Chapter
14 Banking and the Money Supply
I.
Banks, their deposits, and
the money supply
A.
What do banks do?
1.
Banks
are financial intermediaries.
-
Savers
need a safe place to store their money and borrowers need credit; banks try to
earn profit serving both groups.
-
Savers
generally want to save relatively small amounts. Borrowers want to borrow
relatively larger amounts. Savers and borrowers also want to save and borrow
for varying lengths of time. Banks repackage the small savings into larger
amounts for borrowers and offer desirable durations to borrowers and savers.
2.
Banks
cope with Asymmetric Information.
Asymmetric
Information
– Unequal information known by each party to a transaction; borrowers usually
have more information about their credit-worthiness than do lenders
-
Lenders
must identify borrowers who are willing to pay interest and are able to pay
back their loans.
-
Borrowers
know more about their ability to pay back than lenders. Borrowers have
incentive not to report history correctly if it is bad.
-
Because
of experience and expertise, banks are better able to deal with asymmetric
information.
The
economy is more efficient because banks develop expertise in evaluating
borrowers, structuring loans, and enforcing loan contracts.
3.
Banks
reduce risk through diversification.
By
developing a diversified portfolio of assets rather than lending funds to a
single borrower, banks reduce the risk to each saver.
B.
The Narrow Definition of
Money: M1
Monetary
Aggregates
- Measures of the economy’s money supply
M1 – (The most narrowly
defined measure of money) A measure of the money supply consisting of currency and coins held by the non-banking
public, checkable deposits, and travelers checks.
M1
is regarded as money because it serves as a medium of exchange, unit of account
and a store of value.
Checkable
deposits –
Deposits in financial institutions against which checks can be written
(Checkable deposits are liabilities of the issuing banks.)
Currency
sitting in bank vaults is not included as part of the money supply, because it
is not being used as a medium of exchange. Checkable deposits are money because
their owners can write checks against them.
Federal
Reserve Notes are liabilities of the Federal Reserve. (Printed by the U.S.
Bureau of Engraving and Printing.) They can only be exchanged for more
currency, so they are fiat money. Coins are manufactured and distributed by the
U.S. mint. They are token coins.
C.
Broader Money Aggregates
Some
kinds of assets perform the store-of-value function. Some can be converted into
currency or checkable deposits. So these are included under broader definitions
of money.
Savings
deposits –
Deposits that earn interest but have no specific maturity date
Time
deposits –
Deposits that earn a fixed rate of interest if held for the specified period,
which can range anywhere from several months to several years.
Money
market mutual funds – A collection of short-term interest-earning assets purchased with
funds collected from many shareholders
M2 – A monetary aggregate
consisting of M1 plus savings deposits,
small-denomination time deposits, and money market mutual funds
M3 – A monetary aggregate
consisting of M2 plus large-denomination
time deposits
The
difference between M1 and M2 becomes less meaningful when banks allow
depositors to transfer money between one account and another.
Credit
cards are not considered money. They are an easy means of obtaining a
short-term loan from the card issuer.
II.
How Banks Work
Banks
earn a profit by charging a different rate of interest to borrowers than it
gives to depositors.
A.
Starting a bank
Example:
1.
To
get a charter, those who want to form the bank apply to the state banking
authority to start a state bank and to the U.S. Comptroller of the Currency to
start a national bank.
2.
The
bank founders exchange the cash they want to invest for shares of stock. These
shares are the owner’s equity (net worth of the bank).
Net
worth –
Assets minus liabilities
3.
Part
of the cash is used to buy shares in their district Federal Reserve bank to
become a member of the Federal Reserve System. The rest of the money goes to
buying the bank building, etc.
Balance
Sheet – A
financial statement that shows assets, liabilities, and net worth at a given
point in time; since assets must equal liabilities plus net worth, the
statement is in balance
Asset – Anything of value that is
owned
Liability- Anything that is owed to
another individual or institution
4.
The
bank opens and accepts deposits. When a bank accepts a deposit, it promises to
repay the depositor that amount.
B.
Reserve Requirements
Banks
are required by the Fed to set aside, or to hold in reserve, an amount equal to
a certain percentage of their deposits. Reserves must be held as cash in the
vaults or as deposits at the Fed.
Required
Reserve Ratio
– The ratio of reserves to deposits that banks are required, by regulation, to
hold.
Required
Reserves –
The dollar amount of reserves a bank is legally required to hold
If
the required reserve ratio is 10%, our bank must therefore hold
_____________________.
Excess
Reserves –
Bank reserves in excess or required reserves.
Currently,
our bank is holding ________________ in excess reserves. Excess reserves can be
used to make loans or to purchase inter-bearing assets such as government
bonds.
C.
Liquidity v. Profitability
Banks
must be prepared to satisfy depositors’ requests for funds. A bank could fail
if it lacked sufficient reserves to meet all depositors’ requests for funds.
