1. The Banking System and the Money Supply
Topic 6
The Banking System and the Money Supply

2. What Counts as Money
Definition of Money
Money is an asset that is widely accepted as a means of payment
Only assets—things of value that people own—can be considered as money
Can credit cards be considered as money?
Only things that are widely acceptable as a means of payment are regarded as money
Can stocks or bonds be considered as money?
Money has two useful functions
Provides a unit of account
Standardized way of measuring value of things that are traded
Serves as store of value
One of several ways in which households can hold their wealth

3. Measuring the Money Supply
Total amount of money held by the public
Governments use different measures of the money supply
Each measure includes a selection of assets that are widely acceptable as a means of payment and are relatively liquid
An asset is considered liquid if it can be converted to cash quickly and at little cost
So, an illiquid asset can be converted to cash only after a delay, or at considerable cost

4. Assets and Their Liquidity
Most liquid asset is cash in the hands of the public
Next in line are asset categories of about equal liquidity
Demand deposits (Checking accounts)
Other checkable deposits
Travelers checks
Then, savings-type accounts
less liquid than checking-type accounts, since they do not allow you to write checks
Next on the list are deposits in retail money market mutual funds
Time deposits (called certificates of deposit, or CDs)
Require you to keep your money in the bank for a specified period of time (usually six months or longer)
Impose an interest penalty if you withdraw early

5. Figure 1: Monetary Assets and Their Liquidity (July 14, 2003)

6. M1 And M2 Standard measure of money stock (supply) is M1
Sum of the first four assets in our list
M1 = cash in the hands of the public + demand deposits + other checking account deposits + travelers checks
When economists or government officials speak about “money supply,” they usually mean M1
Another common measure of money supply, M2, adds some other types of assets to M1
M2 = M1 + savings-type accounts + retail MMMF balances + small denomination time deposits

7. M1 And M2

8. Money Supply
We will assume money supply consists of just two components
Cash in the hands of the public and demand deposits
Our definition of the money supply corresponds closely to liquid assets that our national monetary authority—the Federal Reserve—can control

9. The Banking System: Financial Intermediaries
What are banks?
Financial intermediaries—business firms that specialize in
Collecting loanable funds from households and firms whose revenues exceed their expenditures
Channeling those funds to households and firms (and sometimes the government) whose expenditures exceed revenues
Intermediaries must earn a profit for providing brokering services
By charging a higher interest rate on funds they lend than rate they pay to depositors

10. A Bank’s Balance Sheet
A balance sheet is a financial statement that provides information about financial conditions of a bank at a particular point in time
On one side, a bank’s assets are listed
Everything of value that it owns
Property and buildings
Bonds
Loans
Vault cash
Account with the Federal Reserve
On the other side, the bank’s liabilities are listed
Amounts it owes
Deposits
Net worth = Total assets – Total liabilities
What bank would owe to its owners if it went out of business
A balance sheet always balances

11. A Bank’s Balance Sheet
Explanations for vault cash and accounts with Federal Reserve
On any given day, some of the bank’s customers might want to withdraw more cash than other customers are depositing
Banks are required by law to hold reserves
Sum of cash in vault and accounts with Federal Reserve
Required reserve ratio tells banks the fraction of their checking accounts that they must hold as required reserves
Set by Federal Reserve

12. Figure 2: The Geography of the Federal Reserve System

13. Figure 3: The Structure of the Federal Reserve System

14. Federal Reserve Functions
Issue currency
Set reserve requirements
Lend money to banks
Collect checks
Act as a fiscal agent for U.S. government
Supervise banks
Control the money supply

15. Federal Reserve Independence
Established by Congress as an independent agency
Protects the Fed from political pressures
Enables the Fed to take actions to increase interest rates in order to stem inflation as needed

