1. Chapter 13 Money and Our Banking System

2. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-2 Did You Know That... Money includes not only coins and dollar bills, but also the balance in your checking account? Anything widely accepted in exchange for items of value is considered to be money?

3. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-3 Money  Any medium that is universally accepted in an economy both by sellers of goods and services and by creditors as payment for debts

4. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-4 Table 15-1 Types of Money

5. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-5 The Functions of Money The functions of money  Medium of exchange  Unit of accounting  Store of value (purchasing power)  Standard of deferred payment

6. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-6 The Functions of Money (cont'd) Medium of Exchange  Any item that sellers will accept as payment Barter  The direct exchange of goods and services for other goods and services without the use of money

7. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-7 The Functions of Money (cont'd) Medium of exchange  Money facilitates exchange by reducing transaction costs associated with means- of-payment uncertainty.  Permits specialization, facilitates efficiencies Barter  Simply a direct exchange  Double coincidence of wants

8. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-8 The Functions of Money (cont'd) Unit of Accounting  A measure by which prices are expressed  The common denominator of the price system  A central property of money

9. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-9 The Functions of Money (cont'd) Store of Value  The ability to hold value over time  A necessary property of money  Money allows you to transfer value (wealth) into the future.

10. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-10 The Functions of Money (cont'd) Standard of Deferred Payment  A property of an item that makes it desirable for use as a means of settling debts maturing in the future  An essential property of money

11. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-11 Liquidity  The degree to which an asset can be acquired or disposed of without much danger of any intervening loss in nominal value and with small transaction costs  Money is the most liquid asset.

12. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-12 Figure 15-1 Degrees of Liquidity

13. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-13 Liquidity (cont'd) Question  What is the cost of holding money (its opportunity cost)? Answer  It is the alternative interest yield obtainable by holding some other asset.

14. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-14 Monetary Standards, or What Backs Money Questions  What backs money?  Is it gold, silver, or the federal government? Answer  Your confidence

15. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-15 Monetary Standards, or What Backs Money (cont'd) Transactions Deposits  Checkable and debitable account balances in commercial banks and other types of financial institutions, such as credit unions and mutual savings banks  Any accounts in financial institutions on which you can easily transmit debit- card and check payments without many restrictions

16. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-16 Example: E-Gold Backed E-Money The Internet has served as a breeding ground for various forms of e-money. Gold-backed e-money effectively provides measures of the purchasing power, in terms of gold, of several major world currencies.

17. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-17 Monetary Standards, or What Backs Money (cont'd) Fiduciary Monetary System  A system in which currency is issued by the government and its value rests on the public’s confidence that it can be exchanged for goods and services  The Latin fiducia means “trust” or “confidence.”

18. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-18 Monetary Standards, or What Backs Money (cont'd) Currency and transactions deposits are money because of their  Acceptability  Predictability of value

19. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-19 Defining Money Money is important  Changes in the rate at which the money supply increases or decreases affect important economic variables (at least in the short run) such as inflation, interest rates, employment, and the level of real GDP. Money Supply  The amount of money in circulation

20. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-20 Defining Money (cont'd) Economists use two basic approaches to define and measure money.  The transactions approach  The liquidity approach

21. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-21 Defining Money (cont'd) Transactions Approach  A method of measuring the money supply by looking at money as a medium of exchange Liquidity Approach  A method of measuring the money supply by looking at money as a temporary store of value

22. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-22 Defining Money (cont'd) The transactions approach to measuring money: M1  Currency  Checkable (transaction) deposits  Traveler’s checks not issued by banks

23. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-23 Figure 15-2 Composition of the U.S. M1 and M2 Money Supply, 2007, Panel (a)

24. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-24 Figure 15-2 Composition of the U.S. M1 and M2 Money Supply, 2007, Panel (b)

25. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-25 Defining Money (cont'd) M1  Currency  Minted coins and paper currency not deposited in financial institutions  The bulk of currency “in circulation” actually does not circulate within the U.S. borders.

26. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-26 Figure 15-3 The Value of U.S. Currency in Circulation Outside the United States

27. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-27 Defining Money (cont'd) M1  Transactions deposits  Any deposits in a thrift institution or a commercial bank on which a check may be written or debit card used  Thrift Institution  Financial institutions that receive most of their funds from the savings of the public

28. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-28 Defining Money (cont'd) M1  Traveler’s Checks  Financial instruments purchased from a bank or a nonbanking organization and signed during purchase that can be used as cash upon a second signature by the purchaser

29. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-29 Defining Money (cont'd) The liquidity approach to measuring money: M2 Near Moneys  Assets that are almost money  Highly liquid  Easily converted to cash  Time deposits are an example

30. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-30 Defining Money (cont'd) The liquidity approach: M2 is equal to M1 plus 1. Savings and small denomination time deposits 2. Balances in retail money market mutual funds 3. MMDAs

31. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-31 Defining Money (cont'd) M2  Savings Deposits  Interest-earning funds that can be withdrawn at any time without payment of a penalty  Depository Institutions  Accept deposits from savers and lend those funds out

32. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-32 Defining Money (cont'd) M2  Money Market Deposit Accounts (MMDAs)  Accounts issued by banks yielding a market rate of interest with a minimum balance requirement and a limit on transactions  They have no minimum maturity

33. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-33 Defining Money (cont'd) M2  Time Deposit  A deposit in a financial institution that requires notice of intent to withdraw or must be left for an agreed period  Early withdrawal may result in a penalty  CD  Time deposit with fixed maturity

34. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-34 Defining Money (cont'd) M2  Money Market Mutual Funds  Funds obtained from the public that investment companies hold in common  Funds used to acquire short-maturity credit instruments  CD’s, U.S. government securities

35. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-35 Defining the U.S. Money Supply Question  Which definition of money correlates best with economic activity? Answer  M2, although some businesspeople and policymakers prefer MZM

36. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-36 Defining Money (cont'd) MZM (money-at-zero-maturity) MZM entails adding deposits without set maturities to M1. MZM includes all MMFs but excludes all deposits with fixed maturities.

37. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-37 Financial Intermediation and Banks Most nations have a banking system that encompasses two types of institutions. 1. One type consists of private banking institutions. 2. The other type of institution is a central bank.

38. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-38 Financial Intermediation and Banks (cont'd) Central Bank  A banker’s bank, usually an official institution that also serves as a country’s treasury’s bank  Central banks normally regulate commercial banks.

39. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-39 Financial Intermediation and Banks (cont'd) Direct finance  Individuals purchase bonds from a business Indirect finance  Individuals hold money in a bank  The bank lends the money to a business

40. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-40 Financial Intermediation and Banks (cont'd) Financial Intermediation  The process by which financial institutions accept savings from businesses, households, and governments and lend the savings to other businesses, households, and governments

41. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-41 Figure 15-4 The Process of Financial Intermediation

42. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-42 Financial Intermediation and Banks (cont'd) Question  Why might people wish to direct their funds through a bank instead of lending directly to a business? Answers  Asymmetric information  Adverse selection  Moral hazard  Larger scale and lower management costs

43. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-43 Financial Intermediation and Banks (cont'd) Asymmetric Information  Information possessed by one party in a financial transaction but not by the other Adverse Selection  The likelihood that borrowers may use their borrowed funds for high-risk projects

44. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-44 Financial Intermediation and Banks (cont'd) Moral Hazard  The possibility that a borrower might engage in riskier behavior after a loan has been obtained Larger scale and lower management costs  People can pool funds in an intermediary, reducing costs, risks.  Pension funds and investment companies are examples.

45. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-45 Financial Intermediation and Banks (cont'd) Liabilities  Amounts owed  The sources of funds for financial intermediaries

46. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-46 Financial Intermediation and Banks (cont'd) Assets  Amounts owned  The uses of funds by financial intermediaries

47. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-47 Table 15-2 Financial Intermediaries and Their Assets and Liabilities

48. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-48 Financial Intermediation and Banks (cont'd) Payment Intermediaries  Institutions that facilitate transfers of funds between depositors who hold transactions deposits with those institutions

49. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-49 Figure 15-5 How a Debit-Card Transaction Clears

50. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-50 Financial Intermediation and Banks (cont'd) Capital Controls  Legal restrictions on the ability of a nation’s residents to hold and trade assets denominated in foreign currencies International Financial Intermediation  Financing investment projects in more than one country

51. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-51 Table 15-3 The World’s Largest Banks

52. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-52 Financial Intermediation and Banks (cont'd) World Index Fund  A portfolio of bonds issued in various nations whose individual yields generally move in offsetting directions, thereby reducing the overall risk of losses

53. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-53 Banking Structures Throughout the World The ways that banks around the world differ  Size  United States has banks of various sizes  Europe and Japan have a few large banks  Legal  Universal banking  Limits on financial services such as insurance and bank stock ownership  Importance in financial system  Major importance  Part of a varied financial system (United States)

54. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-54 Banking Structures Throughout the World (cont'd) Universal Banking  An environment in which banks face few or no restrictions on their powers to offer a full range of financial services and to own shares of stock in corporations

55. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-55 Banking Structures Throughout the World (cont'd) Central banks and their roles 1. Perform banking functions for their nations’ governments 2. Provide financial services for private banks 3. Conduct their nations’ monetary policies

56. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-56 The Federal Reserve System The Fed  The Federal Reserve System; the central bank of the United States  The most important regulatory agency in the U.S. monetary system  Established in 1913 by the Federal Reserve Act

57. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-57 The Federal Reserve System (cont'd) Organization of the Fed  Board of Governors  7 members, 14-year terms  Federal Reserve Banks (12 Districts)  25 branches  Federal Open Market Committee (FOMC)  BOG plus 5 presidents of district banks

58. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-58 Figure 15-6 Organization of the Federal Reserve System

59. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-59 Figure 15-7 The Federal Reserve System

60. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-60 The Federal Reserve System (cont'd) Depository institutions  7,500 commercial banks  1,300 savings and loans  11,000 credit unions All may purchase Fed services

61. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-61 The Federal Reserve System (cont'd) Functions of the Fed 1. Supplies the economy with fiduciary currency 2. Provides a payment-clearing system 3. Holds depository institutions’ reserves 4. Acts as the government’s fiscal agent 5. Supervises depository institutions 6. Acts as a “lender of last resort” 7. Regulates the money supply

62. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-62 Issues and Applications: Check Clearing—A Rapidly Diminishing Fed Function The volume of checks cleared by the Fed grew rapidly during the 1980s. So why has the Fed’s check clearing speed dropped since the 1990s?

63. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-63 Issues and Applications: Check Clearing—A Rapidly Diminishing Fed Function (cont'd) The reason is not due to inefficiency; rather, checks are falling out of favor. Government transfers are transmitted electronically—Social Security, Medicare, Medicaid. Electronic payments by households and businesses—debit cards, Internet bill pay, Web based services.

64. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-64 Figure 15-8 The Volume and Value of Federal Reserve Check Clearings Since 1985

65. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-65 Summary Discussion of Learning Objectives The key functions of money 1. Medium of exchange 2. Unit of accounting 3. Store of value 4. Standard of deferred payment Important properties of goods that serve as money  Acceptability, confidence, and predictable value

66. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-66 Summary Discussion of Learning Objectives (cont'd) Official definitions of the quantity of money in circulation  M1: the narrow definition, focuses on money’s role as a medium of exchange  M2: a broader one, stresses money’s role as a temporary store of value

67. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-67 Summary Discussion of Learning Objectives (cont'd) Why financial intermediaries such as banks exist  Asymmetric information can lead to adverse selection and moral hazard problems  Savers benefit from the economies of scale The basic structure of the Federal Reserve System  12 district banks with 25 branches  Governed by Board of Governors  Federal Open Market Committee

68. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 15-68 Summary Discussion of Learning Objectives (cont'd) Major functions of the Federal Reserve  Supply the economy with currency  Provide systems for transmitting and clearing payments  Holding depository institutions’ reserves  Acting as the government’s fiscal agent  Supervising banks  Acting as a “lender of last resort”  Regulating the money supply  Intervening in foreign exchange markets

69. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-69 Introduction Smart cards permit people to use digital cash, which consists of funds contained in software programs called digital algorithms. By the time you finish this chapter, you will understand how the use of digital cash may affect the quantity of money in circulation.

70. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-70 Did You Know That… Through actions initiated by a central bank such as the Federal Reserve, depository institutions together create money? In this chapter, we shall examine the money multiplier process, which explains how an injection of new money into the banking system leads to an eventual multiple expansion in the total money supply.

71. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-71 Links Between Changes in the Money Supply and Other Economic Variables There are links between changes in the money supply and changes in GDP. There are links between changes in the money supply and the rate of inflation.

72. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-72 Figure 16-1 Money Supply Growth versus the Inflation Rate

73. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-73 Links Between Changes in the Money Supply and Other Economic Variables (cont'd) Fractional Reserve Banking  A system in which depository institutions hold reserves that are less than the amount of deposits  Originated when goldsmiths issued notes that exceeded the value of gold and silver on hand

74. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-74 Depository Institution Reserves What do you think?  Can banks pay off all of their depositors?  How is it possible that they can pay them off eventually but not pay them off simultaneously?

75. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-75 Depository Institution Reserves (cont'd) In a fractional reserve banking system, banks do not keep sufficient reserves on hand to cover 100% of their depositors' accounts. There are three distinguishable types of reserves: legal, required and excess.

76. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-76 Depository Institution Reserves (cont'd) Reserves  In the U.S. Federal Reserve System, deposits held by Federal Reserve district banks for depository institutions, plus depository institutions’ vault cash

77. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-77 Depository Institution Reserves (cont'd) Legal Reserves  Anything that the law permits banks to claim as reserves—for example, deposits held at Federal Reserve district banks and vault cash

78. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-78 Depository Institution Reserves (cont'd) Required Reserves  The value of reserves that a depository institution must hold in the form of vault cash or deposits with the Fed

79. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-79 Depository Institution Reserves (cont'd) Question  Do banks set their own reserve rate? Answer  No, the Federal Reserve sets the reserve requirement  Currently it is 10% on most transactions deposits

80. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-80 Depository Institution Reserves (cont'd) Required Reserve Ratio  The percentage of total transactions deposits that the Fed requires depository institutions to hold in the form of vault cash or deposits with the Fed Required reserves = Transactions deposits  Required reserve ratio

81. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-81 Depository Institution Reserves (cont'd) Excess Reserves  The difference between legal reserves and required reserves Excess reserves = Legal reserves – Required reserves

82. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-82 The Relationship Between Legal Reserves and Total Deposits Balance Sheet  Statements of assets (what is owned) and liabilities (what is owed) How a single bank reacts to an increase in reserves  We will examine the balance sheet of a single bank.

83. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-83 The Relationship Between Legal Reserves and Total Deposits (cont'd) We assume 1. Reserve ratio is 10% 2. Transactions deposits are the bank’s only liabilities and loans are the bank’s assets 3. An individual bank can lend as much as legally allowed 4. Every time a loan is made, the proceeds are put into a deposit account (nothing withdrawn) 5. Zero excess reserves are kept 6. Banks have zero net worth

84. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-84 The Relationship Between Legal Reserves and Total Deposits (cont'd) Net Worth  The difference between assets and liabilities

85. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-85 The Relationship Between Legal Reserves and Total Deposits (cont'd) Description of a Balance Sheet AssetsLiabilities What is owned Reserves Loans What is owed Deposits Net Worth = Assets – Liabilities

86. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-86 Required reserves =.10  $1,100,000 = $110,000 Excess reserves = $200,000 – $110,000 = $90,000 The Relationship Between Legal Reserves and Total Deposits (cont'd) Following the deposit  What are the required reserves of Typical Bank ?  Does Typical Bank have excess reserves?

87. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-87 Balance Sheet 16-2 Typical Bank (cont'd) Typical Bank has required reserves of $110,000 and excess reserves of $90,000.

88. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-88 The Relationship Between Legal Reserves and Total Deposits (cont'd) Following the deposit  What will Typical Bank do with its excess reserves?  Loan them out  Could Typical Bank safely loan out more than its excess reserves?  By law holds a certain amount of required reserves

89. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-89 The Relationship Between Legal Reserves and Total Deposits (cont'd) Effect on the money supply  New reserves for the banking system as a whole are not created when debit-card or check payments are transferred from one bank and deposited in another bank.  The Federal Reserve System can however, create new reserves—the subject of our next section.

90. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-90 The Fed’s Direct Effect on the Overall Level of Reserves The Federal Open Market Committee (FOMC)  Can instruct the New York Federal Reserve Bank trading desk to buy or sell bonds

91. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-91 The Fed’s Direct Effect on the Overall Level of Reserves (cont'd) Open Market Operations  The purchase and sale of existing U.S. government securities (such as bonds) in the open private market by the Federal Reserve System

92. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-92 Money Expansion by the Banking System Consider the entire banking system; for practical purposes, we can look at all depository institutions taken as a whole. To understand how money is created, we must understand how depository institutions respond to Fed actions that increase reserves in the entire system.

93. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-93 This shows Bank 1’s original position before the Fed’s purchase of a $100,000 U.S. government security. Balance Sheet 16-6 Bank 1

94. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-94 Fed transfers $100,000 to Bank 1 immediately increasing the money supply by the same amount. Bank 1 has excess reserves of $90,000. Balance Sheet 16-7 Bank 1

95. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-95 Figure 16-8 shows Bank 1 expands its loans by $90,000. Balance Sheet 16-8 Bank 1

96. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-96 The borrower deposits $90,000 in Bank 2, and Bank 2 now has money to lend out. Balance Sheet 16-9 Bank 2 (Changes Only)

97. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-97 Bank 2 makes a loan for $81,000, the amount of its excess reserves. Balance Sheet 16-10 Bank 2 (Changes Only)

98. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-98 Money Expansion by the Banking System (cont'd) Recall  The Fed bought a bond and deposited it at Bank 1, immediately increasing the money supply by $100,000.  The deposit creation process (in addition to the $100,000) occurs because of the fractional reserve banking system.  Banks will lend out any excess reserves as they can earn interest income on new loans.

99. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-99 Assume the firm borrowing $81,000 from Bank 2 spends these funds, which are deposited in Bank 3. Balance Sheet 16-11 Bank 3 (Changes Only)

100. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-100 We assume Bank 3 will want to lend all of those non-interest-earning assets (excess reserves of $72,900). Balance Sheet 16-12 Bank 3 (Changes Only)

101. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-101 E-Commerce Example: Remote Capture Speeds the Check Clearing Process Traditional check-clearing typically takes one to three days to complete. Internet based institutions pioneered a concept called remote capture. Remote capture cuts the time to just an hour.

102. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-102 Money Expansion by the Banking System (cont'd) Question  Looking over our balance sheets, how much do you think the money supply increased after the Fed’s $100,000 purchase of government securities and the three bank loans?

103. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-103 Money Expansion by the Banking System (cont'd) What do you think? Could Banks 4, 5, 6, etc. create even more money? How much can be created? $100,000Purchase by the Fed 90,000Loan by Bank 1 81,000Loan by Bank 2 72,900Loan by Bank 3 $343,900Total

104. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-104 Table 16-1 Maximum Money Creation with 10 Percent Required Reserves

105. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-105 Figure 16-2 The Multiple Expansion in the Money Supply Due to $100,000 in New Reserves When the Required Reserve Ratio Is 10 Percent

106. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-106 Money Expansion by the Banking System (cont'd) Only when additional new reserves and deposits are created by the Federal Reserve System does the money supply increase. The reverse process occurs when there is a decrease in reserves because the Fed sells $100,000 in government securities.

107. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-107 The Money Multiplier Money Multiplier  Gives the maximum potential change in the money supply due to a change in reserves

108. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-108 The Money Multiplier (cont'd) Actual change in the money supply = Actual money multiplier Change in total reserves  Potential money multiplier = 1 Required reserve ratio

109. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-109 The Money Multiplier (cont'd) Example  Fed buys $100,000 of government securities  Reserve ratio = 10% Potential change in the money supply = $100,000 = $1,000,000 x 1.10

110. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-110 The Money Multiplier (cont'd) Forces that reduce the money multiplier  Leakages  Currency drains  Excess reserves

111. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-111 The Money Multiplier (cont'd) Real-world money multipliers  M1 multiplier = 2.5–3.0  M2 multiplier = 6.5 in the 1960s to over 12 in the 2000s

112. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-112 Ways in Which the Federal Reserve Changes the Money Supply 1.Open market operations 2.Reserve requirement 3.Discount rate

113. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-113 Ways in Which the Federal Reserve Changes the Money Supply (cont'd) Discount Rate  The interest rate that the Federal Reserve charges for reserves it lends to depository institutions

114. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-114 Ways in Which the Federal Reserve Changes the Money Supply (cont'd) Federal Funds Market  A private market in which banks can borrow reserves from other banks that want to lend them Federal Funds Rate  The interest rate that depository institutions pay to borrow reserves in the interbank federal funds market

115. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-115 Ways in Which the Federal Reserve Changes the Money Supply (cont'd) Today’s discount rate policy is to set discount rate above the federal funds rate. Question  Why would the Fed do this?

116. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-116 Ways in Which the Federal Reserve Changes the Money Supply (cont'd) Question  What if the Fed changes reserve requirements it imposes?  What if reserve requirements go from 10 to 20%? Answer  Then the money multiplier changes from 10 to 5.

117. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-117 Table 16-2 Required Reserve Ratios in Selected Nations

118. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-118 Sweep Accounts and the Decreased Relevance of Reserve Requirements Many banks offer automatic transfer accounts, in which savings account balances are transferred to demand deposit accounts only when needed. This feature allows banks to hold fewer reserves as savings deposits are exempt from reserve requirements.

119. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-119 Sweep Accounts and the Decreased Relevance of Reserve Requirements (cont'd) Sweep Account  A depository institution account that entails regular shifts of funds from transactions deposits that are subject to reserve requirements to savings deposits that are exempt from reserve requirements

120. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-120 Figure 16-3 Sweep Accounts and Reserves of U.S. Depository Institutions at Federal Reserve Banks

121. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-121 Sweep Accounts and the Decreased Relevance of Reserve Requirements (cont'd) Banks use sweep accounts to shift funds from checking accounts into savings accounts until they are needed to settle check payments. Consequently, more of money supply growth has been shifted to M2, and M1 is considered a less reliable indicator of total liquidity.

122. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-122 Federal Deposit Insurance When businesses fail, they create hardships for creditors, owners and customers. When a depository institution fails even greater hardship results as many individuals and businesses depend on the safety and security of banks.

123. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-123 Source: Federal Deposit Insurance Corporation Figure 16-4 Bank Failures

124. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-124 Federal Deposit Insurance Federal Deposit Insurance Corporation (FDIC)  A government agency that insures the deposits held in banks and most other depository institutions; all U.S. banks are insured this way. Bank Runs  Attempts by many of a bank’s depositors to convert transactions and time deposits into currency out of fear that the bank’s liabilities may exceed its assets

125. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-125 Federal Deposit Insurance (cont'd) How deposit insurance causes increased risk taking by bank managers  Lack of correlation between risk taking and insurance premiums.

126. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-126 Federal Deposit Insurance (cont'd) Deposit insurance, adverse selection, and moral hazard  Adverse selection arises when there is asymmetric information.  Information possessed by one side of a transaction but not the other  The side with more information will be at an advantage.

127. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-127 Federal Deposit Insurance (cont'd) Deposit insurance, adverse selection, and moral hazard  Moral hazard arises as a result of information asymmetry after a transaction has occurred.

128. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-128 Federal Deposit Insurance (cont'd) The results of moral hazard  The S&L crisis of the mid-1980s  More than 1,500 savings and loan associations failed.  The estimated taxpayer cost was $200 billion.

129. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-129 Issues and Applications: Smart Cards, Digital Cash, and the Money Supply The microchips embedded in smart cards give them a technical edge over debit cards. At present, about 300 million smart cards are used around the globe. In a world in which people widely use digital cash the money multiplier would be larger.

130. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-130 Figure 16-5 The Distribution of the World’s Smart Cards

131. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 13-131 Key Terms and Concepts barter checkable deposits depository institutions digital cash Fed fiduciary monetary system fractional reserve liquidity medium of exchange money market deposit accounts money market mutual funds

132. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 13-132 Key Terms and Concepts (cont.) money multiplier money supply near moneys reserve requirements reserves savings deposits small-denomination time deposits smart cards thrift institutions unit of accounting