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What Counts as Money


Yet credit cards are not considered money, even though you can use them to buy things ... of small savers' funds into custom-designed packages, and lending them ... – PowerPoint PPT presentation

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Title: What Counts as Money

What Counts as Money
  • Money has several useful functions
  • Provides a unit of account
  • Standardized way of measuring value of things
    that are traded
  • Serves as store of value
  • One of several ways in which households can hold
    their wealth
  • Yet credit cards are not considered money, even
    though you can use them to buy things
  • Why is this?
  • A more formal definition of money helps to answer
    questions like this
  • Money is an asset that is widely accepted as a
    means of payment

Measuring the Money Supply
  • Amount of money in circulation can affect
  • Money Supply
  • Total amount of money held by the public
  • In practice, measuring money supply is not as
    straightforward as it might seem
  • Governments have varied measures of the money
  • In effect, alternative ways of defining what is
    and what is not money
  • Each measure includes a selection of assets that
    are widely acceptable as a means of payment and
    are relatively liquid
  • A liquid asset can be converted to cash quickly
    and at little cost
  • An illiquid asset can be converted to cash only
    after a delay, or at considerable cost

Assets and Their Liquidity
  • Most liquid asset is cash in the hands of the
  • Next in line are asset categories of about equal
  • Demand deposits
  • Other checkable deposits
  • Travelers checks
  • Savings-type accounts
  • Next on the list are deposits in retail money
    market mutual funds
  • Time deposits (sometimes called certificates of
    deposit, or CDs)

Figure 1 Monetary Assets and Their Liquidity
(May 23, 2005)
Demand Deposits (332 billion) Other Checkable D
eposits (324 billion) Travelers Checks (8
Less Liquid
More Liquid
M1 And M2
  • Standard measure of money stock is M1
  • Sum of the first four assets in our list
  • M1 cash in the hands of the public demand
    deposits other checking account deposits
    travelers checks
  • When economists or government officials speak
    about money supply, they usually mean M1
  • Another common measure of money supply, M2, adds
    some other types of assets to M1
  • M2 M1 savings-type accounts retail MMMF
    balances small denomination time deposits
  • Other official measures of money supply besides
    M1 and M2 that add in assets that are less liquid
    than those in M2
  • M1 and M2 have been most popular, and most
    commonly watched, definitions

M1 And M2
  • Important to understand that M1 and M2 money
    stock measures exclude many things that people
    use regularly as a means of payment
  • Technological advancesnow and in the futurewill
    continue trend toward new and more varied ways to
    make payments
  • We will assume money supply consists of just two
  • Cash in the hands of the public and demand
  • Our definition of the money supply corresponds
    closely to liquid assets that our national
    monetary authoritythe Federal Reservecan control

The Banking System Financial Intermediaries
  • What are banks?
  • Financial intermediariesbusiness firms that
    specialize in
  • Assembling loanable funds from households and
    firms whose revenues exceed their expenditures
  • Channeling those funds to households and firms
    (and sometimes the government) whose expenditures
    exceed revenues
  • An intermediary helps to solve problems by
    combining a large number of small savers funds
    into custom-designed packages, and lending them
    to larger borrowers
  • Intermediaries earn a profit for providing
    brokering services by charging a higher interest
    rate on the funds they lend than rate they pay to

The Banking System Financial Intermediaries
  • United States boasts a wide variety of financial
    intermediaries, including
  • Commercial banks
  • Savings and loan associations
  • Mutual savings banks
  • Credit unions
  • Insurance companies
  • Some government agencies
  • There are four types of depository institutions
  • Savings and Loan associations
  • Mutual savings banks
  • Credit unions
  • Commercial banks

Commercial Banks
  • A commercial bank (or just bank for short) is a
    private corporation that provides services to the
  • Owned by its stockholders
  • For our purposes, most important service is to
    provide checking accounts
  • Enables banks customers to pay bills and make
    purchases without holding large amounts of cash
    that could be lost or stolen
  • Banks provide checking account services in order
    to earn a profit

A Banks Balance Sheet
  • A balance sheet is a two-column list that
    provides information about financial condition of
    a bank at a particular point in time
  • In one column, banks assets are listed
  • Everything of value that it owns
  • On the other side, the banks liabilities are
  • Amounts bank owes
  • Bond
  • A promise to pay back borrowed funds, issued by a
    corporation or government agency
  • Loan
  • An agreement to pay back borrowed funds, signed
    by a household or noncorporate business
  • Next come two categories that might seem curious
  • Vault cash
  • Account with the Federal Reserve
  • Why does the bank hold them?

