Introduction In this unit we learn about our financial system and its importance to our economy. The money supply is classified by its accessibility. The cash in our wallet or purse being the most accessible form of money. We will also learn about how banks create money. Yes, banks actually create new money from deposits they receive!
Concept 1: Money Before we had money, people engaged in barter. Barter is the direct exchange of one good for another, without the use of money. Barter continues to exist today, especially within countries with unstable currency. Have you ever bartered? For example, if a friend helps you repair your car and in return you help him paint his house you are engaging in barter.
Concept 2: Money Supply Money is considered anything generally accepted as a medium of exchange. Money has a value which can be used to measure the prices of goods and services. In today’s society the concept of money can be applied to not only the currency and coins you have, but checks, ATM cards, credit cards, etc. Checks continue to be the most common form of payment in the U.S. In Japan and Europe, most transactions are handled by cash and credit.
Concept 2: Money Supply The supply of money is measured and placed into categories based upon its accessibility. Accessibility refers to how easily you can access and use the money. The first category is called M1. M1 contains the total dollar amount of currency and coins in circulation. M1 also includes transaction (checking) account balances. M1 also contains traveler’s checks that are not issued by banks. For example, American Express Travelers Checks. Almost $1.3 trillion is found within this first category.
Concept 2: Money Supply The next category of money is called M2. M2 contains all balances under M1, plus: M2 also contains savings accounts and time deposits (certificates of deposit) of less than $100,000. M2 also includes money market mutual funds. M2 does NOT contain stock or bond market mutual funds! The new categories under M2 adds an additional $4.9 trillion to the money supply! Remember that M2 also includes the categories under M1, so the total money supply for both categories is around $6.2 trillion.
Concept 2: Money Supply The next category is called M3. M3 contains everything under M2 and M1. M3 also contains time deposits over $100,000. M3 includes bank repurchase agreements. Bank repurchase agreements are short-term loans to banks. M3 also includes overnight Eurodollars. Overnight Eurodollars are deposits of U.S. currency held at foreign banks, or U.S. currency deposits held by U.S. banks overseas. Overnight refers to the short time period the funds are held on deposit.
Concept 2: Money Supply The highest and least accessible category of the money supply is called L (sorry – it’s NOT M4). L includes all categories of money under M3, M2, and M1, plus: L also contains U.S. Treasury Bills, Treasury Bonds and U.S. Savings Bonds. L also includes bankers’ acceptances, term Eurodollars, and commercial paper issued by corporations. What are these items? Let’s find out!
Concept 2: Money Supply Bankers’ Acceptances are guarantees of payment issued to corporations buying products from overseas entities. Term Eurodollars are time deposits held in U.S. currency by foreign banks or U.S. banks located overseas. Commercial paper is a debt or loan issued by a private corporation not backed by any collateral or assets. Note: The Eurodollars we are referring to here is not the new currency of Europe called the Euro.
Concept 3: Types of Banks Commercial banks are financial institutions that offer a full range of consumer and business services including savings and checking accounts and loans. Most of the demand deposits (checking accounts) and almost half of the total savings deposits are held by commercial banks. Savings and loan associations are financial institutions that offer limited consumer services; usually savings accounts and home mortgages.
Concept 3: Types of Banks Mutual Savings Banks are financial institutions that offer consumer orientated services including checking and savings accounts, loans, and mortgages. Credit Unions are a unique type of financial institution. They are an association formed by a group to offer its members checking and savings services, loans and mortgages. Credit unions require membership in a group and concentrate their services on consumers. Credit unions are non-profit and tax exempt.
Concept 4: Money Creation Banks can create money and increase the supply of money by making loans. Banks can loan a certain percentage of their deposits – checking, savings, and certificates of deposit. A bank must keep a certain portion of its deposits in reserve. Bank reserves are assets held by a bank to fulfill its deposit obligations. The percentage of reserves is controlled by the Federal Reserve.
