chapters 14 and 15 money, banking and financial institutions; money creation

Chapters 14 and 15Chapters 14 and 15

Money, Banking and Financial Money, Banking and Financial Institutions; Money CreationInstitutions; Money Creation

All About MoneyAll About Money

Functions of MoneyFunctions of Money1)1) Unit of ValueUnit of Value

-- common unit for measuring how much something is -- common unit for measuring how much something is worth (i.e. a 42worth (i.e. a 42"" HD TV costs $1,000). HD TV costs $1,000).

2)2) Medium of ExchangeMedium of Exchange-- willing to accept it in exchange for goods/services-- willing to accept it in exchange for goods/services

3) Store of Value3) Store of Value-- money can be held or stored knowing it can be used -- money can be held or stored knowing it can be used to buy future goods/services; holding money is to buy future goods/services; holding money is equivalent to holding wealthequivalent to holding wealth

History of Money1) Commodity Money

-- Goods used as a replacement for money because of its inherent value as a commodity (i.e. furs, metals, spice, etc)

2) Paper Currency (early)-- currency backed by gold or silver-- money would only be issued if the bank received more gold/silver-- people could legitimately go to the bank and trade in their paper currency for gold/silver-- gold conversion was disbanded in 1934 and silver was disbanded in 1963

3) Fiat Money-- Gov’t declared means of payment-- declaration is printed on each bill -- the term “legal tender” means dollar bills cannot be

refused as payment for a debt

Money has 4 Characteristics1) Exists as a unit of account

-- provides a common measurement of the relative value of goods and servicesEg) If price of a CD is $10.00 and the price of a large Duncan Donuts coffee is $2.00, the value of 1 CD = ___ DD coffees

2) Widely accepted as means of payment3) Store of Value and is an asset

-- money holds value over time-- credit cards are not money because they fail to be a store of value (if you exceed your credit limit or your credit is cancelled, the credit card will not allow you to purchase goods on the next purchase

4) Highly Liquid-- assets that are highly liquid can be easily converted into cash and at little cost-- illiquid assets are assets that can not be converted into cash easily

Spectrum of LiquiditySpectrum of Liquidity

Cash in Hands of Public

Demand Deposits / Other Checkable Deposits/Travelers Checks

Savings Type Accounts

Money Market Mutual Funds

Small Time Deposits

Lg Time Deposits

More Liquid Less Liquid

Demand Deposits (DD)

-- checking accounts of households and firms held at financial institutions

Other Checkable Deposits-- quasi-checking accounts such as automatic transfers

from savings accounts. These accounts transfer funds from savings accounts into checking accounts when needed

Retail Money Market Mutual Funds (MMMF’s)-- deposits made to buy a variety of financial assets. -- Can withdrawal money by writing checks

Small and Lg Time Deposits (also known as CD’s)-- requires money to remain in the bank for a specified time

period or subject to penalties for early withdrawal-- small time deposits (< $100,000)-- Lg time deposits (>= $100,000)

Measures of Money Stock

A) M1

-- standard measure of money supply or money stock, which consists of the four most liquid assets.

-- M1 = Cash in hands of public + Demand Deposits + Other Checking Account Deposits + Travelers Checks

B) M2

-- M2 = M1 + Savings Type Accounts + Retail MMMF Balances + Small Denomination Time Deposits

Federal Reserve System

-- established in 1913, it’s our nation’s central bank (indept agency of

the Federal Gov’t)

-- 12 Federal Reserve Banks are divided into 12 districts

1) Boston 5) Richmond 9) Minneapolis

2) New York 6) Atlanta 10) Kansas City

3) Philadelphia 7) Chicago 11) Dallas

4) Cleveland 8) St Louis 12) San Francisco

Structure of Federal Reserve

Chair of Board of Governors (Ben Bernanke)

Board Of Governors (7 members, includes chair)