A Banks Balance Sheet
  • Explanations for vault cash and accounts with
    Federal Reserve
  • On any given day, some of the banks customers
    might want to withdraw more cash than other
    customers are depositing
  • Banks are required by law to hold reserves
  • Sum of cash in vault and accounts with Federal
  • Required reserve ratio tells banks the fraction
    of their checking accounts that they must hold as
    required reserves
  • Set by Federal Reserve
  • Net worth Total assets Total liabilities
  • Include net worth on liabilities side of balance
    sheet because it is, in a sense, what bank would
    owe to its owners if it went out of business
  • A balance sheet always balances

The Federal Reserve System
  • Every large nation controls its money supply with
    a central bank
  • A nations principal monetary authority
  • Most developed countries established central
    banks long ago
  • U.S. waited such a long time to establish a
    central authority because of
  • Suspicion of central authority that has always
    been part of U.S. politics and culture
  • Large size and extreme diversity of our country
  • Fear that a powerful central bank might be
    dominated by the interests of one region to the
    detriment of others

The Federal Reserve System
  • Our central bank is different in form from its
    European counterparts
  • One major difference is indicated in the very
    name of the institution
  • Does not have the word central or bank
    anywhere in its title
  • Another difference is the way the system is
  • Another interesting feature of Federal Reserve
    System is its peculiar status within government
  • Strictly speaking, it is not even a part of any
    branch of government
  • Both President and Congress exert some influence
    on Fed through their appointments of key

Figure 2 The Geography of the Federal Reserve
Figure 3 The Structure of the Federal Reserve
The Structure of the Fed
  • Board of Governors
  • Consists of seven members who are appointed by
    President and confirmed by Senate for a 14-year
  • In order to keep any President or Congress from
    having too much influence over Fed
  • Each of 12 Federal Reserve Banks is supervised by
    nine directors
  • Three are appointed by Board of Governors
  • Other six are elected by private commercial
    banksthe official stockholders of the system
  • Directors of each Federal Reserve Bank choose a
    president of that bank, who manages its
    day-to-day operations
  • Only about 3,500 of the 8,000 or so commercial
    banks in United States are members of Federal
    Reserve System
  • They include all national banks and state banks
  • All of the largest banks in United States are
    nationally chartered banks and therefore member
    banks as well

The Federal Open Market Committee
  • Federal Open Market Committee (FOMC)
  • A committee of Federal Reserve officials that
    establishes U.S. monetary policy
  • Most economists regard FOMC as most important
    part of Fed
  • Consists of all 7 governors of Fed, along with 5
    of the 12 district bank presidents
  • Not even President of United States knows details
    behind the decisions, or what FOMC actually
    discussed at its meeting, until summary of
    meeting is finally released
  • Committee exerts control over nations money
    supply by buying and selling bonds in public
    (open) bond market

The Functions of the Federal Reserve
  • Federal Reserve, as overseer of the nations
    monetary system, has a variety of important
    responsibilities including
  • Supervising and regulating banks
  • Acting as a bank for banks
  • Issuing paper currency
  • Check clearing
  • Controlling money supply

The Fed and the Money Supply
  • Suppose Fed wants to change nations money supply
  • It buys or sells government bonds to bond
    dealers, banks, or other financial institutions
  • Actions are called open market operations
  • Well make two special assumptions to keep our
    analysis of open market operations simple for now
  • Households and business are satisfied holding the
    amount of cash they are currently holding
  • Any additional funds they might acquire are
    deposited in their checking accounts
  • Any decrease in their funds comes from their
    checking accounts
  • Banks never hold reserves in excess of those
    legally required by law

How the Fed Increases the Money Supply
  • To increase money supply, Fed will buy government
    bonds, called an open market purchase
  • Suppose Fed buys 1,000 bond from Lehman
    Brothers, which deposits the total into its
    checking account
  • Two important things have happened
  • Fed has injected reserve into banking system
  • Money supply has increased
  • Demand deposits have increased by 1,000 and
    demand deposits are part of money supply
  • Lehman Brothers bank now has excess reserves
  • Reserves in excess of required reserves
  • If required reserve ratio is 10 bank has excess
    reserves of 900 to lend
  • Demand deposits increase each time a bank lends
    out excess reserves

The Demand Deposit Multiplier
  • How much will demand deposits increase in total?
  • Each bank creates less in demand deposits than
    the bank before
  • In each round, a bank lent 90 of deposit it
  • Whatever the injection of reserves, demand
    deposits will increase by a factor of 10, so we
    can write
  • ?DD 10 x reserve injection
  • Demand deposit multiplier is number by which we
    must multiply injection of reserves to get total
    change in demand deposits
  • Size of demand deposit multiplier depends on
    value of required reserve ratio set by Fed

