34 McGraw-Hill/IrwinCopyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Money,...

34

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Money, Banking, and Financial Institutions

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.


• Learning objectives – After reading this chapter students should be able to:

• Identify and explain the functions of money and the components of the money supply.

• Describe what “backs” the money supply, making us willing to accept it as payment.

• Identify and explain the main factors that contributed to the financial crisis of 2007-2008.

• Explain the basics of a bank’s balance sheet and discuss why the U.S. banking system is called a “fractional reserve” system.

• Explain the distinction between a bank’s actual reserves and its required reserves.

• .LO2


• Describe how a bank can create money • Describe the multiple expansion of loans and money by the

entire banking system.• Define the monetary multiplier, explain how to calculate it,

and demonstrate its relevance • Discuss how the equilibrium interest rate is determined in the

market for money. • List and explain the goals and tools of monetary policy. • Identify the mechanisms by which monetary policy affects

GDP and the price level.

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• Functions of Money• Medium of exchange: Money can be used for buying and

selling goods and services.• Unit of account: Prices are the U.S. are quoted in dollars and

cents.• Store of value: Money allows us to transfer purchasing power

from present to future. It is the most liquid (spendable) of all assets, a convenient way to store wealth.

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• Components of the Money Supply • 1. Narrow definition of money: M1 includes currency and

checkable deposits (see Figure 34.1a).• Currency (coins + paper money) held by public. (51% of M1)

• a. It is “tokentoken” money, which means its intrinsic value is less than actual value. The metal in a dime is worth less than 10¢.

• B. All paper currency consists of Federal Reserve Notes issued by the Federal Reserve.

• 2. Checkable deposits are included in M1, since they can be spent almost as readily as currency and can easily be changed into currency. (49% of M1)• a. Commercial banks are a main source of checkable deposits for

households and businesses.

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• b. Thrift institutions (savings & loans, credit unions, mutual savings banks) also have checkable deposits.

• Money Definition: M2 = M1 + some near-monies which include: (See Figure 34.1b)• Savings deposits Savings deposits and money market deposit accounts.• Small-denominated time deposits Small-denominated time deposits (certificates of deposit) less than

$100,000.• Money market mutual fund balancesMoney market mutual fund balances, which can be redeemed by

phone calls, checks, or through the Internet.

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• C. CONSIDER THIS … Are Credit Cards Money?• Credit cards are not money, but their use involves short‑term

loans; their convenience allows you to keep M1 balances low because you need less for daily purchases.

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• What “backs” the money supply?• A. The government’s ability to keep its value stable

provides the backing.• B. Money is debt; paper money is a debt of Federal Reserve

Banks and checkable deposits are liabilities of banks and thrifts because depositors own them.

• C. Value of money arises not from its intrinsic value, but its value in exchange for goods and services.• 1. It is acceptable as a medium of exchange.• 2. Currency is legal tender or fiat money. • 3. The relative scarcity of money compared to goods and services will

allow money to retain its purchasing power.

• Money’s purchasing power determines its value. Higher prices mean less purchasing power.

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• Excessive inflation may make money worthless and unacceptable. An extreme example of this was German hyperinflation after World War I, which made the mark worth less than 1 billionth of its former value within a four-year period.1. Worthless money leads to use of other currencies that are more

stable.

2. Worthless money may lead to barter exchange system.

• Maintaining the value of money1. The government tries to keep supply stable with appropriate fiscal

policy.

2. Monetary policy tries to keep money relatively scarce to maintain its purchasing power, while expanding enough to allow the economy to grow.

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• The Financial Crisis of 2007 and 2008• In 2007 and 2008 the malfunctioning U.S. financial system

experienced the worst financial crisis since the Great Depression which led to problems in the credits markets and spread to the rest of the economy resulting in a recession.

• The Mortgage Default Crisis: In 2007 there were a huge number of defaults on home mortgages in the United States, mostly subprime loans which previously the Federal government had encouraged banks to make. When banks wrote-off these loans it reduced their reserves and their ability to loan out other funds.

• Banks and mortgage lenders packaged hundreds or thousands of mortgages together and sold them as bonds, believing that this would protect them from defaults on the mortgages.

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• Buyers of the mortgage-backed securities collected the mortgage payments as returns on their investment.

• The banks received a single up-front payment for the mortgage-backed securities.

• Banks lent a substantial amount of money to investment firms so that they could buy the mortgage-backed securities. The banks also bought mortgage-backed securities as investment.