Federal Open Market Committee (7 Governors +

5 Reserve Bank Presidents)

12 Federal Reserve Banks

Appoints 3 Directors for each bank

3,500 Member Banks

Elects 6 Directors for each bank

Breakdown of SectorsI] Board of Governors-- appointed by President and approved by Senate

for 14 yr terms (nonrenewable)Chairman: -- appointed by President/approved by Senate for 4 yr term (renewable) not to coincide with presidential term of office

Specific Duties include:1) Supervise and regulate member banks2) Supervise 12 Federal Reserve Banks3) Set reserve requirements and approve

discount rates

II] 12 Federal Reserve Banks -- Each is supervised by 9 directors (3 appointed by Bd of Governors

and 6 appointed by members banks-- Each bank has a president appointed by the directors-- Specific responsibilities include:

1) Lends reserves2) Issues currency3) Clears Checks (clears about 1/3 of all checks)

III] Federal Open Market Committee (FOMC)-- 7 Bd of Governors + 5 Reserve Bank Presidents (New York is always represented while 4 other positions rotate among the other banks)-- committee responsible for establishing U.S. monetary policy-- primary function is to conduct open market operations (buying/selling of U.S. bonds) to control money supply-- sets Federal Funds rate target

IV] 3.500 Member Banks (not all commercial banks are chartered with the Federal Reserve).-- About 70% of all deposits are in member banks

Functions of the Federal Reserve (sector responsibility in

brackets)

1) Supervising and Regulating Banks [Board of Governors]

-- sets standards for establishing new banks and members banks financial activity

-- establishes reserve requirements for all banks (not just member banks)

2) Acting as a “Bank for Banks” [12 Federal Reserve Banks]

-- Member banks can borrow from the Federal Reserve to meet required reserves

-- Interest rate for borrowed funds is called the discount rate

-- borrowing may be necessary when banks encounter bank runs (many depositors withdrawal money from the bank at one time) and much worse a bank panic (many banks experiencing bank runs at the same time).

3) Issuing Paper Currency

-- puts currency into circulation (does not print it)

-- printing currency is the responsibility of the

Bureau of Engraving

4) Check Clearing

-- transferring funds from one bank’s reserves to another

5) Controlling the Money Supply or Open Market Operations

3 Components of Financial System3 Components of Financial System1)1) Banking SystemBanking System2)2) Bond MarketBond Market3)3) Stock MarketStock Market

Banking SystemBanking System-- Commercial Banks are known as financial intermediaries-- Commercial Banks are known as financial intermediaries

Firms that bridge the relationship between savers Firms that bridge the relationship between savers (individuals and businesses) and borrowers(individuals and businesses) and borrowers

Uses funds from savers to make loansUses funds from savers to make loans

4 types of financial intermediaries4 types of financial intermediaries1)1) Commercial BanksCommercial Banks

-- largest group-- largest group-- obtains funds through checking deposits, savings -- obtains funds through checking deposits, savings deposits and time deposits and makes business deposits and time deposits and makes business (normally small business), mortgage and consumer (normally small business), mortgage and consumer loans loans

2)2) Savings & Loans (S & L’s)Savings & Loans (S & L’s) -- obtain funds through checkable deposits, savings deposits, -- obtain funds through checkable deposits, savings deposits, and other time deposits for mainly mortgage loansand other time deposits for mainly mortgage loans -- owned by outside investors-- owned by outside investors

3) Mutual Savings Banks3) Mutual Savings Banks -- accepts deposits (shares) which are used for mortgage -- accepts deposits (shares) which are used for mortgage loansloans -- owned by shareholders-- owned by shareholders

4) Credit Unions4) Credit Unions -- accepts deposits from a specific group and specializes in -- accepts deposits from a specific group and specializes in consumer and mortgage loansconsumer and mortgage loans

Importance of Financial IntermediariesImportance of Financial Intermediaries-- Financial Intermediaries are necessary because they specialize in -- Financial Intermediaries are necessary because they specialize in evaluating the worthiness of the borrower and have the means for evaluating the worthiness of the borrower and have the means for follow-upfollow-up

