35
Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money by banking system. –Structure of Federal Reserve System. –Tools for Monetary Policy.

Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

  • View
    221

  • Download
    3

Embed Size (px)

Citation preview

Page 1: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE

–Definition of money and functions–History of money–Bank functions and regulations.–Creation of money by banking system. –Structure of Federal Reserve System.–Tools for Monetary Policy.

Page 2: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

HISTORY AND ROLE OF MONEY.

• The barter economy. No money. Trade requires coincidence of wants Specialization and trade fairly difficult. Money:

anything generally acceptable as means of payment

eliminates need for coincidence of wants

Page 3: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

FUNCTIONS OF MONEY

• Medium of exchange – unique to money

• Unit of account – not unique to money

• Store of value– not unique to money– not a good store of value during inflationary

times

Page 4: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

TYPES OF MONEY• Commodity money

– e.g. gold, silver, tobacco– desirable properties: durable, divisible, portable.

• Coins– e.g. $10 of gold in $10 gold piece– problems: shaving or changes in the market value of

gold• Gold standard.

– pure gold standard: • gold coins traded as money and there is no paper money

– gold exchange standard: • paper money traded that is backed by gold and can be

converted to gold at a fixed rate

Page 5: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

TYPES OF MONEY

Fiat money paper money that is not “backed” by a

commodity people cannot trade it for a commodity at a

fixed nominal price. “legal tender” value is based on faith in the government that

issues the currency.Confederate notes in Civil War.

Page 6: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

MONEY IN U.S. HISTORY

• U.S. constitution gave Congress sole right to "coin money and regulate value thereof". Illegal for states to coin money.

Bi-metallic standard initially.• In the 1792 coin act, a $1 coin was quoted in

terms of both silver and gold. 24.75 grains of gold =$1371.25 grains of silver = $1

Page 7: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

GRESHAM’S LAW Greshams Law: "bad money drives out good" Prior to 1834, 24.75 grains of gold was worth more

than 371.25 grains of silver. Only silver coins circulated (a "silver standard" by default).

After 1834, the reverse was true (a "gold standard" by default).

If gold coin has 10 grains and silver has 30 grains, what happens if gold price is 5 times silver price? 2 times silver price?

What happens to coin circulation of price of its metal rises relative to other metals?

Wizard of Oz and bimetallic standard?

Page 8: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

HISTORY OF BANKING

• Initially banks formed as “safekeeping” institutions.

• Gradually evolved to serve several functions:– Create liquidity– Minimize the cost of obtaining funds– Minimize the cost of monitoring borrowers– Pool risks

Page 9: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

HISTORY OF BANKING IN U.S. States could not print or mint money, but privately owned

banks could if licensed by the state government. Banks printed notes that were backed by gold or silver

easier to trade avoided problems with weighing Banks found it profitable to print more notes than

they had "reserves“ (gold/silver) for and loaned out the extra notes.

Fractional reserve banking was started. Fractional reserve banking poses problems if there is a

“bank run”.

Page 10: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

Assets Liabilities

• Reserves (gold) 100 Notes 100

• Total 100 100

Banks would print notes beyond reserves and extend loans.

• Reserves 100 Notes 1000

• Loans 900____

• Total 1000 1000

Page 11: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

• With “fractional reserve banking”, the banking system– “creates money” and lends it out.– has only a fraction of liabilities on reserve. – cannot satisfy customer’s demands if all want

to withdraw deposits at once. • Source of “bank panics”.

– News that loans are not likely to be paid back, customers will make a “run” on the bank.

– Droughts.– Stock market crash.

• Effect of bank panic on economy?

Page 12: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

Bank Panics and Deposit Insurance• 7 major bank panics in the U.S. in the 1800s

– 2 in the early 1900s. – Onset of the great depression in the

1930s, another bank panic occurred. – In 1934, the federal government

established FDIC to help reduce spread of bank panics.

• Deposit insurance has reduced bank panics in the U.S.

• Problems with deposit insurance– Incentives created for risk taking.– The Home State experience in Ohio.

Page 13: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

Federal Reserve System

• established in 1913 by the Federal Reserve Act.

• first central bank of the United States• conducts monetary policy and regulates

banks.• aims to stabilize the macroneconomy.

Page 14: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

Federal Reserve System

• The Structure of the Fed– The Board of Governors– The regional Federal Reserve banks– The Federal Open Market Committee.

Page 15: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

Federal Reserve System

• The Board of Governors:– 7 members appointed by the president and

confirmed by Senate.– terms are for 14 years and overlap so that

one position becomes vacant every 2 years.– 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.

Page 16: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

Federal Reserve System

• The District Banks:

– Monitor economic conditions within region.

– Regulate banks within region.

– Serve as clearinghouse for checks.

– Replace currency

Page 17: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money
Page 18: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

Federal Reserve System

• Federal Open Market Committee (FOMC) – Main policy-making group in the Federal

Reserve System.– members of the Board of Governors, the

president of the FRB of NY, and the 11 presidents of other regional Federal Reserve banks of whom, on a rotating basis, 4 are voting members.

– meets every six weeks to formulate monetary policy.

Page 19: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

Components of the Money Supply

• Bank reserves – bank deposits at the Federal Reserve + cash

• Monetary base – currency held by the nonbank public + bank

reserves.– M1 – currency outside banks, traveler’s checks, and

checking deposits owned by individuals and businesses.

