Lecture 10
Money and the Banking System
&
Monetary Policy
Overview
•
•
•
•
•
•
•
Why are Banks so Heavily Regulated?
Nature of Money
How Quantity of Money is Measured
Banking System
Origins of the Money Supply
Banks & Money Creation
Why the Money Creation Multiplier is
Oversimplified
• Need for Monetary Policy
Why are Banks so Heavily Regulated?
• Major “output” of banking industry is the nation’s
MS --important determinant of AD.
• 1. Bank managers are paid to max shareholder
value & not what is in the best interests of the
economy.
– Gov does not allow banks to determine MS & interest
rates strictly on profit considerations.
• 2. Concern for the safety of depositors
– If banks are allowed to fail, then depositors would lose
their money whenever one went bankrupt.
– “Run on a bank:” if depositors get nervous, they may all
rush to cash their accounts which causes the bank to
fail. This is highly contagious!
3
Figure 1 (a)
Bank failures in the United States, 1915–2009
Bank failures have
been less common
since 1930s –until
recently.
4
Figure 1 (b)
Bank failures in the United States, 1915–2009
‘09
5
The Nature of Money
• Barter
– System of exchange where people directly
trade goods for goods without using money as
an intermediate step
– Requires: “double coincidence of wants”
• Money
– Greases the wheels of exchange & makes the
whole economy more productive
• Dramatically reduces search costs under a barter
system
6
The Nature of Money
• What is Money?
– Medium of exchange
• Standard object used in exchanging goods &
services
– Unit of account
• Standard unit used for quoting prices
– Store of value
• Store wealth from one point in time to
another
– Money is not a good hedge against inflation!
7
The Nature of Money
• What Serves as Money?
– Commodity money
• An object (like cattle, stones, cigarettes, gold)
used as a medium of exchange that also has
substantial value in alternative uses
– Paper money = Fiat money
• Decreed as money by gov & has little value
as a commodity
• Maintains its value as a medium of exchange
because people have faith that the issuer will
back the paper & limit its production
8
How Quantity of Money is Measured
• One measure of MS: M1
– Narrowly defined
– Includes coins, paper money, traveler’s checks,
conventional checking accounts, & certain other
checkable deposits in banks & savings
institutions
– M1 = $1,693 billion in 2009
9
How Quantity of Money is Measured
• Another measure of MS: M2
– Broadly defined
– Includes M1 plus money market deposit
accounts, money market mutual funds, &
savings accounts
– M2 = $8,524 billion in 2009
– Everything in M1 is completely “liquid.”
• Liquidity refers to the ease with which an asset can
be converted into cash.
10
How Quantity of Money is Measured
• Credit cards are not included in MS
– How much money does your credit card
represent?
• Should we count what you owe or your available
credit?
• We will stick with a conventional definition
of money
– Coins, paper money, & checkable deposits
11
The Banking System
• Fractional reserve banking
– is a system under which bankers keep as
reserves only a fraction of the funds they hold
on deposit
• Features
– Bank profitability
• Banks get deposits at zero interest & lend
some of them out at positive interest rates.
12
The Banking System
• Features (cont.)
– Bank discretion over money supply
• Create money by keeping only a fraction of
their total deposits on reserve & lending out
the balance
• Bankers’ decisions on how much to hold in
reserves influence the supply of money
– Exposure to bank runs
• Danger of a run on the bank has induced
bankers to keep prudent reserves & lend
out money carefully
The Banking System
• Banking is an inherently risky business
– Safe only by cautious & prudent management
– Recent events (e.g., subprime mortgage
meltdown) showed that bank managers were
neither cautious nor prudent. Why?
– Caution is not the road to high profits
• Max profits by keeping low reserves & earning high
interest rates on risky borrowers
– Banks need to strike a balance between the
lure of profits & the need for safety
14
The Banking System
• Bank regulations
• Deposit insurance - guarantees the safety of
bank deposits
– FDIC
• Established in 1933 –reduced the # of bank failures
• Your account is insured up to $250,000
• Prevents bank runs
– Moral hazard problem
• If depositors are freed from risk of loss from a failing
bank, then they will not shop around for safer banks.