Researching credit historyResearching credit history Evaluating request for loan Evaluating request for loan putting it towards productive putting it towards productive

useuse Monitoring loan and activity of borrowerMonitoring loan and activity of borrower

---- significant amount of time and money would otherwise be significant amount of time and money would otherwise be

spent by savers to gather necessary information to make a spent by savers to gather necessary information to make a

informed decision about a potential borrowerinformed decision about a potential borrower

-- also aides the borrower by giving them access to credit that -- also aides the borrower by giving them access to credit that

might otherwise be time consuming and difficult to find.might otherwise be time consuming and difficult to find.

Stocks and BondsStocks and Bonds

-- large corporations’ outlet for generating funds for investment -- large corporations’ outlet for generating funds for investment

as well as Gov’t (bonds) for financing deficitas well as Gov’t (bonds) for financing deficit

A)A) BondsBonds

-- a promise to repay a debt, normally involving both a principal -- a promise to repay a debt, normally involving both a principal

amount and interest paymentsamount and interest payments

Key TermsKey Terms

1) 1) Principal AmountPrincipal Amount

-- amount originally lent-- amount originally lent

-- equal to the price of a -- equal to the price of a newlynewly issued bond or when the issued bond or when the bond was newbond was new

-- amount paid at a specific date in the future or at maturity-- amount paid at a specific date in the future or at maturity

2) 2) Coupon PaymentsCoupon Payments

-- regular interest payments made to the owners of the -- regular interest payments made to the owners of the

bondsbonds

Coupon RateCoupon Rate: regular interest payments to the : regular interest payments to the owner of owner of the bonds is derived from a coupon rate or the bonds is derived from a coupon rate or the interest the interest rate. The coupon rate is declared at the time rate. The coupon rate is declared at the time bond is bond is issued.issued.

Coupon PaymentCoupon Payment = Coupon Rate x Principal = Coupon Rate x Principal AmountAmount

Example: Example:

Purchase of a 10 yr bond with principal value of $5,000 and Purchase of a 10 yr bond with principal value of $5,000 and annual coupon payment of $100 has what Coupon Rate?annual coupon payment of $100 has what Coupon Rate?

Coupon Rate = $100/$5,000Coupon Rate = $100/$5,000

= 2.0%= 2.0%

3) Term of Bond3) Term of Bond

-- length of time until bond reaches maturity-- length of time until bond reaches maturity

-- can vary from 1 mth to 30 years-- can vary from 1 mth to 30 years

-- coupon rates are higher on long term bonds than short -- coupon rates are higher on long term bonds than short term onesterm ones

-- borrowers that are high risk or approaching bankruptcy -- borrowers that are high risk or approaching bankruptcy will typically pay higher coupon rateswill typically pay higher coupon rates

Bonds are bought and sold in the bond marketBonds are bought and sold in the bond market

1) Primary Market For Bonds1) Primary Market For Bonds

-- newly issued bonds-- newly issued bonds

2) Secondary Market For Bonds2) Secondary Market For Bonds

-- buying and selling of bonds issued in previous -- buying and selling of bonds issued in previous periodsperiods

Market Value of Bond = Price of Bond and can be greater Market Value of Bond = Price of Bond and can be greater than, less than or equal to principal amount of bondthan, less than or equal to principal amount of bond

-- price is dependent on how the coupon rate compares to -- price is dependent on how the coupon rate compares to the prevailing or current interest ratethe prevailing or current interest rate

Bond Prices and Interest RateBond Prices and Interest Rate

-- in general, as interest rates ↑, price bonds ↓-- in general, as interest rates ↑, price bonds ↓

-- inverse relationship between price of bond and interest -- inverse relationship between price of bond and interest raterate

ExampleExample

Purchase a newly issued 5 yr Gov’t bond with principal Purchase a newly issued 5 yr Gov’t bond with principal amount of $5,000 for $5,000. Bond has an annual coupon amount of $5,000 for $5,000. Bond has an annual coupon rate of 5%rate of 5%