• With the defaults the banks lost money on the loans that they still held, on the money they had loaned to investment funds for the purchase of mortgage-backed securities and on the mortgage-backed securities that they had purchased themselves

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• Causes of the substantial number of defaults:• Government programs that encouraged and subsidized

home ownership for previous renters.• Declining home prices.• Lax standards by banks because they felt protected from

defaults with the mortgage-backed securities.

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• The Fractional Reserve System: • Significance of fractional reserve banking:• Banks can create money by lending more than the original

reserves on hand. • Lending policies must be prudent to prevent bank “panics” or

“runs” by depositors worried about their funds. Also, the U.S. deposit insurance system prevents panics

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• A Single Commercial Bank• A balance sheet states the assets and claims of a bank at

some point in time.• All balance sheets must balance, that is, the value of assets

must equal value of claims.• 1. The bank owners’ claim is called net worth.• 2. Non-owners’ claims are called liabilities.• 3. Basic equation: Assets = liabilities + net worth.

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• The Banking System: Multiple‑Deposit Expansion (all banks combined)

• The entire banking system can create an amount of money which is a multiple of the system’s excess reserves, even though each bank in the system can only lend dollar for dollar with its excess reserves.

• Three simplifying assumptions:

1. Required reserve ratio assumed to be 20 percent.

2. Initially banks have no excess reserves; they are “loaned up.”

3. When banks have excess reserves, they loan it all to one borrower, who writes check for entire amount to give to someone else, who deposits it at another bank. The check clears against original lender.

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Bank

(1)AcquiredReserves

and Deposits

(2)RequiredReserves

(3)Excess

Reserves(1)-(2)

(4)Amount Bank CanLend; New Money

Created = (3)

Bank A $100 $20 $80 $80

Bank B $80 $16 $64 $64

Bank C $64 $12.80 $51.20 $51.20

Bank D $51.20 $10.24 $40.96 $40.96

The process will continue…

The Banking System

LO4

Bank ABank BBank CBank DBank EBank FBank GBank HBank IBank JBank KBank LBank MBank NOther Banks

Bank

(1)AcquiredReserves

and Deposits

(2)RequiredReserves(Reserve

Ratio = .2)

(3)Excess

Reserves(1)-(2)

(4)Amount Bank CanLend; New Money

Created = (3)

$100.0080.0064.0051.2040.9632.7726.2120.9716.7813.4210.748.596.875.50

21.99

$20.0016.0012.8010.248.196.555.244.203.362.682.151.721.371.104.40

$80.0064.0051.2040.9632.7726.2120.9716.7813.4210.748.596.875.504.40

17.59

$80.0064.0051.2040.9632.7726.2120.9716.7813.4210.748.596.875.504.40

17.59$400.00

The Banking System

LO4

The Monetary Multiplier

Monetarymultiplier =

1

required reserve ratio=

1

R

LO5


• System’s lending potential: Suppose a junkyard owner finds a $100 bill and deposits it in Bank A. The system’s lending begins with Bank A having $80 in excess reserves, lending this amount, and having the borrower write an $80 check which is deposited in Bank B. See further lending effects on Bank C. The possible further transactions are summarized in Table 13.2.

• Monetary multiplier is illustrated in Table 35.2.

• Formula for monetary or checkable deposit multiplier is:• Monetary multiplier = 1/required reserve ratio or m = 1/R or

1/.20 in our example.

LO2


• Maximum deposit expansion possible is equal to: excess reserves x monetary multiplier. Figure 35.1 illustrates this process.

• Higher reserve ratios generate lower money multipliers.• a. Changing the money multiplier changes the money

creation potential.• b. Changing the reserve ratio changes the money multiplier

but be careful! It also changes the amount of excess reserves that are acted on by the multiplier. Cutting the reserve ratio in half will more than double the deposit creation potential of the system.

• The process is reversible. Loan repayment destroys money, and the money multiplier increases that destruction.

LO2


• The fundamental objective of monetary policy is to aid the economy in achieving full‑employment output with stable prices.• 1. To do this, the Fed changes the nation’s money supply.• 2. To change money supply, the Fed manipulates size of excess

reserves held by banks.

• Monetary policy has a very powerful impact on the economy; Ben Bernanke, the head of the U.S. Federal Reserve System, and Jean-Claude Trichet, the president of the European Central Bank, are often listed as among the most powerful people in the world.

