© 2013, published by flat world knowledge. published by: flat world knowledge, inc. one bridge...

© 2013, published by Flat World Knowledge

Chapter 9

The Nature and

Creation of Money


Published by:

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1. WHAT IS MONEY?

Learning Objectives1. Define money and discuss its three basic

functions.2. Distinguish between commodity money

and fiat money, giving examples of each.3. Define what is meant by the money

supply and tell what is included in the Federal Reserve System’s two definitions of it (M1 and M2).


1.1 The Functions of Money

− A medium of exchange is anything that is widely accepted as a means of payment.

• To Barter an individual exchanges goods directly for other goods.

− A unit of account is a consistent means of measuring the value of things.

− A store of value is an item that holds value over time.

• Money is anything that serves as a medium of exchange.


1.2 Types of Money

• Commodity money is money that has value apart from its use as money.

– E.g. Mackerel in federal prisons, gold, and silver • Fiat money is money that some authority, generally

a government, has ordered to be accepted as a medium of exchange.

– E.g. paper money and coins in the U.S. “this note is legal tender for all debts public and private”

• Currency is paper money and coins.• Checkable deposits are balances in checking

accounts.• A check is a written order to a bank to transfer

ownership of a checkable deposit.


1.3 Measuring Money

• Money supply refers to the total quantity of money in the economy at any one time.

• Liquidity is the ease with which an asset can be converted into currency.

• M1 is the narrowest of the Fed’s money supply definitions that includes currency in circulation, checkable deposits, and traveler’s checks.

• M2 is a broader measure of the money supply than M1 that includes M1 and other deposits.


The two M’s: January 2012


2. THE BANKING SYSTEMS AND MONEY CREATION

Learning Objectives1. Explain what banks are, what their

balance sheets look like, and what is meant by a fractional reserve banking system.

2. Describe the process of money creation (destruction), using the concept of the deposit multiplier.

3. Describe how and why banks are regulated and insured.


2.1 Banks and Other Financial Intermediaries

• A financial intermediary is an institution that amasses funds from one group and makes them available to another.

• A bank is a financial intermediary that accepts deposits, makes loans, and offers checking accounts.


2.2 Bank Finance and a Fractional reserve System

• A balance sheet is a financial statement showing assets, liabilities, and net worth.

• Assets are anything of value.• Liabilities are obligations to other

parties.• Net worth refers to assets less

liabilities.


2.2 Bank Finance and a Fractional reserve System

• Reserves are bank assets held as cash in vaults and in deposits with the Federal Reserve.

• A fractional reserve banking system is a system in which banks hold reserves whose value is less than the sum of claims outstanding on those reserves.


The Consolidated Balance Sheet for U.S. Commercial Banks, January

2012

Assets Liabilities and Net Worth

Reserves $1,592.9 Checkable deposits $8,517.9

Other assets 1,316.2 Borrowings 1,588.1

Loans 7,042.0 Other liabilities 1,049.4

Securities 2,546.1

Total assets $12,497.2 Total Liabilities $11,155.4

Net worth $1,341.8


2.3 Money Creation

• Required reserves are the quantity of reserves banks are required to hold.

• The required reserve ratio is the ratio of reserves to checkable deposits a bank must maintain.

• Excess reserves are reserves in excess of the required level.

• A bank is said to be loaned up when its excess reserves equal zero.

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Copyright © Houghton Mifflin Company. All rights reserved.

Fractional Reserve Banking

A system in which banks keep less than 100 percent of the deposits available for withdrawal.– Regulated by Federal Reserve Board

15


How Banks Create Money

Reserves: Actual and Required– The reserve ratio is the fraction of a bank’s

total deposits that are held in reserves.– The required reserves ratio is the ratio of

reserves to deposits that banks are required, by regulation, to hold. Required reserves are those reserves which must be kept on hand or on deposit with the Federal Reserve in order to comply with the reserve requirements.

– Excess reserves are the cash reserves beyond those required, which can be loaned.

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17


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NOTE: Cash leakage or excess reserves held in banks will reduce the multiplier effect

Deposit Expansion Multiplier =1

Reserve Requirement (ratio)

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The Multiple Creation of Bank Deposits

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Required Reserve RatioFrom the Federal Reserve web site (5/1/07)

Liability Type RRR in %

Transaction accounts

$8.5 million 0%

$8.5 to $45.8 million 3%

$45.8 million + 10%

Non-personal time deposits 0%

Eurocurrency liabilities 0%


A Balance Sheet for ACME Bank

ACME Bank

Assets Liabilities

Reserves $1,000 Deposits $10,000

Loans $9,000


A Balance Sheet for ACME Bank


2.4 The Deposit Multiplier

• A deposit multiplier is the ratio of the maximum possible change in checkable deposits (ΔD) to the change in reserves (ΔR).