Annual Coupon Payment = $5,000 x 5% or $250Annual Coupon Payment = $5,000 x 5% or $250

At Maturity = $5,000 + $250 or $5,250At Maturity = $5,000 + $250 or $5,250

If, after 4 yrs, you decide to sell the bond (1 yr left before If, after 4 yrs, you decide to sell the bond (1 yr left before maturity)maturity)

-- The price at which you can sell the bond depends on the -- The price at which you can sell the bond depends on the current interest rate where the current interest rate is the current interest rate where the current interest rate is the interest rate on newly issued bonds.interest rate on newly issued bonds.

If current Interest Rate on 1 yr bond = 6%If current Interest Rate on 1 yr bond = 6%

At maturity, newly issued bond will pay: $5,000 + 6% or At maturity, newly issued bond will pay: $5,000 + 6% or $5,300$5,300

---- No one would pay $5,000 for the used bond since 5% No one would pay $5,000 for the used bond since 5% coupon rate is below current interest or would result in $50 coupon rate is below current interest or would result in $50 less revenue than new bondless revenue than new bond

-- In order to sell the bond, the price of the bond will have to be -- In order to sell the bond, the price of the bond will have to be set to a level that will allow a 6% return:set to a level that will allow a 6% return:

Price Bond x (1+ current interest rate) = $5,250Price Bond x (1+ current interest rate) = $5,250

Price Bond x (1.06) = $5,250Price Bond x (1.06) = $5,250

Price Bond = $5,250 / 1.06Price Bond = $5,250 / 1.06

= $4,952.83= $4,952.83

(below original price or principal amount)(below original price or principal amount)

If the prevailing interest rate were 3%:If the prevailing interest rate were 3%:




= $5,097.09= $5,097.09

(above original price or principal amount)(above original price or principal amount)

If the prevailing interest rate were 5%If the prevailing interest rate were 5%




= $5,000= $5,000

(equal to original price or principal amount)(equal to original price or principal amount)

B) StocksB) Stocks

-- partial ownership in a firm-- partial ownership in a firm

-- # of stocks equates to % of ownership in a firm (# shares / # of -- # of stocks equates to % of ownership in a firm (# shares / # of

shares outstanding)shares outstanding)

-- Stocks provide a return on investment in one of two ways:-- Stocks provide a return on investment in one of two ways:

1) Dividends1) Dividends

• Periodic payment to owners of shares of stockPeriodic payment to owners of shares of stock

• Amount is determined by company and is usually tied Amount is determined by company and is usually tied to profitsto profits

2) Capital Gains2) Capital Gains

• Increase in value of stockIncrease in value of stock

Determination of Stock PriceDetermination of Stock Price

1)1) Stock Price with no concern over riskStock Price with no concern over risk

-- riskiness of stock is not a concern-- riskiness of stock is not a concern

-- considers your anticipated or expected level of return -- considers your anticipated or expected level of return when purchasing a stock. Expected level of return is based when purchasing a stock. Expected level of return is based on comparison against alternative financial investments on comparison against alternative financial investments (such as Gov’t bonds)(such as Gov’t bonds)

ExampleExample

-- If a 1 yr Gov’t Bond is earning 3% interest and the stock -- If a 1 yr Gov’t Bond is earning 3% interest and the stock price of a Company A one year from now is expected to be price of a Company A one year from now is expected to be $50.00 and paying a $4.00 dividend$50.00 and paying a $4.00 dividend

Stock Price x 1.03 = $54.00Stock Price x 1.03 = $54.00

Stock Price = $54.00/1.03Stock Price = $54.00/1.03

= $52.43 = $52.43

-- As expected dividends ↑, ↑ in the value of the stock price -- As expected dividends ↑, ↑ in the value of the stock price or what investors would be willing to payor what investors would be willing to pay