• People who are insured against the consequences of
risk will engage in riskier behaviors.
15
The Banking System
• Bank regulations (cont.)
• Bank supervision
– Various regulatory authorities conduct
periodic bank examinations
– Laws & regulations limit the kinds &
qualities of assets in which banks may
invest
• Reserve requirements
– Minimum amount of reserves
• Proportional to volume of deposits
• Not really for safety but to control the MS
The Origins of the Money Supply
• Asset of a bank: item of value that is owned by the
bank (e.g., bank building or loan)
• Liability of a bank: item of value that the bank
owes (e.g., your bank balance)
• Balance sheet: is an accounting statement
• Left side: lists values of all assets
• Right side: values of all liabilities & net worth
– Net worth = value of assets – value of liabilities
– Assets = Liabilities + Net worth
17
Table 1
Balance sheet of Bank-a-mythica,
December 31, 2007
Assets
Assets
Reserves
Loans outstanding
Total
Addendum: Bank Reserves
Actual reserves
Required reserves
Excess reserves
Liabilities and Net Worth
Liabilities
$1,000,000 Checking deposits
$4,500,000
$5,500,500 Net Worth
Stockholder’s
$1,000,000 equity
$1,000,000 Total
0
$5,000,000
$500,000
$5,500,000
Example of a balance sheet. Bank has only two kinds of assets: $1M in
cash reserves & $4.5M in outstanding loans. One kind of liability: $5M in
checking deposits. Net worth = total assets – total liabilities = $500,000.
18
Banks and Money Creation
• Our goal is to understand the process of
deposit creation.
– Fractional reserve banking system can turn $1
of bank reserves into several dollars of bank
deposits
• Excess reserves
– Any reserves held in excess of the legal
minimum
– Earn no interest so banks typically want to keep
excess reserves at zero
19
Table 2
Changes in Bank-a-mythica’s balance sheet,
January 2, 2008
Assets
Liabilities and Net Worth
Reserves
+$100,000
Addendum: Changes in Reserves
Actual reserves
Required reserves
Excess reserves
+$100,000
+$ 20,000
+$ 80,000
Checking deposits
+$100,000
Eccentric widower deposits $100,000 in cash into a checking deposit.
The bank has $100,000 more in cash reserves & in checking deposits.
Assuming the required reserve ratio is 20%, the bank now has excess
reserves of $80,000.
20
Table 3
Changes in Bank-a-mythica’s balance sheet,
January 3–6, 2008
Assets
Liabilities and Net Worth
Loans outstanding
Reserves
+$80,000
-$80,000
Addendum: Changes in Reserves
Actual reserves
Required reserves
Excess reserves
-$80,000
No change
-$80,000
No change
Bank earns 0% interest on the excess reserves, so it will make a loan of
$80,000 to Hard-Pressed Construction Co. Loans rise by $80,000 & cash
reserves fall by $80,000.
21
Table 4
Changes in Bank-a-mythica’s balance sheet,
January 2–6, 2008
Assets
Reserves
Loans outstanding
Addendum: Changes in Reserves
Actual reserves
Required reserves
Excess reserves
Liabilities and Net Worth
+$20,000
+$80,000
Checking deposits
+$100,000
+$20,000
+$20,000
No change
Combine Tables 2 & 3 to show the bank’s transactions. Checking deposits are
up by $100,000, reserves are up by $20,000, loans are up by $80,000.
Money creation has begun! $100,000 in cash deposits has turned into $100,000
in checking deposits + $80,000 loan (which was probably deposited in another
bank by Hard-Pressed). So the original $100,000 deposit is now $180,000.
22
Table 5
Changes in First National Bank’s balance sheet
Assets
Reserves
Loans outstanding
Addendum: Changes in Reserves
Actual reserves
Required reserves
Excess reserves
Liabilities and Net Worth
+$16,000
+$64,000
Checking deposits
+$80,000
+$16,000
+$16,000
No change
Hard-Pressed banks at First National & deposits the $80,000 loan from BAM.
