CHAPTER
Money, Banks, and
the Federal Reserve
PowerPoint Slides
Slides prepared
prepared by:
by:
PowerPoint
Andreea CHIRITESCU
CHIRITESCU
Andreea
Eastern Illinois
Illinois University
University
Eastern
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
1
Money
• Money
– An asset widely accepted as a means of
payment
• Means of payment
– Anything acceptable as payment for goods
and services
• Money supply
– The total amount of money held by the
public
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2
The Money Supply
• Money supply, M1
– Cash in the hands of the public
– Checking account deposits
– Travelers checks
• Cash in the hands of the public
– Currency and coins held by the nonbank
public
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3
The Money Supply
• Checkable deposits
– Accounts held by households and
business firms at commercial banks
– Demand deposits
– Automatic transfers from savings accounts
• Travelers checks
– Specially printed checks that you can buy
from banks or other private companies
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4
Figure 1
The U.S. Money Supply
The most basic definition of the
U.S. money supply consists of
cash in the hands of the public,
checkable deposits, and travelers
checks.
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5
The Money Supply
• Money supply, M2
– M1
– Savings deposits
– Money market deposits
– Money market funds
– Certificates of deposit under $100,000
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6
Functions of Money
• Functions of money
– Means of payment
– Store of value
– Unit of account
• Store of value
– A form in which wealth can held
• Unit of account
– A common unit for measuring how much
something is worth
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7
A Brief History of the Dollar
• Prior to 1790
– Each colony had its own currency, the
“pound”
– Different purchasing power
• 1790, Congress created a new currency,
the dollar
– Merchants and businesses switched
immediately to the new dollar
– The dollar rapidly became the standard
unit of account
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8
A Brief History of the Dollar
• Primary means of payment
– Until the Civil War
– Paper currency issued by private banks
• During the Civil War
– Government issued the first federal paper
currency, the greenback
– Until 1879
• 1913, the Federal Reserve System
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9
A Brief History of the Dollar
• The Federal Reserve System
– Monetary authority of the United States
– Creating and regulating the nation’s supply
of money
• Commodity money
– Precious metals and other valuable
commodities
• Important uses other than means of payment
– The non-money use is what gave
commodity money its ultimate value
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10
A Brief History of the Dollar
• Paper currency
– Initially - a certificate representing a certain
amount of gold or silver held by a bank
– People were willing to accept paper
money:
• Currency could be exchanged for a valuable
commodity such as gold or silver
• The issuer—either a government or a bank—
could print new money only when it acquired
additional gold or silver
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11
A Brief History of the Dollar
• Paper currency
– Today - it is no longer backed by gold or
any other physical commodity
• Fiat money
– Something that serves as a means of
payment by government declaration
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12
The Banking System
• Financial intermediary
– A business firm that specializes in
brokering between savers and borrowers
• Commercial banks
• Savings and loan associations
• Mutual savings banks
• Credit unions
• Insurance companies
• Some government agencies
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13
The Banking System
• Depository institutions
– Financial intermediaries
– Accept deposits from the general public
– Lend the deposits to borrowers
– Largest group: commercial banks
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14
The Banking System
• Commercial banks
– A private corporation, owned by its
stockholders, that provides services to the
public
– Largest group of depository institutions
– Obtain funds mainly by accepting
checkable deposits, savings deposits, and
time deposits
– Use the funds to make business,
mortgage, and consumer loans
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15
The Banking System
• Balance sheet
– Financial statement showing assets,
liabilities, and shareholders’ equity at a
point in time
• Bank’s assets
– Everything of value that it owns
• Bonds, loans, reserves
• Bank’s liabilities
– The amounts that the bank owes
• Checking account deposits, bank borrowing
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16
Table
1
The Balance Sheet of Mid-Size National Bank
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17
The Banking System
• Bond
– A promise to pay back borrowed funds
– Issued by a corporation or government
agency
• Loan
– An agreement to pay back borrowed funds
– Signed by a household or non-corporate
business
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18
The Banking System
• Reserves
– Vault cash plus balances held at the Fed
• Required reserves
– Minimum amount of reserves a bank must
hold
– Depends on the amount of its deposit
liabilities
• Required reserve ratio, RRR
– The minimum fraction of checking account
balances that banks must hold as reserves
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19
The Banking System
• Excess reserves
– Reserves in excess of required reserves
• Shareholders’ equity
– The difference between total assets and
total liabilities
• A balance sheet always balances
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20
The Federal Reserve System
• Central bank
– A nation’s principal monetary authority
responsible for controlling the money
supply
– England: 1694
– France: 1800
– The United States: 1913
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21
The Federal Reserve System
• Federal Reserve System
– 12 Federal Reserve districts
– It is not part of any branch of government
• Was created by Congress
• Could be eliminated by Congress if it so
desired
– President and Congress
• Appoint key officials in the system
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22
Figure 2
The Geography of the Federal Reserve System
The United States is divided into 12 Federal Reserve districts,
each with its own Federal Reserve Bank.