– M2 – M1 plus time deposits, savings deposits, and

money market mutual funds and other deposits.

Page 20: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

How do banks create money?

Suppose that there is $100 million of cash and no bank system.

A bank now begins and $90 million of cash is deposited in the bank in exchange for checking account (demand deposit) balances.

The bank’s owners invest $5 million in plant and equipment and thus have $5 million of owner’s equity. The bank’s balance sheet is now:

Page 21: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

How do banks create money?

The balance sheet

Assets LiabilitiesCash 90 m. Demand

deposits90 m.

Plant & equipment

5 m. Owner’s equity 5 m.

Total assets 95 m. Total Liabilities 95 m.

Note: The balance sheet requires that total assets equal total liabilities.

Page 22: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

How do banks create money?

Fed sets a reserve ratio (let’s suppose it’s 25%). Implying bank must have 25% of it’s demand deposits on reserve.

Reserves = cash + deposits at Fed. Bank can increase demand deposits by creating

new loans to customers until it no longer has any excess reserves.

required reserves = rr * demand deposits Maximum demand deposits = (1/rr) * reserves

Page 23: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

How do banks create money?The balance sheet

Assets LiabilitiesCash 90 m. Demand deposits 90m360

m.

Loans 0270 m Owner’s equity 5 m.

Plant & equipment 5 m.

Total assets 95m365 m.

Total Liabilities 95m365 m.

Note: The bank system created $270 million of additional money by creating new demand deposits for borrowers (loans). This assumes that none of the new loans/demand deposits are withdrawn as cash.

Page 24: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

How Banks Create Money• Deposits lead to a multiplier effect on M1 as banks

convert a $1 deposit into several dollars of demand deposits.

• To illustrate, assume rr=25%– A new deposit of $100,000 is made.– The bank keeps $25,000 in reserve and lends

$75,000.– This loan is credited to someone’s 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.

Page 25: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

How Banks Create Money

– The process continues and keeps repeating with smaller and smaller loans at each “round.”

Page 26: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

How do banks create money?

• Summary of money creation process.• monetary base = nonbank cash + bank reserves

• M1 = nonbank cash + demand dep.

• DDmax = (1/rr)* bank reserves

• The Fed controls the money supply through its control over the monetary base and the deposit multiplier (1/rr).

Page 27: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

Fed Tools

• Open market operations.– The Fed buys (sells) government securities in

the open market to increase (decrease) the money supply.

• Discount window lending.– The Fed loans reserves to member banks and

charges the discount rate.• Reserve requirements.

– The Fed sets the required reserve ratio.– Rarely used.

Page 28: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

OPEN MARKET OPERATIONS.• If the Fed wants to increase the amount

of bank reserves– buy government securities from member

banks– banks give up government bonds and

receive deposit at the Fed or cash.

• By buying government securities– Fed created new reserves that multiply into

new loans and demand deposits (remember the deposit multiplier).

• If the Fed sold government securities, reserves and M1 would decrease.

Page 29: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

DISCOUNT WINDOW LENDING.

• The Fed lends banks reserves at the “discount rate”. – The higher the discount rate, the less likely banks are to borrow

reserves to increase the money supply.

• The federal funds rate is the interest rate that banks charge each other for a loan of reserves. – The federal funds rate tracks the discount rate fairly closely.

• If the Fed wants to increase reserves in the sytem, it would lower the discount rate.

Page 31: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

THE RESERVE REQUIREMENT.

• If the Fed increases the reserve requirement– the deposit multiplier (1/rr) falls – the amount of demand deposits that banks

can create for a given amount of reserves is reduced.

– [Note: you may ignore the “money multiplier” discussed in text. Focus only on “deposit multiplier”]

Page 32: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

OTHER FACTORS INFLUENCING THE MONEY SUPPLY

• The amount of cash people choose to hold– Cash in bank multiplies– Cash outside bank does not.

• The type of deposits people make.– the reserve requirement is higher on demand

deposits (about 3%) than on certificates of deposit.

– If people switch between different types of accounts, the “average” reserve requirement and money multiplier will change.

Page 33: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

Changes in the money supply

Suppose the Fed purchases $10 m. of government securities. What is the effect on:

Loans Demand deposits M1

The balance sheet

COB=$10m; rr=25%

Assets LiabilitiesCash 90 m. Demand deposits 360 m.

Loans 270 m Owner’s equity 5 m.

Plant & equipment 5 m.

Total assets 365 m. Total Liabilities 365 m.

Page 34: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

Changes in the money supply

Suppose the public withdraws $10m. Of DD as cash. What is the effect on:

Loans Demand deposits M1

The balance sheet

COB=$10m; rr=25%

Assets LiabilitiesCash 90 m. Demand deposits 360 m.

Loans 270 m Owner’s equity 5 m.

Plant & equipment 5 m.

Total assets 365 m. Total Liabilities 365 m.

Page 35: Ch. 10: MONEY, BANKS, AND THE FEDERAL RESERVE –Definition of money and functions –History of money –Bank functions and regulations. –Creation of money

Changes in the money supply

Suppose the Fed reduces the rr to 20% What is the effect on:

Loans Demand deposits M1

The balance sheet

COB=$10m; rr=25%

Assets LiabilitiesCash 90 m. Demand deposits 360 m.

Loans 270 m Owner’s equity 5 m.

Plant & equipment 5 m.

Total assets 365 m. Total Liabilities 365 m.