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Banking and the Money Supply

Chapter 29

© 2006 Thomson/South-Western

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Definitions of the Money Supply: M1

Money aggregates: measures of the economy’s money supply – M1, M2, M3

M1: the narrowest measure of money supply: currency, including coins, held byNon-banking publicCheckable deposits:

Deposits in financial institutions against which checks can be written and ATM or debit cards can be applied

Travelers checks

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Definitions of the Money Supply: M2

Includes M1, plusSavings deposits

Earn interest, but have no specific maturity date

Time depositscalled certificates of deposit, or CDs, specific

maturity date

Money market mutual funds carry additional restrictions

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Definitions of the Money Supply: M3

Includes M2, plus large-denomination time deposits ($100,000

or more)

M3 is less liquid than M2,Which is less liquid than M1

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Exhibit 1: Alternative Measures of the Money Supply

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Credit Cards

Definitions of money include debit cards but not credit cards

Credit cards offer an easy way to get a loan from the card issuer

Money isn’t needed until the credit car holder must repay the credit card issuer

The credit card has not eliminated the use of money, merely delayed it

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Debit Cards

Debit CardCheck cardCombines the functions of an ATM and

checkSafer than credit cards

DisadvantagesDraw down checking account immediatelyCannot dispute bill or withhold or stop

payment

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Financial Intermediaries

Banks serve as financial intermediaries, or as go-betweens by bringing together the two sides of the money market

Banks reduce the transaction costs of channeling savings to credit worthy borrowers Coping with asymmetric information Reducing risk through diversification

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Asymmetric Information

As lenders, banks try to identify borrowers who are willing to pay interest and are able to repay the loans

However, borrowers have more reliable information about their own credit history and financial plans than do lenders: in the market for loans there is asymmetric information – an inequality in what’s known by each party to the transaction

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Asymmetric Information

Because they have experience in evaluating applicants, banks have a greater ability to cope with asymmetric information and draw up and enforce contracts than would an individual saver Savers are better off dealing with banks

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Reducing Risk

By developing a diversified portfolio of assets rather than lending funds to a single borrower, banks reduce the risk to each individual saver

A bank, in effect, lends a tiny fraction of each saver’s deposits to each of its many borrowers

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Starting a Bank

Founders obtain a charter, or the right to operate, by appling to the state banking authority (for a state bank) or to the U.S. Comptroller of the Currency (for a national bank)

The founders invest $500,000 for shares which become the owner’s equity or the net worth of the bank

Part of this goes to the Fed to buy shares in their district bank, leaving $450,000

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Exhibit 2: Home Bank’s Balance Sheet

Balance sheet shows a balance between the two sides of the bank’s accounts: The left side lists the bank’s assets (any physical property or financial claim owned by the bank)The right side lists the bank’s liabilities (an amount the bank owes) and net worth Reflects the basic equality that Assets = Liabilities + Net Worth

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Exhibit 3: Home Bank’s Balance Sheet after $1,000,000 Deposit

Suppose a customer deposits $1,000,000 into a new checking account. In accepting this, the bank promises to repay the depositor that amount – it is a liability to the bank: bank’s assets and liabilities both increase by $1,000,000

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Reserve Accounts

Recall that banks are required by the Fed to set aside, or to hold in reserve, a percentage of their checkable deposits

The dollar amount that must be held in reserve is called required reserves: checkable deposits multiplied by the required reserve ratio

The required reserve ratio dictates the minimum proportion of deposits the bank must hold in reserve

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Reserve Accounts

The current reserve requirement is 10% on checkable deposits, held either as cash in the bank’s vault or as deposits at the Fed, but neither earns the bank any interest

In our example, Home Bank must therefore hold $100,000 as reserves ($1,000,000 * .10)

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Reserve Accounts

If Home Bank deposits their required reserves with the FED, they now have $900,000 in excess reserves held as cash in the vault

Excess reserves have two additional usesThey can be used to make loans, or To purchase interest-bearing assets, such as

government bonds

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Liquidity versus Profitability

Management of a bank must structure the portfolio of assets with an eye towards Liquidity Profitability

Liquidity is the ease with which an asset can be converted into cash without a significant loss of value – if all of its cash held is as reserves, it forgoes profits

At the other extreme, if the bank uses all its excess reserves to acquire high-yielding but illiquid assets, it will run into problems whenever withdrawals exceed new deposits

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Federal Funds Market

Federal funds market: a market for overnight lending and borrowing of reserves among banks; the market for reserves on account at the Fed

