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MONEY, BANKS, AND THE FEDERAL RESERVE

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26 MONEY, BANKS, AND THE FEDERAL RESERVE CHAPTER Objectives After studying this chapter, you will able to Define money and describe its functions Explain the economic ... – PowerPoint PPT presentation

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Title: MONEY, BANKS, AND THE FEDERAL RESERVE


1
26
MONEY, BANKS, AND THE FEDERAL RESERVE
CHAPTER
2
Objectives
  • After studying this chapter, you will able to
  • Define money and describe its functions
  • Explain the economic functions of banks and other
    depository institutions and describe how they are
    regulated
  • Explain how banks create money
  • Describe the structure of the Federal Reserve
    System (the Fed), and the tools used by the Fed
    to conduct monetary policy
  • Explain what an open market operation is, how it
    works, and how it changes the quantity of money

3
Money makes the World Go Around
  • Money has taken many forms what is money now?
  • What do banks do, and can they create money?
  • What is the Fed and what does it do?
  • How does the Fed ensure that the economy has the
    right amount of money to function properly?

4
What is Money?
  • Money is any commodity or token that is generally
    acceptable as a means of payment.
  • A means of payment is a method of settling a
    debt.
  • Money has three other functions
  • Medium of exchange
  • Unit of account
  • Store of value

5
What is Money?
  • Medium of Exchange
  • A medium of exchange is an object that is
    generally accepted in exchange for goods and
    services.
  • In the absence of money, people would need to
    exchange goods and services directly, which is
    called barter.
  • Barter requires a double coincidence of wants,
    which is rare, so barter is costly.
  • Unit of Account
  • A unit of account is an agreed measure for
    stating the prices of goods and services.

6
What is Money?
  • Store of Value
  • As a store of value, money can be held for a time
    and later exchanged for goods and services.
  • Money in the United States Today
  • Money in the United States consists of
  • Currency
  • Deposits at banks and other depository
    institutions
  • Currency is the general term for bills and coins.

7
What is Money?
  • The two main official measures of money in the
    United States are M1 and M2.
  • M1 consists of currency outside banks, travelers
    checks, and checking deposits owned by
    individuals and businesses.
  • M2 consists of M1 plus time deposits, savings
    deposits, and money market mutual funds and other
    deposits.

8
What is Money?
  • Figure 26.1 illustrates the composition of these
    two measures in 2001 and shows the relative
    magnitudes of the components of money.

9
What is Money?
  • The items in M1 clearly meet the definition of
    money the items in M2 do not do so quite so
    clearly but still are quite liquid.
  • Liquidity is the property of being instantly
    convertible into a means of payment with little
    loss of value.
  • Checkable deposits are money, but checks are not
    checks are instructions to banks to transfer
    money.
  • Credit cards are not money. Credit cards enable
    the holder to obtain a loan quickly, but the loan
    must be repaid with money.

10
Depository Institutions
  • A depository institution is a firm that accepts
    deposits from households and firms and uses the
    deposits to make loans to other households and
    firms.
  • The deposits of three types of depository
    institution make up the nations money
  • Commercial banks
  • Thrift institutions
  • Money market mutual funds

11
Depository Institutions
  • Commercial Banks
  • A commercial bank is a private firm that is
    licensed to receive deposits and make loans.
  • A commercial banks balance sheet summarizes its
    business and lists the banks assets,
    liabilities, and net worth.
  • The objective of a commercial bank is to maximize
    the net worth of its stockholders.

12
Depository Institutions
  • To achieve its objective, a bank makes risky
    loans at an interest rate higher than that paid
    on deposits.
  • But the banks must balance profit and prudence
    loans generate profit, but depositors must be
    able to obtain their funds when they want them.
  • So banks divide their funds into two parts
    reserves and loans.
  • Reserves are the cash in a banks vault and
    deposits at Federal Reserve Banks.
  • Bank lending takes the form of liquid assets,
    investment securities, and loans.

13
Depository Institutions
  • Thrift Institutions
  • The thrift institutions are
  • Savings and loan associations
  • Savings banks
  • Credit unions.

14
Depository Institutions
  • A savings and loan association (SL) is a
    depository institution that accepts checking and
    savings deposits and that make personal,
    commercial, and home-purchase loans.
  • A savings bank is a depository institution owned
    by its depositors that accepts savings deposits
    and makes mainly mortgage loans.
  • A credit union is a depository institution owned
    by its depositors that accepts savings deposits
    and makes consumer loans.

15
Depository Institutions
  • Money Market Mutual Funds
  • A money market fund is a fund operated by a
    financial institution that sells shares in the
    fund and uses the proceeds to buy liquid assets
    such as U.S. Treasury bills.

