1. McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Money and Banks Chapter 13

2. 2 Part 5 – Monetary Policy Options Chapter 13 - Money and Banks 1 - What is Money? 2 - The Money Supply 3 - Creation of Money 4 - The Money Multiplier 5 - Banks and the Circular Flow

3. 3 1. What is “Money”?

4. 4 What Is Money? Money: A means of exchange, eliminates the need for barter: the direct exchange of one good for another, without the use of money. Barter economies are very inefficient. Money has several “properties:” Divisibility, portability, stability, acceptability, etc. LO1

5. 5 What Is Money? Money performs the following functions: Medium of exchange. Store of value. Standard (or measure) of value. LO1

6. 6 Types of Money Three historical phases of money: Commodity money, Representative money, Fiat money. = Because I Said So!

7. 7 Background - Many “Types” of Money Commodity money: In colonial America, there were no U.S. dollars so many different things were used as mediums of exchange. Tobacco. LO1

8. 8 Background - Many “Types” of Money Commodity money: In colonial America, there were no U.S. dollars so many different things were used as mediums of exchange. Tobacco. LO1 1727 - VIRGINIA: "Tobacco notes" Become Legal Tender in Virginia. Tobacco Notes attesting to quality and quantity of one's tobacco kept in public warehouses were authorized as legal tender in Virginia. They were used as units of monetary exchange throughout 18th Century. The notes were more convenient than the actual leaf, which had been in use as money for over a century.

9. 9 Background - Many “Types” of Money Commodity money: In colonial America, there were no U.S. dollars so many different things were used as mediums of exchange. Tobacco. Skins. Liquor. Grains. Wampum. LO1

10. 10 Background - Many “Types” of Money After independence, bank-notes and state- issued paper money acted as money along with gold, silver, or commodities. The federal government first issued paper money to finance the Civil War in 1861. The National Banking Act of 1863 gave the federal government permanent & exclusive authority to issue money. The US came off the gold-standard in 1971. LO1

11. 11 2. The Money Supply

12. 12 Liquidity Liquidity: The speed and ease with which an asset can be converted into currency (cash). = = =

13. 13 The Money Supply – M1 Money supply definitions are rooted in liquidity. Money supply (M1): this is the narrowest definition of the money supply. It includes: Currency (cash) in circulation, transaction-account balances (“checking accounts”), traveler’s checks. LO1

14. 14 Ken Sehlmeyer Transaction Accounts The distinguishing feature of transaction accounts is that they permit direct payment to a third party (by check or debit card). LO1

15. 15 The Money Supply – M2 A broader definition of the money supply is M2. M2 money supply = M1 plus… savings accounts, and… money market mutual funds (a more sophisticated savings account). Savings-account balances are almost as good a substitute for cash as transaction-account balances. LO1

16. 16 Composition of the Money Supply Currency in circulation ($750 billion) Transactions-account balances ($603 billion) Savings account balances ($4,926 billion) Money market mutual funds and deposits ( $827 billion) Traveler’s checks ($7 billion) M2 ($7,113 billion) M1 ($1,360 billion) LO1

17. 17 Why Is This Important? How much money is available affects consumers’ ability to purchase goods and services – Aggregate Demand! LO1

18. 18 3. Creation of Money

19. 19 Important terminology: Deposits: the amount of $ (cash) that a bank owes to its depositors. ***the bank doesn’t actually have most of this $ in the bank, it’s just kept on record the amount that each person is owed. Reserves: Cash kept in the bank. Reserve Ratio : the amount of cash the bank has on hand compared to total deposits. REQUIRED Reserves/Ratio : the amount of cash the bank HAS TO HAVE on hand based on total deposits. EXCESS Reserves : the amount of reserves held by the bank beyond required reserves.

20. 20 Terminology Practice: So, if a bank has: - Deposits:………………..$200,000 - Reserves:………………...$50,000 - Required reserve ratio:……....20% 1.What is the amount of required reserves? 2.What is the level of excess reserves? 3.How much money can the bank still loan? $40,000 $10,000

21. 21 The Function of Banks One of the essential functions that banks perform in the macro economy is: The transfer of money from savers to spenders by lending funds (reserves) held on deposit. ***This provides banks with the ability to CREATE MONEY!!!

22. 22 Deposit Creation - Money Creation Banks create money based on two basic principles of the money supply : Transactions-account balances are a large portion of our money supply. Banks CREATE (!!!) transactions- account balances by making loans. LO2

23. 23 Creation of Money We know: Currency is printed. Coins are minted. But… Where do transaction accounts come from?

24. 24 Deposit Creation When a bank lends someone money, it simply credits that individual’s bank account - (their “transaction account”- it doesn’t actually give them cash). Deposit creation: the creation of transactions account deposits by bank lending. LO2

25. 25 Composition Change v. Creation Step one: The deposit of cash or coins into a bank: changes the composition of the money supply, not its size. LO2

26. 26 Composition of the Money Supply Currency in circulation ($750 billion) Transactions-account balances ($603 billion) Savings account balances ($4,926 billion) Money market mutual funds and deposits ( $827 billion) Traveler’s checks ($7 billion) M2 ($7,113 billion) M1 ($1,360 billion) LO1

27. 27 Composition Change v. Creation Step one: The deposit of cash or coins into a bank: changes the composition of the money supply, not its size. Step two: The bank makes loans from its excess reserves by crediting (or creating) a transactions account: “Deposit creation.” Money creation! LO2

