Money, Banking, and the Federal Reserve System Chapter 14

What are some examples of money? The Meaning of Money What are some examples of money? Money is an asset that can easily be used to purchase goods and services. Currency in circulation is cash held by the public. Checkable bank deposits are bank accounts on which people can write checks. The money supply is the total value of financial assets in the economy that are considered money. Narrowest: currency in circulation, traveler’s checks, and checkable bank deposits (M1) Broader: currency in circulation, traveler’s checks, and checkable bank deposits PLUS “almost” checkable—savings accounts. (M2)

Global Comparison: Currency

Roles of Money Medium of exchange Store of value Unit of Account

Money of Medium of Exchange A medium of exchange is an asset that individuals acquire for the purpose of trading rather than for their own consumption. Money makes the transactions easier. The alternative is barter.

Money as Store of Value A store of value is a means of holding purchasing power over time. Money keeps its value over time. What can threaten the “store of value” of money?

Money as Unit of Account A unit of account is a measure used to set prices and make economic calculations. Money as a unit of account allows one to compare the values of goods and services.

Types of Money Commodity Money Representative Money Fiat Money Good that is used as a medium of exchange that has value in its own right. Examples are gold and silver. Representative Money Commodity-backed money is a medium of exchange with no intrinsic value whose ultimate value is guaranteed by a promise that it can be converted into valuable goods. An example is a bank note redeemable for a commodity like gold or silver. Fiat Money Something that has value because government says that it has value—US $.

Measuring the Money Supply Monetary Aggregates An overall measure of the money supply Federal Reserve calculates the size of two monetary aggregates M1: currency in circulation, traveler’s checks, and checkable bank deposits M2: currency in circulation, traveler’s checks, and checkable bank deposits PLUS “almost” checkable—savings accounts—example of near-moneys.

Monetary Aggregates, Sept. 2011

Monetary Role of Banks What do banks do? A bank is a financial intermediary that uses liquid assets in the form of banks deposits to finance the illiquid investments of borrowers. Bank reserves are the currency banks hold in their vaults plus their deposits at the Federal Reserve. The reserve ratio is the fraction of bank deposits that a bank holds as reserves. T-account summarizes a bank’s financial position Bank’s assets include its reserves as well as loans Bank’s liabilities include the deposits it holds.

Bank Regulation A bank run is a phenomenon in which many of a bank’s depositors try to withdraw their funds due to fears of a bank failure. Deposit insurance guarantees that a bank’s depositors will be paid even if the bank does not have the funds, up to a maximum per account. Federal Deposit Insurance Corporation (FDIC) currently guarantees the first $250,000 held in each account at a bank. Capital requirements are requirements by the Federal Reserve that bank owners hold substantially more assets than the value of bank deposits. Reserve requirements are rules set by the Federal Reserve that determine the minimum reserve ratio for a bank. (10%) The Federal Reserve lends money to banks through an arrangement known as the discount window.

Reserves, Bank Deposits, and the Money Multiplier Excess reserves are a bank’s reserves over and above its required reserves. Money is created when a bank loans any excess reserves it holds. Banks lending leads to new deposits in the banking system and a multiplier effect on the money supply. In a checkable-deposits-only system, the money supply equals bank reserves divided by the reserve ratio.

Determining the Money Supply How Banks Create Money When Silas keeps his cash under the mattress, there is $1,000 in circulation and $1,000 in money supply. When Silas deposits $1,000 (which had been stashed under his mattress) into a bank account, there is initially no effect on the money supply: currency in circulation falls by $1,000, but bank deposits rise by $1,000. The corresponding entries on the bank’s T-account show deposits initially rising by $1,000 and the bank’s reserves initially rising by $1,000. In the second stage, the bank holds 10% of Silas’s deposit ($100) as reserves and lends out the rest ($900) to Mary. As a result, its reserves fall by $900 and its loans increase by $900. Its liabilities, including Silas’s $1,000 deposit, are unchanged. The money supply, the sum of bank deposits and currency in circulation, has now increased by $900—the $900 now held by Mary.

Practice: The A&Z Bank has $250,000 in deposits. If the reserve ratios is 10%, how much of these deposits must the bank hold in reserve? How much in loans can the A&B Bank issue in the given situation? What does the T-Account for A&B Bank look like? ASSETS LIABILITIES Loans $225,000 Deposits $250,000 Reserves $25,000

Practice: Steve deposits his $15,000 Christmas bonus into his savings account at the New Market Bank. If the required reserve ratio is 15%, how much must the bank hold in required reserves? Sam deposits $5,000 in cash into his checking account at the First Bank of Macroland. If the required reserve ratio is 20% what are the bank’s excess reserves?

