1. PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University 1 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Money and the Banking System [Money] is a machine for doing quickly and commodiously what would be done, though less quickly and commodiously, without it. JOHN STUART MILL

2. The Nature of Money Run on a bank –Many depositors withdraw cash from their accounts All at once Banks are heavily regulated –Money supply Important determinant of aggregate demand –Safety of depositors 2 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3. Figure 1 (a) Bank Failures in the United States, 1915–2010 3 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4. Figure 1 (b) Bank Failures in the United States, 1915–2010 4 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

5. The Nature of Money Barter –System of exchange –People trade one good for another Without using money as an intermediate step –Desired: double coincidence of wants Money –Greases the wheels of exchange –Makes the economy more productive 5 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

6. The Nature of Money Money –Medium of exchange - standard object used in exchanging goods and services –Unit of account - standard unit for quoting prices –Store of value - store wealth from one point in time to another Commodity money –An object in use as medium of exchange –Has substantial value in alternative uses 6 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

7. The Nature of Money Paper money = Fiat money –Decreed as money by government –Little value as commodity –Maintains value as a medium of exchange People have faith that the issuer will stand behind the pieces of printed paper and limit their production 7 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

8. Quantity of Money How the quantity of money is measured Money supply M1 –Narrowly defined money supply –Coins and paper money in circulation –Traveler’s checks –Conventional checking accounts –Certain other checkable deposit balances Banks and savings institutions 8 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

9. Quantity of Money Money supply M2 –Broadly defined money supply –M1 –Money market deposit accounts –Money market mutual funds –Savings accounts Near moneys –Liquid assets that are close substitutes for money 9 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

10. Figure 2 Two Definitions of the Money Supply, December 2010 10 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

11. Quantity of Money An asset’s liquidity –The ease with which it can be converted into cash Credit cards –Not included in money supply Convention: Money –Coins –Paper money –Checkable deposits 11 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

12. The Banking System Fractional reserve banking system –Bankers keep as reserves only a fraction of deposits Features of fractional reserve banking –Bank profitability Banks are in business to earn profits –Bank discretion over money supply –Exposure to bank runs Keep prudent reserves and to lend out money carefully 12 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13. The Banking System Bankers - reputation for prudence –Checking deposits - pure fiat money –Sufficiently generous level of reserves Minimize vulnerability to runs –Cautious in making loans and investments Large losses – undermine confidence Abandoned by too many banks during the housing boom of 2003-2006 13 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

14. The Banking System Banking - inherently risky business –Safe only by cautious and prudent management –Maximize profits Low reserves Make loans to borrowers with questionable credit standing - higher interest rates –Many mortgages, 2003-2007 14 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

15. The Banking System Bank regulations –Designed to ensure depositors’ safety and to control the money supply Deposit insurance –Guarantees that depositors will not lose money even if their bank goes bankrupt –Federal Deposit Insurance Corporation/ FDIC –Moral hazard problem 15 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

16. The Banking System Moral hazard problem –If insured against consequences of risk –People engage in riskier behavior Bank supervision –Periodic bank examinations –Tighter regulation since 2006 Bureau of consumer financial protection Mechanism for dealing with potential failure of giant banks 16 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

17. The Banking System Other laws and regulations –Limit the kinds and quantities of assets in which banks may invest Own only limited amounts of common stock Restrictions on banks’ ability to engage in “proprietary trading” Reserve requirements –Minimum amount of reserves required by law –Proportional to the volume of deposits 17 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

18. Systemic Risk Systemic risk & “too big to fail” doctrine Systemic risk –Risks to the entire system of banks or financial institutions –Arises because these institutions, especially the largest ones, are interlinked in many ways –Inhere mainly in the largest financial institutions 18 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

19. Systemic Risk A systemically important (or “too big to fail”) financial institution –Is one which, by virtue of its size or interconnectedness, can threaten the entire system if it runs into trouble Lehman Brothers –Not systemically important –Chaotic bankruptcy –Worldwide financial panic 19 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