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23
The Federal Reserve System
• Board of Governors
– Seven members
• Appointed by the president
– Confirmed by the Senate
– For a 14-year term
– Chairman
• One of the seven governors
– Appointed by the president
– Approved by the with Senate
– 4-year term
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24
The Federal Reserve System
• 12 Federal Reserve Banks
– Each - supervised by nine directors
• Three - appointed by the Board of Governors
• Six - elected by private commercial banks
– Each – a president
• Chosen by the directors
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25
Figure 3
The Structure of the Federal Reserve System
Principal decision-making
power at the Fed is vested in
the Board of Governors, who
are appointed by the president
and confirmed by the Senate.
Monetary policy is set by the
Federal Open Market
Committee, which consists of
the seven governors plus five
of the presidents of Federal
Reserve Banks.
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26
The Federal Reserve System
• Federal Open Market Committee (FOMC)
– A committee of Federal Reserve officials
that establishes U.S. monetary policy
– All seven governors of the Fed
– Five of the twelve bank presidents
• Discount rate
– The interest rate the Fed charges on loans
to banks
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27
The Federal Reserve System
• The functions of the Fed
– Supervising and regulating banks
– Acting as a “bank for banks”
– Issuing paper currency
– Check clearing
– Guiding the macroeconomy
– Dealing with financial crises
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28
The Fed and the Money Supply
• Open market operations
– Purchases or sales of bonds by the
Federal Reserve System
– The primary way the Fed increases or
decreases the money supply
• Open market purchase
– Fed buys government bonds
– Money supply increases
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29
The Fed and the Money Supply
• Assumptions
– Banks never hold excess reserves
– Households and businesses do not
withdraw or deposit cash
– Required reserve ratio is 0.1
• For each $1,000 increase in deposits at a
bank, its reserves must rise by $100
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30
The Fed and the Money Supply
• The Fed purchases government bonds
– The Fed buys $100,000 worth of bonds
from Acme Bond Company
• Has its own checking account with Mid-Size
National Bank
• Result:
– The Fed injected $100,000 in reserves into
the banking system
– The money supply already increased by
$100,000 (checking accounts)
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31
The Fed and the Money Supply
• Changes in Mid-Size’s balance sheet:
• Mid-Size National Bank
– $10,000 required reserves
– $90,000 excess reserves
– Lends $90,000 to Paula
• She deposits the check in her checking
account at Second-Bank
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32
The Fed and the Money Supply
• New changes in Mid-Size’s balance sheet:
• From beginning to end, net changes on
Mid-Size’s balance sheet:
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33
The Fed and the Money Supply
• Second Bank
– $90,000 checking account
– $9,000 required reserve
– $81,000 excess reserves
– Lends out the excess reserves
• Changes in Second Bank’s balance sheet:
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34
Table
2
Effects of a $100,000 Open Market Purchase
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35
The Fed and the Money Supply
• Money multiplier =1/RRR
– The number by which we multiply the
injection of reserves to get the total
change in the money supply
– Where RRR is the required reserve ratio
• Δ Money Supply
= Δ Checking Deposits
= [1/RRR] ˣ Δ Reserves
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36
The Fed and the Money Supply
• Open market sale
– Fed sells government bonds
– Money supply decreases
• The Fed sells government bonds
– The Fed now sells $100,000 in
government bonds to Acme bond dealers
• Acme will pay with a $100,000 check drawn
on its account at Mid-Size
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37
The Fed and the Money Supply
• Changes in Mid-Size National Bank’s
balance sheet
• Mid-Size National Bank
– Total reserves decreased by $100,000
– Required reserves decreased by $10,000
– Deficient reserves $90,000
– Calling in loans: $90,000
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38
The Fed and the Money Supply
• Changes in Mid-Size’s balance sheet
• A withdrawal of reserves
– Is a negative change in reserves
• Provisos about the money multiplier
– Changes in the public’s cash holdings
– Increased reserve holdings
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39
The Fed and the Money Supply
• Other Fed actions that change the money
supply
– Changes in the required reserve ratio
– Changes in the discount rate
– Changes in the interest rate on reserves
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40
The Fed and the Money Supply
• Changes in the required reserve ratio
– Lower the required reserve ratio
• Increase in money supply
– Increase the required reserve ratio
• Decrease in money supply
– The Fed cannot count on the effectiveness
