1. Money, Banks, and the Federal Reserve Chapter 13

2. Money Money Money supply
an asset that has a unique feature: its widely accepted as a means of payment (you can use it to buy stuff)
you can store your wealth in cash, if you desire
Money supply
the total amount of money held by the public

3. Two Measures of the Money Supply
M1 Money supply –
cash in the hands of the public
checking account deposits (checkable deposits)
travelers checks
Cash in the hands of the public
currency and coins held by the nonbank public
currency sitting in a bank vault or an ATM is not part of the M1 money supply

4. The Money Supply Checkable deposits Travelers checks
demand deposits (non-interest earning checking accounts)
other checkable deposits
Travelers checks
specially printed checks that you can buy from banks or other private companies

5. M1 Money Supply Currently $2,988 billion

6. The Money Supply Money supply, M2 includes all of M1 plus
savings account deposits
money market deposits
certificates of deposit under $100,000
money market funds

7. Three Functions of Money
Means of payment
you can use it to buy stuff
Store of value
a form in which wealth can held
Unit of account
a common unit for measuring how much something is worth

8. Types of Money Commodity money
Precious metals and other valuable commodities used to buy stuff
Important non-money use is what gave commodity money its ultimate value, called intrinsic value.

9. A Brief History of the Dollar
Paper currency
Initially, a certificate representing a certain amount of gold or silver held by a bank
People were willing to accept paper money:
Currency could be exchanged for a valuable commodity such as gold or silver
The issuer - either a government or a bank -could print new money only when it acquired additional gold or silver

10. A Brief History of the Dollar
Paper currency
Today - it is no longer backed by gold or any other physical commodity
Fiat money
Something that serves as a means of payment by government declaration

11. Financial Markets Financial intermediary
A business firm that specializes in channeling funds between savers and borrowers. For example,
Commercial banks
Savings and loan associations
Mutual savings banks
Credit unions
Insurance companies

12. The Banking System Depository institutions:
Commercial banks
Savings and loan associations
Mutual savings banks
Credit unions
are financial intermediaries
accept deposits from the general public
lend the deposits to borrowers
largest group is commercial banks

13. The Banking System Commercial banks
a private corporation, owned by its stockholders, that provides services to the public
Obtain funds mainly by accepting checkable deposits, savings deposits, and time deposits
Use the funds to make business loans, mortgage loans, and consumer loans

14. The Banking System Balance sheet Bank’s assets Bank’s liabilities
Financial statement showing assets, liabilities, and shareholders’ equity at a point in time
Bank’s assets
Everything of value that it owns
Bonds, loans, reserves
Bank’s liabilities
The amounts that the bank owes
Checking account deposits, bank borrowing

15. The Balance Sheet of Mid-Size National Bank
Question: Which items on this balance sheet are included in the M1 money supply? M2?

16. The Banking System Bond Loan A promise to pay back borrowed funds
It’s legal a contract
Issued by a corporation or the government
Loan
An agreement to pay back borrowed funds. It’s a legal contract.
Commercial and Industrial loans, mortgage loans, consumer

17. The Banking System Reserves balances held at the Fed plus vault cash
Required reserves
Minimum amount of reserves a bank must hold based on the amount of its checking account deposits
Required Reserve Ratio or reserve requirement – currently 10%
The minimum fraction (%) of checking account deposits that banks must hold as reserves
If less than 100% => Fractional Reserve System

18. The Banking System Excess reserves Shareholders’ equity
Reserves in excess of required reserves
Shareholders’ equity
The difference between total assets and total liabilities
A balance sheet always balances

19. The Federal Reserve The Federal Reserve is the central bank of the US.
A nation’s monetary authority responsible for controlling the money supply
England: 1694
France: 1800
United States: 1913
Canada: 1934

20. The Federal Reserve System
12 Federal Reserve districts
It is not part of any branch of government
Was created by Congress - Federal Reserve Act (1913)
Could be eliminated by Congress if it so desired

21. The Geography of the Federal Reserve System
The United States is divided into 12 Federal Reserve districts, each with its own Federal Reserve Bank.
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22. Structure of The Federal Reserve System
Board of Governors
Seven members
Appointed by the president
Confirmed by the Senate
For a 14-year term
Chairman
One of the seven governors
Approved by with Senate
4-year term

23. Structure of The Federal Reserve System
12 Federal Reserve Banks
Each is supervised by nine directors
Three - appointed by the Board of Governors
Six - elected by private commercial banks
Each has a president
Chosen by the directors

