Chapter 16
Banking and other Tidbits
Other tidbits
BANKING, MONEY AND THE FED
What is money?
Why do we need it?
How can we get it?
Is there ever enough?
Is there ever too much????
What backs the dollar?
Early Banking continued
• GOLD STANDARD- 1900 Congress passed the
Gold Standard Act- tied to the basic unit of
currency and equal to it. Currency could be
traded in for gold- people felt secure.
– Advantage: confidence of people- prevented
government from printing too much currency.
– Disadvantage- economic growth is tied to the money
supply – no flexibility for productive growth.
– Most countries between 1871 and 1914 were on Gold
Standard. U.S was last to get on.
Early Banking
• 1933- U.S. government went off the gold standard
• Britain went of two years earlier.
• 1934 Gold Reserve Act passed- required citizens to turn in
their gold and gold certificates- people were given Federal
Reserve Notes in exchange- those who refused to turn in
gold had their gold confiscated
• 1971- President Nixon declared no gold backing whatever for
dollar- placed the exchange equivalent with other currencies
(dollar v pound v yen v mark) (now in 2008… dollar v pound
v Euro) Gold window was closed!
• And as we know, the dollar will fluctuate with currency
market. .Referred to as
Exchange rate.
What Gives Money Its Value?
 Our money today has value because of its
general acceptability.
Money vs. Barter
Money - Any good that is widely accepted for
purposes of exchange and in the repayment of
debt.
Barter - Exchanging goods and services for
other goods and services without the use of
money.
Barter is inefficient and expensive
• Deteriorates after few trades
• Requires a double co-incidence of wants.
• Too costly to travel long distances
(trading a cow for a fuzzy fleece from L.L. Bean
in Maine.)
MONEY SUPPLY
Key to money is…………do people have faith in it?
If not, they rush out and spend it….. No savings!
SO… what do we have today in our economyhigh/low savings rate
What has the federal government done lately to
increase our spending?
Money supply means- all the money available for
spending at any one time.
Fed used to use M1 as barometer. Today, they use
M2.
History of Why American Banks were
created
The warm(Revolutionary) left us in debt. Some states
were bankrupt. We needed one unified currency ...
Hamilton suggested a central bank. The First Bank's
charter was drafted in 1791 by the Congress and
signed by George Washington. In 1811, Congress
voted to abandon
Progression to FED
• 1812 War with Britain- no money to financealmost lost- scraped enough at last moment to
win – British distracted with Napoleonic Wars.
• 1815 Second Bank of U.S.
• 1836 – Andrew Jackson took it down- only
wanted State Banks
Free-for-all began….
EARLY PROBLEMS OF U.S. BANKING
SYSTEM.
Before the Fed was established 1913- U.S. could not adjust
supplies of money to business activity
Banks were often short of cash- if people deposited their
money- wanted it on the spot, had legal right to withdraw it.
Banks often kept some $ in their reserve accts, and
deposited money in other banks.
Sometimes demand for currency was >than the amount of
money on hand.
Banks would draw on deposits from other banks and sell
other assets such as government securities.
banking system problems
 Pressure from depositors often caused a chain reaction
of money shortage in a number of banks.
People panicked. If bank could not meet its demand
for currency- it “failed”
Bank closings brought on periods of economic
depression called “money panics” (people lost
confidence in their bank and wanted their money out)
Panic of 1907- Congress decided the U.S. needed a
central banking system where money supply could
expand and contract.- Federal Reserve System- 1913
Previous cyclical depressions prior to Federal Reserve
being created
1819 – Several years of inflation engineered by the 2nd
Bank of the U.S.
1836 – 2nd Bank of U.S. went down after Andrew
Jackson did away with central banking. He felt
central banking was inherently inflationary.
1857 – depression in northern states and not
southern states.. Reflected by state chartered
banks requiring state banks to buy state bonds by
state govts.
 1893 – happened as a result of silver legislationcaused inflated currency- lasted 4 years.
1907 – Panic… set the stage for Federal Reserve
System.
EARLY BANKING
• Under what authority can
the U.S. Treasury print
dollars?
(Article I, Section 8, clause 5)
• In early days:
most banks were state
banks – issued their own
currency backed by their
own supply of either gold or
silver
• Bank of the U.S. – only
national bank- acted much
like the U.S. Treasury by
collecting and paying debts
owed to the federal
government
• No regulation of state
banks-no limit on amount of
currency they could print.
• Early years- many banks
went bankrupt.
So… what’s the bottom line?
• Beginning government – attempt at national
banking… that failed
• States wanted to control banking and that failed.