The Demand Deposit Multiplier
  • For any value of required reserve ratio (RRR),
    formula for demand deposit multiplier is 1/RRR
  • Using general formula for demand deposit
    multiplier, can restate what happens when Fed
    injects reserves into banking system as follows
  • ?DD (1 / RRR) x ?Reserves
  • Since weve been assuming that the amount of cash
    in the hands of the public (the other component
    of the money supply) does not change, we can also
  • ?Money Supply (1 / RRR) x ?Reserves

The Feds Influence on the Banking System as a
  • Can also look at what happened to total demand
    deposits and money supply from another
  • Where did additional 1,000 in reserves end up?
  • In the end, additional 1,000 in reserves will be
    distributed among different banks in system as
    required reserves
  • After an injection of reserves, demand deposit
    multiplier stops workingand the money supply
    stops increasingonly when all reserves injected
    are being held by banks as required reserves
  • In the end, total reserves in system have
    increased by 1,000
  • Amount of open market purchase

How the Fed Decreases the Money Supply
  • Just as Fed can increase money supply by
    purchasing government bonds
  • Can also decrease money supply by selling
    government bonds
  • An open market sale
  • Process of calling in loans will involve many
  • Each time a bank calls in a loan, demand deposits
    are destroyed
  • Total decline in demand deposits will be a
    multiple of initial withdrawal of reserves
  • Keeping in mind that a withdrawal of reserves is
    a negative change in reserves
  • Can still use our demand deposit
    multiplier1/(RRR)and our general formula
  • ?DD (1/RRR) x ?Reserves

Some Important Provisos About the Demand Deposit
  • Though the process of money creation and
    destruction weve described illustrates the basic
    ideas, formula for demand deposit
    multiplier1/RRRis oversimplified
  • In reality, multiplier is likely to be smaller
    than formula suggests, for two reasons
  • Weve assumed that as money supply changes,
    public does not change its holdings of cash
  • Weve assumed that banks will always lend out all
    of their excess reserves

Other Tools for Controlling the Money Supply
  • While other tools can affect the money supply,
    open market operations have two advantages over
  • Precision and secrecy
  • This is why open market operations remain Feds
    primary means of changing money supply
  • Feds ability to conduct its policies in
    secretand its independent status in generalis
  • In recent years, because Fed has been so
    successful in guiding economy, controversy has
    largely subsided

Other Tools for Controlling the Money Supply
  • There are two other tools Fed can use to increase
    or decrease money supply
  • Changes in required reserve ratio
  • Changes in discount rate
  • Changes in either required reserve ratio or
    discount rate could set off the process of
    deposit creation or deposit destruction in much
    the same way outlined in this chapter
  • In reality, neither of these policy tools is used
    very often
  • Why are these other tools used so seldom?
  • Partly because they can have unpredictable effects

Using the Theory Bank Failures and Banking
  • A bank failure occurs when a bank cannot meet its
    obligations to those who have claims on the bank
  • Historically, many bank failures have occurred
    when depositors began to worry about a banks
    financial health
  • Run on the bank
  • Ironically, a bank can fail even if it is in good
    financial health, with more than enough assets to
    cover its liabilities
  • Banking panic occurs when many banks fail

Using the Theory Bank Failures and Banking
  • Banking panics can cause serious problems for the
  • Hardship suffered by people who lose their
    accounts when their bank fails
  • Even when banks do not fail, withdrawal of cash
    decreases banking systems reserves
  • Money supply can decrease suddenly and severely,
    causing a serious recession
  • Banking panic of 1907 convinced Congress to
    establish Federal Reserve System
  • But creation of Fed did not, in itself, solve
  • Great Depression is a good example of this
  • Officials of Federal Reserve System, not quite
    grasping seriousness of the problem, stood by and
    let it happen

Using the Theory Bank Failures and Banking
  • For five-year period ending in May 2003, a total
    of 26 banks failedan average of about 6 per year
  • Why the dramatic improvement?
  • Federal Reserve learned an important lesson from
    Great Depression
  • It now stands ready to inject reserves into
    system more quickly in a crisis
  • In 1933 Congress created Federal Deposit
    Insurance Corporation (FDIC) to reimburse those
    who lose their deposits
  • FDIC has had a major impact on the psychology of
    banking public
  • FDIC protection for bank accounts has not been
  • To many observers, experience of late 1980s and
    early 1990s was a reminder of the need for a
    sound insurance system and close monitoring of
    banking system

Figure 4 Bank Failures in the United States,
Number of Bank Failures
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