1. 10 The Money Supply and the Federal Reserve System An Overview of Money What Is Money? Commodity and Fiat Monies Measuring the Supply of Money in the United States The Private Banking System How Banks Create Money A Historical Perspective: Goldsmiths The Modern Banking System The Creation of Money The Money Multiplier The Federal Reserve System Functions of the Federal Reserve Expanded Fed Activities Beginning in 2008 The Federal Reserve Balance Sheet How the Federal Reserve Controls the Money Supply The Required Reserve Ratio The Discount Rate Open Market Operations Excess Reserves and the Supply Curve for Money

2. Three Functions of Money Money is anything that is generally accepted as a medium of exchange. (1) A Means of Payment, or Medium of Exchange barter The direct exchange of goods and services for other goods and services. medium of exchange, or means of payment What sellers generally accept and buyers generally use to pay for goods and services.

3. Need Double Coincidence of Wants in a Barter Economy Cook Farmer Mover Writer Carpenter Barber wants furniture wants haircut wants corn needs to eat needs to move wants to read a novel

4. Three Functions of Money (2) A Store of Value store of value An asset that can be used to transport purchasing power from one time period to another. (3) A Unit of Account unit of account A standard unit that provides a consistent way of quoting prices. liquidity property of money The property of money that makes it a good medium of exchange as well as a store of value: It is portable and readily accepted and thus easily exchanged for goods.

5. AN OVERVIEW OF MONEY commodity monies Items used as money that also have intrinsic value in some other use. COMMODITY AND FIAT MONIES fiat, or token, money Items designated as money that are intrinsically worthless. legal tender Money that a government has required to be accepted in settlement of debts. currency debasement The decrease in the value of money that occurs when its supply is increased rapidly.

6. AN OVERVIEW OF MONEY MEASURING THE SUPPLY OF MONEY IN THE UNITED STATES M1, or transactions money: Money that can be directly used for transactions. You can buy stuff with it! M1 ≡ currency held outside banks + demand deposits + traveler’s checks + other checkable deposits Demand Deposits are checking accounts.

7. AN OVERVIEW OF MONEY M2: Broad Definition of Money near monies Close substitutes for transactions money, such as savings accounts and money market accounts. M2 ≡M1 + savings accounts + money market accounts + other near monies M2, or broad money M1 plus savings accounts, money market accounts, and other near monies.

8. Government Money Private Money http://www.federalreserve.gov/releases/h6/ current/default.htm

9. Question: US population about 325 million people Currency in circulation about $1300 billion, mostly $100 bills $4,000 per person Where is this money?

10. financial intermediaries Banks and other institutions that act as a link between those who have money to lend and those who want to borrow money. The Private Banking System The main types of financial intermediaries are commercial banks, followed by savings and loan associations, life insurance companies, and pension funds.

11. A Historical Perspective: Goldsmiths How Banks Create Money The origins of the modern banking system date back to the fifteenth and sixteenth centuries, when gold was used as money but was also inconvenient to carry around. People began to place their gold with goldsmiths for safekeeping. The receipts issued to the depositor became a form of paper money. The receipts were backed 100 percent by gold.

12. The goldsmiths found that people did not come often to withdraw gold. Could lend out “extra” gold sitting around Effectively changed from depositories to bank like institutions that had the power to create money. Without adding any more gold to the system, the goldsmiths increased the amount of money in circulation by increasing the number of receipts. How Banks Create Money A Historical Perspective: Goldsmiths

13. run on a bank Occurs when many of those who have claims on a bank (deposits) present them at the same time. Goldsmiths-turned-bankers did face certain problems. Once they started making loans, their receipts outstanding (claims on gold) were greater than the amount of gold they had in their vaults at any given moment. In normal times, goldsmiths were safe, but once people started to doubt the safety of the goldsmith, they would be foolish not to demand their gold back from the vault. How Banks Create Money A Historical Perspective: Goldsmiths

14. Assets − Liabilities ≡ Net Worth or Assets ≡ Liabilities + Net Worth The Modern Banking System A Brief Review of Accounting Assets are things a firm owns that are worth something. For a bank, these assets include the bank building, its furniture, its holdings of government securities, bonds, stocks, and so on. Most important among a bank’s assets, for our purposes at least, are the loans it has made. Other bank assets include cash on hand (sometimes called vault cash) and deposits with the U.S. central bank.