of this tool
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41
The Fed and the Money Supply
• Changes in the discount rate
– Lower discount rate
• Encourages banks to borrow more
• Increase the money supply
– Increase the discount rate
• Decrease the money supply
– Banks are hesitant to borrow from the Fed
– Little effect on bank borrowing, bank
reserves, or the money supply
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42
The Fed and the Money Supply
• Changes in the interest rate on reserves
– The Fed began paying interest on
reserves (IOR) in 2008
• Reduced bank’s opportunity cost of holding
reserves
– If the Fed lowers the IOR rate
• The opportunity cost of holding excess
reserves rises
• Encourage bank lending
• Increase the money supply
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43
Banking Panics
• Fractional reserve system
– A system in which banks hold only a
fraction of their deposit liabilities as
reserves
• Bank becomes insolvent
– When its total assets are less than its total
liabilities
• Bank failure
– When an insolvent bank goes out of
business
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44
Table
3
Bad Loans Cause Mid-Size Bank to Become Insolvent
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45
Banking Panics
• Run on the bank
– An attempt by many of a bank’s depositors
to withdraw their funds
• Banking panic
– A situation in which depositors attempt to
withdraw funds from many banks
simultaneously
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46
Figure 4
Bank Failures in the United States, 1921–2011
The bank failure rate was high even after the Fed was created in 1913. It peaked when a major banking panic
struck during the Great Depression and a large number of banks failed. The creation of the Federal Deposit
Insurance Corporation in 1933 strengthened faith in the stability of the banking system. Even during the
financial crisis of 2008–2009, bank failures were far fewer than in the 1930s.
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47
Banking Panics
• Banking panics
– Would force many banks to “close their
doors” (be unable to honor their
depositors’ requests for funds)
• Even if they were solvent
– Were largely eliminated after 1933
• Federal Reserve - ready to inject reserves into
the system more quickly in a crisis
• Federal Deposit Insurance Corporation:
reimburse those who lose their deposits
• Increased government regulation of banks
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48
Banking Panics
• Bank regulation
– Continuous monitoring of their financial
condition
• Focus on the shareholders’ equity
– Legal capital requirements:
• Banks must hold a significant percentage of
their assets as bank capital
• Encourages banks to lend responsibly
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49
Banking Panics
• Bank capital
– Another name for shareholders’ equity in a
bank
• Capital ratio
– A bank’s capital (shareholders’ equity) as
a percentage of its total assets
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50
Banking Panics
• Higher capital ratios
– Greater incentives to avoid risky loans
• Reduces the likelihood of bank failures that
pass losses onto non-owners
– Reduce the amount of interest-earning
assets a bank can hold for each dollar of
capital that the owners have invested
• Reduces the rate of return to the bank’s
owners
• Discourages people from forming or investing
in banks
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51
The Shadow Banking System
• Non-bank
– A financial intermediary less strictly
regulated than a bank
– And with no government-guaranteed
deposits
• Shadow banking system
– The entire collection of non-bank financial
intermediaries
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52
The Shadow Banking System
• Non-banks share four characteristics:
1. Short-term liabilities
2. Long-term assets
3. Liabilities do not include governmentinsured deposits
4. Not closely regulated by government
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53
The Shadow Banking System
• During the 1990s and 2000s
– The shadow banking system grew larger,
more complex, and more interconnected
with the regular banking system
• When the financial crisis hit
– It became clear that bank regulations had
not struck the right balance
– Financial institutions around the world
failed
– Governments had to come to the rescue
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54
The Financial Crisis of 2008
• 2007
– The collapse of housing prices
– Followed by a recession
• In 2008
– The United States and dozens of other
countries experienced a financial crisis
• Major disruption of the financial system
• Seriously affected lending and other financial
services
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55
The Financial Crisis of 2008
• When the crisis ended
– Preliminary estimates of total losses in
asset values at U.S. banks: well beyond
$1 trillion
• With at least another trillion lost in banks
outside the U.S.
• Banks
– Invested heavily in mortgages and
mortgage-backed securities
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56
The Financial Crisis of 2008
• How did these losses come about?
