortgage lenders packaged hundreds or thousands of mortgages together and sold them as bonds, believing that this would protect them from defaults on the mortgages. LO2 Money, Banking, and Financial Institutions • Buyers of the mortgage-backed securities collected the mortgage payments as returns on their investment. • The banks received a single up-front payment for the mortgage-backed securities. • Banks lent a substantial amount of money to investment firms so that they could buy the mortgage-backed securities. The banks also bought mortgage-backed securities as investment. • With the defaults the banks lost money on the loans that they still held, on the money they had loaned to investment funds for the purchase of mortgagebacked securities and on the mortgage-backed securities that they had purchased themselves LO2 Money, Banking, and Financial Institutions • Causes of the substantial number of defaults: • Government programs that encouraged and subsidized home ownership for previous renters. • Declining home prices. • Lax standards by banks because they felt protected from defaults with the mortgage-backed securities. LO2 Money, Banking, and Financial Institutions • The Fractional Reserve System: • Significance of fractional reserve banking: • Banks can create money by lending more than the original reserves on hand. • Lending policies must be prudent to prevent bank “panics” or “runs” by depositors worried about their funds. Also, the U.S. deposit insurance system prevents panics LO2 Money, Banking, and Financial Institutions • A Single Commercial Bank • A balance sheet states the assets and claims of a bank at some point in time. • All balance sheets must balance, that is, the value of assets must equal value of claims. • 1. The bank owners’ claim is called net worth. • 2. Non-owners’ claims are called liabilities. • 3. Basic equation: Assets = liabilities + net worth. LO2 Money, Banking, and Financial Institutions • The Banking System: Multiple-Deposit Expansion (all banks combined) • The entire banking system can create an amount of money which is a multiple of the system’s excess reserves, even though each bank in the system can only lend dollar for dollar with its excess reserves. • Three simplifying assumptions: 1. Required reserve ratio assumed to be 20 percent. 2. Initially banks have no excess reserves; they are “loaned up.” 3. When banks have excess reserves, they loan it all to one borrower, who writes check for entire amount to give to someone else, who deposits it at another bank. The check clears against original lender. LO2 The Banking System (3) Excess Reserves (1)-(2) (1) Acquired Reserves and Deposits (2) Required Reserves Bank A $100 $20 $80 $80 Bank B $80 $16 $64 $64 Bank C $64 $12.80 $51.20 $51.20 Bank D $51.20 $10.24 $40.96 $40.96 Bank (4) Amount Bank Can Lend; New Money Created = (3) The process will continue… LO4 The Banking System Bank (1) Acquired Reserves and Deposits Bank A $100.00 Bank B 80.00 Bank C 64.00 Bank D 51.20 Bank E 40.96 Bank F 32.77 Bank G 26.21 Bank H 20.97 Bank I 16.78 Bank J 13.42 Bank K 10.74 Bank L 8.59 Bank M 6.87 Bank N 5.50 Other Banks 21.99 LO4 (2) Required Reserves (Reserve Ratio = .2) (3) Excess Reserves (1)-(2) $20.00 16.00 12.80 10.24 8.19 6.55 5.24 4.20 3.36 2.68 2.15 1.72 1.37 1.10 4.40 $80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.59 (4) Amount Bank Can Lend; New Money Created = (3) $80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.59 $400.00 The Monetary Multiplier Monetary multiplier LO5 = 1 required reserve ratio = 1 R Money, Banking, and Financial Institutions • System’s lending potential: Suppose a junkyard owner finds a $100 bill and deposits it in Bank A. The system’s lending begins with Bank A having $80 in excess reserves, lending this amount, and having the borrower write an $80 check which is deposited in Bank B. See further lending effects on Bank C. The possible further transactions are summarized in Table 13.2. • Monetary multiplier is illustrated in Table 35.2. • Formula for monetary or checkable deposit multiplier is: • Monetary multiplier = 1/required reserve ratio or m = 1/R or 1/.20 in our example. LO2 Money, Banking, and Financial Institutions • Maximum deposit expansion possible is equal to: excess reserves x monetary multiplier. Figure 35.1 illustrates this process. • Higher reserve ratios generate lower money multipliers. • a. Changing the money multiplier changes the money creation potential. • b. Changing the reserve ratio changes the money multiplier but be careful! It also changes the amount of excess reserves that are acted on by the multiplier. Cutting the reserve ratio in half will more than double the deposit creation potential of the system. • The process is reversible. Loan repayment destroys money, and the money multiplier increases that destruction. LO2 Money, Banking, and Financial Institutions • The fundamental objective of monetary policy is to aid the economy in achieving full-employment