24. Structure of the Federal Reserve System
Federal Open Market Committee (FOMC)
a committee of Federal Reserve officials that establishes U.S. monetary policy
includes all seven governors of the Fed
plus five of the twelve bank presidents
Discount rate
Banks can borrow from the Fed
The discount rate is the interest rate the Fed charges on loans to banks

25. The Federal Reserve System - Structure

26. The Federal Reserve System
The functions of the Fed
Supervising and regulating banks
Acting as a “bank for banks”
Issuing paper currency
Check clearing
Guiding the macro economy (Monetary Policy)
Dealing with financial crises

27. Monetary Policy and the Money Supply
Open market operations
Purchases or sales of bonds by the Federal Reserve System
The primary way the Fed increases or decreases the money supply
Open market purchase
Fed buys government bonds
Money supply increases
Open market sale
Fed sells government bonds
Money supply decreases

28. Monetary Policy and the Money Supply
We make the following assumptions
Banks never hold excess reserves
Households and businesses do not withdraw or deposit cash
Required Reserve Ratio or Reserve Requirement is 10% (0.1)
For each $1,000 increase in checking account deposits at a bank, its reserves must rise by $100

29. Open Market Purchase
What happens when the Fed purchases government bonds
Suppose the Fed buys $100,000 worth of bonds from Acme Bond Company
Acme has a checking account with Mid-Size National Bank and deposits $100,000
3 players: The Fed, Acme Bond Company and Mid-size bank.

30. Acme sends bonds to the Fed Fed give Acme check for $100,000
Open market Purchase - Fed buys $100,000 worth of bonds from Acme Bond Company
Acme sends bonds to the Fed
Fed give Acme check for $100,000
Acme deposits check in bank
Bank sends check to Fed
Fed gives bank reserves

31. Open Market Purchase Result: Mid-Size National Bank now has:
$100,000 in reserves
$10,000 required reserves (10% reserve requirement)
$90,000 excess reserves
Result:
The Fed injected $100,000 in reserves into the banking system
Important ! The money supply also increased by $100,000 (checking accounts)

32. The Fed and the Money Supply
Mid-Size National Bank now has $90,000 excess reserves to lend.
Mid-Size National bank lends $90,000 to Paula so she can buy new equipment for her pizza business (or maybe a new BMW)
The bank gives Paula a check for $90,000.

33. Paula deposits the check in her checking account at Second Bank
Mid- Size National bank lends $90,000 to Paula
Paula deposits the check in her checking account at Second Bank
The check clears – which means Second Bank sends Paula’s check to the Fed to collect $90,000 from Mid-size bank.
$90,000 in reserves are transferred from Mid-Size bank to Second Bank.

34. The Fed and the Money Supply
Second Bank
$90,000 checking account deposit
$9,000 required reserve
$81,000 excess reserves
Lends out the excess reserves

35. Effects of a $100,000 Open Market Purchase
Open Market Purchase increases the Money Supply

36. The Fed and the Money Supply

37. The Fed and the Money Supply
Open market sale
Fed sells government bonds
Money supply decreases
The Fed sells $100,000 government bonds to Acme Bond
Acme will pay with a $100,000 check drawn on its account at Mid-Size Bank

38. The Fed and the Money Supply
Changes in Mid-Size National Bank’s balance sheet
Mid-Size National Bank
Total reserves decreased by $100,000
Required reserves decreased by $10,000
Deficient reserves $90,000
“Calling in” loans: $90,000

39. The Fed and the Money Supply
Changes in Mid-Size’s balance sheet

40. Open market purchase Open market sale Fed buys government bonds
Summary of Open Market Operation
Open market purchase
Fed buys government bonds
Reserves in the banking system increase
Money supply increases
Open market sale
Fed sells government bonds
Reserves in the banking system decrease
Money supply decreases

41. The Fed and the Money Supply
Other Fed actions that change the money supply
Changes in the required reserve ratio
Changes in the discount rate
Changes in the interest rate on reserves
Tools of monetary policy:
Open market operations

42. Change in the Required Reserve Ratio
Lower the required reserve ratio
Increase in money supply
Increase the required reserve ratio
Decrease in money supply
Very Powerful Tool - seldom used

43. CHANGE IN THE REQUIRED RESERVE RATIO
A Decrease in the Required Reserve Ratio from 20 Percent to 12.5
Percent Increases the Supply of Money (All Figures in Billions of Dollars)
PANEL 1: REQUIRED RESERVE RATIO = 20%
Federal Reserve
Commercial Banks
Assets
Liabilities
Government
$200
$100
Reserves
$500
Deposits
securities
Currency
Loans
$400
Note: Money supply (M1) = Currency + Deposits = $600.
PANEL 2: REQUIRED RESERVE RATIO = 12.5%
$800
Loans (+ $300)
$700
(+ $300)
Note: Money supply (M1) = Currency + Deposits = $900.