-- As interest rates ↑, ↓ in the value of stock price as stocks -- As interest rates ↑, ↓ in the value of stock price as stocks compete against the financial benefits of buying bondscompete against the financial benefits of buying bonds

Certain financial assets carry more risk than others (Gov’t bondsCertain financial assets carry more risk than others (Gov’t bonds

tend to be one of the least risky) and therefore the level of risk tend to be one of the least risky) and therefore the level of risk

needs to be considered in the investment. Riskier assets is saidneeds to be considered in the investment. Riskier assets is said

to carry a to carry a risk premiumrisk premium

Risk PremiumRisk Premium

Rate of Return for -- Rate of Return onRate of Return for -- Rate of Return on

Risky Assets Risky Assets On Low Risk Ones On Low Risk Ones

Joe’s Bank Balance SheetJoe’s Bank Balance Sheet

Assets (in millions)Assets (in millions) Liabilities (in millions)Liabilities (in millions)

Property & BldgsProperty & Bldgs $20$20 Demand Deposits (DD)Demand Deposits (DD) $100$100

SecuritiesSecurities 2525

LoansLoans 6565 Net Worth or Stockholders Net Worth or Stockholders EquityEquity

2020

Reserves (Cash in Reserves (Cash in Vaults + on deposit w Vaults + on deposit w Federal reserve)Federal reserve)

1010

Total AssetsTotal Assets 120120 Total Liabilities + Net WorthTotal Liabilities + Net Worth 120120

TermsTermsSecuritiesSecurities: Banks hold securities such as Gov’t and corporate : Banks hold securities such as Gov’t and corporate

bond and treasury billsbond and treasury billsLoansLoans: Borrowed funds by households & non-corporate: Borrowed funds by households & non-corporate businessesbusinessesDemand DepositsDemand Deposits: A liability for the bank because the banks owes: A liability for the bank because the banks owes this money on the spot if withdrawnthis money on the spot if withdrawnNet Worth or Stockholders equityNet Worth or Stockholders equity: Total Assets – Total Liabilities: Total Assets – Total Liabilities

-- the value of the firm if it closed-- the value of the firm if it closedReserves:Reserves:

1)1) Vault Cash: money stored in a vaultVault Cash: money stored in a vault2)2) Accounts with Federal ReserveAccounts with Federal Reserve

-- banks have accounts with the Federal Reserve Banks-- banks have accounts with the Federal Reserve Banks Purpose of ReservesPurpose of Reserves

i) Must have enough available cash for withdrawalsi) Must have enough available cash for withdrawalsii) Law requires a specific amount of reserves called ii) Law requires a specific amount of reserves called required required

reservesreserves-- the larger the amount of deposit liabilities (i.e. -- the larger the amount of deposit liabilities (i.e.

demand deposits), the larger the required reservesdemand deposits), the larger the required reserves

Required Reserve Ratio (RR):Required Reserve Ratio (RR): the minimum the minimum fraction of demand deposits balances that fraction of demand deposits balances that banks banks must hold as reservesmust hold as reserves

-- set by Federal Reserve-- set by Federal Reserve

-- current RR is 10%-- current RR is 10%

Example: Using Joe’s Banks Balance Sheet, Example: Using Joe’s Banks Balance Sheet, since since demand deposits are $100 million, the bank is demand deposits are $100 million, the bank is required required to hold $____________ in reserves. Since to hold $____________ in reserves. Since the sum of the sum of reserves or vault cash + Accts w the reserves or vault cash + Accts w the Federal Reserve Federal Reserve equals $___________, the bank equals $___________, the bank meets the minimum meets the minimum reserve requirement.reserve requirement.