16
Depository Institutions
  • The Economic Functions of Depository Institutions
  • Depository institutions make a profit from the
    spread between the interest rate they pay on
    their deposits and the interest rate they charge
    on their loans.
  • This spread exists because depository
    institutions
  • Create liquidity
  • Minimize the cost of obtaining funds
  • Minimize the cost of monitoring borrowers
  • Pool risk

17
Financial Regulation, Deregulation, and Innovation
  • Financial Regulation
  • Depository institutions face two types of
    regulations
  • Deposit insurance
  • Balance sheet rules

18
Financial Regulation, Deregulation, and Innovation
  • Deposits at banks, SLs, savings banks, and
    credit unions are insured by the Federal Deposit
    Insurance Corporation (FDIC).
  • This insurance guarantees deposits in amounts of
    up to 100,000 per depositor.
  • This guarantee gives depository institutions the
    incentive to make risky loans because the
    depositors believe their funds to be perfectly
    safe because of this incentive balance sheet
    regulations have been established.

19
Financial Regulation, Deregulation, and Innovation
  • There are four main balance sheet rules
  • Capital requirements
  • Reserve requirements
  • Deposit rules
  • Lending rules

20
Financial Regulation, Deregulation, and Innovation
  • Deregulation in the 1980s and 1990s
  • During the 1980s many restrictions on depository
    institutions were lifted and distinctions between
    banks and others depository institutions ended.
  • In 1994 the Riegle-Neal Interstate Banking and
    Branching Efficiency Act was passed, which
    permits U.S. banks to establish branches in any
    state.
  • This change in the law led to a wave of bank
    mergers.

21
Financial Regulation, Deregulation, and Innovation
  • Financial Innovation
  • The 1980s and 1990s have been marked by financial
    innovationthe development of new financial
    products aimed at lowering the cost of making
    loans or at raising the return on lending.
  • Financial innovation occurred for three reasons
  • The economic environment--high inflation
  • Massive technological change
  • Avoid regulation

22
Financial Regulation, Deregulation, and Innovation
  • Deregulation, Innovation, and Money
  • The combination of deregulation and innovation
    has produced large changes in the composition of
    money, both M1 and M2.

23
How Banks Create Money
  • Reserves Actual and Required
  • The fraction of a banks total deposits held as
    reserves is the reserve ratio.
  • The required reserve ratio is the fraction that
    banks are required, by regulation, to keep as
    reserves. Required reserves are the total amount
    of reserves that banks are required to keep.
  • Excess reserves equal actual reserves minus
    required reserves.

24
How Banks Create Money
  • Creating Deposits by Making Loans
  • To see how banks create deposits by making loans,
    suppose the required reserve ratio is 25 percent.
  • A new deposit of 100,000 is made.
  • The bank keeps 25,000 in reserve and lends
    75,000.
  • This loan is credited to someones bank deposit.
  • The person spends the deposit and another bank
    now has 75,000 of extra deposits.
  • This bank keeps 18,750 on reserve and lends
    56,250.

25
How Banks Create Money
  • The process continues and keeps repeating with
    smaller and smaller loans at each round.
  • Figure 26.2 illustrates the money creation
    process.

26
The Federal Reserve System
  • The Federal Reserve System, or the Fed, is the
    central bank of the United States.
  • A central bank is the public authority that
    regulates a nations depository institutions and
    controls the quantity of money.

27
The Federal Reserve System
  • The Feds Goals and Targets
  • The Fed conducts the nations monetary policy,
    which means that it adjusts the quantity of money
    in circulation.
  • The Feds goals are to keep inflation in check,
    maintain full employment, moderate the business
    cycle, and contribute toward achieving long-term
    growth.
  • In pursuit of its goals, the Fed pays close
    attention to interest rates and sets a target
    that is consistent with its goals for the federal
    funds rate, which is the interest rate that the
    banks charge each other on overnight loans of
    reserves.

28
The Federal Reserve System
  • The Structure of the Fed
  • The key elements in the structure of the Fed are
  • The Board of Governors
  • The regional Federal Reserve banks
  • The Federal Open Market Committee.

29
The Federal Reserve System
  • The Board of Governors has seven members
    appointed by the president of the United States
    and confirmed by the Senate.
  • Board terms are for 14 years and overlap so that
    one position becomes vacant every 2 years.
  • The president appoints one member to a
    (renewable) four-year term as chairman.
  • Each of the 12 Federal Reserve Regional Banks has
    a nine-person board of directors and a president.

30
The Federal Reserve System
  • Figure 26.3 shows the regions of the Federal
    Reserve System.

31
The Federal Reserve System
  • The Federal Open Market Committee (FOMC) is the
    main policy-making group in the Federal Reserve
    System.
  • It consists of the members of the Board of
    Governors, the president of the Federal Reserve
    Bank of New York, and the 11 presidents of other
    regional Federal Reserve banks of whom, on a
    rotating basis, 4 are voting members.
  • The FOMC meets every six weeks to formulate
    monetary policy.

