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Chapter 25 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—things of value that people own—can be considered as money. Can credit cards be considered as money?

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chapter 25
Chapter 25

The Banking System and the Money Supply

what counts as money
What Counts as Money
  • Definition of Money

Money is an asset that is widely accepted as a means of payment.

      • Only assets—things of value that people own—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 two 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.
measuring the money supply
Measuring the Money Supply
  • Money Supply
    • Total amount of money held by the public
  • Governments use different measures of the money supply.
    • 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
Assets and Their Liquidity
  • Most liquid asset is cash in the hands of the public.
  • Next in line are asset categories of about equal liquidity.
    • Demand deposits (Checking accounts)
    • Other checkable 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 deposits in retail money market mutual funds.
    • Time deposits (called certificates of deposit, or CDs)
      • Require you to keep your money in the bank for a specified period of time (usually six months or longer)
        • Impose an interest penalty if you withdraw early
m1 and m2
M1 And M2
  • Standard measure of money stock (supply) 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
m1 and m27
M1 And M2
  • We will assume money supply consists of just two components.
    • Cash in the hands of the public and demand deposits
  • Our definition of the money supply corresponds closely to liquid assets that our national monetary authority—the Federal Reserve—can control.
the banking system financial intermediaries
The Banking System: Financial Intermediaries
  • What are banks?
    • Financial intermediaries—business 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 the rate they pay to depositors.
a bank s balance sheet
A Bank’s 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 bank’s assets are listed
      • Everything of value that it owns
        • Bonds
        • Loans
        • Vault cash
        • Account with the Federal Reserve
    • On the other side, the bank’s liabilities are listed
      • Amounts it owes
        • Deposits
    • Net worth = Total assets – Total liabilities
a bank s balance sheet10
A Bank’s Balance Sheet
  • Explanations for vault cash and accounts with Federal Reserve
    • On any given day, some of the bank’s 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 Reserve
  • Required reserve ratio tells banks the fraction of their checking accounts that they must hold as required reserves.
    • Set by Federal Reserve
the federal open market committee
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 nation’s money supply by buying and selling bonds in public (“open”) bond market.
the fed and the money supply
The Fed and the Money Supply
  • Suppose Fed wants to change nation’s money supply
    • It buys or sells government bonds to bond dealers, banks, or other financial institutions.
      • Actions are called open market operations
  • We’ll 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
How the Fed Increases the Money Supply
  • To increase money supply, Fed will buy government bonds.
    • 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
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 received
    • 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
    • ΔDD = 10 x reserve injection
the demand deposit multiplier17
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
    • ΔDD = (1 / RRR) x ΔReserves
  • 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 write
    • ΔMoney Supply = (1 / RRR) x ΔReserves
how the fed decreases the money supply
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 banks.
    • 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 multiplier—1/(RRR), we can calculate the decrease in money supply with the same formula.
      • ΔDD = (1/RRR) x Δreserves
      • This time, the change in reserve is negative.
some important provisos about the demand deposit multiplier
Some Important Provisos About the Demand Deposit Multiplier
  • Although process of money creation and destruction as we’ve described it illustrates the basic ideas, formula for demand deposit multiplier—1/RRR—is oversimplified.
    • In reality, multiplier is likely to be smaller than formula suggests, for two reasons:
      • We’ve assumed that as money supply changes, public does not change its holdings of cash.
      • We’ve assumed that banks will always lend out all of their excess reserves.
other tools for controlling the money supply
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.