ECON 201

1. ECON 201 Chapter 9 Money & Banking

2. Learning Objectives • Functions of money and the components of the U.S. money supply. • What “backs” the money supply. • Makeup of the Federal Reserve & the U.S. banking system. • Functions and responsibilities of the Federal Reserve. • How banks create money in a “fractional reserve” banking system.

3. Functions of Money • Medium of exchange: money can be used for buying and selling goods and services. • Unit of account: dollars and cents. • Store of value: Money allows us to transfer purchasing power from present to future. It is the most liquid (spendable) of all assets, a convenient way to store wealth.

4. Components of the Money Supply • Currency coins + paper money in hands of the public. • Checkable Deposits Commercial Banks & thrifts. • Other liquid savings Currency and checkable deposits held by the federal government, Federal Reserve, or other financial institutions (not included in M1).

5. Components of the Money Supply • Currency (coins + paper money) in hands of the public. • (Coins are token money) (Paper currency – consists of Federal Reserve Notes issued by the Federal Reserve) • Checkable Deposits (Commercial Banks & thrifts). • A Qualification (Currency and checkable deposits held by the federal government, Federal Reserve, or other financial institutions (not included in M1).

6. Liquidity • Ease with which an asset can be converted into cash. • Cold Hard Cash – perfectly liquid. • House – highly illiquid. • Loss of purchasing power • Loss of time • Other forms of money – highly liquid.

7. Money defined: M1 & M2 • M1= Currency + Checkable Deposits • M2 = M1 + Near Monies • Near-Monies • Savings Deposits Including Money Market Deposit Accounts (MMDA) • Small Time Deposits (less than $100,000) • Money Market Mutual Funds (MMMF)

8. Money defined: MZM • MZM – money zero maturity • It is basically money that is available right now to consumers and businesses at NO COST • Take the money that consumers can get their hands on now w/o penalty (like checking accounts) and add Money Market Mutual Fund (MMMF) that businesses can get their hands on now w/o penalty.

9. Consider This … Are Credit Cards Money? Of course not! Their use involves short‑term loans; their convenience allows you to keep M1 balances low because you need less for daily purchases.

10. What “backs” the money supply? Government’s ability to keep its value stable provides the backing. Money is debt; paper money is a debt of Federal Reserve Banks and checkable deposits are liabilities of banks and thrifts because depositors own them. Value of money arises not from its intrinsic value, but its value in exchange for goods and services.

11. The relative scarcity of money compared to goods and services will allow money to retain its purchasing power. Money’s purchasing power determines its value. Higher prices mean less purchasing power. If you found a chest full of money from the Civil War era, could you use it?

12. Excessive inflation may make money worthless and unacceptable. An extreme example of this was German hyperinflation after World War I, which made the mark worth less than 1 billionth of its former value within a four-year period. Worthless money leads to use of other currencies that are more stable. Worthless money may lead to barter exchange system.

13. The Federal Reserve and the Banking System Established by Congress in 1913. Holds power over the money and banking system. Board of Governors has seven members appointed by the President for staggered 14‑year terms. Chairman of the board – Ben Bernanke!

14. The Federal Reserve…cont. Federal Open Market Committee (FOMC) includes the seven governors plus five regional Federal Reserve Bank presidents whose terms alternate. System has twelve districts, each with its own district bank and two or three branch banks.

15. The Federal Reserve and the Banking System Board of Governors Federal Open Market Committee 12 Federal Reserve Banks Commercial Banks Thrift Institutions (Savings and Loan Associations, Mutual Savings Banks, Credit Unions) The Public (Households and Businesses)

16. Functions of the Fed Issues Currency Sets Reserve Requirements Lends money to banks and thrifts Provides for check collection Acts as fiscal agent Supervises banks Controls money supply

17. The 12 Federal Reserve Banks Source: Federal Reserve Bulletin

18. http://www.federalreserve.gov/

19. Developments • Number of banks & thrifts declining • Consolidation of banks & thrifts • Convergence of services • Credit Unions vs Thrifts (S&Ls) vs Comm. Banks • Ins. Companies, pension funds, securities firms • Globalization • Electronic transactions

21. Fractional Reserve Banking System • The U.S. has a fractional reserve banking system. • Only a portion of the total money supply is held in reserve as currency. • Banks create money through lending. A fractional reserve banking system is one in which banks and thrifts are required to hold less than 100 percent of their checkable-deposit liabilities as cash reserves. LO: 9-5

22. History Early traders used gold. They realized that method was unsafe & inconvienient. By the 16’th century, people deposited their gold with goldsmiths for storing. Depositor was issued a receipt (first paper money).

23. Fractional Reserve Banking Began with the Goldsmiths • At first they used a 100% reserve system (all receipts were backed 100% with gold). • Goldsmiths realized they could “loan” gold by issuing receipts to borrowers, who agreed to pay back gold plus interest. • Such loans began “fractional reserve banking,” because the actual gold in the vaults became only a fraction of the receipts held by borrowers and owners of gold.