15. Assets − Liabilities ≡ Net Worth or Assets ≡ Liabilities + Net Worth The Modern Banking System A Brief Review of Accounting A firm’s liabilities are its debts—what it owes. A bank’s most important liabilities are its deposits. Deposits are debts owed to the depositors because when you deposit money in your account, you are in essence making a loan to the bank. Net worth represents the value of the firm to its stockholders or owners.

16. HOW BANKS CREATE MONEY T-Account for a bank (millions of dollars) When some item on a bank’s balance sheet changes, there must be at least one other change somewhere else to maintain balance. A Brief Review of Accounting The balance sheet of a bank must always balance, so that the sum of assets (reserves and loans) equals the sum of liabilities (deposits and net worth).

17. reserves The deposits that a bank has at the central bank (Federal Reserve) plus its cash on hand. required reserve ratio The percentage of its total deposits that a bank must keep as reserves at the Federal Reserve. required reserves The required reserve ratio multiplied by deposits Some important banking concepts

18. HOW BANKS CREATE MONEY excess reserves The difference between a bank’s actual reserves and its required reserves. THE CREATION OF MONEY excess reserves ≡ actual reserves − required reserves

19. How Banks Create Money Suppose we have a country with $100 in currency. When someone deposits the $100, the bank has $100 in total reserves. Balance Sheets of a Bank in a Single-Bank Economy In Panel 2, there is an initial deposit of $100. Panel 1Panel 2 ASSETSLIABILITIESASSETSLIABILITIES Reserves 00 DepositsReserves 100100 Deposits Has the M1 money supply changed? NO! M1 = Currency + Demand Deposits = $100.

20. HOW BANKS CREATE MONEY Balance Sheets of a Bank in a Single-Bank Economy If the required reserve ratio is 20%, the bank with $100 in reserves can support $500 in deposits as shown in Panel 3. Why? Because $100 is 20% of $500. The bank is meeting its require reserves.

21. HOW BANKS CREATE MONEY Balance Sheets of a Bank in a Single-Bank Economy Look at Panel 2. The bank has excess reserves of $80. With $80 of excess reserves, the bank in a single-bank economy can have up to $400 of additional deposits (5 x $80 = $400). It creates the deposits by extending $400 in loans to borrowers. The $100 in reserves plus $400 in loans equal $500 in deposits. Has the M1 changed? YES! M1 = Currency + Demand Deposits = $500.

22. HOW BANKS CREATE MONEY The Creation of Money When There Are Many Banks In panel 1, there is an initial deposit of $100 in bank 1. In panel 2, bank 1 makes a loan of $80 by creating a deposit of $80. A check for $80 by the borrower is then written on bank 1 (panel 3) and deposited in bank 2 (panel 1). The process continues with bank 2 making loans and so on. In the end, loans of $400 have been made and the total level of deposits is $500.

23. HOW BANKS CREATE MONEY money multiplier The multiple by which deposits can increase for every dollar increase in reserves; equal to 1 divided by the required reserve ratio. Better name is the “deposit multiplier” THE MONEY MULTIPLIER An increase in bank reserves leads to a greater than one-for- one increase in the money supply. Economists call the relationship between the final change in deposits and the change in reserves that caused this change the money multiplier.

24. HOW BANKS CREATE MONEY THE MONEY MULTIPLIER In the United States, the required reserve ratio varies depending on the size of the bank and the type of deposit. For large banks and for checking deposits, the ratio is currently 10 percent, which makes the potential money multiplier 1/.10 = 10. This means that an increase in reserves of $1 could cause an increase in deposits of $10 if there were no leakage out of the system.