• Chaos evident with no confidence and market
crashes/ depression- banks failed… attempt to rebuild national stability
• For a period of years, banking stability seemed
assured.
• Today,(2010) we have seen that banking took
• a turn of strong instability.
Additional info on Banking….legalities
Has Congress the power to incorporate a bank? (Yes,
“necessary and proper clause”
“to make all laws which shall be necessary and proper for
carrying into execution” the expressed powers in the
Constitution.”
May a state tax a U.S. Bank?
(No, the power to tax involves the power to destroy. Such a tax
could be used to destroy an institution vitally necessary to
carry out the operations of the federal government, and
therefore is unconstitutional and void. McCulloch vs.
Maryland (1819)
Banks Today!
 Community Reinvestment Act (Carter Administration)required banks to provide loans to low-income families.
 Continued with no-income families.
 Banks bundled the risky loans- sold paper- good investment
for other banks, financials, global players entered here also.
 Continued for about 10 years, with banks continuing the risky
loans.
 Hedge fund investors played their cards, and entered the
scene.
 Off to the races!
Bailout Begins!@ U.S. Government.gov
Federal Reserve/Treasury Department have
orchestrated the biggest bailout of banks,
financials, Fannie and Freddie, AIG, etc. etc.
The automobile industry is also in on the act.
Fed has pumped billions into system
Treasury has trillions extra and
200 billion for Fannie and Freddie
Crisis of Banking Part 1 and 2
Part I
K:\videos for class\HornK8 sent you a video The
Crisis of Credit Visualized - Part 1.htm
Part 2
http://www.youtube.com/watch?v=iYhDkZjKB
Ew&feature=relmfu
COMPONENTS OF MONEY
• M1= Currency coins, demand
deposits, travelers checks
• M2=M1+Savings deposits,
small time deposits (under
$100,000), money market
mutual funds.
• M3=M1+M2+large
denomination time deposits
(over $100,000)
• LM3 + liquid assets (T-bills,
U.S.Savings bonds,
commercial paper)
• Near Monies:
Credit cards
Stocks and Bonds
IRA’s
Keogh Accounts
Four functions of money
Medium of exchange
Basis for quoting prices
Store of value (can accumulate wealth by
saving)
Standard of deferred payment (buy now, pay
later… no payments until 2020) Money will be
good to pay in 2020 as is today.
Are Credit and Debit Cards Money?
Yes!
Credit card use represents loans which must
be repaid. They represent the use of someone
else's money.
Debit cards give access to checkable deposits
which are already part of the money supply.
Value of Money
• How much money do you have:
in your pocket
in your checking account
in your savings account
 Money has value- too much in circulation, decreases
its value……. inflation is BAD
 What backs our currency?
 Our money is called what?
 What will a dollar buy today?
MONEY SUPPLY
Key to money is…………do people have faith in it?
If not, they rush out and spend it….. No savings!
SO… what do we have today in our economyhigh/low savings rate
What has the federal government done lately to
increase our spending?
Money supply means- all the money available for
spending at any one time.
Fed used to use M1 as barometer. Today, they use
M2.
Supply and Demand for Credit
•Banks and other lending institutions lend money- expect
to be paid for its use.
•Amount they lend (subject to some legal restrictions) is
determined by how much they have to lend and how much the
borrower is willing to pay.
•This charge or price for use of money = interest
Demand for Money
 Represents the inverse
relationship between the
quantity demanded of
money balances and the
price of holding money
balances.
 Interest rate is the price
(opportunity cost) of
holding money balances.
Equilibrium in the Money Market
•
At an interest
rate of i1, the
money market is
in equilibrium:
There is neither
an excess supply
of money nor an
excess demand
for money
• Interest rates fluctuate with changes in
demand for money in relationship to changes
in supply of money available.
• Money becomes valuable just like other value
created for other commodities (demand
relative to supply)
• So when the FED began lowering the FF Rate,
and money was almost “free,” did this affect
our financial crisis today????
HOW DID WE GET FRACTIONAL BANKING
SYSTEM?
• Goldsmiths: Knights brought back gold when
making conquests…what to do with it? –
measured it for purity of value
• Gold treasure more than King could use
• Receipt was given for deposits- based on
purity value
• People who had gold began to deposit with
Goldsmiths- receipts given - receipts
exchanged rather than gold and used for
purchase.
• Church entered and said it was fraudulent for
Goldsmiths to do this.
• Easier to exchange receipts than pick up actual
gold and exchange for g/s
• Goldsmiths began to make loans on deposits
not claimed… kept a fraction on
reserve…loaned out rest
Federal Reserve
FEDERAL RESERVE STRUCTURE
One of 7 is
Chairman
Board of Governors
7 Members
12 District
Banks
Member Banks
FED Can Issue Federal Reserve Notes……………….
