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The Banking System and the Money Supply What is money? How is it measured? How is money created or destroyed in the economy? Need to understand this before we study how changes in money supply and demand affect the economy. What Counts as Money Money has several useful functions

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the banking system and the money supply

The Banking System and the Money Supply

What is money?

How is it measured?

How is money created or destroyed in the economy?

Need to understand this before we study how changes in money supply and demand affect the economy.

what counts as money
What Counts as Money
  • Money has several useful functions
    • Provides a unit of account
    • Serves as store of value
    • Means of payment
  • Money is an asset that is widely accepted as a means of payment
    • Credit card is accepted for payment, but not an asset
    • Stocks and bonds, gold bars are assets but not accepted as payment
measuring the money supply
Measuring the Money Supply
  • Money Supply
    • Total amount of money held by the public
  • Several ways measure money supply
    • Assets that are widely accepted for payment and are relatively liquid
      • A liquid asset can be converted to cash quickly and at little cost
      • 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
  • Then asset categories of about equal liquidity
    • Demand deposits
      • Checking accounts held by households and firms in banks
      • Other checkable deposits
        • Similar to demand deposits (e.g. automatic transfers from savings accounts)
      • Travelers checks
  • Savings-type accounts
      • Less liquid than checking-type accounts, since you cannot write checks
  • Deposits in money market mutual funds
  • Time deposits (sometimes 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)
m1 and m2
M1 And M2
  • Standard measure of money stock 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 measure of money supply, M2, adds some other assets to M1
    • M2 = M1 + savings-type accounts + Money Market Mutual Funds balances + small denomination time deposits
  • Other official measures of money supply besides M1 and M2 that add in assets that are less liquid than those in M2
    • M1 and M2 are the most popular, and most commonly used, definitions
m1 and m28
M1 And M2
  • M1 and M2 exclude many things that used as a means of payment (such as credit cards)
  • Technological advances—now and in the future—will continue trend toward new and more varied ways to make payments (such as electronic cash)
  • 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 financial intermediaries?
    • Firms that specialize in
      • Assembling 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
  • An intermediary combines a large number of small savers’ funds into custom-designed packages
    • Then lends them to larger borrowers
  • Charge a higher interest rate on funds they lend than rate they pay to depositors to earn profit
the banking system
The Banking System
  • Why do lenders (households) need their loans “intermediated”?
    • Intermediaries reduce risk for depositors (lenders) by spreading their money among several borrowers.
    • Lenders earn higher rates at lower risk than if they individually bargained with borrowers.
the banking system financial intermediaries11
The Banking System: Financial Intermediaries
  • There are four types of depository institutions
    • Savings and Loan associations
    • Mutual savings banks
    • Credit unions
  • The above three types of institutions take money from depositors and make mainly mortgage or consumer loans.
    • Commercial banks (make mortgage, business, consumer loans).
commercial banks
Commercial Banks
  • A commercial bank (or just “bank” for short) is a private corporation that provides services to the public
    • Owned by its stockholders
  • For our purposes, most important service is to provide checking accounts
    • Enables bank’s customers to pay bills and make purchases without holding large amounts of cash that could be lost or stolen
  • Banks provide checking account services in order to earn a profit from lending out that money as well as checking account fees
a bank s balance sheet
A Bank’s Balance Sheet
  • A balance sheet is a list that provides information about financial condition of a bank at a particular point
    • In one column, bank’s assets are listed
    • On the other side, the bank’s liabilities are listed
  • What are the assets of a bank?
    • Bonds- A promise to pay back borrowed funds, issued by a corporation or government agency
    • Loans- An agreement to pay back borrowed funds, signed by a household or non corporate business
    • “Cash in the Vault”
    • “Account with the Federal Reserve”
  • What are these and why does the bank hold them?
a bank s balance sheet14
A Bank’s Balance Sheet
  • 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
a bank s balance sheet15
A Bank’s Balance Sheet
  • Liabilities
    • Demand Deposits
    • Net Worth= Total assets – Total liabilities
      • Include net worth on liabilities side of balance sheet because it is, in a sense, what bank would owe to its owners if it went out of business
  • A balance sheet always balances!! On the left hand side are assets and on the right are liabilities + Net Worth.
a bank s balance sheet16
Assets (million)