First National’s reserves rise by $80,000 & it loans out the excess reserves of
$64,000 to Al’s Auto Shop.
Now $244,000 worth of money is circulating = $100,000 initial deposit + $80,000
(loan & deposit of Hard-Pressed) + $64,000 (loan & presumed deposit of Al).
23
Table 6
Changes in Second National Bank’s balance sheet
Assets
Liabilities and Net Worth
Reserves
Loans outstanding
+$12,800
+$51,200
Addendum: Changes in Reserves
Actual reserves
Required reserves
Excess reserves
+$12,800
+$12,800
No change
Checking deposits
+$64,000
Al deposits the $64,000 loan from FN to his bank, Second National. Second
National now has $51,200 in excess reserves which it will loan out. And the
money creation process continues…
24
Banks and Money Creation
• Assumptions of our money creation process
– Each bank holds exactly 20% required reserves
– Each loan recipient re-deposits proceeds in the
next bank
• Sum of infinite geometric progression
1
1  R  R  R  ... 
1 R
2
3
where R = 0.80
$100,000 + $80,000 + $64,000 + $51,200 + …
= $100,000 X 1/(1 – 0.80) = $100,000/(0.20) = $500,000
25
Figure 2. Chain of Multiple Deposit Creation
The initial deposit of
$100,000 in cash is
eventually absorbed in
bank reserves (col. 1),
leading to a total of
$500,000 in new
deposits (col. 2), &
$400,000 in new loans
(col. 3). Money supply
rises by $400,000
because the nonbank
public holds $100,000
less in currency &
$500,000 more in
checking deposits.
26
Banks and Money Creation
• Reserve ratio = m
– R = 1-m
– Deposits expand by 1/m of each $1 of new
reserves that are injected into the system
• Oversimplified money multiplier formula
– ∆MS = (1/m) x ∆reserves
• Our example: ∆reserves = $100,000 x 1/0.20 = $500,000
but $500,000 is not the ∆MS because money includes both
checking deposits & cash –which increases by only
$400,000. There are $500,000 in new deposits but
$100,000 less in cash.
27
Banks and Money Creation
• Multiple contractions of MS
– Deposit destruction shown in Tables 7 & 8
• Now the eccentric widower withdrawals $100,000
from his checking deposit at BAM & places it under
his mattress.
• Decrease BAM’s reserves by $100,000
– BAM needs $80,000 to meet its reserve requirement
• As outstanding loans are paid off it would cease
granting new loans until the $80,000 is acquired
• Where did the borrowers get this $80,000?
– Probably by making withdrawals from other banks
28
Banks and Money Creation
• Assume funds came from FNB which now loses
$80,000 in deposits & $80,000 in reserves.
• It is now short $64,000 in reserves & must reduce
its loan commitments by $64,000 as shown in
Table 8.
• This reaction causes some other bank to suffer a
loss of reserves & deposits of $64,000 & the
whole process repeats.
• Overall, process looks like Figure 2 but with minus
signs.
– Deposits shrink by $500,000; loans fall by $400,000;
bank reserves fall by $100,000; & M1 falls by $400,000.
Table 7
Changes in the balance sheet of Bank-a-mythica
(a)
Assets
Liabilities and Net Worth
Reserves
-$100,000
Addendum: Changes in Reserves
Actual reserves
Required reserves
Excess reserves
-$100,000
-$20,000
-$80,000
Checking deposits
-$100,000
(b)
Assets
Liabilities and Net Worth
Reserves
Loans outstanding
+$80,000
-$80,000
Addendum: Changes in Reserves
Actual reserves
Required reserves
Excess reserves
+$80,000
No change
+$80,000
No change
30
Table 8
Changes in the balance sheet of First National Bank
(a)
Assets
Liabilities and Net Worth
Reserves
-$80,000
Addendum: Changes in Reserves
Actual reserves
Required reserves
Excess reserves
-$80,000
-$16,000
-$64,000
Checking deposits
-$80,000
(b)
Assets
Liabilities and Net Worth
Reserves
Loans outstanding
+$64,000
-$64,000
Addendum: Changes in Reserves
Actual reserves
Required reserves
Excess reserves
+$64,000
No change
+$64,000
No change
31
Money-Creation Formula Is Oversimplified
• Oversimplified money multiplier is only
accurate under very particular
circumstances:
1. Every recipient of cash must redeposit the
cash into another bank rather than hold it.