output with stable prices. • 1. To do this, the Fed changes the nation’s money supply. • 2. To change money supply, the Fed manipulates size of excess reserves held by banks. • Monetary policy has a very powerful impact on the economy; Ben Bernanke, the head of the U.S. Federal Reserve System, and Jean-Claude Trichet, the president of the European Central Bank, are often listed as among the most powerful people in the world. LO2 Money, Banking, and Financial Institutions • The Demand for Money: Two Components • A. Transactions demand, Dt, is money kept for purchases and will vary directly with GDP (Key Graph 36.1a). • B. Asset demand, Da, is money kept as a store of value for later use. Asset demand varies inversely with the interest rate, since that is the price of holding idle money (Key Graph 36.1b). • C. Total demand will equal quantities of money demanded for assets plus that for transactions (Key Graph 36.1c). LO2 Rate of interest, i percent Demand for Money (a) Transactions demand for money, Dt (b) Asset demand for money, Da 10 Sm 7.5 =5 + 5 2.5 Dt 0 50 100 Da 150 200 Amount of money demanded (billions of dollars) LO1 (c) Total demand for money, Dm and supply 50 100 150 200 Amount of money demanded (billions of dollars) Dm 50 100 150 200 250 300 Amount of money demanded and supplied (billions of dollars) Money, Banking, and Financial Institutions • The Equilibrium Interest Rate and Bond Prices • A. Key Graph 36.1c illustrates the money market. It combines demand with supply of money. • B. If the quantity demanded exceeds the quantity supplied, people sell assets like bonds to get money. This causes bond supply to rise, bond prices to fall, and a higher market rate of interest. • C. If the quantity supplied exceeds the quantity demanded, people reduce money holdings by buying other assets like bonds. Bond prices rise, and lower market rates of interest result (see example in text). LO2 Money, Banking, and Financial Institutions • Tools of Monetary Policy • A. Open-market operations refer to the Fed’s buying and selling of government bonds. • 1. Buying securities will increase bank reserves and the money supply (see Figure 36.2) • a. If the Fed buys directly from banks, then bank reserves go up by the value of the securities sold to the Fed. See impact on balance sheets using text example. • b. If the Fed buys from the general public, people receive checks from the Fed and then deposit the checks at their bank. Bank customer deposits rise and therefore bank reserves rise by the same amount. Follow text example to see the impact. LO2 • i. Banks’ lending ability rises with new excess reserves. • ii. Money supply rises directly with increased deposits by the public. Tools of Monetary Policy • Fed buys bonds from commercial banks Federal Reserve Banks Assets Liabilities and Net Worth + Securities + Reserves of Commercial Banks (a) Securities Assets -Securities (a) +Reserves (b) LO2 (b) Reserves Commercial Banks Liabilities and Net Worth Tools of Monetary Policy • Fed sells bonds to commercial banks Federal Reserve Banks Assets Liabilities and Net Worth - Securities - Reserves of Commercial Banks (a) Securities Assets + Securities (a) - Reserves (b) LO2 (b) Reserves Commercial Banks Liabilities and Net Worth Open Market Operations • Fed buys $1,000 bond from a commercial bank New Reserves $1000 Excess Reserves $5000 Bank System Lending Total Increase in the Money Supply, ($5,000) LO2 Open Market Operations • Fed buys $1,000 bond from the public Check is Deposited New Reserves $1000 $800 Excess Reserves $4000 Bank System Lending $200 Required Reserves $1000 Initial Checkable Deposit Total Increase in the Money Supply, ($5000) LO2 Money, Banking, and Financial Institutions • When Fed buys bonds from bankers, reserves rise and excess reserves rise by same amount since no checkable deposit was created. • When Fed buys from public, some of the new reserves are required reserves for the new checkable deposits. • Conclusion: When the Fed buys securities, bank reserves will increase and the money supply potentially can rise by a multiple of these reserves. • Note: When the Fed sells securities, points a-e above will be reversed. Bank reserves will go down, and eventually the money supply will go down by a multiple of the banks’ decrease in reserves. LO2 Money, Banking, and Financial Institutions • How the Fed attracts buyers or sellers: • i. When Fed buys, it raises demand and price of bonds, which in turn lowers effective interest rate on bonds. The higher price and lower interest rates make selling bonds to Fed attractive. • ii.When Fed sells, the bond supply increases and bond prices fall, which raises the effective interest rate yield on bonds. The lower price and higher interest rates make buying bonds from Fed attractive. LO2 Money, Banking, and Financial Institutions • B. The reserve ratio is another “tool” of monetary policy. It is the fraction of reserves required relative to their customer