25. The Fed is the central bank of the United States. Founded in 1913 by an act of Congress The United States is divided into 12 Federal Reserve districts, each with its own Federal Reserve bank. The district banks are like branch offices of the Fed in that they carry out the rules, regulations, and functions of the central system in their districts and report to the Board of Governors on local economic conditions. THE FEDERAL RESERVE SYSTEM – The FED

26. The Board of Governors is the most important group within the Federal Reserve System. The Fed is an independent agency in that it does not take orders from the president or from Congress. THE FEDERAL RESERVE SYSTEM – The FED

27. THE FEDERAL RESERVE SYSTEM FIGURE 10.4 The Structure of the Federal Reserve System

28. THE FEDERAL RESERVE SYSTEM Federal Open Market Committee (FOMC) A group composed of the seven members of the Fed’s Board of Governors, the president of the New York Federal Reserve Bank, and four of the other 11 district bank presidents on a rotating basis; it sets goals concerning the money supply and interest rates and directs the operation of the Open Market Desk in New York. Open Market Desk The office in the New York Federal Reserve Bank from which government securities are bought and sold by the Fed.

29. DIE HARD WITH A VENGEANCE Goldfinger had it wrong, Simon Gruber (Jeremy Irons) had it right.

30. The Gold Vault at the New York Fed 250 million ounces Over $250 billion at current market prices 10% of all the gold that has ever been taken out of the ground One bar weights about 400 ounces

31. The Federal Reserve Bank of New York’s cash vault is the largest in the world. It three stories high and the size of a football field. It holds 5400 pallets of currency.

32. THE FEDERAL RESERVE SYSTEM The Fed does it. The funds move at the speed of electricity from one computer account to another. FUNCTIONS OF THE FEDERAL RESERVE Clearing Interbank Payments

33. THE FEDERAL RESERVE SYSTEM Other Duties of the Fed lender of last resort One of the functions of the Fed: It provides funds to troubled banks that cannot find any other sources of funds.

34. THE FEDERAL RESERVE BALANCE SHEET Assets and Liabilities of the Federal Reserve System, August, 2007, the beginning of the financial crisis (Millions of Dollars) ASSETSLIABILITIES Gold$11,037$777,769Federal Reserve notes (outstanding) Loans to banks1,342Deposits: U.S. Treasury securities 779,64212,771Bank reserves (from depository institutions) 4,572U.S. Treasury Deposits All other assets 82,451 79,360All other liabilities and net worth Total$874,472$874,472Total Source: Board of Governors of the Federal Reserve System. http://www.federalreserve.gov/releases/h41/Current/

35. THE FEDERAL RESERVE BALANCE SHEET Assets and Liabilities of the Federal Reserve System, August, 2009 (Millions of Dollars) ASSETSLIABILITIES Gold$11,037$872,150Federal Reserve notes (outstanding) Loans to banks339,335Deposits: U.S. Treasury securities 705,331724,650Bank reserves (from depository institutions) 261,487U.S. Treasury Deposits All other assets 936,031 133,447All other liabilities and net worth Total $1,991,734$1,991,734 Total Source: Board of Governors of the Federal Reserve System. http://www.federalreserve.gov/releases/h41/Current/

36. THE FEDERAL RESERVE BALANCE SHEET Assets and Liabilities of the Federal Reserve System, October, 2010 (Millions of Dollars) ASSETSLIABILITIES Gold$11,037$923,000Federal Reserve notes (outstanding) Loans to banks50,000Deposits: U.S. Treasury securities 821,0001,033,000Bank reserves (from depository institutions) Mortgages(MBS) 1,000,000 215,000U.S. Treasury All other assets 430,900 142,000All other liabilities and net worth Total $2,313,000$2,313,000 Total Source: Board of Governors of the Federal Reserve System. http://www.federalreserve.gov/releases/h41/Current/

37. TABLE 10.1 Assets and Liabilities of the Federal Reserve System, January 30, 2013 (Billions of Dollars) AssetsLiabilities Gold$ 11$ 1,156Currency in circulation U.S. Treasury securities1,7101,645Reserve balances Federal agency debt securities7571U.S. Treasury deposits Mortgages (MBS)966 180All other liabilities and net worth All other assets 290$3,052Total $3,052 The Federal Reserve Balance Sheet Gold is trivial. Do not think that this gold has anything to do with money in circulation. U.S. Treasury securities are the traditional assets held by the Fed. The new assets of the Fed (since 2008) are federal agency debt securities and mortgage-backed securities. Currency in circulation accounts for about 38 percent of the Fed’s liabilities. Reserve balances account for about 54 percent of the Fed’s liabilities.