2. Every bank must hold reserves no larger than
the legal minimum.
32
Money-Creation Formula Is Oversimplified
• If individuals & firms hold more cash, the multiple
expansion of bank deposits is curtailed because
fewer dollars of cash will be available for use as
reserves to support checking deposits. So the MS
will be smaller.
• If banks wish to keep excess reserves, the multiple
expansion of bank deposits will be limited. A given
amount of cash will support a smaller MS than
would be the case if banks held no excess
reserves.
33
The Need for Monetary Policy
• During a recession
– Banks would reduce MS by increasing their
excess reserves & refusing to lend to less
creditworthy applicants
• Tight credit deepens a recession
• Need government intervention
• During Great Depression, MS contracted violently
because banks held excess reserves rather than
making loans that might not be repaid.
34
The Need for Monetary Policy
• During an economic boom
– Banks would expand MS by keeping reserves at
a minimum & lending to firms when AD and
profits are high
• Adds undesirable momentum to the economy &
paves the way for inflation
• Need government intervention
35
Managing Aggregate Demand:
Monetary Policy
Overview
•
•
•
•
•
•
Money & Income
Federal Reserve System
Open Market Operations
Other Methods of Monetary Control
How Monetary Policy Works
Money & the Price Level
Money and Income: Difference
• Money
– At one point in time
• How much money do you have right now?
• E.g., money stock (M1)
• Income
– Over a period of time
• What is your income? (per month or per year)
• E.g., nominal GDP per year
• Examine how interest rates and stock of money
influence rate at which people earn income –or
how monetary policy affects GDP
38
The Federal Reserve System
• Federal Reserve System “The Fed”
– U.S. central bank
• Bank for banks
– Created in 1907
• After four severe banking panics (1873-1907)
– 12 central banks
• Each is a corporation whose stockholders are
member banks
– Immense profits go to U.S. Treasury
39
The Federal Reserve System
• (7 member) Board of Governors
– Appointed by U.S. President
• Chairman serves a 4-year term
• Most powerful central banker in the world
– Advice & consent of Senate
• The Fed
– Independent
• Makes decisions without political interference
– Sets monetary policy
40
The Federal Reserve System
• Federal Open Market Committee (FOMC)
– Determines short-term interest rates & size of
U.S. MS
– 12 voting members
• 7 governors of the Fed
• President of the NY Fed
• 4 (of remaining 11) district bank presidents
– Meets 8 times a year in Washington
– Very limited access to meetings; no press
– Decisions are announced at the meeting’s end
41
Implementing Monetary Policy
• Fed normally relies on open-market operations
to control interest rates
– Fed’s purchase or sale of gov securities
• Open market operations either give banks more
reserves or take reserves away from them,
thereby triggering a multiple expansion in MS
• To see how open-market operations affect interest
rates, we need to understand the market for bank
reserves
42
Implementing Monetary Policy
• Market for bank reserves
– (upward-sloping) Supply curve
• Fed decides how many dollars of reserves to supply
– ∆Fed policy shifts the S curve
– (downward-sloping) Demand curve
• Banks are required to hold reserves
– Required reserve ratio (m) = 0.10 in U.S.
• Reflects the demand for bank deposits
– People hold bank deposits to conduct transactions
» GDP reflects the number of transactions & P level reflects the
average price per transaction
– ∆GDP or ∆P level will shift the D curve
43
Figure 1
The market for bank reserves
S
D
Interest Rate
For given
Fed policy
E
∆Fed policy will
shift the S curve
∆GDP or ∆P level
will shift the D curve
For given
Y and P
D
S
Quantity of Bank Reserves
44
Implementing Monetary Policy
• Market for bank reserves
– Interest rate in Fig. 1 is the federal funds rate
• Interest rate that banks pay/receive when they
borrow reserves from one another
– Banks lend or borrow from one another to
maintain a desired level of reserves
– D (S) for reserves slopes downward (upward)
because as interest rates rise borrowing
(lending) becomes more expensive (attractive)
45
Figure 2
The effects of an open-market purchase
S0
S1
If Fed wants to lower
federal funds rate, it
provides additional
reserves by purchasing
T-Bills from banks. This
shifts S curve outward.
