1. 12 Money and the Banking System [Money] is a machine for doing quickly and commodiously what would be done, though less quickly and commodiously, without it. JOHN STUART MILL Money and the Banking System [Money] is a machine for doing quickly and commodiously what would be done, though less quickly and commodiously, without it. JOHN STUART MILL

2. ●The Nature of Money ●How the Quantity of Money is Measured ●The Banking System ●The Origins of the Money Supply ●Banks and Money Creation ●Why the Deposit Creation Formula Is Oversimplified ●The Need for Monetary Policy ●The Nature of Money ●How the Quantity of Money is Measured ●The Banking System ●The Origins of the Money Supply ●Banks and Money Creation ●Why the Deposit Creation Formula Is Oversimplified ●The Need for Monetary Policy Contents Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

3. ●Barter versus Monetary Exchange ♦A barter system (with no money) would be awkward and extremely inefficient. ♦Money greases the wheels of exchange and, thus, makes the whole economy more productive. ●Barter versus Monetary Exchange ♦A barter system (with no money) would be awkward and extremely inefficient. ♦Money greases the wheels of exchange and, thus, makes the whole economy more productive. The Nature of Money

4. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. The Nature of Money ●The Conceptual Definition of Money ♦The functions of money: ■Medium of exchange ■Unit of account ■Store of value ♦Money = whatever serves as the medium of exchange ●The Conceptual Definition of Money ♦The functions of money: ■Medium of exchange ■Unit of account ■Store of value ♦Money = whatever serves as the medium of exchange

5. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●What Serves as Money? ♦Societies have gradually moved from the use of commodity monies to the use of money that has no commodity backing at all. ●What Serves as Money? ♦Societies have gradually moved from the use of commodity monies to the use of money that has no commodity backing at all. The Nature of Money

6. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●There is no single, obvious place to draw the line between “money” and “near money.” ●M1 = coins and paper money in circulation, plus checkable deposits ●M2 = M1 + money market deposit accounts, money market mutual funds, and savings accounts ●There is no single, obvious place to draw the line between “money” and “near money.” ●M1 = coins and paper money in circulation, plus checkable deposits ●M2 = M1 + money market deposit accounts, money market mutual funds, and savings accounts How the Quantity of Money is Measured

7. FIGURE 2: Two Definitions of the Money Supply, January 2005 Copyright © 2006 South-Western/Thomson Learning. All rights reserved. M1 = $1361 billion Currency Outside banks $710 billion Other checkable deposits $321 billions Checking deposits In commercial Banks $330 billion M2 = $6443 billion Money market mutual funds $704 billion M1 $1361 billion Savings deposits $4378 billion

8. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●How Banking Began ♦Fractional reserve banking began when goldsmiths realized they could profitably lend out a portion of the gold that had been deposited with them for safekeeping. ●How Banking Began ♦Fractional reserve banking began when goldsmiths realized they could profitably lend out a portion of the gold that had been deposited with them for safekeeping. The Banking System

9. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. The Banking System ●How Banking Began ♦Three important features of the fractional reserve banking system: ■Bank profitability ■Banks discretion over the money supply ■Exposure to bank runs ●How Banking Began ♦Three important features of the fractional reserve banking system: ■Bank profitability ■Banks discretion over the money supply ■Exposure to bank runs

10. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. The Banking System ●Principles of Bank Management: Profits versus Safety ♦To make a profit, a banker must take risks. ♦But because the business is risky, the same banker must also emphasize safety. ♦The heart of banking is to be torn between the two principles. ●Principles of Bank Management: Profits versus Safety ♦To make a profit, a banker must take risks. ♦But because the business is risky, the same banker must also emphasize safety. ♦The heart of banking is to be torn between the two principles.

11. FIGURE 1: Bank Failures in the United States, 1915-2003 Copyright © 2006 South-Western/Thomson Learning. All rights reserved. 19151920 51930 519401945 0 200 400 600 800 1,000 1,200 1,400 1,600 1,800 2,000 2,200 Year (a) Number of Bank Failures FDIC established Great Depression begins 0 200 160 120 80 40 19451955196519751985 Number of Bank Failures 1995 '03 (b)

12. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. The Banking System ●Bank Regulation ♦Deposit insurance (FDIC) ■Eliminates the motive for customers to withdraw funds because of bad news regarding the bank’s finances ♦Moral hazard ■When an individual is insured against risk, he/she puts forth little effort to avoid risk ■FDIC could make the banking system less safe ●Bank Regulation ♦Deposit insurance (FDIC) ■Eliminates the motive for customers to withdraw funds because of bad news regarding the bank’s finances ♦Moral hazard ■When an individual is insured against risk, he/she puts forth little effort to avoid risk ■FDIC could make the banking system less safe

13. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. The Banking System ●Bank Regulation ♦Bank Supervision ■Needed to reduce moral hazard problem ■Ensures banks take only sensible, defensible risks ■Controls the money supply ♦Reserve Requirements ■Helps control the money supply ●Bank Regulation ♦Bank Supervision ■Needed to reduce moral hazard problem ■Ensures banks take only sensible, defensible risks ■Controls the money supply ♦Reserve Requirements ■Helps control the money supply

14. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●How Bankers Keep Books ♦Banks keep balance sheets ■Assets = liabilities + net worth ♦Assets include: ■Reserves ■Loans ♦Liabilities include: ■Deposits owed to customers. ●How Bankers Keep Books ♦Banks keep balance sheets ■Assets = liabilities + net worth ♦Assets include: ■Reserves ■Loans ♦Liabilities include: ■Deposits owed to customers. The Origins of the Money Supply

15. TABLE 1: Balance Sheet of Bank- a-mythica, Dec. 31, 2004 Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

16. Banks and Money Creation ●The Limits to Money Creation by a Single Bank ♦Banks can lend money in their vault that is above the minimum required reserve ratio. ♦In doing so, they create new money. ●The Limits to Money Creation by a Single Bank ♦Banks can lend money in their vault that is above the minimum required reserve ratio. ♦In doing so, they create new money.

17. TABLE 2: Bank-a-mythica’s Balance Sheet, Jan. 2, 2005 Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

18. TABLE 3: Bank-a-mythica’s Balance Sheet, Jan. 3-6, 2005 Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

19. TABLE 4: Bank-a-mythica’s Balance Sheet, Jan. 2-6, 2005 Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

20. Banks and Money Creation ●Multiple Money Creation by a Series of Banks ♦When all banks make loans with funds they have that are above the required reserve ratio, the society’s money supply expands. ●Multiple Money Creation by a Series of Banks ♦When all banks make loans with funds they have that are above the required reserve ratio, the society’s money supply expands.

21. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Banks and Money Creation ●Multiple Money Creation by a Series of Banks ♦  deposits = (1/m) x  reserves ■Assumes banks keep the minimum reserve ratio, m ■Assumes all new money held in the form of deposits ■Oversimplified deposit multiplier formula ●Multiple Money Creation by a Series of Banks ♦  deposits = (1/m) x  reserves ■Assumes banks keep the minimum reserve ratio, m ■Assumes all new money held in the form of deposits ■Oversimplified deposit multiplier formula

22. TABLE 5: Changes in First National Bank’s Balance Sheet Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

23. TABLE 6: Changes in Second National Bank’s Balance Sheet Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

24. FIGURE 3: The Chain of Multiple Deposit Creation Copyright © 2006 South-Western/Thomson Learning. All rights reserved. $400,000 $268,928 $236,160 $195,200 $144,000 (3) $80,000 Loans $100,000 $500,000 $336,160 $295,200 $244,000 $180,000 Running Sums (2) $100,000 Deposits $67,232 $59,040 $48,800 $36,000 (1) $20,000 Reserves And so on... $40,960 deposit $32,768 lent out$8,192 on reserve $51,200 deposit $40,960 lent out$10,240 on reserve $64,000 deposit $51,200 lent out$12,800 on reserve $80,000 deposit $64,000 lent out$16,000 on reserve $100,000 deposit $80,000 lent out$20,000 on reserve

25. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Banks and Money Creation ●The Process in Reverse: Multiple Contractions of the Money Supply ♦Deposits, and with them the money supply, contract when reserves are reduced. ■Banks reduce their loan commitments. ■Calculation of the contraction in the money supply utilizes the same formula as for money expansion.

26. TABLE 7: Changes in Balance Sheet of Bank-a-mythica Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

27. TABLE 8: Changes, Balance Sheet of First National Bank Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

28. ●Individuals hold some portion of additions to their money in the form of cash. ●Banks sometimes hold reserves above the required minimum. ●Individuals hold some portion of additions to their money in the form of cash. ●Banks sometimes hold reserves above the required minimum. Why the Deposit Creation Formula Is Oversimplified

29. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. The Need for Monetary Policy ●Left uncontrolled, banks would: ♦Reduce the money supply in a recession ♦Increase the money supply during boom periods ●Changes in the money supply would exacerbate the business cycle. ●One reason for monetary policy, therefore, is to prevent this behavior on the part of banks. ●Left uncontrolled, banks would: ♦Reduce the money supply in a recession ♦Increase the money supply during boom periods ●Changes in the money supply would exacerbate the business cycle. ●One reason for monetary policy, therefore, is to prevent this behavior on the part of banks.