Property and buildings 5

Government & Corporate Bonds 25

Loans 65

Cash in Vault 2

Accounts with Federal Reserve 8

Total 105

Liabilities (million)

Demand Deposits 100

Net Worth 5

Total Liabilities and Net Worth 105

A Bank’s Balance Sheet
the federal reserve system
The Federal Reserve System
  • Every large nation controls its money supply with a central bank
    • A nation’s principal monetary authority
    • Most developed countries established central banks long ago
      • England’s central bank—Bank of England—was created in 1694
      • France established Banque de France in 1800
      • United States established Federal Reserve System in 1913
the federal reserve system18
The Federal Reserve System
  • An interesting feature of Federal Reserve System is its peculiar status within government
    • Strictly speaking, it is not even a part of any branch of government
    • Both President and Congress exert some influence on Fed through their appointments of key officials
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
  • Most economists regard FOMC as most important part of Fed
  • 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
    • Committee exerts control over nation’s money supply by buying and selling bonds in public (“open”) bond market
the functions of the federal reserve
The Functions of the Federal Reserve
  • Federal Reserve, as overseer of the nation’s monetary system, has a variety of important responsibilities including
    • Supervising and regulating banks
    • Acting as a “bank for banks”
    • Issuing paper currency
    • Check clearing
    • Controlling money supply
the fed and the money supply
The Fed and the Money Supply
  • How does the Fed change the money supply?
    • It buys or sells government bonds to bond dealers, banks, or other financial institutions
      • Actions are called open market operations
  • Two assumptions to simplify our analysis of open market operations
    • 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, the Fed will buy government bonds
    • Called an open market purchase
  • Suppose Fed buys $1,000 bond from Lehman Brothers
    • Gives Lehman Brothers $1000
    • Lehman Brothers deposits this in its checking account in Bank A
  • Fed has injected reserves into the system and two important things have happened
    • Money supply has increased
      • Demand deposits (part of money supply) have increased by $1,000
    • Bank A now has excess reserves (reserves in excess of required reserves)
      • If required reserve ratio is 10% bank has excess reserves of $900 to lend
how the fed increases money supply
How the Fed Increases Money Supply
  • The bank (Bank A) will issue a check to the borrower for $900 who will deposit it in her bank (Bank B). Money supply increases by $900.
    • Increase in money supply=1000+900=1900
  • Now Bank B has $900 of deposits, of which it only needs to keep $90. So it lends out $810 to a borrower who deposits it in her bank (Bank C). Money supply increases again by $810.
    • Increase in money supply=1900+810=2710
  • Now Bank C will keep (0.10*810) or $81 dollars in reserve and lend out the remaining (810-81)=$729. Money Supply increases by $729.
    • Increase in money supply=2710+729=3439
  • And so on
the demand deposit multiplier
The Demand Deposit Multiplier
  • This is beginning to look like a multiplier.
  • Increase in money supply is
    • 1000+(0.9*1000)+(0.9)2*1000+(0.9)3*1000+..

=1000(1+0.9+(0.9)2 +(0.9)3+….)