28. 28 Bank Reserves & Bank Regulation Bank reserves: the currency held by the banks to meet their obligations to depositors. The Federal Reserve System (“The Fed”) requires banks to maintain some minimum reserve ratio. Required reserves = minimum reserve ratio X total deposits

29. 29 Limits - Bank Regulation The Fed sets the minimum reserve requirement: this regulates and limits the amount of bank lending and deposit creation, … thereby controlling the basic money supply. So long as a bank has excess reserves, it can make loans: i.e., create money. LO2

30. 30 Excess Reserves Excess reserves: reserves in excess of the required minimum. So long as a bank has excess reserves, it can make loans: i.e., create money. LO2 Excess reserves = Total reserves – Required reserves

31. 31 4. The Money Multiplier

32. 32 Vocab Review Reserves Deposits Reserve ratio Required reserve ratio Required reserves Excess reserves = Account totals (bank obligations). = Cash in the bank. = reserves/deposits. = minimum required = minimum of cash needed in the bank: ( required reserve ratio x deposits) = Cash held beyond required reserves.

33. 33 The Money Multiplier Money multiplier: the number of deposit (loan) dollars that the banking system can create from $1 of excess reserves. LO3 A reserve requirement of 20% = a multiplier value of… $100 of excess reserves = deposit creation of 500. 5 (Money creation = $500) Money Multiplier = 1 Reserve requirement

34. 34 The Money Multiplier The money supply can be increased through the process of deposit creation to this limit: Potential deposit creation = Excess reserves x Money multiplier LO3 (Potential MONEY creation = Excess reserves x Money multiplier)

35. 35 The Money Multiplier at Work LO3 - Given a required reserve ratio of 20%: - Assume $0 excess reserves pre-deposit: ***New money created = $400

36. 36 The Money Multiplier The Bottom Line: (Assume a reserve requirement of 10%) 1.If banks have no excess reserves, then: $100 deposit … becomes $1,000 in the system. ($100, + $90 x 10). 2.If Banks have excess reserves, then: $100 excess reserves… = $1,000 created money. LO3 (Excess reserves x Money multiplier = Potential MONEY creation) Excess Reserves$ Multiplier = $900 created money

37. 37 The Money Multiplier LO3

38. 38 The Money Multiplier LO3 Other Assets Deposits (Deposits)

39. 39 Practice: If the banking system has: - Deposits:………………..$500,000 - Reserves:……………....$100,000 - Required reserve ratio:……...10% 1.What is the amount of required reserves? 2.What is the level of excess reserves? 3.What is the potential amount of transaction deposits that can be created? $50,000 $500,000

40. 40 1.A single bank with $20,000 of reserves and a reserve ratio of 5 percent could support total transactions account balances of at most: 2.A single bank with $10,000 of reserves and a reserve ratio of 25 percent could support total transactions account balances of at most: 3.If the required reserve ratio is 0.15. How much can the money supply increase in response to a $1 million increase in excess reserves for the whole banking system? Practice: $400,000 $40,000 $6,666,667

41. 41 5. Money and the Circular Flow

42. 42 Banks and the Circular Flow Review: Banks perform two essential functions for the macro economy: 1. Banks transfer money from savers to spenders by lending funds (reserves) held on deposit. 2. The banking system creates additional money by making loans in excess of total reserves.

43. 43 Banks and the Circular Flow By making loans, and transferring income from savers to spenders: Banks can help maintain any desired rate of aggregate demand.

44. 44 Banks in the Circular Flow Loans Factor markets Product markets Business firms Consumers BANKS Saving Investment expenditures Sales receipts Wages, dividends, etc. Income Domestic consumption

45. 45 Financing Injections The consumer saving is a leakage. A substantial portion of consumer saving is deposited in banks. Bank deposits can be used to make loans, which returns purchasing power to the circular flow.

46. 46 Banks in the Circular Flow Loans Factor markets Product markets Business firms Consumers BANKS Saving Investment expenditures Sales receipts Wages, dividends, etc. Income Domestic consumption

47. 47 Constraints on Deposit Creation There are three major constraints on deposit creation: Deposits – Consumers must be willing to use and accept checks rather than cash. Borrowers – Borrowers must be willing to borrow the money that banks provide. Regulation – The Federal Reserve sets the ceiling on deposit creation.

48. 48 Bank Panics

49. 49 Bank Panics

50. 50 When Banks Fail In the past, “runs” of depositors rushing to withdraw their funds have created panics. Bank closed, wiping out customer deposits, curtailing lending, and often pushing the economy into recession. In the early part of the Great Depression (1930-1933), 9000 banks failed.

51. 51 Deposit Insurance The FDIC and FSLIC were created by Congress in 1933-34, to ensure depositors that their money would be safe -- thus eliminating the motivation for deposit runs.

52. 52 The S & L Crisis In the 1970s many S&Ls were stuck earning money on low-interest, long- term loans while having to pay out higher short-term high-interest rates to their customers.

53. 53 The S & L Crisis Competition from new financial institutions (e.g. money-market mutual funds) enticed deposits away from S&Ls. Consequently, many S&Ls failed.

54. 54 Bank Bailouts S&L failures cost the federal government billions – over $60 billion in 1992 alone – as the FSLIC and FDIC paid off depositors.

55. 55 Bank Bailouts The Resolution Trust Corporation was created in 1989 to manage the outstanding loans of banks the federal government had to bail out. TARP - 2008: “Troubled Asset Relief Fund.” $800 Billion!

56. McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Money and Banks End of Chapter 13