16. The Federal Open Market Committee
Federal Open Market Committee (FOMC)
A committee of Federal Reserve officials that establishes U.S. monetary policy
Consists of all 7 governors of Fed, along with 5 of the 12 district bank presidents
Not even President of United States knows details behind the decisions, or what FOMC actually discussed at its meeting, until summary of meeting is finally released
The FOMC exerts control over nation’s money supply by buying and selling bonds in public (“open”) bond market

17. The Fed and the Money Supply
Suppose Fed wants to change nation’s money supply
It buys or sells government bonds to bond dealers, banks, or other financial institutions
Actions are called open market operations
We’ll make two special assumptions to keep our analysis of open market operations simple for now
Households and business are satisfied holding the amount of cash they are currently holding
Any additional funds they might acquire are deposited in their checking accounts
Any decrease in their funds comes from their checking accounts
Banks never hold reserves in excess of those legally required by law

18. How the Fed Increases the Money Supply
To increase money supply, Fed will buy government bonds
Called an open market purchase
Suppose, by writing a check, Fed buys $1,000 bond from Citi Bank, which deposits the total into its checking account
Two important things have happened
Fed has injected reserve into banking system
Money supply has increased
Demand deposits have increased by $1,000 and demand deposits are part of money supply (for instance, M1)
Citi Bank now has excess reserves
Reserves in excess of required reserves
If required reserve ratio is 10% bank has excess reserves of $900 to lend
Demand deposits increase each time a bank lends out excess reserves

19. The Demand Deposit Multiplier
How much will demand deposits increase in total?
Each bank creates less in demand deposits than the bank before
In each round, a bank lends 90% of deposit it received
So, the total increase in demand deposits is
Whatever the injection of reserves, demand deposits will increase by a factor of 10, so we can write
ΔDD = 10 x reserve injection

20. The Demand Deposit Multiplier
For any value of required reserve ratio (RRR), formula for demand deposit multiplier is 1/RRR
Using general formula for demand deposit multiplier, can restate what happens when Fed injects reserves into banking system as follows
ΔDD = (1 / RRR) x ΔReserves
With the assumption that the amount of cash in the hands of the public (the other component of the money supply) does not change, we can also write
ΔMoney Supply = (1 / RRR) x ΔReserves

21. How the Fed Decreases the Money Supply
Just as Fed can decrease money supply by selling government bonds
An open market sale
Banks have to call in loans in order to meet the required reserve amount with Fed
Process of calling in loans will involve many banks
Each time a bank calls in a loan, demand deposits are destroyed
Total decline in demand deposits will be a multiple of initial withdrawal of reserves
Using demand deposit multiplier—1/(RRR), we can calculate the decrease in money supply with the same formula
ΔDD = (1/RRR) x Δreserves
This time, the change in reserve is negative

22. Some Important Provisos About the Demand Deposit Multiplier
Although process of money creation and destruction as we’ve described it illustrates the basic ideas, formula for demand deposit multiplier—1/RRR—is oversimplified
In reality, multiplier is likely to be smaller than formula suggests, for two reasons
We’ve assumed that as money supply changes, public does not change its holdings of cash
We’ve assumed that banks will always lend out all of their excess reserves

23. Other Tools for Controlling the Money Supply
There are two other tools Fed can use to increase or decrease money supply
Changes in required reserve ratio
Changes in discount rate
Changes in either required reserve ratio or discount rate could set off the process of deposit creation or deposit destruction in much the same way outlined in this chapter
In reality, neither of these policy tools is used very often
Why are these other tools used so seldom?
Partly because they can have unpredictable effects

24. The Financial Crisis of 2007 and 2008
Mortgage Default Crisis
Many causes
Government programs that encouraged home ownership
Declining real estate values
Bad incentives provided by mortgage-backed bonds

25. The Financial Crisis of 2007 and 2008
Securitization- the process of slicing up and bundling groups of loans into new securities
As loans defaulted, the system collapsed
“Underwater” homeowners abandoned homes and mortgages