Money, Banking, and the Federal Reserve System


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Money, Banking, and the Federal Reserve System


Money, Banking, and the Federal Reserve System Chapter 14 – PowerPoint PPT presentation

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Title: Money, Banking, and the Federal Reserve System

Money, Banking, and the Federal Reserve System
  • Chapter 14

The Meaning of Money
What are some examples of money?
  • Money is an asset that can easily be used to
    purchase goods and services.
  • Currency in circulation is cash held by the
  • Checkable bank deposits are bank accounts on
    which people can write checks.
  • The money supply is the total value of financial
    assets in the economy that are considered money.
  • Narrowest currency in circulation, travelers
    checks, and checkable bank deposits (M1)
  • Broader currency in circulation, travelers
    checks, and checkable bank deposits PLUS almost
    checkablesavings accounts. (M2)

Global Comparison Currency
Roles of Money
  1. Medium of exchange
  2. Store of value
  3. Unit of Account

Money of Medium of Exchange
  • A medium of exchange is an asset that individuals
    acquire for the purpose of trading rather than
    for their own consumption.
  • Money makes the transactions easier.
  • The alternative is barter.

Money as Store of Value
  • A store of value is a means of holding purchasing
    power over time.
  • Money keeps its value over time.
  • What can threaten the store of value of money?

Money as Unit of Account
  • A unit of account is a measure used to set prices
    and make economic calculations.
  • Money as a unit of account allows one to compare
    the values of goods and services.

Types of Money
  • Commodity Money
  • Good that is used as a medium of exchange that
    has value in its own right.
  • Examples are gold and silver.
  • Representative Money
  • Commodity-backed money is a medium of exchange
    with no intrinsic value whose ultimate value is
    guaranteed by a promise that it can be converted
    into valuable goods.
  • An example is a bank note redeemable for a
    commodity like gold or silver.
  • Fiat Money
  • Something that has value because government says
    that it has valueUS .

Measuring the Money Supply
  • Monetary Aggregates
  • An overall measure of the money supply
  • Federal Reserve calculates the size of two
    monetary aggregates
  • M1 currency in circulation, travelers checks,
    and checkable bank deposits
  • M2 currency in circulation, travelers checks,
    and checkable bank deposits PLUS almost
    checkablesavings accountsexample of

Monetary Aggregates, Sept. 2011
Monetary Role of Banks
What do banks do?
  • A bank is a financial intermediary that uses
    liquid assets in the form of banks deposits to
    finance the illiquid investments of borrowers.
  • Bank reserves are the currency banks hold in
    their vaults plus their deposits at the Federal
  • The reserve ratio is the fraction of bank
    deposits that a bank holds as reserves.
  • T-account summarizes a banks financial position
  • Banks assets include its reserves as well as
  • Banks liabilities include the deposits it holds.

Bank Regulation
  • A bank run is a phenomenon in which many of a
    banks depositors try to withdraw their funds due
    to fears of a bank failure.
  • Deposit insurance guarantees that a banks
    depositors will be paid even if the bank does not
    have the funds, up to a maximum per account.
  • Federal Deposit Insurance Corporation (FDIC)
    currently guarantees the first 250,000 held in
    each account at a bank.
  • Capital requirements are requirements by the
    Federal Reserve that bank owners hold
    substantially more assets than the value of bank
  • Reserve requirements are rules set by the Federal
    Reserve that determine the minimum reserve ratio
    for a bank. (10)
  • The Federal Reserve lends money to banks through
    an arrangement known as the discount window.

Reserves, Bank Deposits, and the Money Multiplier
  • Excess reserves are a banks reserves over and
    above its required reserves.
  • Money is created when a bank loans any excess
    reserves it holds.
  • Banks lending leads to new deposits in the
    banking system and a multiplier effect on the
    money supply.
  • In a checkable-deposits-only system, the money
    supply equals bank reserves divided by the
    reserve ratio.

Determining the Money Supply How Banks Create
  1. The AZ Bank has 250,000 in deposits. If the
    reserve ratios is 10, how much of these deposits
    must the bank hold in reserve?
  2. How much in loans can the AB Bank issue in the
    given situation?
  3. What does the T-Account for AB Bank look like?

  1. Steve deposits his 15,000 Christmas bonus into
    his savings account at the New Market Bank. If
    the required reserve ratio is 15, how much must
    the bank hold in required reserves?
  2. Sam deposits 5,000 in cash into his checking
    account at the First Bank of Macroland. If the
    required reserve ratio is 20 what are the banks
    excess reserves?

Money Multiplier in Reality
  • Federal Reserve controls the sum of bank reserves
    and currency in circulation, monetary base.
  • The money multiplier is the ratio of the money
    supply to the monetary base.
  • The size of the money multiplier is reduced when
    funds are held as cash rather than as checkable
  • In reality, the money multiplier is smaller than
    the bank reserves divided by the reserve ratio.

Money Multiplier

  • Assume reserve requirement 20
  • 100 put in bank

1 . rr
New Reserves
Graphic Example
20 Required Reserves
80 Excess Reserves
100 Initial Deposit
400 Bank System Lending
Money Created
Think, Pair, Share
  • What is the difference between the monetary base
    and the money supply?
  • Bank reserves are in the monetary base and not in
    the money supply.