Have you ever seen a Federal Reserve Note?
Do any of you have any Federal Reserve Notes?
A=Boston
B= New York
C= Philadelphia
D= Cleveland
E= Richmond, VA
F= Atlanta
G= Chicago
H= St. Louis
I= Minneapolis
J= Kansas City
K= Dallas
L= San Francisco
12 Regional Banks
10. J. Kansas City
11. K. Dallas*
12.L. San Francisco
1. A.Boston
2. B. NY
3.C. Philadelphia
4.D. Cleveland
5.E. Richmond,VA
6.F. Atlanta
7. G. Chicago
8.H. St. Louis
9. I. Minneapolis
12 District Banks.
Dallas is the 11th District… K
http://www.dallasfed.org/
25 Regional Banks.
Dallas has region banks in El Paso, San Antonio,
Houston.
Is the Fed effective???--------What is the Discount Rate today 11/26/12
4/18/12 .75
8/8/11 .75
11/2/10 .75
4/22/10 .75
4/20/09 .50
11/17/08 1.25%
4/15/08 2.50
4/16/07 6.25%
6/29/06 6.00%
4/17/06 5.75%
11/21/05 5.00%
Spring, 2005 3.75%
Dec. 2004, 3.00%
What is the Federal Funds Rate –Today 11/26/12
4/18.12 .25
8/8/11 .25
11/2/10 .25
422/10 .25
4/20/09 .25
11/17/08 1.00%
4/15/08 2.25 %
4/16/07 5.25%
6/29/06 5.18%
4/17/06, 5.00%
11/21/05, 4.15%
Was 2.875%(spring, 2005)
(was 2% 12/2004)
(2003, FFR was 1.0%)
Prime Rate? – Today –11/26/12 3.25
4/18/12 3.25
8/8/11 3.25
11/2/10 3.25
4/22/10 3.25%
4/20/09 3.25%
11/17/08 4.00%
5/15/08 5.25%
4/16/07 8.25%
6/29/06, 8.00%
4/17/06, 7.75%,
11/21, 7.00%
(was 5.75% in spring 2005)
(was 5.00 12/2004)?
Where does fiscal policy enter in here?
What would constitute a counter cyclical move by either the
Federal government or the Federal Reserve?
3 Monetary Tools for the FED
1. Reserve Requirement
2. Discount Rate
3. FOMC
One Tool to Control Money Supply
Reserve Requirement
• The Fed requires banking
institutions, including S&Ls,
Credit Unions, Loan Assns, to
maintain reserves against the
demand deposits of their
customers. Required and
excess are important concepts
• Required Reserves are: vault
cash and deposits held for
them at the Fed.
• This RR can alter the loans that
members can make by:
a) Lowering RR = creating
more money to loan
b) Raising the RR=
decreasing money
creation.
RR’s do not change very
often.
Changes in RR can be
disruptive of banking
operations. RR change
could force banks to sell
securities quickly or call
in loans to meet the Fed
requirement.
Current: 3% 0-$46.5 Mil
10% $46.5 +
How Fractional Banking Works
Fed RR is 20%(bank required to hold a
percentage of its deposits on RR
Deposit made = $100,000
-20,000 (bank holds in reserve
$ 80,000 (bank can loan this amount)
This $80,000 is considered new money
Whoever receives the $80,000 as a loan then deposits it
into an account and can write checks immediately, but
the bank views it as “never seen before.”
CONTINUED RR/FRACTIONAL
BANKING EXAMPLE
$80,000
-16,000 (20% reserve required)
$64,000 (potential new loan which can be
created and loaned out to another customer
$64,000 new deposit in mind of bank
- 12,800 (20 % must be kept in reserve)
$51,200 considered new money available for
loan
CONTINUED RR/FRACTIONAL
EXAMPLE
This cycle keeps going on and onThe money multiplier factor for 20% RR is 5 to 1
Using the above example- banks could create 5
times the $100,000 at 20% reserve required or in
other words, it can create $500,00 “NEW MONEY”
At 25% required as opposed to say 10%- higher
requirement would lower the multiplier effect from
10 to 4 which in turn would not allow banks to have
as much money to loan- or would be taking money
out of circulation.
Summary/RR/Fractional
Banking/Multiplier
The higher the required reserve- the lower the
multiplier.
The potential deposit expansion multiplier is
merely the reciprocal of the required reserve
ratio (r ) In case of 20% example or l/5 of total
deposits to be held- deposit expansion
multiplier is 5
If 10% was to be held- deposit expansion
multiplier is 10.