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• The Demand for Money: Two Components• A. Transactions demand, Dt, is money kept for purchases

and will vary directly with GDP (Key Graph 36.1a).• B. Asset demand, Da, is money kept as a store of value for

later use. Asset demand varies inversely with the interest rate, since that is the price of holding idle money (Key Graph 36.1b).

• C. Total demand will equal quantities of money demanded for assets plus that for transactions (Key Graph 36.1c).

LO2

Demand for MoneyR

ate

of

inte

rest

, i p

erce

nt

10

7.5

5

2.5

050 100 150 200 50 100 150 200 50 100 150 200 250 300

Amount of moneydemanded(billions of dollars)

Amount of moneydemanded(billions of dollars)

Amount of moneydemanded and supplied(billions of dollars)

=+

(a)Transactionsdemand formoney, Dt

(b)Assetdemand formoney, Da

(c)Totaldemand formoney, Dm

and supply

Dt Da Dm

Sm

5

LO1


• The Equilibrium Interest Rate and Bond Prices• A. Key Graph 36.1c illustrates the money market. It

combines demand with supply of money.• B. If the quantity demanded exceeds the quantity

supplied, people sell assets like bonds to get money. This causes bond supply to rise, bond prices to fall, and a higher market rate of interest.

• C. If the quantity supplied exceeds the quantity demanded, people reduce money holdings by buying other assets like bonds. Bond prices rise, and lower market rates of interest result (see example in text).

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• Tools of Monetary Policy• A. Open‑market operations refer to the Fed’s buying and

selling of government bonds.• 1. Buying securities will increase bank reserves and the

money supply (see Figure 36.2)• a. If the Fed buys directly from banks, then bank reserves go

up by the value of the securities sold to the Fed. See impact on balance sheets using text example.

• b. If the Fed buys from the general public, people receive checks from the Fed and then deposit the checks at their bank. Bank customer deposits rise and therefore bank reserves rise by the same amount. Follow text example to see the impact.• i. Banks’ lending ability rises with new excess reserves.• ii. Money supply rises directly with increased deposits by the public.LO2

Tools of Monetary Policy

• Fed buys bonds from commercial banks

Assets Liabilities and Net Worth

Federal Reserve Banks

+ Securities + Reserves of Commercial Banks

(b) Reserves

Commercial Banks

-Securities (a)

+Reserves (b)


LO2

(a) Securities

Tools of Monetary Policy

• Fed sells bonds to commercial banks


Federal Reserve Banks

- Securities - Reserves of Commercial Banks

Commercial Banks

+ Securities (a)

- Reserves (b)


(a) Securities (b) Reserves

LO2

Open Market Operations

• Fed buys $1,000 bond from a commercial bank

New Reserves

$5000Bank System Lending

Total Increase in the Money Supply, ($5,000)

$1000ExcessReserves

LO2

Open Market Operations

• Fed buys $1,000 bond from the public

Check is DepositedNew Reserves

$1000

Total Increase in the Money Supply, ($5000)

$200RequiredReserves

$800ExcessReserves

$1000InitialCheckableDeposit

$4000Bank System Lending

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• When Fed buys bonds from bankers, reserves rise and excess reserves rise by same amount since no checkable deposit was created.

• When Fed buys from public, some of the new reserves are required reserves for the new checkable deposits.

• Conclusion: When the Fed buys securities, bank reserves will increase and the money supply potentially can rise by a multiple of these reserves.

• Note: When the Fed sells securities, points a‑e above will be reversed. Bank reserves will go down, and eventually the money supply will go down by a multiple of the banks’ decrease in reserves.

LO2


• How the Fed attracts buyers or sellers:• i. When Fed buys, it raises demand and price of bonds, which

in turn lowers effective interest rate on bonds. The higher price and lower interest rates make selling bonds to Fed attractive.

• ii.When Fed sells, the bond supply increases and bond prices fall, which raises the effective interest rate yield on bonds. The lower price and higher interest rates make buying bonds from Fed attractive.

LO2


• B. The reserve ratio is another “tool” of monetary policy. It is the fraction of reserves required relative to their customer deposits.

• 1. Raising the reserve ratio increases required reserves and shrinks excess reserves. Any loss of excess reserves shrinks banks’ lending ability and, therefore, the potential money supply by a multiple amount of the change in excess reserves.

• Lowering the reserve ratio decreases the required reserves and expands excess reserves. Gain in excess reserves increases banks’ lending ability and, therefore, the potential money supply by a multiple amount of the increase in excess reserves.