Fed and control of the Money SupplyFed and control of the Money Supply-- Changes in the money supply are accomplished -- Changes in the money supply are accomplished through Open Market Operations (buying / selling of Gov’t through Open Market Operations (buying / selling of Gov’t bonds)bonds)

2 Assumptions2 Assumptions1)1) Households and businesses are satisfied with cash at Households and businesses are satisfied with cash at

hand. Additional funds are deposited in checking hand. Additional funds are deposited in checking accounts/Decrease in funds are transferred from accounts/Decrease in funds are transferred from checking accountchecking account

2)2) Banks never hold any more than required reserves and Banks never hold any more than required reserves and RR = 10%RR = 10%

I] Increase in the Money SupplyI] Increase in the Money Supply

-- Fed buys Gov’t bonds, called an open market purchase-- Fed buys Gov’t bonds, called an open market purchase

Example: Fed buys $1,000 bond from Bond Dealer who has a Example: Fed buys $1,000 bond from Bond Dealer who has a checking account with National City Bankchecking account with National City Bank

Changes in National City’s Balance SheetChanges in National City’s Balance Sheet

AssetsAssets LiabilitiesLiabilities

Reserves Reserves + $1,000+ $1,000 Demand Demand DepositsDeposits

+$1,000+$1,000

Check is deposited in Bonds Dealers account (increasing demand deposits) and at the same time reserves increase by $1,000. This Gov’t transaction increases the money supply by $1,000

-- Since the RR = 10%, required reserves have -- Since the RR = 10%, required reserves have increased by $______. Since reserves have gone up increased by $______. Since reserves have gone up by $1,000, there is excess reserves of by $1,000, there is excess reserves of $_____________$_____________

Excess Reserves = Reserves - Required Excess Reserves = Reserves - Required ReservesReserves

-- National City will now try to lend out excess reserves -- National City will now try to lend out excess reserves of $__________. Ironically, Bob walks into National of $__________. Ironically, Bob walks into National City and needs a $_______ loan for a boat. After City and needs a $_______ loan for a boat. After examining his credit history and financials, he is examining his credit history and financials, he is awarded a loan and money is deposited in his awarded a loan and money is deposited in his checking account with the bank (increase in demand checking account with the bank (increase in demand deposits). Bob is buying the boat from Jack who has a deposits). Bob is buying the boat from Jack who has a checking account with Corporate America Bank where checking account with Corporate America Bank where the funds will be deposited (increase in demand the funds will be deposited (increase in demand deposits).deposits).



Reserves Reserves + $1,000+ $1,000 Demand Demand DepositsDeposits

+ $1,000+ $1,000

LoansLoans + 900+ 900 Demand Demand DepositsDeposits

+ 900+ 900

With this loan, the money supply increases by $900 (↑ in DD). Once the check clears, the balance sheets become the following:

Changes in National City’s Balance Sheet (check clears)Changes in National City’s Balance Sheet (check clears)


Reserves Reserves + $1,000+ $1,000 Demand DepositsDemand Deposits + $1,000+ $1,000

LoansLoans + 900+ 900 Demand DepositsDemand Deposits + 900+ 900

ReservesReserves -900-900 Demand DepositsDemand Deposits -900-900

Changes in Corporate America Bank’s Balance SheetChanges in Corporate America Bank’s Balance Sheet


Reserves Reserves + $900+ $900 Demand DepositsDemand Deposits + $900+ $900

Note: check clears @ Nat’l City (Bob’s bank) causing both demand Note: check clears @ Nat’l City (Bob’s bank) causing both demand deposits and reserves to decrease. Notice that reserves are now deposits and reserves to decrease. Notice that reserves are now $100 or equal to the amount of required reserves. Since National $100 or equal to the amount of required reserves. Since National City has no excess reserves, they are “loaned up”City has no excess reserves, they are “loaned up”

Note: At Corp America Bank (Jack’s bank), demand deposits Note: At Corp America Bank (Jack’s bank), demand deposits increase and reserves increase when check is deposited.increase and reserves increase when check is deposited.




