The Banking System and the Money Supply © 2003 South-Western/Thomson Learning

The property of being easily converted into cash What Counts as Money Liquidity The property of being easily converted into cash

Liquid Assets An asset is considered liquid if it can be converted into cash quickly at little cost

Illiquid Assets An asset is illiquid if it can be converted into cash only: after a delay, or at considerable cost

Measuring the Money Stock Assets and Their Liquidity M1 and M2

Assets in Order of Liquidity #1 - Cash in the Hands of the Public #2 - Demand Deposits #3 - Other Checkable Deposits #4 - Travelers Checks #5 - Savings-type Accounts #6 - Money Market Mutual Funds #7 - Time Deposits

Assets and Their Liquidity #1 - Cash in the Hands of the Public Currency and coins held outside of banks #2 - Demand Deposits Checking accounts that do not pay interest

Assets and Their Liquidity Savings Type Accounts ($2,312 billion) Money Market Mutual Funds Small Time Demand Deposits ($984 billion) Deposits ($330 billion) ($962 billion) Large Time + Deposits Cash in the Other Checkable ($797 billion) Hands of the Deposits Public ($260 billion) ($586 billion) + Travelers Checks ($8 billion) More Less Liquid Liquid a

M1 and M2 M1 A standard measure of the money supply, including cash in the hands of the public, demand and other checking account deposits, and travelers checks

M1 and M2 M2 M1 plus savings account balances, noninstitutional money market mutual fund balances, and small denomination time deposits

cash in the hands of the public + M1 and M2 Money supply = cash in the hands of the public + demand deposits

Financial Intermediaries The Banking System Financial Intermediaries Commercial Banks A Bank’s Balance Sheet

Financial Intermediaries Financial Intermediary A business firm that specializes in brokering between savers and borrowers

Financial Intermediaries Savings and Loan Associations Mutual Savings Banks Credit Unions Commercial Banks

Commercial Banks A commercial bank is a private corporation, owned by its stockholders, that provides services to the public.

The most important service is to provide checking accounts. Commercial Banks The most important service is to provide checking accounts. The public holds about as much money in the form of demand deposits and other checking-type accounts as it holds in cash.

Commercial Banks A bank’s profit comes mostly from lending out the funds that people deposit and charging interest on the loans.

A Bank’s Balance Sheet Balance Sheet A financial statement showing assets, liabilities, and net worth at a point in time

A Bank’s Balance Sheet Bond An IOU issued by a corporation or government agency when it borrows funds Loan An IOU issued by a household or noncorporate business when it borrows funds

Reserves Vault cash plus balances held at the Fed A Bank’s Balance Sheet Reserves Vault cash plus balances held at the Fed Required Reserves The minimum amount of reserves a bank must hold, depending on the amount of its deposit liabilities

Required Reserve Ratio A Bank’s Balance Sheet Required Reserve Ratio The minimum fraction of checking account balances that banks must hold as reserves

Net Worth The difference between assets and liabilities A Bank’s Balance Sheet Net Worth The difference between assets and liabilities Net worth = Total assets – Total Liabilities

The Federal Reserve System The Structure of the Fed The Federal Open Market Committee The Functions of the Federal Reserve

The Federal Reserve System Central Bank A nation’s principal monetary authority

The Structure of the Fed Chair of Board of Governors Board of Governors Federal Open Market Committee 12 Federal Reserve District Banks Member Banks

The Structure of the Fed

Federal Open Market Committee (FOMC) The FOMC Federal Open Market Committee (FOMC) A committee of Federal Reserve officials that establishes U.S. monetary policy

Functions of the Federal Reserve Supervising and Regulating Banks Acting as a “Bank for Banks” Issuing Paper Currency Check Clearing Controlling the Money Supply

The interest rate the Fed charges on loans to banks Functions of the Fed Discount Rate The interest rate the Fed charges on loans to banks

The Fed and the Money Supply How the Fed Increases the Money Supply The Demand Deposit Multiplier The Fed’s Influence on the Banking System as a Whole How the Fed Decreases the Money Supply Some Important Provisos About the Demand Deposit Multiplier Other Tools for Controlling the Money Supply

The Fed and the Money Supply Open Market Operations When the Fed wants to increase or decrease the money supply, it buys ro sells government bonds to bond dealers, banks, or other financial institutions, a process called open market operations.

How the Fed Increases the Money Supply Excess Reserves Reserves in excess of required reserves

How the Fed Increases the Money Supply Demand deposits increase each time a bank lends out excess reserves. In the end, demand deposits will increase by a multiple of the original dollars in reserves injected into the banking system by the open market purchase.

The Demand Deposit Multiplier The number by which a change in reserves is multiplied to determine the resulting change in demand deposits For any value of the required reserve ratio (RRR), the formula is 1/RRR.

The Fed’s Influence on the Banking System After an injection of reserves, the demand deposit multiplier stops working - and the money supply stops increasing - only when all the reserves injected are being held by banks as required reserves.

How the Fed Decreases the Money Supply Just as the Fed can increase the money supply by purchasing government bonds, it can also decrease the money supply by selling government bonds - an open market sale.

Demand Deposit Multiplier In reality, banks often want to hold excess reserves, for a variety of reasons.

Other Tools for Controlling the Money Supply Changes in the Required Reserve Ratio Changes in the Discount Rate

Other Tools for Controlling the Money Supply While other tools can affect the money supply, open market operations have two advantages: precision and accuracy. This is why open market operations remain the Fed’s primary means of changing the money supply.