– With the collapse of housing prices and
declining incomes income
• Millions of homeowners began to default on
their mortgages
– No one wanted to buy mortgage-backed
securities at prices even close to their
previous value
– Bank capital declined
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57
The Financial Crisis of 2008
• As bank capital declined, banks had three
choices:
1. Acquire more capital by issuing and
selling new shares - unappealing
2. Reduce the risk of their assets
• Sell risky assets and replace them with safer
ones
– Banks tried to do this . . . all at the same time
3. Wait and hope
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58
The Financial Crisis of 2008
• Wait-and-hope strategy
– By many banks (U.S., around the world)
• Exploited existing leeway in accounting rules
– Side effect: Reluctance to lend to banks in
general
• Banks would have to sell even more assets to
pay back the debts coming due
• Causing the market value of the assets to fall
further
– FDIC: banks avoided a “banking panic”
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59
Figure 5
The Downward Spiral for Banks
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60
The Financial Crisis of 2008
• Financial crisis of 2008, non-banks
– Mortgage-backed securities declined in
value
• Causing a drop in capital (shareholders’
equity)
– Fearing these institutions might fail,
lenders would only lend to them for very
short periods and at very high interest
rates
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61
The Financial Crisis of 2008
• Financial crisis of 2008, non-banks
– The institutions had to continue paying off
short-term debts
• Pay very high interest rates to roll over their
debt
• Or sell assets at fire-sale prices
• Either option reduced their capital further
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62
The Financial Crisis of 2008
• Non-banks
– No insured deposits, only short-term debt
• Cannot use the “wait-and-hope” strategy
– Not closely regulated
• Held very little capital relative to their assets
• Were very highly leveraged
• September 2008
– One of the largest non-bank, Lehman
Brothers, declared bankruptcy
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The Financial Crisis of 2008
• Non-banks
– The flow of credit to non-banks ceased
– Only option to pay back debts: sell their
assets at fire-sale prices
• And watch their capital disappear
• Asset prices
– Fell further
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Figure 6
How Non-Banks Contributed to Problems for Banks
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The Financial Crisis of 2008
• Events in the shadow banking system
infected the regular banking system
– Non-banks held many of the same assets
as the banks
• Intensified the fire sales of assets
• Causing their prices to fall even further
• Worsened capital at the banks
– Many banks had extended loans to the
non-banks
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Bank Failures and Government Rescue
• The Federal Reserve
– Emergency loans to financial institutions
– Various policies designed to boost the
prices of mortgage-backed securities
• October 2008, Congress approved the
Troubled Asset Relief Program (TARP)
– Authorized the government to purchase
$700 billion in mortgage-backed securities
and similar assets
– Repurposed!
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Bank Failures and Government Rescue
• The government used TARP funds to buy
shares of stock
– Banks
– A major non-bank (the insurance company
AIG)
– A major automobile company (General
Motors)
• In the end, the government used less than
$400 billion of the $700 billion
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Bank Failures and Government Rescue
• TARP
– Losses: less than $25 billion
• Government’s shares rose in value
– Helped restore confidence in some of the
nation’s largest banks and financial
institutions
– Helped to keep the financial system
running
– Prevented the recession from being even
worse than it was
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Bank Failures and Government Rescue
• The Dodd-Frank Act
– The Dodd- Frank Wall Street Reform and
Consumer Protection Act of 2010
– To prevent the need for another TARP-like
rescue in the future
– Extended the regulatory power of the
Federal Reserve
– Enabled the Fed to impose minimum
capital ratios on any financial institution
• Bank or non-bank
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Bank Failures and Government Rescue
• The Dodd-Frank Act
– Created the Financial Stability Oversight
Council
• Collect information from financial institutions
• Identify threats to the financial system
• Formulate policies to avert them
– Focused on regular banks
• Investments – more closely monitored
• New restrictions on risky lending and high-risk
financial trading
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Capital and Leverage at Financial Institutions
• Simple leverage ratio (for an asset owner)
= Value of asset / Equity in asset
• Financial institutions’ simple leverage ratio
= Total assets / Shareholder’s equity
• Leverage ratio
– Acts as a “rate-of-return” multiplier
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Capital and Leverage at Financial Institutions
• The greater the leverage ratio
– The more interest-earning assets the bank
can acquire with each dollar of its capital
(shareholders’ equity)
– The greater the return it can earn for its
shareholders
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Capital and Leverage at Financial Institutions
• Deleveraging
– The process of reducing leverage
– Reducing the risk to your capital from any
further declines in asset prices
• Lower leverage ratios
– Sell off assets rapidly
– Increasing capital
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