1. Banking and the Money Supply
Chapter 29
Banking and the Money Supply
© 2006 Thomson/South-Western

2. Definitions of the Money Supply: M1
Money aggregates: measures of the economy’s money supply – M1, M2, M3
M1: the narrowest measure of money supply: currency, including coins, held by
Non-banking public
Checkable deposits:
Deposits in financial institutions against which checks can be written and ATM or debit cards can be applied
Travelers checks

3. Definitions of the Money Supply: M2
Includes M1, plus
Savings deposits
Earn interest, but have no specific maturity date
Time deposits
called certificates of deposit, or CDs, specific maturity date
Money market mutual funds
carry additional restrictions

4. Definitions of the Money Supply: M3
Includes M2, plus
large-denomination time deposits ($100,000 or more)
M3 is less liquid than M2,
Which is less liquid than M1

5. Exhibit 1: Alternative Measures of the Money Supply

6. Credit Cards
Definitions of money include debit cards but not credit cards
Credit cards offer an easy way to get a loan from the card issuer
Money isn’t needed until the credit car holder must repay the credit card issuer
The credit card has not eliminated the use of money, merely delayed it

7. Debit Cards Debit Card Disadvantages Check card
Combines the functions of an ATM and check
Safer than credit cards
Disadvantages
Draw down checking account immediately
Cannot dispute bill or withhold or stop payment

8. Financial Intermediaries
Banks serve as financial intermediaries, or as go-betweens by bringing together the two sides of the money market
Banks reduce the transaction costs of channeling savings to credit worthy borrowers
Coping with asymmetric information
Reducing risk through diversification

9. Merchant banks
classically defined at investment banks.
• Rothschild is a current example of the classical European merchant bank (rare)
• In the U.S., investment banks eg JP Morgan, Goldman Sachs, Morgan Stanley
use their own capital to finance corporate underwriting.
• Today, many investment banks are public firms, so they now risk outside investor money
(although not depositors)

10. Asymmetric Information
As lenders, banks try to identify borrowers who are willing to pay interest and are able to repay the loans
However, borrowers have more reliable information about their own credit history and financial plans than do lenders: in the market for loans there is asymmetric information – an inequality in what’s known by each party to the transaction

11. Asymmetric Information
Because they have experience in evaluating applicants, banks have a greater ability to cope with asymmetric information and draw up and enforce contracts than would an individual saver
Savers are better off dealing with banks

12. Reducing Risk
By developing a diversified portfolio of assets rather than lending funds to a single borrower, banks reduce the risk to each individual saver
A bank, in effect, lends a tiny fraction of each saver’s deposits to each of its many borrowers

13. Starting a Bank
Founders obtain a charter, or the right to operate, by appling to the state banking authority (for a state bank) or to the U.S. Comptroller of the Currency (for a national bank)
The founders invest $500,000 for shares which become the owner’s equity or the net worth of the bank
Part of this goes to the Fed to buy shares in their district bank, leaving $450,000

14. Exhibit 2: Home Bank’s Balance Sheet
Balance sheet shows a balance between the two sides of the bank’s accounts:
The left side lists the bank’s assets (any physical property or financial claim owned by the bank)
The right side lists the bank’s liabilities (an amount the bank owes) and net worth
Reflects the basic equality that Assets = Liabilities + Net Worth

15. Exhibit 3: Home Bank’s Balance Sheet after $1,000,000 Deposit
Suppose a customer deposits $1,000,000 into a new checking account.
In accepting this, the bank promises to repay the depositor that amount – it is a liability to the bank: bank’s assets and liabilities both increase by $1,000,000

16. Reserve Accounts
Recall that banks are required by the Fed to set aside, or to hold in reserve, a percentage of their checkable deposits
The dollar amount that must be held in reserve is called required reserves: checkable deposits multiplied by the required reserve ratio
The required reserve ratio dictates the minimum proportion of deposits the bank must hold in reserve

17. Reserve Accounts
The current reserve requirement is 10% on checkable deposits, held either as cash in the bank’s vault or as deposits at the Fed, but neither earns the bank any interest
In our example, Home Bank must therefore hold $100,000 as reserves ($1,000,000 * .10)

18. Reserve Accounts
If Home Bank deposits their required reserves with the FED, they now have $900,000 in excess reserves held as cash in the vault
Excess reserves have two additional uses
They can be used to make loans, or
To purchase interest-bearing assets, such as government bonds

19. Liquidity versus Profitability
Management of a bank must structure the portfolio of assets with an eye towards
Liquidity
Profitability
Liquidity is the ease with which an asset can be converted into cash without a significant loss of value – if all of its cash held is as reserves, it forgoes profits
At the other extreme, if the bank uses all its excess reserves to acquire high-yielding but illiquid assets, it will run into problems whenever withdrawals exceed new deposits