Money Multiplier in Reality Federal Reserve controls the sum of bank reserves and currency in circulation, monetary base. The money multiplier is the ratio of the money supply to the monetary base. The size of the money multiplier is reduced when funds are held as cash rather than as checkable deposits. In reality, the money multiplier is smaller than the bank reserves divided by the reserve ratio.

required reserve ratio Money Multiplier Monetary multiplier = 1 required reserve ratio 1 = rr Assume reserve requirement = 20% $100 put in bank 1 . rr 1 .2 = 5 = Graphic Example New Reserves $100 $80 Excess Reserves $20 Required Reserves $100 Initial Deposit $400 Bank System Lending Money Created 32-18

Think, Pair, Share What is the difference between the monetary base and the money supply? Bank reserves are in the monetary base and not in the money supply.

Structure of the Federal Reserve A central bank is an institution that oversees and regulates the banking system and controls the monetary base. Federal Reserve, established in 1913, is the central bank of the US. Federal Reserve system consists of: Board of Governors 12 regional Federal Reserve banks that provide various banking and supervisory services to commercial banks. What does your bill say?

Federal Reserve Regions

Federal Reserve System Seven members of the Board of Governors are appointed by the president with Senate approval. Serve 14-year terms Terms staggered so one member is replaced every two years. (above political pressure) The chairman of the Fed is appointed by the president with Senate approval and serves a four-year term with possible reappointment. Ben Bernake (2006 to Present) Alan Greenspan (1987 to 2006)

Role of Federal Reserve A bank to banks and to the Federal government Regulate the banks in their district Provide a safe and stable financial system Implement Monetary Policy

Policy Tools of Fed Reserve requirements Discount rate Increase or decrease the amount that banks must hold in reserve. Discount rate The federal funds market allows banks that fall short of the reserve requirement to borrow funds from banks with excess reserves. Interest rate the Fed charges banks to borrow for reserves Rate is normally 1% above the federal funds rates although reduced in 2007 with financial crisis. Open-market operations An open-market operation is a purchase or sale of government debt by the Fed. The Federal Reserve’s assets include government debt, mainly in the form of US Treasury bills. The Fed’s liabilities include the currency in circulation plus bank reserves which comprise the monetary base.

Open-Market Operations Federal Open Market Committee comprised of Board of Governors President of the New York Federal Reserve Bank + five other regional Federal Reserve Bank presidents Federal Open Market Committee makes decisions regarding monetary policy.| An open-market purchase of Treasury bills increases the monetary base and the money supply. An open-market sale of Treasury bills decreases the monetary base and money supply.

European Central Bank Created in January 1999 when 11 European nations decided to adopt the euro as their common currency. Equivalent to the Fed’s Board of Governors

Overview of 21st Century American Banking System Crisis at turn of century 1907 panic originated in less regulated institutions known as trusts The Fed was created in response to panic to centralize holding of reserves, inspect banks’ books and make the money supply sufficiently responsive to varying economic situations. Responding to bank crises Widespread banks runs in the early 1930s Emergency measures were adopted that gave RFC powers to stabilize and restructure banking industry Glass-Steagall Act (1933) separated banks into 2 categories: Commercial bank accepts deposits and is covered by deposit insurance Investment bank trades in financial assets (stocks and corporate bonds) and is not covered by deposit insurance. Adoption of federal deposit insurance was most important to stop bank runs. Regulation Q prevented commercial banks from paying interest on checking accounts. With a long period of financial and banking stability, regulation Q was eliminated in 1980 and Glass-Steagall Act significantly weakened by 1999.

Overview of 21st Century American Banking System Savings and Loan Crisis of 1980s A savings and loan (thrift) is a type of deposit-taking bank, usually specialized in home loans. Crisis of 1980s caused sharp losses in the financial and real estate sectors, resulting in an early 1990s recession.

Overview of 21st Century American Banking System Financial Crisis of 2008 Long-term Capital Management (LTCM) was a hedge fund created in 1994. A financial institution engages in leverage when it finances its investments with borrowed funds. Balance sheet effect is when sales of assets depress asset prices all over the world and other firms see the value of their balance sheets fall. When asset prices falling from the balance sheet effect go below a critical threshold, creditors call in loans--leading to more asset sales as borrowers try to get cash to repay loans-leading to more defaults-leading to more declines in asset prices-leading to more loans called in and thus a vicious cycle of deleveraging. Federal Reserve Bank of New York arranged a $3.625 billion bailout of LCTM in 1998 and revived world credit markets.

Overview of 21st Century American Banking System Financial Crisis of 2008 Subprime lending and the housing bubble Subprime lending involves loans to people who don’t meet the usual criteria for borrowing and for being unable to afford their payments. Securitization is the process of assembling pools of loans and selling shares in the income from these pools. Housing boom turned out to be a bubble. When it burst, banks and nonbank financial instructions led to widespread collapse in the financial system. Crisis and Response Collapse of trust in the financial system, combined with large losses suffered by financial firms, led to a severe cycle of deleveraging and a credit crunch for the economy. As the crisis originated in nontraditional banks institutions, the crisis of 2008 indicated a wider safety net and broader regulation are needed in the financial sector.