38. HOW THE FEDERAL RESERVE CONTROLS THE MONEY SUPPLY If the Fed wants to increase the supply of money, it creates more reserves, thereby freeing banks to create additional deposits by making more loans. If it wants to decrease the money supply, it reduces reserves. Three tools are available to the Fed for changing the money supply: (1) changing the required reserve ratio; (2) changing the discount rate; and (3) engaging in open market operations.

39. HOW THE FEDERAL RESERVE CONTROLS THE MONEY SUPPLY TABLE 10.2 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 ReserveCommercial Banks AssetsLiabilitiesAssetsLiabilities Government$200$100Reserves $100$500Deposits securities $100CurrencyLoans$400 Note: Money supply (M1) = Currency + Deposits = $600. PANEL 2: REQUIRED RESERVE RATIO = 12.5% Federal ReserveCommercial Banks AssetsLiabilitiesAssetsLiabilities Government$200$100Reserves $100$800Deposits securities $100CurrencyLoans (+ $300) $700 (+ $300) Note: Money supply (M1) = Currency + Deposits = $900. THE REQUIRED RESERVE RATIO

40. HOW THE FEDERAL RESERVE CONTROLS THE MONEY SUPPLY THE REQUIRED RESERVE RATIO Decreases in the required reserve ratio allow banks to have more deposits with the existing volume of reserves. As banks create more deposits by making loans, the supply of money (currency + deposits) increases. The reverse is also true: If the Fed wants to restrict the supply of money, it can raise the required reserve ratio, in which case banks will find that they have insufficient reserves and must therefore reduce their deposits by “calling in” some of their loans. The result is a decrease in the money supply.

41. HOW THE FEDERAL RESERVE CONTROLS THE MONEY SUPPLY THE DISCOUNT RATE discount rate Interest rate that banks pay to the Fed to borrow from it. Bank borrowing from the Fed leads to an increase in the money supply. The higher the discount rate, the higher the cost of borrowing, and the less borrowing banks will want to do. Bank borrowing from the Fed leads to an increase in the money supply.

42. HOW THE FEDERAL RESERVE CONTROLS THE MONEY SUPPLY TABLE 10.3 The Effect on the Money Supply of Commercial Bank Borrowing from the Fed (All Figures in Billions of Dollars) PANEL 1: NO COMMERCIAL BANK BORROWING FROM THE FED Federal ReserveCommercial Banks AssetsLiabilitiesAssetsLiabilities Securities$160$80Reserves $80$400Deposits $80CurrencyLoans$320 Note: Money supply (M1) = Currency + Deposits = $480. PANEL 2: COMMERCIAL BANK BORROWING $20 FROM THE FED Federal ReserveCommercial Banks AssetsLiabilitiesAssetsLiabilities Securities$160$100Reserves (+ $20) $100$500Deposits (+ $300) Loans$20$80CurrencyLoans (+ $100) $420$20Amount owed to Fed (+ $20) Note: Money supply (M1) = Currency + Deposits = $580. What is the reserve requirement in this example? Bank Borrowing from the Fed

43. HOW THE FEDERAL RESERVE CONTROLSTHE MONEY SUPPLY OPEN MARKET OPERATIONS open market operations The purchase and sale by the Fed of government securities in the open market; a tool used to expand or contract the amount of reserves in the system and thus the money supply. OMO is the main tool of monetary policy

44. HOW THE FEDERAL RESERVE CONTROLS THE MONEY SUPPLY Two Branches of Government Deal in Government Securities The Treasury Department is responsible for collecting taxes and paying the federal government’s bills. To finance the deficit, (G - T) is the amount the Treasury must borrow each year. This means that the Treasury cannot print money to finance the deficit. The Fed is not the Treasury. Instead, it is a quasi- independent agency authorized by Congress to buy and sell outstanding (preexisting) U.S. government securities on the open market.