20. Systemic Risk American International Group (AIG) –Systemically important –Massive loans from the Federal Reserve and then from the U.S. Treasury The Dodd-Frank Act, 2010 –The Fed: supervise systemically important financial institutions Tougher regulatory regime –New procedure in case of failure 20 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

21. The Origins of the Money Supply Asset –Item of value owned Liability –Item of value owed [Debt] Balance sheet - accounting statement Left side: values of all assets Right side: values of all liabilities and net worth Net worth = Assets – Liabilities Assets = Liabilities + Net worth 21 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

22. Table 1 Balance Sheet of Bank-a-Mythica, December 31, 2010 22 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

23. Banks and Money Creation Deposit creation –Process by which a fractional reserve banking system –Turns $1 of bank reserves –Into several dollars of bank deposits Excess reserves –Reserves held in excess of legal minimum 23 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

24. Table 2 Changes in Bank-a-Mythica’s Balance Sheet, January 2, 2011 24 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

25. Table 3 Changes in Bank-a-Mythica’s Balance Sheet, January 3–6, 2011 25 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

26. Table 4 Changes in Bank-a-Mythica’s Balance Sheet, January 2–6, 2011 26 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

27. Banks and Money Creation Multiple money creation –Initial deposit $100,000 –Increase reserves by $100,000 Required reserves by $20,000 Excess reserves by $80,000 –Extend more loans $80,000 Increase deposits by $80,000 Increase reserves by $80,000 –Required reserves and Excess reserves increase –Extend more loans 27 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

28. Table 5 Changes in First National Bank’s Balance Sheet 28 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

29. Table 6 Changes in Second National Bank’s Balance Sheet 29 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

30. Banks and Money Creation Assumptions –Each bank holds exactly 20% required reserves –Each loan recipient redeposits proceeds - next bank Reserve ratio = m Then R = 1 - m Sum of infinite geometric progression 30 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

31. Figure 3 The Chain of Multiple Deposit Creation 31 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

32. Banks and Money Creation Banking system –Can convert each $1 of reserves into $1/m in new money Money multiplier –Ratio of newly created bank deposits to new reserves Change in money supply =(1/m) ˣ Change in reserves 32 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

33. Banks and Money Creation Multiple contractions of money supply –Deposit destruction –Withdrawal $100,000 –Decrease reserves by $100,000 Need $80,000 to meet reserve requirement –Outstanding loans – paid off $80,000 Borrowers – withdrawal $80,000 Decrease reserves Loans – paid off 33 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

34. Table 7 Changes in the Balance Sheet of Bank-a-Mythica 34 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

35. Table 8 Changes in the Balance Sheet of First National Bank 35 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

36. Money-Creation Formula Why the money-creation formula is oversimplified Oversimplified money multiplier –Accurate - very particular circumstances: 1.Every recipient of cash Must redeposit cash to another bank Rather than hold it 2.Every bank Must hold reserves no larger than the legal minimum 36 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

37. Money-Creation Formula If individuals and business firms hold more cash –Limited multiple expansion of bank deposits –Fewer dollars of cash Available for use as reserves –Smaller money supply 37 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

38. Money-Creation Formula If banks hold excess reserves –Limited multiple expansion of bank deposits –Smaller supply of money U.S. after September 2008 –Collapse of Lehman Brothers set off a financial panic –Banks clung to reserves 38 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

39. Money-Creation Formula Excess reserves, U.S. –$2 billion just before Lehman –$267 billion by October 2008 –$800 billion by January 2009 –$1 trillion today August 2008 – January 2009 –Total bank reserves - rose by 1,750% –M1 money supply - rose 13% 39 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

40. Figure 4 Excess Reserves in the U.S. Banking System, 2008–2010 40 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

41. The Need for Monetary Policy During a recession –Banks - reduce money supply Increase excess reserves Decrease lending to less creditworthy applicants –Aggravate recession –Need government intervention 41 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

42. The Need for Monetary Policy During an economic boom –Banks – expand money supply –Undesirable momentum to economy Inflation –Need government intervention 42 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.