Interest Rate
D
E
A
D
S0
S1
Quantity of Bank Reserves
46
Implementing Monetary Policy
• Table 1 shows the bookkeeping behind the
Fed’s open-market purchase of $100m
worth of T-Bills.
• Fed makes payment by giving banks $100m
in new reserves.
– These reserves are liabilities of Fed & assets of
banks.
– Bank deposits have not increased so required
reserves are unchanged but actual reserves are
$100m higher.
• Now banks have $100m in excess reserves.
47
Table 1
Effects of an open-market purchase of gov securities
on the balance sheets of banks and the Fed
Federal Reserve System
Banks
Assets
Reserves +$100 million
U.S. government
securities -$100 million
Addendum: Changes
in Reserves
Actual Reserves
+$100 million
Required Reserves
No Change
Excess Reserves
+$100 million
Liabilities
Assets
Liabilities
Bank Reserves
U.S. government
+$100 million
securities +$100 million
Bank gets Reserves
Fed gets securities
48
Implementing Monetary Policy
• Additional bank reserves can support a
multiple expansion of MS.
– Banks lend to rid themselves of excess
reserves.
– Estimate ultimate ↑MS = $100m ∕ “m” = $500m
• If m = 0.20
• Difficult to estimate ultimate ↑MS because
– People may want to hold more cash
– Banks may want to hold excess reserves
• Oversimplified money multiplier assumes that neither
is true.
49
Implementing Monetary Policy
• Fed controls the federal funds rate directly by
buying just the right volume of securities.
• Consider the case when Fed wants to increase
interest rates (contractionary monetary policy)
– Fed sells T-Bills in the open market
– Banks pay with reserves
• They draw down on their deposits at the Fed
– Banks acquire reserves by curtailing their
lending
– Multiple contraction process ensues
50
Implementing Monetary Policy
• Bond Prices & Interest Rates
– always move in the opposite direction
• Bonds (e.g., T-Bills) pay a fixed number of dollars
of interest per year.
– E.g., Bond pays $60/year. If P = $1,000 → interest
rate = 6%. If P = $1,200 → interest rate = 5%
– If ↑P of bond → ↓interest rate and vice versa.
51
Figure 3
Open-market purchases and treasury bill prices
Price of a Treasury Bill
S1
S0
D
P1
B
A
Expansionary Monetary Policy: Fed
buys T-Bills and S shifts in as number
of T-Bills available to private investors
falls. Price of T-Bills rises which
lowers the interest rate.
Figure 3 is another way to understand
how Fed open-market operations
influence interest rates.