Concept 4: Money Creation Banks are required by the Federal Reserve to keep a percentage of their deposits in reserve. The percentage a bank is required to keep in reserve is called the reserve ratio. Reserve ratio – the ratio of a bank’s reserves to its total transactions deposits. Using the reserve ratio, a bank can determine the actual dollar amount of reserves it is required to keep. Required reserves – the minimum amount of reserves a bank is required to hold. The amount of required reserves is based upon the reserve ratio.
Concept 4: Money Creation Required reserves = reserve ratio X total deposits For example, if a bank has total deposits of $100,000, and the reserve ratio is.75, then the required reserves =.75 X $100,000 = $75,000 The bank would be required to keep $75,000 in reserves and could loan up to $25,000.
Concept 4: Money Creation The amount a bank has available for loans and money creation is called the excess reserves. Excess reserves are bank reserves in excess of required reserves. Excess reserves = total reserves – required reserves Looking at our previous example of a bank with $100,000 in deposits and required reserves of $75,000: Excess reserves = $100,000 - $75,000 = $25,000
Concept 4: Money Creation Another example: Suppose a bank has total deposits of $500,000, loans in the amount of $300,000, and a required reserve ratio of.20. What is the dollar amount of the required reserves? Required reserves = reserve ratio X total deposits.20 X $500,000 = $100,000, answer What is the dollar amount of excess reserves for this bank? Hmmm…
Concept 4: Money Creation This bank has deposits of $500,000, loans of $300,000 and required reserves of $100,000. $500,000 - $300,000 - $100,000 = $100,000 in Excess Reserves Remember to subtract the loan balance from the deposits, and then subtract the dollar amount required in reserves, to find the Excess Reserves.
Concept 4: Money Creation The total amount of excess reserves is available for loans and money creation. Banks make most of their profits on the interest they charge on loans to consumers and businesses. When a bank makes a loan, the loan recipient uses the loan to purchase something. The loan check is either deposited by the borrower or by the entity the purchase was made from. By depositing the check at the same bank or another bank, bank reserves are increased.
Concept 4: Money Creation Further bank loans can be made from the deposited loan check, subject to the reserve requirement. For example, a bank makes a $1000 loan to a consumer. The consumer buys a new TV and the electronics store deposits the check in a bank. The bank can use the additional deposit to increase the supply of money by more than the original $1000 bank loan. This increase in the supply of money is called the money multiplier. The money multiplier is the number of deposit (loan) dollars that the banking system can create from each $1 of excess reserves.
Concept 4: Money Creation Money Multiplier = 1/required reserve ratio For example, if the required reserve ratio is 20% or.20, then the money multiplier = 1/.20 = 5 We use the money multiplier to determine what happens to the money supply if excess reserves are increased or decreased. For example, if excess reserves are $100 and the money multiplier is 5, we know that the potential deposit creation ( growth of the money supply) is = $500.
The Money Multiplier at Work Reserve Ratio: 20% Multiplier: 5
Concept 4: Money Creation Through the money multiplier process, banks create additional funds that can be borrowed by individuals and businesses. Funds are borrowed to purchase many items: cars, homes, machinery, land, etc. The borrowing activity stimulates the economy. Therefore, if more or less economic activity is desired, banks can play a major role in changing economic conditions.
Concept 5: Constraints The banking system faces four constraints as it creates deposits and money: People must continue to use checks and banking accounts. If cash becomes a preferred method of payment rather than checks, the money multiplier is affected. People and businesses are interested in borrowing money to purchase goods and services. If consumers or businesses are reluctant to borrow money because of economic uncertainty, banks will be unable to use their excess reserves to increase the supply of money.
Concept 5: Constraints The reserve requirement can change which affects the lending ability of banks. If the Federal Reserve increases the reserve requirement, banks will have fewer excess reserves. A decrease in excess reserves reduces the ability of banks to increase the supply of money (limits deposit creation). Banks must be willing to lend money. If there is economic uncertainty, very low interest rates or problems with increasing loan defaults, banks may be less willing to lend money.