LO2


• Changing the reserve ratio has two effects.• a. It affects the size of excess reserves.• b. It changes the size of the monetary multiplier. For

example, if ratio is raised from 10 percent to 20 percent, the multiplier falls from 10 to 5.

• Changing the reserve ratio is very powerful since it affects banks’ lending ability immediately. It could create instability, so Fed rarely changes it.

LO2


• C: The third “tool” is the discount rate, which is the interest rate that the Fed charges to commercial banks that borrow from the Fed.

• An increase in the discount rate signals that borrowing reserves is more difficult and will tend to shrink excess reserves.

• A decrease in the discount rate signals that borrowing reserves will be easier and will tend to expand excess reserves.

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• For several reasons, open‑market operations give the Fed most control of the four “tools.”

• Open‑market operations are most important. This decision is flexible because securities can be bought or sold quickly and in great quantities. Reserves change quickly in response.

• The reserve ratio is rarely changed since this could destabilize bank’s lending and profit positions.

• Changing the discount rate has become a passive tool of monetary policy. During the financial crisis of 07- 08, banks borrowed billions as the discount rate was decreased by the Fed.

LO2

Monetary Policy and Equilibrium GDP

10

8

6

0

Rat

e o

f In

tere

st, i

(P

erce

nt)

Amount of moneydemanded and supplied(billions of dollars)

Amount of investment (billions of dollars)

Pri

ce

Le

ve

l

Real GDP(billions of dollars)

Q1 Qf Q3$125 $150 $175 $15 $20 $25

P2

P3

Sm1 Sm2 Sm3

Dm

IDAD1

I=$15

AD2

I=$20

AD3

I=$25

(a)The marketfor money

(b)Investmentdemand

(c)Equilibrium realGDP and thePrice level

AS

LO4

Pri

ce

Le

ve

l

Real GDP(billions of dollars)

Q1 Qf Q3

P2

P3

AD1

I=$15

AD2

I=$20

AD3

I=$25

(c)Equilibrium realGDP and thePrice level

AS

Pri

ce

Le

ve

lReal GDP(billions of dollars)

Q1 Qf Q3

P2

P3

AD1

I=$15

AD2

I=$20

AD3

I=$25

(d)Equilibrium realGDP and thePrice level

AS

abc

AD4

I=$22.5

Monetary Policy and Equilibrium GDP

LO4

Expansionary Monetary Policy

Problem: Unemployment and Recession

Fed buys bonds, lowers reserve ratio, lowers the discount rate, or increases reserve auctions

Excess reserves increase

Federal funds rate falls

Money supply rises

Interest rate falls

Investment spending increases

Aggregate demand increases

Real GDP risesLO4

CA

US

E-E

FF

EC

T C

HA

IN

Restrictive Monetary Policy

Problem: Inflation

Fed sells bonds, increases reserve ratio, increases the discount rate, or decreases reserve auctions

Excess reserves decrease

Federal funds rate rises

Money supply falls

Interest rate rises

Investment spending decreases

Aggregate demand decreases

Inflation declines

CA

US

E-E

FF

EC

T C

HA

IN

LO4


• Targeting the Federal Funds Rate • The Federal funds rate is the interest rate that banks charge

each other for overnight loans.• Banks lend to each other from their excess reserves, but

because the Fed is the only supplier of Federal funds (the currency used as reserves), it can set the Federal funds rate and then use open-market operations to make sure that rate is achieved.

• 1. The Fed will increase the availability of reserves if it wants the Federal funds rate to fall (or keep it from rising).

• 2. Reserves will be withdrawn if the Fed wants to raise the Federal funds rate (or keep it from falling).

LO2


• Targeting the Federal Funds Rate • The Fed may use an expansionary monetary policy if the

economy is experiencing a recession and rising rates of unemployment.

• Restrictive monetary policy is used to combat rising inflation.• 1. The initial step is for the Fed to announce a higher target

for the Federal funds rate, followed by the selling of bonds to soak up reserves. Raising the reserve ratio and/or discount rate is also an option.

• 2. Reducing reserves will produce results opposite of what we saw for an expansionary monetary policy.

LO2


• a. The reduced supply of Federal funds will raise the Federal funds rate to the new target.

• b. Multiple contraction of the money supply, through the money multiplier process (Chapter 35).

• 3. Restrictive monetary policy results in higher interest rates, including the prime rate.

LO2

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34 McGraw-Hill/IrwinCopyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Money,...

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