deposits. • 1. Raising the reserve ratio increases required reserves and shrinks excess reserves. Any loss of excess reserves shrinks banks’ lending ability and, therefore, the potential money supply by a multiple amount of the change in excess reserves. • Lowering the reserve ratio decreases the required reserves and expands excess reserves. Gain in excess reserves increases banks’ lending ability and, therefore, the potential money supply by a multiple amount of the increase in excess reserves. LO2 Money, Banking, and Financial Institutions • Changing the reserve ratio has two effects. • a. It affects the size of excess reserves. • b. It changes the size of the monetary multiplier. For example, if ratio is raised from 10 percent to 20 percent, the multiplier falls from 10 to 5. • Changing the reserve ratio is very powerful since it affects banks’ lending ability immediately. It could create instability, so Fed rarely changes it. LO2 Money, Banking, and Financial Institutions • C: The third “tool” is the discount rate, which is the interest rate that the Fed charges to commercial banks that borrow from the Fed. • An increase in the discount rate signals that borrowing reserves is more difficult and will tend to shrink excess reserves. • A decrease in the discount rate signals that borrowing reserves will be easier and will tend to expand excess reserves. LO2 Money, Banking, and Financial Institutions • For several reasons, open-market operations give the Fed most control of the four “tools.” • Open-market operations are most important. This decision is flexible because securities can be bought or sold quickly and in great quantities. Reserves change quickly in response. • The reserve ratio is rarely changed since this could destabilize bank’s lending and profit positions. • Changing the discount rate has become a passive tool of monetary policy. During the financial crisis of 07- 08, banks borrowed billions as the discount rate was decreased by the Fed. LO2 (a) The market for money Sm1 Sm2 Sm3 AS 10 P3 8 AD3 I=$25 AD2 I=$20 AD1 I=$15 P2 Dm 6 ID 0 $125 $150 $175 Amount of money demanded and supplied (billions of dollars) LO4 (c) Equilibrium real GDP and the Price level (b) Investment demand Price Level Rate of Interest, i (Percent) Monetary Policy and Equilibrium GDP $15 $20 $25 Amount of investment (billions of dollars) Q1 Qf Q3 Real GDP (billions of dollars) Monetary Policy and Equilibrium GDP (d) Equilibrium real GDP and the Price level (c) Equilibrium real GDP and the Price level AS AS P3 AD3 I=$25 AD2 I=$20 AD1 I=$15 P2 Q1 Qf Q3 Real GDP (billions of dollars) b a AD3 I=$25 AD4 I=$22.5 AD2 I=$20 AD1 I=$15 Price Level Price Level P3 LO4 c P2 Q1 Qf Q3 Real GDP (billions of dollars) Expansionary Monetary Policy CAUSE-EFFECT CHAIN Problem: Unemployment and Recession Fed buys bonds, lowers reserve ratio, lowers the discount rate, or increases reserve auctions Excess reserves increase Federal funds rate falls Money supply rises Interest rate falls Investment spending increases Aggregate demand increases Real GDP rises LO4 Restrictive Monetary Policy CAUSE-EFFECT CHAIN Problem: Inflation Fed sells bonds, increases reserve ratio, increases the discount rate, or decreases reserve auctions Excess reserves decrease Federal funds rate rises Money supply falls Interest rate rises Investment spending decreases Aggregate demand decreases Inflation declines LO4 Money, Banking, and Financial Institutions • Targeting the Federal Funds Rate • The Federal funds rate is the interest rate that banks charge each other for overnight loans. • Banks lend to each other from their excess reserves, but because the Fed is the only supplier of Federal funds (the currency used as reserves), it can set the Federal funds rate and then use open-market operations to make sure that rate is achieved. • 1. The Fed will increase the availability of reserves if it wants the Federal funds rate to fall (or keep it from rising). • 2. Reserves will be withdrawn if the Fed wants to raise the Federal funds rate (or keep it from falling). LO2 Money, Banking, and Financial Institutions • Targeting the Federal Funds Rate • The Fed may use an expansionary monetary policy if the economy is experiencing a recession and rising rates of unemployment. • Restrictive monetary policy is used to combat rising inflation. • 1. The initial step is for the Fed to announce a higher target for the Federal funds rate, followed by the selling of bonds to soak up reserves. Raising the reserve ratio and/or discount rate is also an option. • 2. Reducing reserves will produce results opposite of what we saw for an expansionary monetary policy. LO2 Money, Banking, and Financial Institutions • a. The reduced supply of Federal funds will raise the Federal funds rate to the new target. • b. Multiple contraction of the money supply, through the money multiplier process (Chapter 35). • 3. Restrictive monetary policy results in higher interest rates, including the prime rate. LO2