Money and the Banking System & Monetary Policy

Money and the Banking System & Monetary Policy
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!

Figure 1 (a) Bank failures in the United States, 1915–2009
Bank failures have been less common since 1930s –until recently.

Figure 1 (b) Bank failures in the United States, 1915–2009 ‘09

The Nature of Money Barter Money
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

The Nature of Money What is Money? Medium of exchange Unit of account
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!

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

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

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.

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

The Banking System Fractional reserve banking Features
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.

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

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.

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

Liabilities and Net Worth
Table 1 Balance sheet of Bank-a-mythica, December 31, 2007 Assets Liabilities and Net Worth Reserves Loans outstanding Total Addendum: Bank Reserves Actual reserves Required reserves Excess reserves $1,000,000 $4,500,000 $5,500,500 Liabilities Checking deposits Net Worth Stockholder’s equity $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.

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

Table 2 Changes in Bank-a-mythica’s balance sheet, January 2, 2008 Assets Liabilities and Net Worth Reserves Addendum: Changes in Reserves Actual reserves Required reserves Excess reserves +$100,000 +$ 20, $ 80,000 Checking deposits 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.

Table 3 Changes in Bank-a-mythica’s balance sheet, January 3–6, 2008 Assets Liabilities and Net Worth Loans outstanding Reserves Addendum: Changes in Reserves Actual reserves Required reserves Excess reserves +$80,000 -$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.

Table 4 Changes in Bank-a-mythica’s balance sheet, January 2–6, 2008 Assets Liabilities and Net Worth Reserves Loans outstanding Addendum: Changes in Reserves Actual reserves Required reserves Excess reserves +$20,000 +$80,000 +$20, No change Checking deposits +$100,000 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.

Table 5 Changes in First National Bank’s balance sheet Assets Liabilities and Net Worth Reserves Loans outstanding Addendum: Changes in Reserves Actual reserves Required reserves Excess reserves +$16,000 +$64,000 +$16, No change Checking deposits +$80,000 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).

Table 6 Changes in Second National Bank’s balance sheet Assets Liabilities and Net Worth Reserves Loans outstanding Addendum: Changes in Reserves Actual reserves Required reserves Excess reserves +$12,800 +$51,200 +$12, 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…

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 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

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.

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.

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

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.

Liabilities and Net Worth Liabilities and Net Worth
Table 7 Changes in the balance sheet of Bank-a-mythica (a) Assets Liabilities and Net Worth Reserves Addendum: Changes in Reserves Actual reserves Required reserves Excess reserves -$100,000 -$20, $80,000 Checking deposits (b) Assets Liabilities and Net Worth Reserves Loans outstanding Addendum: Changes in Reserves Actual reserves Required reserves Excess reserves +$80,000 -$80,000 No change

Liabilities and Net Worth Liabilities and Net Worth
Table 8 Changes in the balance sheet of First National Bank (a) Assets Liabilities and Net Worth Reserves Addendum: Changes in Reserves Actual reserves Required reserves Excess reserves -$80,000 -$16, $64,000 Checking deposits (b) Assets Liabilities and Net Worth Reserves Loans outstanding Addendum: Changes in Reserves Actual reserves Required reserves Excess reserves +$64,000 -$64,000 No change

Money-Creation Formula Is Oversimplified
Oversimplified money multiplier is only accurate under very particular circumstances: Every recipient of cash must redeposit the cash into another bank rather than hold it. Every bank must hold reserves no larger than the legal minimum.

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.

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.

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

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
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 ( ) 12 central banks Each is a corporation whose stockholders are member banks Immense profits go to U.S. Treasury 39

(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

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

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
Interest Rate ∆Fed policy will shift the S curve ∆GDP or ∆P level will shift the D curve D For given Fed policy E For given Y and P Quantity of Bank Reserves 44

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
Quantity of Bank Reserves Interest Rate S0 D S1 E A If Fed wants to lower federal funds rate, it provides additional reserves by purchasing T-Bills from banks. This shifts S curve outward. 46

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

Federal Reserve System
Table 1 Effects of an open-market purchase of gov securities on the balance sheets of banks and the Fed Banks Assets Liabilities Federal Reserve System Assets Liabilities Reserves +$100 million U.S. government securities +$100 million Bank Reserves +$100 million U.S. government securities -$100 million Bank gets Reserves Addendum: Changes in Reserves Actual Reserves +$100 million Required Reserves No Change Excess Reserves Fed gets securities 48

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

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

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
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. Price of a Treasury Bill S1 S0 D B P1 A P0 Quantity of Treasury Bills 52

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

Federal Reserve System
Table 2 Balance sheet changes for borrowing from the Fed Banks Assets Liabilities Federal Reserve System Assets Liabilities Reserves +$5 million Loan from Fed +$5 million Loan to Bank +$5 million Bank Reserves +$5 million Addendum: Changes in Reserves Actual Reserves +$5 million Required No Change Excess Reserves 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 Open-market purchase of T-Bills Lower discount rate Lower required reserve ratio Contractionary monetary policy Open-market sale of T-Bills Raise discount rate Raise required reserve ratio **Fed primarily uses open-market transactions to conduct monetary policy** 57

Expansionary Monetary Policy Contractionary Monetary Policy
Figure 4 The effects of monetary policy on interest rates S0 S2 S1 S0 Interest Rate D Interest Rate D E B A E Bank Reserves Bank Reserves (a) Expansionary Monetary Policy (b) Contractionary Monetary Policy 58

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

(higher interest rate)
Figure 5 The effect of interest rates on total expenditure 45° Real Expenditure C+I+G+(X-IM) (lower interest rate) C+I+G+(X-IM) C+I+G+(X-IM) (higher interest rate) Real GDP 60

Expansionary monetary policy Lowers r → Encourages I → higher total spending → shifts expenditure schedule up → multiplier effect on AD → raises GDP 61

Figure 6 The effect of expansionary monetary policy on total expenditure 45° Real Expenditure C+I1+G+(X-IM) E1 C+I0+G+(X-IM) E0 6,500 6,000 Real GDP 5,500 7,000 62

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 64

Figure 7 Inflationary effects of expansionary monetary policy S
D1 Price Level S D0 $500 billion Expansionary monetary policy causes some inflation. But how much depends on the slope of AS. B 103 E 6,400 100 6,000 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. Bank Reserves Interest Rate S D0 D1 Effect of a higher P E1 E0 67

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