44. The Fed and the Money Supply
Changes in the discount rate
Lower discount rate
Encourages banks to borrow reserves
Increase the money supply
Increase the discount rate
Discourage banks from borrowing
Decrease the money supply
Not a powerful tool
- Banks are hesitant to borrow from the Fed
- Little effect on bank borrowing, bank reserves, or the money supply

45. The Fed and the Money Supply
Changes in the interest rate on reserves
The Fed began paying interest on reserves (IOR) in 2008
Reduced bank’s opportunity cost of holding reserves
If the Fed lowers the IOR rate
The opportunity cost of holding excess reserves rises
Encourage bank lending
Increase the money supply

46. Banking Panics Fractional reserve system
a system in which banks hold only a fraction of their deposit liabilities as reserves (10% in the U.S.)
Assets Liabilities
Reserves $100 Deposits $1,000
Loans $900

47. Banking Panics Insolvent Bank failure
banks become insolvent when total assets are less than its total liabilities
Bank failure
when an insolvent bank goes out of business

48. The Balance Sheet of Mid-Size National Bank
Equity Ratio = Equity / Assets
In this case = $125 /$1,000 = .125 or 12.5%

49. Suppose Borrows Fail to Repay $150 million in Loans loansBecome Insolvent
15% of assets are bad
Total Assets = $850 million; Total Liabilities = $875
Total Assets – Total Liabilities = $850 – 875 = $-25
The bank is insolvent

50. Bad Loans Cause Mid-Size Bank to Become Insolvent
15% of assets are bad
If the bank had $150 million in equity (15%) or more, it would not be insolvent
Lehman Brothers equity ratio was 3% when it failed.

51. Banking Panics Run on the bank (Bank run) Banking panic
an attempt by a lot of a bank’s depositors to withdraw their funds
Banking panic
depositors attempt to withdraw funds from many banks simultaneously
forces many banks to “close their doors” (unable to honor their depositors’ requests for funds)
Even if they were solvent

52. Bank Failures in the United States, 1921–2011
About 10,000 banks (1/3 of banks in the US) failed
during the Great Depression
FDIC created in 1933
During the Great Depression a large number of banks failed. The creation of the Federal Deposit Insurance Corporation in 1933 strengthened faith in the stability of the banking system. Even during the financial crisis of 2008–2009, bank failures were far fewer than in the 1930s.

53. Banking Panics Largely eliminated after 1933
Federal Reserve – learned important lesson during the Great Depression - ready to lend to banks more quickly in a crisis
Federal Deposit Insurance Corporation: reimburse those who lose their deposits
Increased government regulation of banks

54. Bank Regulation
Continuous monitoring of bank financial condition with a focus on the shareholders’ equity (called bank capital)
Legal capital requirements:
Banks must hold a percentage of their assets as equity (bank capital, 5% to 8%)
Dr. Neri does not believe the percentage is high enough.
High equity encourages banks to lend responsibly because the owner’s loose if lend recklessly.

55. 𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓 𝒆𝒒𝒖𝒊𝒕𝒚 𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔
Bank Regulation
Bank Capital
another name for shareholders’ equity in a bank
Capital ratio (equity ratio)
A bank’s capital (shareholder equity) as a percentage of its total assets
𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓 𝒆𝒒𝒖𝒊𝒕𝒚 𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔

56. Bank Regulation Why require higher capital ratios
Greater incentives to avoid risky loans
Reduces the likelihood of bank failures that pass losses onto non-owners
Some argue (the banks, duh!) this reduces the amount of interest-earning assets a bank can hold for each dollar of capital that the owners have invested
Reduces the rate of return to the bank’s owners
Discourages people from forming or investing in banks ( I don’t believe this)

57. Banking Panics
Look at the slide on bank failures. What happened in the 1980s and 90s?
many undercapitalized banks, not enough equity
many without FDIC insurance
Poorly regulated
– banks made bad loans and had low capital ratio
Reminder of the need for deposit insurance and high capital requirements.