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The Banking System and the Money Supply


Only things that are widely acceptable as a means of payment are regarded as money ... information about financial conditions of a bank at a particular point in time ... – PowerPoint PPT presentation

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Title: The Banking System and the Money Supply

  • The Banking System and the Money Supply

What Counts as Money
  • Definition of Money
  • Money is an asset that is widely accepted
    as a means of payment
  • Only assets can be considered as money
  • Can credit cards be considered as money?
  • Only things that are widely acceptable as a means
    of payment are regarded as money
  • Can stocks or bonds be considered as money?
  • Money has three useful functions
  • Serves as a medium of exchange
  • accepted in exchange for goods and services
  • Provides a unit of account
  • Standardized way of measuring value of things
    that are traded
  • Serves as a store of value
  • One of several ways in which households can hold
    their wealth

History of Currency
  • In a barter economy, where there is no commonly
    accepted currency cows, sheep, fish
  • Commodity money (with intrinsic value) like
    precious metals gold, silver, copper,etc.
  • Paper currency
  • used to be backed by physical commodity
  • Now, we have fiat money, i.e. a means of
    payment by government declaration.
  • Legal tender payment that cannot be refused
    in settlement of a debt denominated in the same
    currency by virtue of law.

Measuring the Money Supply
  • Money Supply
  • Total amount of money held by the public
  • Governments use different measures of the money
  • Each measure includes a selection of assets that
    are widely acceptable as a means of payment and
    are relatively liquid
  • An asset is considered liquid if it can be
    converted to cash quickly and at little cost
  • So, 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
  • Checkable deposits (demand deposits and other
    checking accounts)
  • Travelers checks
  • Then, savings-type accounts
  • less liquid than checking-type accounts, since
    they do not allow you to write checks
  • Next on the list are time deposits
  • Time deposits (called certificates of deposit, or
  • Require you to keep your money in the bank for a
    specified period of time (usually six months or
  • Impose an interest penalty if you withdraw early

M1 And M2
  • Standard measure of money stock (supply) is M1
  • M1 cash in the hands of the public checkable
    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 small
    denomination time deposits
  • M3M2large denomination time deposits

The Banking System Financial Intermediaries
  • What are banks?
  • Financial intermediariesbusiness firms that
    specialize in
  • Collecting 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
  • Intermediaries must earn a profit for providing
    brokering services
  • By charging a higher interest rate on funds they
    lend than rate they pay to depositors

Figure 1 The Geography of the Federal Reserve
Figure 2 The Structure of the Federal Reserve
The Federal Open Market Committee
  • Federal Open Market Committee (FOMC)
  • A committee of Federal Reserve officials that
    establishes U.S. monetary policy
  • 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
  • The FOMC exerts control over nations money
    supply by buying and selling bonds in public
    (open) bond market

A Banks Balance Sheet
  • A balance sheet is a financial statement that
    provides information about financial conditions
    of a bank at a particular point in time
  • On one side, a banks assets are listed
  • Everything of value that it owns
  • Property and buildings
  • Bonds
  • Loans
  • Vault cash
  • Account with the Federal Reserve
  • On the other side, the banks liabilities are
  • Amounts it owes
  • Deposits
  • Net worth Total assets Total liabilities
  • What bank would owe to its owners if it went out
    of business
  • A balance sheet always balances

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

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
  • Called an open market purchase
  • Suppose, by writing a check, 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 (for
    instance, M1)
  • 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 lends 90 of deposit it
  • So, the total increase in demand deposits is
  • Whatever the injection of reserves, demand
    deposits will increase by a factor of 10, so we
    can write
  • ?DD 10 x reserve injection

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
  • With the assumption 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

How the Fed Decreases the Money Supply
  • Just as Fed can decrease money supply by selling
    government bonds
  • An open market sale
  • Banks have to call in loans in order to meet the
    required reserve amount with Fed
  • 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
  • Using demand deposit multiplier1/(RRR), we can
    calculate the decrease in money supply with the
    same formula
  • ?DD (1/RRR) x ?reserves
  • This time, the change in reserve is negative

Some Important Provisos About the Demand Deposit
  • Although process of money creation and
    destruction as weve described it 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
  • 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