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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.
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
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
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
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.
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
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?
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
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”.
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
• 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?
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.
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.
Federal Reserve System
• The Structure of the Fed– The Board of Governors– The regional Federal Reserve banks– The Federal Open Market Committee.
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.
Federal Reserve System
• The District Banks:
– Monitor economic conditions within region.
– Regulate banks within region.
– Serve as clearinghouse for checks.
– Replace currency
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.
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.
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:
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.
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
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.
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.
How Banks Create Money
– The process continues and keeps repeating with smaller and smaller loans at each “round.”
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).
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.
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.
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.
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”]
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.
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.
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.
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.