Required reserves are not meant to be used for this purpose, so banks hold
excess reserves and easily convertible assets for this purpose.
Liquidity – A measure of the ease
with which an asset can be converted into money without significant loss of
value
In
general, assets offering a high rate of interest are not as liquid.
***
The objectives of profitability and liquidity are at odds.
Since
reserves earn no interest, banks usually try to keep their excess reserves to a
minimum.
Federal
funds market
– A market for overnight lending and borrowing of reserves among banks; the
market for reserves on account with the Fed
Federal
funds rate
– The interest rate prevailing in the federal funds market; the interest rate
banks charge one another for overnight borrowing
III.
How Banks Create Money
A.
Creating Money through
Excess Reserves
The
Fed influences the amount of excess reserves by:
1.
buying
or selling U.S. government bonds
2.
extending
discount loans to banks
3.
changing
the required reserve ratio
The
most important is buying and selling government bonds.
Example:
Bank
1
Bank
2
Bank
3
Summary
B.
Excess Reserves, Reserve
Requirements, and Money Expansion
Money
Multiplier –
The multiple by which the money supply increases as a result of an increase in
excess reserves in the banking system
Simple
Money Multiplier – The reciprocal of the required reserve ration, or 1/r; the maximum
multiple of excess reserves by which the money supply can increase
The
simple money multiplier assumes that banks don’t hold excess reserves,
borrowers don’t let funds sit idle, and nobody withdraws cash.
The
higher the reserve requirement, the smaller the money multiplier. Excess
reserves fuel the deposit expansion process, and a higher reserve requirement
drains this fuel from the banking system, thereby reducing the amount of new
money that can be created.
C.
Limitations on Money Expansion
Various
leakages from the multiple expansion process reduce the size of the money
multiplier.
Our
model assumed three things:
1.
Borrowers
do something with the money they borrow
2.
People
do not withdraw cash.
3.
Banks
do not let reserves sit idle
To
the extent that people prefer to hold cash, the actual money multiplier will be
smaller than the simple money multiplier because cash withdrawals reduce
reserves in the banking system.
Reduced
reserves give banks less ability to make loans or buy bonds.
If
banks do nothing with excess reserves, they don’t fuel an increase in the money
supply.
D.
Multiple Contraction of the
Money Supply
1.
Assume
again that excess reserves are zero and the required reserve ratio is 10%.
2.
The
Fed sells a government bond to a commercial bank for $1,000.
3.
The
Fed decreases the bank's reserves at the Fed by $1,000.
4.
To
replenish reserves, the bank must recall loans, sell some other asset, or
borrow additional reserves.
5.
If
the bank recalls $1,000 in loans, the borrower writes a check from bank 2 to
repay the loan. Bank 1’s reserves increase just enough to meet the requirement.
6.
Bank
2’s reserves fall by $1,000. Since we assumed no excess reserves initially,
bank 2 had $100 in required reserves for the $1,000 in checkable deposits, so required
reserves are now short $900.
7.
Bank
2 must recall $900 worth of loans.
The
maximum possible effect is to reduce the money supply by the amount of the
original reduction in bank reserves times the simple money multiplier which
again equals 1 divided by the reserve requirement, 1/r.
IV.
Fed Tools of Monetary
Control
The
Fed clears checks for, extends loans to, and holds deposits of banks.
The
Fed also tries to prevent major disruptions and financial panics.
The
Fed’s 3 tools:
1.
Open-market
operations
2.
Discount
rate
3.
Required
reserve ratio
1.
Open-Market Operations- Purchases or sales of U.S. government bonds in an
effort to influence the money supply.
Open-market
purchase –
The purchase of U.S. government bonds by the Fed for the purpose of increasing
the money supply
Open-market
sale – The
sale of U.S. government bonds by the Fed for the purpose of reducing the money
supply
Federal
Open Market Committee (meets every six weeks) à New York Fed buys or sells bonds.
2.
The Discount Rate – The interest rate charged by the Fed for loans to banks
Banks
borrow from the Fed when they need loans to satisfy their reserve requirements.
When the Fed extends loans, reserves increase and banks can offer more loans.
So lowering or raising the discount rate encourages or discourages banks from
borrowing.
Lower
discount rate à banks borrow more reserves à more bank lending à increased money supply
Fed’s
Board of Governors sets the discount rate.
-
More
of a signal to banks about monetary policy
-
Emergency
tool for making banks more liquid.
3.
Reserve Requirements
Reserve
requirements influence how much money the banking system can create with each
dollar of reserves.
Changed
by a majority vote of the Board of Governors
Reserve
requirement down à increases the fraction of
each dollar on deposit that can be lent out à increases the money supply
***To
control the money supply the Fed relies primarily on open-market operations.