EQUATION 2.1

EQUATION 2.2

EQUATION 2.3

EQUATION 2.4

EQUATION 2.5

10000,1$

000,10$

R

Dmd

rrrDR

DrrrR

DRrrr

1

dmR

D

rrr

1


2.5 The Regulation of Banks

• Deposit insurance– In the U.S., if a commercial bank fails, the FDIC

guarantees to reimburse depositors up to at least $250,000 per account.

• Regulation to Prevent Bank Failure– The FDIC audits banks to ensure they are

operating safely (i.e. not making investments deemed too risky and maintaining a minimum level of net worth as a fraction of total assets)

• Regulation in Response to Financial Crises– The Glass-Steagall Act post Great Depression

created the FDIC and the separation between commercial banks and investment banks.



• Regulation in Response to Financial Crises– In the U.S. in 1999 the Glass-Steagall Act

was largely repealed.– The financial crisis of 2008 led to the

passage of the Dodd-Frank Act. – Elimination of the separation between the

two types of banks by a law passed in 1999.



• Regulation in Response to Financial Crises– Creation of the Dodd-Frank Wall Street

Reform and Consumer Protection Act post financial crisis of 2008.

• Supervision and regulation of consumer credit markets, such as credit card and bank fees and mortgage contracts.


3. THE FEDERAL RESERVE SYSTEM

Learning Objectives1. Explain the primary functions of central banks.2. Describe how the Federal Reserve System is

structured and governed.3. Identify and explain the tools of monetary policy.4. Describe how the Fed creates and destroys money

when it buys and sells federal government bonds.

• A central bank is a bank that acts as a banker to the central government, acts as a banker to banks, acts as a regulator of banks, conducts monetary policy, and supports the stability of the financial system.

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The Federal Reserve System

The Federal Reserve System (“the Fed”) serves as the central bank for the United States.

A central bank typically has the following functions:– It is the banks’ bank: it accepts deposits from

and makes loans to commercial banks.– It acts as banker for the federal government.– It controls the money supply.– Performs certain regulatory functions for the

financial industry.

31


Structure of the Federal Reserve System

The primary elements in the Federal Reserve System are:

1. The Board of Governors

2. The Regional Federal Reserve District Banks (FRBs)

3. The Federal Open Market Committee (FOMC)

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The Federal Reserve Banks

12 District banks Nine directorsThe directors appoint the district

president who is approved by the Board of Governors

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The Federal Reserve System

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The Board of Governors

Seven members Appointed by the President Confirmed by the Senate Serve 14-year term Terms are staggered so that one comes

vacant every two years President appoints a member as Chairman

to serve a four-year term – Confirmed by the US Senate

35


Federal Open Market Committee (FOMC)

Meets approximately every six weeks to review the economy

Made up of the following voting members:– 7 members of the Board of Governors– 5 of the FRB presidents (they rotate

yearly)= 12 FOMC members

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Functions of the Fed (1)

Banking Services and Supervision– It supplies currency to banks through its 12 district

banks.– It holds the reserves of banks in the district bank of

each bank.– It processes and routes checks to banks through its

district banks and processing centers.– It makes loans to banks—it is the “lender of last resort”,

the “banker’s bank”.– It supervises and regulate banks, ensuring that they

operate in a sound and prudent manner.– It is the banker for the U.S. government. It sells

government securities for the U.S. Treasury.

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Functions of the Fed (2)

Controlling the Money Supply– The money supply is varied through the course

of the year to meet seasonal fluctuations in the demand for money. This helps keep interest rates less volatile.

• Example: 4th quarter holiday season creates an increased demand for money to buy gifts.

– The Fed also changes the money supply to achieve policy goals set by the FOMC.

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Policy Goals of the Fed

Ultimate Goal:Economic growth with stable prices. This means greater output (GDP) and a low, steady rate of inflation.

Intermediate Targets:– The Fed does not control output or the prices

directly. It does control the money supply.– The Fed establishes target growth rates for the

money supply, which it believes are consistent with its ultimate goals.

– The money supply growth rate becomes an intermediate target, an objective used to achieve some ultimate policy goal.


3.2 Powers of the Fed

• Reserve requirements• The discount window and other credit

facilities– The discount rate is the interest rate

changed by the Fed when it lends reserves to banks.

– The federal funds market is a market in which banks lend reserves to one another.

– A federal funds rate is the interest rate charged when one bank lends reserves to another.



• Open market operations– A bond is a promise by the issuer of the bond

to pay the owner of the bond a payment or a series of payments on a specific date or dates.

– Open market operations are the buying and selling of federal government bonds by the Fed.



The Fed

Banks

The Public

Reserves

DepositsLoans

© 2013, published by flat world knowledge. published by: flat world knowledge, inc. one bridge...

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