Structure of the Federal Reserve
  • A central bank is an institution that oversees
    and regulates the banking system and controls the
    monetary base.
  • Federal Reserve, established in 1913, is the
    central bank of the US.
  • Federal Reserve system consists of
  • Board of Governors
  • 12 regional Federal Reserve banks that provide
    various banking and supervisory services to
    commercial banks.

What does your bill say?
Federal Reserve Regions
Federal Reserve System
  • Seven members of the Board of Governors are
    appointed by the president with Senate approval.
  • Serve 14-year terms
  • Terms staggered so one member is replaced every
    two years. (above political pressure)
  • The chairman of the Fed is appointed by the
    president with Senate approval and serves a
    four-year term with possible reappointment.
  • Ben Bernake (2006 to Present) Alan
    Greenspan (1987 to 2006)

Role of Federal Reserve
  • A bank to banks and to the Federal government
  • Regulate the banks in their district
  • Provide a safe and stable financial system
  • Implement Monetary Policy

Policy Tools of Fed
  • Reserve requirements
  • Increase or decrease the amount that banks must
    hold in reserve.
  • Discount rate
  • The federal funds market allows banks that fall
    short of the reserve requirement to borrow funds
    from banks with excess reserves.
  • Interest rate the Fed charges banks to borrow for
  • Rate is normally 1 above the federal funds rates
    although reduced in 2007 with financial crisis.
  • Open-market operations
  • An open-market operation is a purchase or sale of
    government debt by the Fed.
  • The Federal Reserves assets include government
    debt, mainly in the form of US Treasury bills.
  • The Feds liabilities include the currency in
    circulation plus bank reserves which comprise the
    monetary base.

Open-Market Operations
  • Federal Open Market Committee comprised of
  • Board of Governors
  • President of the New York Federal Reserve Bank
    five other regional Federal Reserve Bank
  • Federal Open Market Committee makes decisions
    regarding monetary policy.
  • An open-market purchase of Treasury bills
    increases the monetary base and the money supply.
  • An open-market sale of Treasury bills decreases
    the monetary base and money supply.

European Central Bank
  • Created in January 1999 when 11 European nations
    decided to adopt the euro as their common
  • Equivalent to the Feds Board of Governors

Overview of 21st Century American Banking System
  • Crisis at turn of century
  • 1907 panic originated in less regulated
    institutions known as trusts
  • The Fed was created in response to panic to
    centralize holding of reserves, inspect banks
    books and make the money supply sufficiently
    responsive to varying economic situations.
  • Responding to bank crises
  • Widespread banks runs in the early 1930s
  • Emergency measures were adopted that gave RFC
    powers to stabilize and restructure banking
  • Glass-Steagall Act (1933) separated banks into 2
  • Commercial bank accepts deposits and is covered
    by deposit insurance
  • Investment bank trades in financial assets
    (stocks and corporate bonds) and is not covered
    by deposit insurance.
  • Adoption of federal deposit insurance was most
    important to stop bank runs.
  • Regulation Q prevented commercial banks from
    paying interest on checking accounts.
  • With a long period of financial and banking
    stability, regulation Q was eliminated in 1980
    and Glass-Steagall Act significantly weakened by

Overview of 21st Century American Banking System
  • Savings and Loan Crisis of 1980s
  • A savings and loan (thrift) is a type of
    deposit-taking bank, usually specialized in home
  • Crisis of 1980s caused sharp losses in the
    financial and real estate sectors, resulting in
    an early 1990s recession.

Overview of 21st Century American Banking System
  • Financial Crisis of 2008
  • Long-term Capital Management (LTCM) was a hedge
    fund created in 1994.
  • A financial institution engages in leverage when
    it finances its investments with borrowed funds.
  • Balance sheet effect is when sales of assets
    depress asset prices all over the world and other
    firms see the value of their balance sheets fall.
  • When asset prices falling from the balance sheet
    effect go below a critical threshold, creditors
    call in loans--leading to more asset sales as
    borrowers try to get cash to repay loans-leading
    to more defaults-leading to more declines in
    asset prices-leading to more loans called in and
    thus a vicious cycle of deleveraging.
  • Federal Reserve Bank of New York arranged a
    3.625 billion bailout of LCTM in 1998 and
    revived world credit markets.

Overview of 21st Century American Banking System
  • Financial Crisis of 2008
  • Subprime lending and the housing bubble
  • Subprime lending involves loans to people who
    dont meet the usual criteria for borrowing and
    for being unable to afford their payments.
  • Securitization is the process of assembling pools
    of loans and selling shares in the income from
    these pools.
  • Housing boom turned out to be a bubble. When it
    burst, banks and nonbank financial instructions
    led to widespread collapse in the financial
  • Crisis and Response
  • Collapse of trust in the financial system,
    combined with large losses suffered by financial
    firms, led to a severe cycle of deleveraging and
    a credit crunch for the economy.
  • As the crisis originated in nontraditional banks
    institutions, the crisis of 2008 indicated a
    wider safety net and broader regulation are
    needed in the financial sector.