DOES MULTIPLIER ALWAYS
WORK? no
Creating New Money with the deposit expansion
multiplier effect will not work if:
All excess reserves are tied up. (purchase securities,
loans, etc.)
If person receiving the loan decides to hold currency
rather than deposit it into the bank
If banks decide not to extend loans even though they
have excess reserves available (referred in the early
90’s as “credit crunch.” And… is happening today!
Banking Change 1993
Sweet Accounts
Banks are in business to make money!!!
When they get greedy- they often fail as we have seen
To get around the RR requirement- Banks got creative
Transfer from savings to deposit accounts if accounts
were negative
Transfer out of deposit to savings if too much not
“earning interest”
Reducing the amount in deposit accounts can lower %
required for RR.
SECOND TOOL TO CONTROL MONEY
SUPPLY- DISCOUNT RATE
• There are two types of interest: Simple and
discount.
– Simple- paid each time a payment is made on the
loan.
– Discount- entire amount of interest owed is
deducted from loan before it is issued
Discount Rate Continued
-Member banks “lent out” (have no money to loan
and a good corporate customer wants a loan)
- Or, perhaps they can’t cover their required reserve
requirement.
- Need to pay out customer request for deposited
funds and poor management of prior loans left
bank short of cash
DISCOUNT RATE CONTINUED
• District Bank is not a charity bank… charges interest
on money loaned to member banks.
– If Member Bank borrows $100,000 at 10%
– The interest is discounted up-front- Member has $90,000
to take back to loan.
– Member bank is not going to loan at 10%
– Adds 2 to 3 points to constitute prime rate. In this example
is 13%
Discount Rate continued
– If ordinary citizen wants to borrow, points added
to prime depending on type of loan, collateral,
history, etc.
– Prime rate is always higher than discount- each
bank sets own prime, but large banks tend to all
have the same.
– Prime is rate given to best corporate customers.
DISCOUNT RATE CONTINUED
 If Fed wants to cut down on bank loans, they can
raise the discount rate.
 Recently the Fed lowered the discount rate to
encourage loans
 **Banks will borrow from Federal Funds Rate before
going to the Fed to borrow. Too many trips to the
Fed to borrow signals poor fiscal management of
the bank
 What is the Federal Funds Rate? The rate banks can
charge (as set by the BOG) for short-term loans
between each other – often overnight.
 Federal Funds rate will be lower than discount rate.
Why?
 1.25 vs 1.00 (11/24/08) Today: .50% vs .25%
ON May 17, 2002- Fed revised Discount
program
• Type of discount would be called Primary Credit.
• Available for very short term back-up source of liquidity to
depository institutions in sound financial condition.
• Would be extended at a rate above the “usual” level of shortterm federal funds rate.
• Interest rate on primary credit would be 100 basis points above
targeted federal funds rate.
• If FF rate is .5 the primary credit would be 1.5
• This encourages banks to borrow from each other rather than
going to Fed. Allows Fed to eliminate a lot of bank investigations
and paperwork.
• Also establishing a secondary credit = another 50 basis points to
financial depositories not quite as sound.
THIRD TOOL TO CONTROL OPEN MARKET
COMMITTEE (FOMC)
• This is the most common tool used by Fed to alter
the money supply.
• Buying and Selling of U.S. securities on the open
market
• FOMC meets about every six weeks.
• FOMC = all 7 BOG, 12 District Presidents
• N.Y. President permanent member, other 11
Presidents rotate on the voting 12 on yearly basis.
• FOMC constitutes 12 persons.
• Can directly influence the money supply in a nondisruptive way.
FOMC Continued
 FED can write a check without funds in an account so to
speak.
 FED holds large portfolio of U.S. government securities
 FED engages in open market trading with approximately
3 dozen major securities dealers.
 These transactions take place at NY Fed Trading Desk
A SELL OPERATION
 When Fed wishes to restrain money supply growth, the
Fed sells U.S. government securities on the open market.
FOMC Continued
 Call goes out from NY Desk to pre-selected security
dealers. Go out to the banks with the offer.
 Securities dealers then pay the Fed from deposits
held at their banks, and the Fed simply deducts an
equivalent amount from the banks’ reserve account.
 As result- banks have less credit in reserve-(taken
from excess reserves) and cannot make as many
loans
 Banks might even have to sell some of their
investments… reduced supply of credit throughout
the banking system.
• FED controls this operation by enticing banks to
buy government securities by offering “good deals.”
• Example: Treasury Bond issued to FED. $10,000.