the demand deposit multiplier25
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 lent 90% of deposit it received
  • Demand deposit multiplier is number by which we must multiply injection of reserves to get total change in demand deposits
  • Size of demand deposit multiplier depends on value of required reserve ratio set by Fed
the demand deposit multiplier26
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
  • Since we’ve been assuming 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
the fed s influence on the banking system as a whole
The Fed’s Influence on the Banking System as a Whole
  • Can also look at what happened to total demand deposits and money supply from another perspective
    • Where did additional $1,000 in reserves end up?
    • In the end, additional $1,000 in reserves will be distributed among different banks in system as required reserves
      • After an injection of reserves, demand deposit multiplier stops working—and the money supply stops increasing—only when all reserves injected are being held by banks as required reserves
  • In the end, total reserves in system have increased by $1,000
    • Amount of open market purchase
how the fed decreases the money supply
How the Fed Decreases the Money Supply
  • Fed can decrease money supply by selling government bonds
    • An open market sale of government bonds
  • What happens when the Fed sells $1000 worth of government bonds to Merrill Lynch?
  • Merrill Lynch will pay the Fed with a $1000 check on its bank (Bank 1).
    • Bank 1 has lost demand deposits worth $1000 and reserves worth $1000.
      • Money Supply reduces by 1000
    • Bank 1 can reduce reserves by $100. So it is $900 short of reserves
    • Calls in $900 worth of loans from a borrower
    • The borrower repays the money from his demand deposits with Bank 2. Bank 2 now has lost reserves and demand deposits worth $900.
      • Money supply reduced by 1000+900
    • Bank 2 is $810 short of reserves. So it calls in loans worth $810. These come out of demand deposits and reserves from Bank 3
      • Money supply reduced by 1000+900+810
    • And so on…
how the fed decreases money supply
How the Fed decreases money supply
  • 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
    • Keeping in mind that a withdrawal of reserves is a negative change in reserves
      • Can still use our demand deposit multiplier—1/(RRR)—and our general formula
      • ΔDD = (1/RRR) x ΔReserves
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
  • While other tools can affect the money supply, open market operations have two advantages over them
    • Precision and secrecy
    • This is why open market operations remain Fed’s primary means of changing money supply
other tools for controlling the money supply32
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 (Currently 10%)
      • Decreasing the required reserve ratio sets off the process of deposit creation (through increased lending)
    • Changing the Discount Rate
      • The rate at which the Fed lends to banks.
      • Reducing/Increasing the rate would mean that banks could borrow more/less, increase/reduce reserves and increase/decrease the money supply
  • Neither of these tools are used much till recently
    • Discount Rate has been changed recently.
using the theory bank failures and banking panics
Using the Theory: Bank Failures and Banking Panics
  • A bank failure occurs when a bank cannot meet its obligations to those who have claims on the bank
    • Includes those who have lent money to the bank, as well as those who deposited their money there
  • Historically, many bank failures have occurred when depositors began to worry about a bank’s financial health
  • Run on the bank
    • An attempt by many of a bank’s depositors to withdraw their funds
  • Ironically, a bank can fail even if it is in good financial health, with more than enough assets to cover its liabilities
    • Just because people think bank is in trouble
  • Banking panic occurs when many banks fail simultaneously
using the theory bank failures and banking panics34
Using the Theory: Bank Failures and Banking Panics
  • Banking panics can cause serious problems for the nation
    • Hardship suffered by people who lose their accounts when their bank fails
    • Even when banks do not fail, withdrawal of cash decreases banking system’s reserves
      • Money supply can decrease suddenly and severely, causing a serious recession
  • Banking panic of 1907 convinced Congress to establish Federal Reserve System
    • But creation of Fed did not, in itself, solve problem
  • Great Depression is a good example of this problem
    • Officials of Federal Reserve System, not quite grasping seriousness of the problem, stood by and let it happen
using the theory bank failures and banking panics35
Using the Theory: Bank Failures and Banking Panics
  • For five-year period ending in May 2003, a total of 26 banks failed—an average of about 6 per year
    • Why the dramatic improvement?
      • Federal Reserve learned an important lesson from Great Depression
        • It now stands ready to inject reserves into system more quickly in a crisis
      • In 1933 Congress created Federal Deposit Insurance Corporation (FDIC) to reimburse those who lose their deposits
  • FDIC has had a major impact on the psychology of banking public
  • FDIC protection for bank accounts has not been costless. Insurance costs for banks, which are passed on as fees to depositors.
  • Also banks worry less about the quality of their loans and need to be regulated by the Fed.
bank failures some recent numbers
Bank Failures – Some Recent Numbers
  • 2000 2
  • 2001 4
  • 2002 11
  • 2003 3
  • 2004 4
  • 2005 0
  • 2006 0
  • 2007 3
  • 2008 26
  • 2009 111 so far
the most recent bank panic 2008
The Most Recent Bank Panic (2008)
  • In July 2008, IndyMac, a California based bank suffered a panic

  • What happens when a bank fails?