24. Fractional Reserve System Only a fraction of checkable deposits are backed up by cash in bank vaults or deposits at the central bank. Banks can create money by lending more than the original reserves on hand. (Note: Today gold is not used as reserves).

25. Exchanging GoldDangerous Business

26. Knowledge Until 1971, gold backed the U.S. dollar and is still held by central banks around the world for use in times of emergency. President Nixon took the country off the gold standard in 1971.

27. Fractional Reserve System Lending policies must be prudent to prevent bank “panics” or “runs” by depositors worried about their funds. Also, the U.S. deposit insurance system prevents panics. The first depositary savings bank is thought to be the Philadelphia Savings Fund Society, est. in 1816. It launched an industry that profoundly changed the American economy.

28. Commercial bank’s Required reserves Reserve Ratio (R) = Commercial bank’s Checkable-deposit liabilities Required Reserves • All commercial banks and thrifts that provide checkable deposits must by law keep required reserves. • The amount of required reserves is determined by the reserve ratio (R). Required reserves are an amount of funds equal to a specified percentage of the bank’s own deposit liabilities. They must be kept on deposit with the Federal Reserve Bank or held as cash in the bank’s vault. LO: 9-5

29. Excess Reserves • When a bank holds more in reserves then is required, it holds excess reserves. • Excess reserves are actual bank or thrift reserves minus legally required reserves. • An individual bank can only lend an amount equal to its excess reserves, but the commercial banking system can lend by a multiple of its excess reserves. • The banking system magnifies any original excess reserves into a larger amount of newly created checkable-deposit money. LO: 9-5

30. Economic Panic in Bedford Falls

31. Bank Panics of 1930-1933 led to a multiple contraction of the money supply, which worsened Depression. More than 9,000 banks failed in three years. As people withdrew funds, this reduced banks’ reserves and, in turn, their lending power fell significantly.

32. FDIC President Roosevelt declared a “bank holiday,” closing banks temporarily while Congress started the Federal Deposit Insurance Corporation (FDIC), which ended bank panics on insured accounts.

33. Single Commercial Bank • Balance Sheet • States the assets and claims of a bank at some point in time. • Value of assets must equal value of claim (i.e. it must balance). • Assets = liabilities + net worth.

34. Bank must Keep Reserve Deposits in its District Federal Reserve Bank Banks can keep reserves at Fed or cash in vaults (“vault cash”). Banks keep enough cash on hand to meet depositors’ needs. Required reserves are a fraction of deposits.

35. Required Reserves Funds that banks must deposit with the Federal Reserve (or hold as vault cash) to meet the legal reserve requirement; a fixed % of the bank’s checkable deposits. Required Reserves help the Fed control credit and money creation. Excess Reserves = actual reserves minus required reserves. Banks cannot loan beyond their excess reserves.

36. Commercial Bank’s Required Reserves Reserve Ratio = Commercial Bank’s Checkable-Deposit Liabilities Reserve Ratio The specified % of checkable deposit liabilities that a commercial bank must keep as reserves.

37. Profits, liquidity, and the federal funds market Profits: Banks are in business to make a profit like other firms. They earn profits primarily from interest on loans and securities they hold. Liquidity: Banks must seek safety by having liquidity to meet cash needs of depositors and to meet check clearing transactions.

38. Profits, liquidity, and the federal funds market. Cont. • Federal funds rate: Banks can borrow from one another to meet cash needs in the federal funds market, where banks borrow from each other’s available reserves on an overnight basis. • The rate paid is called the federal funds rate.

39. Multiple‑Deposit Expansion (all banks combined) • 3 simplifying assumptions: • Reserve ratio for all banks is 20 % • Initially banks have no excess reserves; they are “loaned up.” • When banks have excess reserves, they loan it all to one borrower, who writes check for entire amount to give to someone else, who deposits it at another bank. The check clears against original lender.

40. Multiple‑Deposit Expansion (all banks combined) The entire banking system can create an amount of money which is a multiple of the system’s excess reserves, even though each bank in the system can only lend dollar for dollar with its excess reserves.

41. Checkable Deposit Multiplier or Monetary Multiplier Magnify excess reserves into a larger amount. Monetary Multiplier = 1/required reserve ratio or m = 1/R. m

42. Study Questions • Why must a balance sheet always balance? • It must balance because every asset is claimed by someone, so that assets (the left‑hand side) = liabilities + net worth (the right‑hand side).

43. Why does the Federal Reserve require commercial banks to have reserves? Reserves provide the Fed a means of controlling the money supply. It is through increasing and decreasing excess reserves that the Fed is able to achieve a money supply of the size it thinks best for the economy.

44. End