The interest rate paid on these loans is called the federal funds rate, the rate that the Fed targets as a tool of monetary policy

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How Banks Create Money

Notice the pattern of deposits and loans in the money creation process: Each time a bank gets a fresh deposit, 10% goes to

required reserves The rest becomes excess reserves, which fuel new

loans or other asset acquisitions

An individual bank can lend no more than its excess reserves

When the borrower spends the amount loaned, reserves at one bank usually fall, but total reserves in the banking system do not

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How Banks Create Money

The recipient bank uses most of the new deposit to extend more loan, more checkable deposits

The potential expansion of checkable deposits in the banking system equals some multiple of the initial increase in reserves

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Exhibit 7: Summary

During each round, the increase in checkable deposits (1) minus the increase in required reserves (2) equals the potential increase in loans (3). Checkable deposits in this example can potentially increase by as much as $10,000.

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Reserve Requirements and Money Expansion

Money multiplier: the multiple by which the money supply increases as a result of an increase fresh reserves in the banking system

The simple money multiplier equals the reciprocal of the required reserve ratio, or 1 / r, where r is the reserve ratioIt is the maximum multiple of fresh reserves

by which the money supply can increase

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Checkable Deposits / Money Supply

The formula for the multiple expansion of the money supply can be written as

Change in the money supply = Change in reserves x 1/r

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Money Multiplier

The higher the reserve requirement, the greater the fraction of deposits that must be held as reserves and the smaller the money multiplier

Reserve requirement of 20% = money multiplier of 5

Reserve requirement of 5% = money multiplier of 20

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Limitations on Money Expansion

Various leakages from the multiple expansion process reduce the size of the money multiplier. Assume thatBanks do not let excess reserves sit idleBorrowers do something with the money People do not choose to increase their cash

holdings

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Contraction of the Money Supply

Fed’s sale of government bonds reduces bank reserves, forcing banks to recall loans or to somehow replenish reserves and the same multiple contraction would work

For example, with a reserve requirement of 10%, a $1,000 sale of bonds would reduce the checkable deposits and the money supply by a maximum of $10,000

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Tools for Controlling Reserves

The Fed has three tools for controlling reserves Conducting open market operations, buying

and selling of U.S. government bondsSetting the discount rate, the interest rate

the Fed charges for loans it makes to banksSetting the required reserve ratio, the

minimum fraction of reserves that banks must hold against deposits

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Open Market Operations

Open market operations refers to the buying and selling of U.S. government bonds in the open market To increase the money supply, the Fed buys U.S.

bonds: open-market purchase To reduce the money supply, the Fed sells U.S.

bonds: open-market saleAdvantage of open-market operations

Relatively easy to carry out Require no change in laws or regulations Can be executed in any amount The tool of choice by the Fed

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Federal Funds Market

Through open-market operations, the Fed influences bank reserves and the federal funds rate

Recall that the federal funds rate is the interest rate banks charge one another for borrowing excess reserves at the Fed, typically overnight

Banks that are unable to meet their legal reserve requirements can borrow in the federal funds market

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Federal Funds Market

The federal funds rate serves as a good indicator of the tightness of monetary policy

For example, suppose the Fed buys bonds in the open market and thereby increases reserves in the banking system banks have more excess reserves demand for excess reserves falls while the supply

increases the federal funds rate declines

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Discount Rate

Discount rate is the interest rate the Fed charges on loans it makes to banks

Banks can borrow from the Fed when they need reserves to satisfy their reserve requirements

By lowering or raising the discount rate, the Fed encourages or discourages banks from borrowing, which alters reserves and affects the money supply

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Discount Rate

A lower discount rate reduces the cost of borrowing, encouraging banks to borrow reserves from the Fed more bank lending leads to an increase in the money

supply

Higher discount rate increases the cost of borrowing reserves from the Fed less bank lending leads to reduced money supply

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Reserve Requirements

Reserve requirements are the regulations regarding the minimum amount of reserves that banks must hold to back up deposits

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Reserve Requirements

If the Fed increases the reserve requirement, banks must hold more reserves a reduction in the fraction of each dollar that

can be lent out reduces the banking system’s ability to

create money

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Reserve Requirements

Conversely, a decrease in the reserve requirement increases the fraction of each dollar on deposit that can be lent out, which increases the banking system’s ability to create money

Reserve requirements can be changed by a simple majority vote by the Board of Governors

Since even a small change in the reserve requirement can be disruptive, the Fed seldom employs this tool

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Exhibit 8: Federal Reserve Bank Balance Sheet as of December 31, 2003 (millions of dollars)