FED offers this Bond interest to pay a fixed rate of
10% yearly until bond expires.- Fed (through
Security dealer) goes to bank and says (sell this
$10,000 bond for $8,000 – still pay the 10%- (this is
selling below par)
• This pulls lump sum out of circulation (actual rate
bank will make over bond life is 12l/2 % . Money
supply has shrunk.
If the banks elect to buy- less money to loan.
Banks prefer buy government securities because of
the risk factor being lowered.
FOMC CONTINUED
BUY OPERATION:
 When FED wants to increase the money supply, it reverses
the procedure and purchases U.S. government securities on
the open market. It then credits the reserve accounts of the
banks in which securities dealers keep their deposits. End
result is that banks have more funds to lend.
 Example: Fed offers to buy the $10,000 bond sold on open
market for $12,000. Bank sells- this puts money in circulation
or creates potential for banks to loan more to member banks.
FOMC CONTINUED
• Open Market is not in the business to make moneythey actually lose money on most transactions
• Main function is to control loans the banks can make.
• Securities desk in N.Y. puts the bonds for buy or sell out
to Security dealers for best bid.
• Every security purchased lowers the money supply.
• FED can use this tool as major way to offset cyclical
economic swings. Can also supply money for seasonal
adjustment demands made by business and
consumers. Or, as we saw, provide money when
disaster strikes.
FOMC Video
• http://educationportal.com/academy/lesson/open-marketoperations-the-federal-reserve-definitionexamples.html
• FOMC assesses growth operations
directed to 4 objectives:
• full employment,
• economic growth,
• stable prices and
• balance of payments.
• No bank will ever loan
out ALL of its excess
reserves• This would leave them
with no flexibility in
buying Govt Securities.
• Banks are in business to
make a profit!
PART III
FED AS THE NATION’S CENTRAL
BANK
MONETARY POLICY AS REQUIRED BY Congress
 Provide a flow of credit and money that will foster economic
stability and growth
 Establish a high level of employment
 Provide stability in purchasing power of the dollar.
 Reminder- Fed is autonomous
Three principal tools to implement monetary policy:
1. Reserve requirements
2. Discount rate
3. Open market operations
Money and Production
• Money is the means of helping to facilitate our
economic purposes of production, distribution, and
consumption of goods and services
• Relationship between money supply, price levels
and business is important aspect of macro theory.
• Equation of Exchange: MV=PT or MV=PQ
Money x Velocity = Prices x Business Transactions (real
levels of output)
MV= total spending for the year (velocity is # times $
turns over in a year )
PQ= total business for that year.
If any of these get out of balance- economy out of
sync.
Equation of Exchange
• MxV≡PxQ
where:
M represents Money Supply
V represents Velocity*
≡ means must be equal to
P represents Price
Q represents Real GDP
*The average number of times a dollar is spent to
buy final goods and services in a year
Demand for Money
What is so magical about the $$$$
Store of Value
1. Need for transactions
2. Emergencies/ safeguards
3. Rather hold $ than other
assets- equity plus
4. Assume stability of the
dollar or all bets off.
HOW MONETARY POLICY CAN AFFECT
INTERNATIONAL TRADE
Contractionary Monetary
Policy
Expansionary Monetary Policy
(increases rate of growth in money supply)
(decrease the growth in money supply
Decreases interest rates
Increase in interest rates
Encourages foreign financial investors in U.S.
Discourages foreign financial investment in the
U.S.
Strengthens the international value of
dollar
Increases imports
Weakens the international value of the dollar
Decrease exports
Increases exports
Employment may decrease
Inflation may decrease
Employment may increase..Inflation may
increase
Decreases imports
U.S. has a Stop/Go Monetary Policy
Expansion
Contraction
S1
S
S1
S
Interest
rate
Interest
rate
D
D
Quantity of money
Quantity of money
FED IN ACTION
Fed wants to affect Consumption and
Investment by adjusting the monetary policy.
Invese relationship between price of existing
bonds and rate of interest
Interest rate
Bond value
Today…. Interest rate ? Bond value ?
Figure 16-4 Determining the Price of
Bonds, Panel (a)
Contractionary Policy
• Fed sells bonds
• Supply of bonds increases
• Bond prices fall
Figure 16-4 Determining the Price of
Bonds, Panel (b)
Expansionary Policy
• Fed buys bonds
• Supply of bonds falls
• Bond prices rise
BIG PICTURE FOR FED
• To forestall depressions in
period of prosperity
• To stimulate the economy in
period of declining economic
activity.
• I.E. To smooth out the swings
of the business cycle… uses
counter-cyclical moves
So, are you better off?
Or is the federal government the Grinch?
Kiley puts all her excess bones in the
bank!