45. The Mechanics of Open Market Operations The Fed buys government securities from the public TABLE 10.4 Open Market Operations (The Numbers in Parentheses in Panels 2 and 3 Show the Differences Between Those Panels and Panel 1. All Figures in Billions of Dollars) PANEL 1 Federal ReserveCommercial BanksJane Q. Public AssetsLiabilitiesAssetsLiabilitiesAssetsLiabilities Securities$100$20Reserves $20$100DepositsSecurities$5$0Debts $80CurrencyLoans$80$5Net Worth Money supply (M1) = Currency + Deposits = $80 + $100 = $180.$80Currency PANEL 2 Federal ReserveCommercial BanksJane Q. Public AssetsLiabilitiesAssetsLiabilitiesAssetsLiabilities Securities (  $5) $105$25Reserves (  $5) $25$105Deposits (+$5) Deposits (  $5) $5$0Debts $80CurrencyLoans$80Securities (- $5) $0$5Net Worth Note: Money supply (M1) = Currency + Deposits = $80 + $105 = $185. PANEL 3 Federal ReserveCommercial BanksJane Q. Public AssetsLiabilitiesAssetsLiabilitiesAssetsLiabilities Securities (  $5) $105$25Reserves (+ $5) $25$125Deposits (  $25) Deposits (+ $5) $5$0Debts $80CurrencyLoans (+$20) $100Securities (- $5) $0$5Net Worth Money supply (M1) = Currency + Deposits = $80 + $125 = $205.

46. The Mechanics of Open Market Operations The Fed sells government securities to the public TABLE 10.4 Open Market Operations (The Numbers in Parentheses in Panels 2 and 3 Show the Differences Between Those Panels and Panel 1. All Figures in Billions of Dollars) PANEL 1 Federal ReserveCommercial BanksJane Q. Public AssetsLiabilitiesAssetsLiabilitiesAssetsLiabilities Securities$100$20Reserves $20$100Deposits $5$0Debts $80CurrencyLoans$80$5Net Worth Money supply (M1) = Currency + Deposits = $80 + $100 = $180. $80Currency PANEL 2 Federal ReserveCommercial BanksJane Q. Public AssetsLiabilitiesAssetsLiabilitiesAssetsLiabilities Securities (  $5) $95$15Reserves (  $5) $15$95Deposits (  $5) $0 Debts $80CurrencyLoans$80Securities (+ $5) $5 Net Worth Note: Money supply (M1) = Currency + Deposits = $80 + $95 = $175. PANEL 3 Federal ReserveCommercial BanksJane Q. Public AssetsLiabilitiesAssetsLiabilitiesAssetsLiabilities Securities (  $5) $95$15Reserves (  $5) $15$75Deposits (  $25) Deposits (  $5) $0 Debts $80CurrencyLoans (  $20) $60Securities (+ $5) $5 Net Worth Money supply (M1) = Currency + Deposits = $80 + $75 = $155.

47. HOW THE FEDERAL RESERVE CONTROLS THE MONEY SUPPLY ■ An open market purchase of securities by the Fed results in an increase in reserves and an increase in the supply of money by an amount equal to the money multiplier times the change in reserves. ■An open market sale of securities by the Fed results in a decrease in reserves and a decrease in the supply of money by an amount equal to the money multiplier times the change in reserves. We can sum up the effect of these open market operations this way:

48. Open Market Operations Open market operations are the Fed’s preferred means of controlling the money supply because: they can be used with some precision, are extremely flexible, and are fairly predictable.

49. The Supply Curve for Money Through open market operations, the Fed can have the money supply be whatever value it wants.

50. barter commodity monies currency debasement discount rate excess reserves Federal Open Market Committee (FOMC) Federal Reserve Bank (the Fed) fiat, or token, money financial intermediaries legal tender lender of last resort liquidity property of money M1, or transactions money M2, or broad money medium of exchange, or means of payment money multiplier moral suasion near monies Open Market Desk open market operations required reserve ratio reserves run on a bank store of value unit of account 1. M1 ≡ currency held outside banks + demand deposits + traveler’s checks + other checkable deposits 2. M2 ≡ M1 + savings accounts + money market accounts + other near monies 3. Assets ≡ Liabilities + Net Worth 4. Excess reserves ≡ actual reserves − required reserves 5. Money multiplier ≡ R E V I E W T E R M S A N D C O N C E P T S

51. Looking Ahead This chapter has discussed only the supply side of the money market. In the next chapter, we turn to the demand side of the money market. We will examine the demand for money and see how the supply of and demand for money determine the equilibrium interest rate.