P0
D
S1
S0
Quantity of Treasury Bills
52
Implementing Monetary Policy
• Open-market purchase of T-Bills
(expansionary monetary policy)
– ↑MS → ↑P of T-bills → ↓interest rates
• Open-market sale of T-Bills
(contractionary monetary policy)
– ↓MS → ↓ P of T-bills → ↑interest rates
53
Other Methods of Monetary Control
• Fed is a “lender of last resort”
– Occurred in summer & fall of 2007 when financial crisis
made banks wary of lending
– In 2008, Fed also began lending to securities firms –not
done since 1930s
• In Table 2, Fed loans $5m to a bank
– Expands (actual & excess) reserves by $5m, which
should lead to an expansion of the MS
• Discount rate is the interest rate Fed charges on
loans to banks
– Fed can ↓discount rate to encourage banks to have
more reserves (occurred in 2007 & 2008)
54
Table 2
Balance sheet changes for borrowing from the Fed
Federal Reserve System
Banks
Assets
Liabilities
Reserves
Loan from
+$5 million Fed +$5 million
Addendum:
Changes in
Reserves
Actual Reserves
+$5 million
Required
Reserves
No Change
Excess Reserves
+$5 million
Assets
Liabilities
Loan to
Bank +$5 million
Bank Reserves
+$5 million
Bank borrows $5 million
And the proceeds are credited
to its reserve account
55
Other Methods of Monetary Control
• Minimum required reserve ratio
• Decrease m
– Increase banks’ excess reserves → money expansion
– Lower the D for reserves & thereby lower interest rates
• Increase m
– Decrease banks’ reserves → money contraction
– Raise the D for reserves & thereby raise interest rates
• “m” has been 10% since 1992
– Infrequently used by Fed as a policy tool
56
How Monetary Policy Works
•
Expansionary monetary policy
1. Open-market purchase of T-Bills
2. Lower discount rate
3. Lower required reserve ratio
•
Contractionary monetary policy
1. Open-market sale of T-Bills
2. Raise discount rate
3. Raise required reserve ratio
• **Fed primarily uses open-market transactions
to conduct monetary policy**
57
Figure 4
The effects of monetary policy on interest rates
S0
S2
S1
S0
D
D
Interest Rate
Interest Rate
E
A
S0
D
S1
Bank Reserves
(a)
Expansionary Monetary Policy
B
E
S2
S0
D
Bank Reserves
(b)
Contractionary Monetary Policy
58
How Monetary Policy Works
• Recall: AD: total exp = C + I + G + (X-IM)
• Most sensitive components of AD to
monetary policy:
– Investments are largely financed through
borrowing, so interest rates (r) impact the cost
of investments
• ↑r → ↓I
• ↓r → ↑I
– Net exports
• ↑r → ↑$ → ↓(X-IM)
• ↓r → ↓$ → ↑(X-IM)
59
Figure 5
The effect of interest rates on total expenditure
45°
C+I+G+(X-IM)
(lower interest rate)
Real Expenditure
C+I+G+(X-IM)
C+I+G+(X-IM)
(higher interest rate)
Real GDP
60
How Monetary Policy Works
• Expansionary monetary policy
– Lowers r → Encourages I → higher total
spending → shifts expenditure schedule up →
multiplier effect on AD → raises GDP
Federal Reserve 1
2
3





M
and
r

I



Policy


3 C  I  G  ( X  IM ) 4 GDP
61
Figure 6
The effect of expansionary monetary policy on total
expenditure
45°
C+I1+G+(X-IM)
Real Expenditure
E1
C+I0+G+(X-IM)
E0
0
5,500
6,000
6,500
Real GDP
7,000
62
How Monetary Policy Works
• Effect of monetary policy on AD
– Depends on
• Sensitivity of interest rates to open-market
operations
• Responsiveness of investment spending to
the interest rate
• Size of basic expenditure multiplier
63
Money & Price Level in Keynesian Model
• Expansionary monetary policy
– Increases quantity of AD
• At any given price level
– Causes some inflation
• Depends on slope of AS curve
Federal Reserve 1
2
3





M
and
r

I



Policy


3 C  I  G  ( X  IM ) 4 Y and P 
64
Figure 7
Inflationary effects of expansionary monetary policy
D0
D1
S
Price Level
$500 billion
Expansionary
monetary policy
causes some
inflation. But how
much depends on
the slope of AS.
B
103
E
100
S
D0
0
6,000
D1
6,400
Real GDP
65
Money & Price Level in Keynesian Model
• Why does AD curve slope downward?
– Higher price level
• Reduces purchasing power of money fixed
assets & thereby lowers C
• Depress X & Stimulate IM
• Increases the quantity of bank deposits
demanded
– D for bank reserves shifts outward → increases
federal funds rate → higher interest rate →
discourages I → lowers aggregate quantity
demanded
66
Figure 8
The effect of a higher price level on the market for
bank reserves
At higher P levels, the
quantity of bank reserves
demanded is greater. Thus,
higher prices lead to higher
interest rates.
S
D1
Interest Rate
D0
E1
Effect of a
higher P
E0
S
D0
D1
Bank Reserves
67