32
The Federal Reserve System
Figure 26.4 summarizes the Feds structure and
policy tools.
33
The Federal Reserve System
  • The Feds Power Center
  • In practice, the chairman of the Board of
    Governors (since 1987 Alan Greenspan) is the
    center of power in the Fed.
  • He controls the agenda of the Board, has better
    contact with the Feds staff, and is the Feds
    spokesperson and point of contact with the
    federal government and with foreign central banks
    and governments.

34
The Federal Reserve System
  • The Feds Policy Tools
  • The Fed uses three monetary policy tools
  • Required reserve ratios
  • The discount rate
  • Open market operations

35
The Federal Reserve System
  • The Fed sets required reserve ratios, which are
    the minimum percentages of deposits that
    depository institutions must hold as reserves.
  • The Fed does not change these ratios very often.
  • The discount rate is the interest rate at which
    the Fed stands ready to lend reserves to
    depository institutions.
  • An open market operation is the purchase or sale
    of government securitiesU.S. Treasury bills and
    bondsby the Federal Reserve System in the open
    market.

36
The Federal Reserve System
  • The Feds Balance Sheet
  • On the Feds balance sheet, the largest and most
    important asset is U.S. government securities.
  • The most important liabilities are Federal
    Reserve notes in circulation and banks deposits.
  • The sum of Federal Reserve notes, coins, and
    banks deposits at the Fed is the monetary base.

37
Controlling the Quantity of Money
  • How Required Reserve Ratios Work
  • An increase in the required reserve ratio boosts
    the reserves that banks must hold, decreases
    their lending, and decreases the quantity of
    money.
  • How the Discount Rate Works
  • An increase in the discount rate raises the cost
    of borrowing reserves from the Fed, decreases
    banks reserves, which decreases their lending
    and decreases the quantity of money.

38
Controlling the Quantity of Money
  • How an Open Market Operation Works
  • When the Fed conducts an open market operation by
    buying a government security, it increases banks
    reserves.
  • Banks loan the excess reserves.
  • By making loans, they create money.
  • The reverse occurs when the Fed sells a
    government security.

39
Controlling the Quantity of Money
  • Although the details differ, the ultimate process
    of how an open market operation changes the money
    supply is the same regardless of whether the Fed
    conducts its transactions with a commercial bank
    or a member of the public.
  • An open market operation that increases banks
    reserves also increases the monetary base.

40
Controlling theQuantity of Money
  • Figure 26.5 illustrates both types of open market
    operation.

41
Controlling the Quantity of Money
  • Bank Reserves, the Monetary Base, and the Money
    Multiplier
  • The money multiplier is the amount by which a
    change in the monetary base is multiplied to
    calculate the final change in the money supply.
  • An increase in currency held outside the banks is
    called a currency drain.
  • Such a drain reduces the amount of banks
    reserves, thereby decreasing the amount that
    banks can loan and reducing the money multiplier.

42
Controlling the Quantity of Money
  • The money multiplier differs from the deposit
    multiplier.
  • The deposit multiplier shows how much a change in
    reserves affects deposits.
  • The money multiplier shows how much a change in
    the monetary base affects the money supply.

43
Controlling the Quantity of Money
  • The Multiplier Effect of an Open Market Operation
  • When the Fed conducts an open market operation,
    the ultimate change in the money supply is larger
    than the initiating open market operation.
  • Banks use excess reserves from the open market
    operation to make loans so that the banks where
    the loans are deposited acquire excess reserves
    which they, in turn, then loan.

44
Controlling the Quantity of Money
  • Figure 26.6 illustrates a round in the multiplier
    process following an open market operation.

45
Controlling the Quantity of Money
  • Figure 26.7 illustrates the multiplier effect of
    an open market operation.

46
Controlling the Quantity of Money
  • The Size of the Multiplier
  • To calculate the size of the money multiplier,
    first define
  • R reserves
  • C currency in circulation
  • D deposits
  • M quantity of money
  • B monetary base
  • c ratio of currency to deposits
  • r required reserve ratio

47
Controlling the Quantity of Money
  • The quantity of money, M, is
  • M C D (1 c) ? D
  • The monetary base, B, is
  • B R C (r c) ? D
  • Divide the first equation above by the second one
    to get
  • M/B (1 c)/(r c)
  • or
  • M (1 c)/(c r) ? B

48
Controlling the Quantity of Money
  • The money multiplier is (1 c)/(c r)the
    amount by which a change in B is multiplied to
    determine the resulting change in M.
  • With c 0.5 and r 0.1, the money multiplier is
  • 1.5/0.6 2.5.

49
THE END
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