Since Demand Deposits increased by $900, required Since Demand Deposits increased by $900, required reserves increase by $90. Excess reserves are now reserves increase by $90. Excess reserves are now $810. Corporate America Bank will now try to loan out $810. Corporate America Bank will now try to loan out $810 or amount of excess reserves. $810 or amount of excess reserves.

Say Susie walks into Corporate America Bank (where Say Susie walks into Corporate America Bank (where she also has a checking account) and asks for a loan of she also has a checking account) and asks for a loan of $810 to buy an antique lamp from Monica (has a $810 to buy an antique lamp from Monica (has a checking account at Fifth Avenue Bank). This checking account at Fifth Avenue Bank). This transaction has the following effect:transaction has the following effect:

II Changes in Corporate America Bank’s Balance Changes in Corporate America Bank’s Balance SheetSheet


Reserves Reserves + $900+ $900 Demand Demand DepositsDeposits

+ $900+ $900

LoansLoans + 810+ 810 Demand Demand DepositsDeposits

+ 810+ 810

With this loan, the money supply increases by $810. Once the check clears, the balance sheets become the following:

Changes in Corporate America Bank’s Balance Sheet (check clears)Changes in Corporate America Bank’s Balance Sheet (check clears)



LoansLoans + 810+ 810 Demand DepositsDemand Deposits + 810+ 810

ReservesReserves - 810- 810 Demand DepositsDemand Deposits - 810- 810

Changes in Fifth Avenue Bank’s Balance SheetChanges in Fifth Avenue Bank’s Balance Sheet



Note: Check clears @ Corporate America Bank (Susie’s bank) causingNote: Check clears @ Corporate America Bank (Susie’s bank) causing

both demand deposits and reserves to decrease. Notice that reserves both demand deposits and reserves to decrease. Notice that reserves are now $90 or equal to the amount of required reserves. Since are now $90 or equal to the amount of required reserves. Since Corporate America has no excess reserves, they are “loaned up”Corporate America has no excess reserves, they are “loaned up”

Note: At Fifth Avenue Bank (Monica’s bank), demand deposits increase Note: At Fifth Avenue Bank (Monica’s bank), demand deposits increase and reserves increase when check is deposited.and reserves increase when check is deposited.

ResultsResults-- Demand Deposits increase each time a bank lends money out from -- Demand Deposits increase each time a bank lends money out from its excess reserves or money supply increasesits excess reserves or money supply increases-- Demand deposits increase by 90% when each loan is made-- Demand deposits increase by 90% when each loan is madeBank Bank Addt’l Demand Deposits Cumulative Demand Addt’l Demand Deposits Cumulative Demand

(DD) per bank (DD) per bank Deposits (DD) all banksDeposits (DD) all banksNat’l CityNat’l City $1,000$1,000 $1,000$1,000Corp AmericaCorp America $ 900$ 900 $1,900$1,900Fifth AveFifth Ave $ 810$ 810 $2,710$2,710

. . . .

.. . . .. . .$2,826$2,826 $10,000$10,000

DerivationDerivation∆∆DD (all banks) = DD (all banks) = Demand Deposit MultiplierDemand Deposit Multiplier x initial ∆ reserves x initial ∆ reserves

Demand Deposit Multiplier = 1/RR or 1/.10Demand Deposit Multiplier = 1/RR or 1/.10∆∆DD (all banks) = DD (all banks) = 1/.10 x 10001/.10 x 1000

= 10 x 1,000 or $10,000= 10 x 1,000 or $10,000 ∆ ∆Money Supply = ∆DD + ∆currency held by the publicMoney Supply = ∆DD + ∆currency held by the public ∆ ∆Money Supply = $10,000 + $0Money Supply = $10,000 + $0

II] Decrease in the Money SupplyII] Decrease in the Money Supply

-- Fed sells Gov’t bonds, called an open market sale-- Fed sells Gov’t bonds, called an open market sale

Example: Fed sells a $1,000 bond to local investment firm who Example: Fed sells a $1,000 bond to local investment firm who has a checking account with National City Bankhas a checking account with National City Bank