20. Federal Funds Market
Federal funds market: a market for overnight lending and borrowing of reserves among banks; the market for reserves on account at the Fed
The interest rate paid on these loans is called the federal funds rate, the rate that the Fed targets as a tool of monetary policy

21. How Banks Create Money
Notice the pattern of deposits and loans in the money creation process:
Each time a bank gets a fresh deposit, 10% goes to required reserves
The rest becomes excess reserves, which fuel new loans or other asset acquisitions
An individual bank can lend no more than its excess reserves
When the borrower spends the amount loaned, reserves at one bank usually fall, but total reserves in the banking system do not

22. How Banks Create Money
The recipient bank uses most of the new deposit to extend more loan, more checkable deposits
The potential expansion of checkable deposits in the banking system equals some multiple of the initial increase in reserves

23. Exhibit 7: Summary
During each round, the increase in checkable deposits (1) minus the increase in required reserves (2) equals the potential increase in loans (3). Checkable deposits in this example can potentially increase by as much as $10,000.

24. Reserve Requirements and Money Expansion
Money multiplier: the multiple by which the money supply increases as a result of an increase fresh reserves in the banking system
The simple money multiplier equals the reciprocal of the required reserve ratio, or 1 / r, where r is the reserve ratio
It is the maximum multiple of fresh reserves by which the money supply can increase

25. Checkable Deposits / Money Supply
The formula for the multiple expansion of the money supply can be written as
Change in the money supply = Change in reserves x 1/r

26. Money Multiplier
The higher the reserve requirement, the greater the fraction of deposits that must be held as reserves and the smaller the money multiplier
Reserve requirement of 20% = money multiplier of 5
Reserve requirement of 5% = money multiplier of 20

27. Limitations on Money Expansion
Various leakages from the multiple expansion process reduce the size of the money multiplier. Assume that
Banks do not let excess reserves sit idle
Borrowers do something with the money
People do not choose to increase their cash holdings

28. Contraction of the Money Supply
Fed’s sale of government bonds reduces bank reserves, forcing banks to recall loans or to somehow replenish reserves and the same multiple contraction would work
For example, with a reserve requirement of 10%, a $1,000 sale of bonds would reduce the checkable deposits and the money supply by a maximum of $10,000

29. Tools for Controlling Reserves
The Fed has three tools for controlling reserves
Conducting open market operations, buying and selling of U.S. government bonds
Setting the discount rate, the interest rate the Fed charges for loans it makes to banks
Setting the required reserve ratio, the minimum fraction of reserves that banks must hold against deposits

30. Open Market Operations
Open market operations refers to the buying and selling of U.S. government bonds in the open market
To increase the money supply, the Fed buys U.S. bonds: open-market purchase
To reduce the money supply, the Fed sells U.S. bonds: open-market sale
Advantage of open-market operations
Relatively easy to carry out
Require no change in laws or regulations
Can be executed in any amount
The tool of choice by the Fed

31. Federal Funds Market
Through open-market operations, the Fed influences bank reserves and the federal funds rate
Recall that the federal funds rate is the interest rate banks charge one another for borrowing excess reserves at the Fed, typically overnight
Banks that are unable to meet their legal reserve requirements can borrow in the federal funds market

32. Federal Funds Market
The federal funds rate serves as a good indicator of the tightness of monetary policy
For example, suppose the Fed buys bonds in the open market and thereby increases reserves in the banking system
banks have more excess reserves
demand for excess reserves falls while the supply increases
the federal funds rate declines

33. Discount Rate
Discount rate is the interest rate the Fed charges on loans it makes to banks
Banks can borrow from the Fed when they need reserves to satisfy their reserve requirements
By lowering or raising the discount rate, the Fed encourages or discourages banks from borrowing, which alters reserves and affects the money supply

34. Discount Rate
A lower discount rate reduces the cost of borrowing, encouraging banks to borrow reserves from the Fed
more bank lending leads to an increase in the money supply
Higher discount rate increases the cost of borrowing reserves from the Fed
less bank lending leads to reduced money supply

35. Reserve Requirements
Reserve requirements are the regulations regarding the minimum amount of reserves that banks must hold to back up deposits

36. Reserve Requirements
If the Fed increases the reserve requirement, banks must hold more reserves
a reduction in the fraction of each dollar that can be lent out
reduces the banking system’s ability to create money

37. Reserve Requirements
Conversely, a decrease in the reserve requirement increases the fraction of each dollar on deposit that can be lent out, which increases the banking system’s ability to create money
Reserve requirements can be changed by a simple majority vote by the Board of Governors
Since even a small change in the reserve requirement can be disruptive, the Fed seldom employs this tool

38. Exhibit 8: Federal Reserve Bank Balance Sheet as of December 31, 2003 (millions of dollars)