1. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 1 ECON Designed by Amy McGuire, B-books, Ltd. McEachern 2010-2011 15 CHAPTER Banking and the Money Supply Macro

2. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 2 Money Aggregates LO 1  Money aggregates  Measure of money supply  Defined by the Fed  M1 = Narrow definition of money  Currency (including coins)  Nonbanking public  Checkable deposits  Bank deposits  Write checks to third parties  Traveler’s checks

3. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 3 Money Aggregates LO 1  Currency = Fiat money  Federal Reserve Notes  U.S. Bureau of Engraving and Printing  Issued by & Liabilities of  12 Federal Reserve Banks  60% - abroad  Coins  U.S. Mint

4. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 4 Money Aggregates LO 1  M2 = Broader definition of money  M1  Savings deposits  Earn interest; no specific maturity date  Small-denomination time deposits  Certificates of deposits, CDs  Earn interest; specific maturity date  Money market mutual fund accounts  Restrictions

5. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 5 LO 1 Measures of the Money Supply (February 2009) Exhibit 1

6. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 6 Money Aggregates LO 1  Credit cards  Loan from the card issuer  Repay later  Dispute a charge  Not part of money supply  Debit cards  From checking account  Part of M1

7. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 7 How Banks Work  Banks earn profit  Attract deposits from savers  Lend to borrowers  Banks are financial intermediaries  Reduce transaction costs  Cope with asymmetric information  Reduce risk through diversification LO 2

8. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 8 Starting a Bank  Home Bank – obtains a charter  Net worth = Owner’s equity  Shares of stock in the bank  Balance sheet  Assets = Liabilities + Net worth  Asset – owned by bank  Physical property  Financial claim  Stock in district Fed  Liabilities – owned by bank LO 2

9. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 9 LO 2 Home Bank’s Balance Sheet Exhibit 2

10. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 10 Home Bank’s Balance Sheet After $1,000,000 Deposit Into Checking Account LO 2 Exhibit 3

11. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 11 Reserve Accounts  Required reserve  Dollar amount  Must be held in reserve  Required by Fed  Required reserve ratio  Percentage of checkable deposits (10%)  Must be held in reserve  Reserves (Earn no interest)  Cash in bank’s vault  Deposits at the Fed  Excess reserves LO 2

12. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 12 Liquidity vs. Profitability  Liquidity  Ease to convert assets into cash  Safety  Profitability  Federal funds markets  Day-to-day lending and borrowing  Among banks  Excess reserves on account at the Fed  Interest: federal funds rate LO 2

13. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 13 How Banks Create Money LO 3  Creating money through excess reserves –Round one Fed buys $1,000 U.S. government bond –Creates reserves Money supply: +$1,000 Required reserves: +$100 Excess reserves: +$900

14. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 14 Changes in Home Bank’s Balance Sheet After Fed Buys a $1,000 Bond from Securities Dealer LO 3 Exhibit 4

15. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 15 How Banks Create Money LO 3  Creating money through excess reserves –Round two $900 loan Money supply: +$900 Required reserves: +$90 Excess reserves: +$810

16. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 16 Changes in Home Bank’s Balance Sheet After Lending $900 to You LO 3 Exhibit 5

17. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 17 How Banks Create Money LO 3  Creating money through excess reserves –Round three $810 loan Money supply: +$810 Required reserves: +$81 Excess reserves: +$729

18. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 18 Changes in Merchants Trust’s Balance Sheet After Lending $810 to English Major LO 3 Exhibit 6

19. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 19 How Banks Create Money LO 3  Creating money through excess reserves –Round four and beyond Excess reserves – new loans Required reserves: +10% of new checkable deposits –Excess reserve – maximum amount for loans –Money supply expansion

20. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 20 How Banks Create Money LO 3  Creating money through excess reserves  A summary of rounds –Fed: $1,000 injection in fresh reserves –Increased excess reserves –Money supply increase: Up to $10,000 Checkable deposits –Banking system Eliminates excess reserves –Expand money supply

21. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 21 Summary of the Money Creation Resulting from the Fed’s Purchase of $1,000 U.S. Government Bond LO 3 Exhibit 7

22. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 22 Reserve Requirements & Money Expansion LO 3  Assumptions –No bank holds excess reserves –Borrowed funds don’t sit idle –People don’t want to hold more cash

23. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 23 Reserve Requirements & Money Expansion LO 3  Required reserve ratio = r  Money multiplier  Simple money multiplier = 1/r  Change in the money supply = Change in fresh reserves × 1/r

24. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 24 Limitations of Money Expansion LO 3  Leakages from expansion –Smaller money multiplier –Cash – preferred to checking accounts People hold money Fewer excess reserves

25. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 25 Multiple Contraction of Money Supply LO 3  The Fed sells a $1,000 bond –Money supply: -$1,000 –Required reserves: -$900 –Recall loans –Money supply: -$900 –Required reserves: -$810 –Maximum effect Decrease money supply = Original decrease in reserve requirements × 1/r

26. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 26 The Fed’s Tools of Monetary Control LO 4  Open-market operations –Buy/sell U.S. government bonds  The discount rate –Interest rate, the Fed –For loans made to banks  The required reserve ratio –Minimum fraction of reserves

27. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 27 Open-Market Operations LO 4  Increase money supply –The Fed buys U.S. bonds Open-market purchase  Reduce money supply –The Fed sells U.S. bonds Open-market sale

28. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 28 Open-Market Operations LO 4  Tool of choice for the Fed  Influences bank reserves  Influences federal funds rate –Interest rate –Borrowing among banks –Of excess reserves at the Fed

29. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 29 The Discount Rate LO 4  Discount rate –Interest rate charged by the Fed –Loans to banks  Bank borrow ‘Discount window’ –Satisfy reserve requirements  The Fed –Lender of last resort

30. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 30 The Discount Rate LO 4  Primary discount rate  Secondary discount rate  Signal to financial markets –Monetary policy  Emergency tool –Injecting liquidity

31. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 31 Reserve Requirements LO 4  Required reserve ratio  Money creation for each dollar of fresh reserves  Disruptive –Banking system

32. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 32 Coping with Financial Crisis LO 4  Regulation of financial markets  Prevents major disruptions and financial panics  Sufficient liquidity –Financial system

33. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 33 The Fed Is a Money Machine LO 4  Assets –U.S. government bonds, 24% –Earns interest  Liabilities –Federal Reserve notes, 43% –Fed pays no interest  The Fed is a money machine –Supplies Federal Reserve notes –Main asset: earns interest –Main liability: no interest payment

34. Chapter 15Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 34 Federal Reserve Bank Balance Sheet as of April 1, 2009 (Billions) LO 4 Exhibit 8