Reserves Reserves - $1,000- $1,000 Demand Demand DepositsDeposits

- $1,000- $1,000

Money is withdrawn from investment firms’ account (decreasing demand deposits) and at the same time reserves decrease by $1,000 (money supply decreases by $1,000

-- Since the RR = 10%, required reserves have -- Since the RR = 10%, required reserves have decreased by $______. Since reserves have decreased by $______. Since reserves have decreased by $1,000, there is now deficient decreased by $1,000, there is now deficient reserves of $_____________reserves of $_____________

-- In order to gain these reserves, National City -- In order to gain these reserves, National City will now try to call-in loans or ask for will now try to call-in loans or ask for repayment equal to amount of deficient repayment equal to amount of deficient reserves or $__________. Say a loan equal to reserves or $__________. Say a loan equal to amount of deficient reserves is paid from a amount of deficient reserves is paid from a client holding a checking account with client holding a checking account with Corporate America Bank.Corporate America Bank.

Changes in National City’s Balance Sheet (check clears)Changes in National City’s Balance Sheet (check clears)


Reserves Reserves - $1,000- $1,000 Demand DepositsDemand Deposits - $1,000- $1,000

ReservesReserves + 900+ 900

LoansLoans - 900- 900



Reserves Reserves - $900- $900 Demand DepositsDemand Deposits - $900- $900

Note: check clears and reserves increase by $900 and loans Note: check clears and reserves increase by $900 and loans decrease by $900. Notice that change in reserves is now -$100 or decrease by $900. Notice that change in reserves is now -$100 or equal to the reduction allowable given the RR. equal to the reduction allowable given the RR.

Note: At Corp America Bank, demand deposits decrease and Note: At Corp America Bank, demand deposits decrease and reserves decrease when check clears and loan payment is made to reserves decrease when check clears and loan payment is made to National CityNational City

-- Since the RR = 10%, required -- Since the RR = 10%, required reserves have decreased by $90. Since reserves have decreased by $90. Since reserves however have decreased by reserves however have decreased by $900, there is now deficient reserves of $900, there is now deficient reserves of $810.$810.

-- In order to gain these reserves, -- In order to gain these reserves, Corporate America Bank will now try to Corporate America Bank will now try to call-in loans or ask for repayment equal call-in loans or ask for repayment equal to amount of deficient reserves or $810.to amount of deficient reserves or $810.

ResultsResults-- Demand Deposits decrease each time a bank calls-in loans or the -- Demand Deposits decrease each time a bank calls-in loans or the money supply decreasesmoney supply decreases-- Demand deposits decrease by 90% with each loan called-in-- Demand deposits decrease by 90% with each loan called-inBank Bank ↓↓ in Demand Deposits Cumulative in Demand Deposits Cumulative ↓ in ↓ in Demand Demand

(DD) per bank (DD) per bank Deposits (DD) all Deposits (DD) all banksbanksNat’l CityNat’l City $1,000$1,000 $1,000$1,000Corp AmericaCorp America $ 900$ 900 $1,900$1,900

.. . . .. . . .. . .$2,826$2,826 $10,000$10,000

DerivationDerivation∆∆DD (all banks) = DD (all banks) = Demand Deposit MultiplierDemand Deposit Multiplier x initial ∆ reserves x initial ∆ reserves

Demand Deposit Multiplier = 1/RR or 1/.10Demand Deposit Multiplier = 1/RR or 1/.10∆∆DD (all banks) = 10 x -1,000 or -$10,000DD (all banks) = 10 x -1,000 or -$10,000 ∆∆Money Supply = ∆DD + ∆currency held by the publicMoney Supply = ∆DD + ∆currency held by the public

= -10,000 + 0 = -10,000 + 0 = -10,000= -10,000

chapters 14 and 15 money, banking and financial institutions; money creation

Documents

money functions of money

commodity money

withdrawal money

history of money

fiat money

measures of money stock

savings accounts

checking accounts