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Money and Banks

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Title: Money and Banks


1
Money and Banks
  • Chapter 13

2
What Is Money?
  • Without money, you would have to use barter to
    get items you want.
  • Barter is the direct exchange of one good for
    another, without the use of money.
  • Money solves the double coincidence of wants.

3
The Money Supply
  • Anything that serves all of the following
    purposes can be thought of as mey
  • Medium of exchange
  • Unit of account
  • Store of value

4
Modern Concepts
  • Money is anything generally accepted as a medium
    of exchange.
  • The currency (greenbacks) we carry around today
    are not the only form of money we use.
  • Checking accounts can and do perform the same
    market functions as cash.
  • Credit cards are another popular medium of
    exchange but are not money.
  • They are only a payment service with no store of
    value in and of themselves.

5
Diversity of Bank Accounts
  • There are many forms of bank accounts.
  • Some bank accounts are better substitutes for
    cash than others.
  • How much money is available affects consumers
    ability to purchase goods and services and
    affects aggregate demand.

6
M1 Cash and Transactions Accounts
  • M1 money supply includes currency in circulation,
    transaction-account balances, and travelers
    checks.
  • A transactions account is a bank account that
    permits direct payment to a third party, for
    example, with a check or debit card.

7
M2 M1 Savings Accounts, etc.
  • M2 money supply M1 plus balances in most
    savings accounts and money market mutual funds.
  • Savings-account balances are almost as good a
    substitute for cash as transaction-account
    balances.

8
Composition of the Money Supply
A Question of Liquidity
M2 (6,293 billion)
9
Bank Regulation
  • The deposit-creation activities of banks are
    regulated by the government.
  • The central bank influences the amount of bank
    lending, thereby affecting the basic money
    supply.
  • Bank reserves are assets held by a bank to
    fulfill its deposit obligations.

10
Fractional Reserves
  • The central bank requires banks to maintain some
    minimum reserve ratio.
  • Bank reserves are only a fraction of total
    transaction deposits.
  • The reserve ratio is the ratio of a bank's
    reserves to its total deposits.

11
Creation of Money
  • Currency is printed.
  • Coins are minted.

12
Deposit Creation
  • When a bank lends someone money, it simply
    credits that individuals bank account.
  • Deposit creation is the creation of transactions
    deposits by bank lending.
  • When a bank makes a loan, it effectively creates
    money because transactions-account balances are
    counted as part of the money supply.

13
Deposit Creation
  • There are two basic principles of the money
    supply
  • Transactions-account balances are a large portion
    of our money supply.
  • Banks can create transactions-account balances by
    making loans.

14
Deposit Creation
  • When someone deposits cash or coins in a bank,
    they are changing the composition of the money
    supply, not its size.
  • Assume a student deposits SK1000 from their piggy
    bank into the University Bank and receives a new
    checking account.

15
Deposit Creation
  • The University Bank loans SK1000 to the
    University Bookstore by crediting its checking
    account.
  • Money has been created because checking accounts
    are money.
  • Total bank reserves have remained unchanged.

16
Secondary Deposits
  • If there is only one bank, when Campus Bookstore
    uses the loan, the proceeds of the loan are
    re-deposited in the University Bank.

17
The T-account of the Bank
  • The books of a bank must always balance, because
    all of the assets of the bank must belong to
    someone (its depositors or its owners).

18
Money Creation
19
Money Creation
20
Required Reserves
  • A minimum reserve requirement directly limits
    deposit-creation possibilities.
  • Required reserves are the minimum amount of
    reserves a bank is required to hold by government
    regulation
  • Equals required reserve ratio times transactions
    deposits.

Required reserves minimum reserve ratio X
total deposits
21
A Multibank World
  • In reality, there is more than one bank.
  • The ability of banks to make loans depends on
    access to excess reserves.
  • Example If a bank is required to hold 20 in
    reserves and has 100 in deposits, then it must
    keep 20 in reserves and can lend out the 80
    excess.

Excess reserves Total reserves Required
reserves
22
Changes in the Money Supply
  • As the excess reserves are loaned out again, more
    transaction deposits are created and thus more
    money is created.

23
Deposit Creation
24
Deposit Creation
25
Deposit Creation
26
Deposit Creation
27
Deposit Creation
28
The Money Multiplier
  • In a multi-bank system, deposits created by one
    bank invariably end up as reserves in another
    bank.
  • Required reserves represent leakage from the flow
    of money, since they cannot be used to create new
    loans.
  • Excess reserve can be used for new loans.
  • This process can theoretically continue until all
    banks have zero excess reserves (no more loans
    can be made).

29
The Money Multiplier
  • The money multiplier is the number of deposit
    (loan) dollars that the banking system can create
    from 1 of excess reserves.

30
The Money Multiplier
  • The money supply can be increased through the
    process of deposit creation to this limit

Potential deposit creation Excess reserves of
banking system X Money multiplier
31
The Money Multiplier Process
32
Excess Reserves as Lending Power
  • Each bank may lend an amount equal to its excess
    reserves and no more.
  • The banking system can increase the volume of
    loans by the amount of excess reserves multiplied
    by the money multiplier.

33
The Money Multiplier at Work
34
Banks and the Circular Flow
  • Banks perform two essential functions for the
    macro economy
  • Banks transfer money from savers to borrowers by
    lending funds (excess reserves) held on deposit.
  • The banking system creates additional money by
    making loans in excess of total reserves.
  • This financial intermediation helps maintain any
    desired rate of aggregate demand.

35
Financing Injections
  • Consumer saving is a leakage.
  • A substantial portion of consumer saving is
    deposited in banks.
  • Bank deposits can be used to make loans, which
    returns purchasing power to the circular flow.

36
Banks in the Circular Flow
Domestic consumption
Income
Sales receipts
Business firms
Investment expenditures
Wages, dividends, etc.
37
Constraints on Deposit Creation
  • There are three major constraints on deposit
    creation
  • Deposits Consumers must be willing to use and
    accept checks rather than cash.
  • Borrowers Borrowers must be willing to borrow
    the money that banks provide.
  • Regulation The central bank sets the ceiling on
    deposit creation.

38
When Banks Fail
  • In the past, runs of depositors rushing to
    withdraw their funds have created panics.
  • Bank closed, wiping out customer deposits,
    curtailing lending, and often pushing the economy
    into recession.
  • In the early part of the Great Depression
    (1930-1933), 9000 banks failed.

39
Deposit Insurance
  • The FDIC and FSLIC were created by Congress in
    1933-34, to ensure depositors that their money
    would be safe -- thus eliminating the motivation
    for deposit runs.

40
Monetary Policy
  • Chapter 15

41
Policy Tools
  • Monetary Policy
  • Changes in the supply of money used to try to
    influence the levels of output, employment, and
    prices.
  • GDP C I G (Ex-Im)

42
Money Balances
  • Most of the money in the money supply (M1 and M2)
    is in the form of bank balances.
  • Money Supply (M1) Currency held by the public,
    plus balances in transactions accounts.
  • Money Supply (M2) - M1 plus balances in most
    savings accounts and money market mutual funds.

43
The Money Market
  • The price of money is determined by the supply
    and demand of money.
  • The interest rate is the price paid for the use
    of money.
  • Foregone interest is the opportunity cost of
    money and affects why people choose to hold money.

44
The Demand for Money
  • The demand for money reflects the quantity of
    money people are willing and able to hold at
    alternative interest rates, ceteris paribus.
  • A portfolio decision is the choice of how to hold
    idle funds.

45
The Demand for Money
  • Although holding money provides little or no
    interest, there are reasons for doing so.
  • Transactions demand
  • Money held for the purpose of making everyday
    market purchases.
  • Precautionary demand
  • Money held for unexpected market transactions or
    for emergencies.
  • Speculative demand
  • Money held for later financial opportunities.

46
Demand and Supply in the Money Market
  • The quantity of money that people are willing and
    able to hold (demand) increases as interest rates
    fall (ceteris paribus).
  • The money supply is determined by the central
    bank and does not respond to interest rates.
  • The equilibrium rate of interest is the interest
    rate at which the quantity of money demanded in a
    given time period equals the quantity of money
    supplied.

47
Money Market Equilibrium
Money supply
The amount of money demanded (held) depends on
interest rates
E1
Interest Rate (percent per year)
7
Money demand
g1
0
Quantity Of Money (billions of dollars)
48
Changing Interest Rates
  • To increase the equilibrium rate of interest, the
    central bank decreases the money supply.
  • To lower the equilibrium rate of interest, the
    central bank increases the money supply.
  • People are willing to hold larger money balances
    only at lower interest rates.

49
Changing Interest Rates
Money supply
The amount of money demanded (held) depends on
interest rates
E1
Interest Rate (percent per year)
7
Money demand
g1
0
Quantity Of Money (billions of dollars)
50
Changing Interest Rates
E1
Interest Rate(percent per year)
7
E3
Demand for money
6
g1
g3
0
Quantity Of Money (billions of dollars)
51
Inter-Bank Rate
  • When the central bank injects or withdraws
    reserves from the banking system, the inter-bank
    rate is most directly affected.
  • The inter-bank rate reflects the cost of funds
    for banks.
  • Federal Funds Rate The interest rate for
    inter-bank reserve loans.

52
Consumption and Investment
  • Changes in interest rates affect consumer,
    investor, and net export spending.
  • Lowering interest rates lowers the cost of
    borrowing which encourages investment.
  • Increased investment injects new spending into
    the circular flow.
  • The multiplier effect results in an even larger
    increase in aggregate demand.

53
Increasing Aggregate Demand
  • To lower unemployment pressures, the central bank
    will apply a policy of monetary stimulus.
  • The central banks objective of stimulating the
    economy is achieved in three steps
  • An increase in the money supply.
  • A reduction in interest rates.
  • An increase in aggregate demand.

54
Monetary Stimulus
55
Decreasing Aggregate Demand
  • To lower inflationary pressures, the central bank
    will apply a policy of monetary restraint.
  • Monetary restraint is achieved with
  • A decrease in the money supply.
  • An increase in interest rates.
  • A decrease in aggregate demand.

56
Monetary Restraint
An increase in the rate of interest lowers
investment
Less investment decreases aggregate demand
(including multiplier effects)
AS
Investment demand
7
Interest Rate
Price Level
6
AD1
AD2
0
I2
I1
Rate Of Investment
Income (Output)
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