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CHAPTER 4CHAPTER 4

The Money Supply andBanking System

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An Overview of Money

Money is anything that is generally accepted as a medium of exchange.

• Money is not income, and money is not wealth. Money is:

• a means of payment,

• a store of value, and

• a unit of account.

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What is Money?

Barter is the direct exchange of goods and services for other goods and services.

A barter system requires a double coincidence of wants for trade to take place. Money eliminates this problem.

As a medium of exchange, or means of payment, money is generally accepted by buyers and sellers as payment for goods and services.

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What is Money?

As a store of value, money serves as an asset that can be used to transport purchasing power from one time period to another.

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What is Money?

As a unit of account, money is a standard that provides a consistent way of quoting prices.

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Measuring the Supply ofMoney in the United States

M1, or transactions money is money that can be directly used for transactions.

M1 = currency held outside banks + demand deposits + traveler’s checks + other checkable deposits

M1 is a stock measure—it is measured at a point in time—on a specific day.

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Measuring the Supply ofMoney in the United States

M2, or broad money, includes near monies, or close substitutes for transactions money.M2 = M1 + savings accounts + money market accounts + other near monies

The main advantage of looking at M2 instead of M1 is that M2 is sometimes more stable.

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The Private Banking System

Financial intermediaries are banks and other financial institutions that act as a link between those who have money to lend and those who want to borrow money.

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The Modern Banking System

A brief review of accounting:

Assets – liabilities = Net Worth, or

Assets = Liabilities + Net Worth A bank’s most important assets are its loans. Other

assets include cash on hand (or vault cash) and deposits with the Fed.

A bank’s liabilities are its debts—what it owes. Deposits are debts owed to the bank’s depositors.

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The Modern Banking System

Reserves are the deposits that a bank has at the Federal Reserve bank plus its cash on hand.

The required reserve ratio is the percentage of its total deposits that a bank must keep as reserves at the Federal Reserve.

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T-Account for a Typical Bank

The balance sheet of a bank must always balance, so that the sum of assets (reserves and loans) equals the sum of liabilities (deposits and net worth).

T-Account for a Typical Bank (millions of dollars)

ASSETS LIABILITIES

Reserves 20 100 Deposits

Loans 90 10 Net worth

Total 110 110 Total

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The Creation of Money

Banks usually make loans up to the point where they can no longer do so because of the reserve requirement restriction (or up to the point where their excess reserves are zero).

e x c e s s r e s e r v e s a c t u a l r e s e r v e s r e q u i r e d r e s e r v e s≡ −

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The Creation of Money

When someone deposits $100 in a bank, and the bank deposits the $100 with the central bank, the bank has $100 in total reserves.

Balance Sheets of a Bank in a Single-Bank Economy

In Panel 2, there is an initial deposit of $100. In Panel 3, the bank has made loans of $400.

Panel 1 Panel 2 Panel 3

ASSETS LIABILITIES ASSETS LIABILITIES ASSETS LIABILITIES

Reserves 0 0 Deposits Reserves 100 100 Deposits Reserves 100 500 Deposits

Loans 400

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The Creation of Money

If the required reserve ratio is 20%, the bank has excess reserves of $80. With $80 of excess reserves, the bank can have up to $400 of additional deposits. The $100 in reserves plus $400 in loans equal $500 in deposits.

Balance Sheets of a Bank in a Single-Bank Economy

In Panel 2, there is an initial deposit of $100. In Panel 3, the bank has made loans of $400.

Panel 1 Panel 2 Panel 3

ASSETS LIABILITIES ASSETS LIABILITIES ASSETS LIABILITIES

Reserves 0 0 Deposits Reserves 100 100 Deposits Reserves 100 500 Deposits

Loans 400

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The Creation of MoneyThe Creation of Money When There Are Many Banks

Panel 1 Panel 2 Panel 3ASSETS LIABILITIES ASSETS LIABILITIES ASSETS LIABILITIES

Reserves 100 100 Deposits Reserves 100Loans 80

180 Deposits Reserves 20Loans 80

100 Deposits

Reserves 80 80 Deposits Reserves 80Loans 64

144 Deposits Reserves 16Loans 64

80 Deposits

Reserves 64 64 Deposits Reserves 64 115.20 Deposits Reserves 12.80 64 Deposits

.00500Total

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.2051Bank 464Bank 380Bank 2

100Bank 1DepositsSummary:

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The Money Multiplier

The money multiplier is the multiple by which deposits can increase for every dollar increase in reserves.

• In the example above, the required reserve ratio is 20%. Each dollar increase in reserves could cause an increase in deposits of $5 when there is no leakage out of the system. An additional $100 of reserves result in additional deposits of $500.

M o n e y m u l t i p l i e r =1

R e q u i r e d r e s e r v e r a t i o.00500Total

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.2051Bank 464Bank 3

80Bank 2

100Bank 1DepositsSummary:

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How the Federal ReserveControls the Money Supply

Three tools are available to the Fed for changing the money supply:

1. changing the required reserve ratio;

2. changing the discount rate; and

3. engaging in open market operations.

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The Required Reserve Ratio

The required reserve ratio establishes a link between the reserves of the commercial banks and the deposits (money) that commercial banks are allowed to create.

If the Fed wants to increase the money supply, the Fed can decrease the required reserve ratio, which allows the bank to create more deposits by making loans.

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The Required Reserve RatioA Decrease in the Required Reserve Ratio From 20 Percent to 12.5 Percent Increases the Supply of Money (All Figures in Billions of Dollars)

PANEL 1: REQUIRED RESERVE RATIO = 20%

Federal Reserve Commercial Banks

Assets Liabilities Assets Liabilities

Government $200 $100 Reserves Reserves $100 $500 Deposits

securities $100 Currency Loans $400

Note: Money supply (M1) = Currency + Deposits = $600.

PANEL 2: REQUIRED RESERVE RATIO = 12.5%

Federal Reserve Commercial Banks

Assets Liabilities Assets Liabilities

Government $200 $100 Reserves Reserves $100 $800 Deposits

securities $100 Currency Loans(+ $300)

$700 (+ $300)

Note: Money supply (M1) = Currency + Deposits = $900.

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The Discount Rate

The discount rate is the interest rate that banks pay to the Fed to borrow from it.

Bank borrowing from the Fed leads to an increase in the money supply. The higher the discount rate, the higher the cost of borrowing, and the less borrowing banks will want to do.

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The Discount RateThe Effect On the Money Supply of Commercial Bank Borrowing from the Fed (All Figures in Billions of Dollars)

PANEL 1: NO COMMERCIAL BANK BORROWING FROM THE FED

Federal Reserve Commercial Banks

Assets Liabilities Assets Liabilities

Securities $160 $80 Reserves Reserves $80 $400 Deposits

$80 Currency Loans $320Note: Money supply (M1) = Currency + Deposits = $480.

PANEL 2: COMMERCIAL BANK BORROWING $20 FROM THE FED

Federal Reserve Commercial Banks

Assets Liabilities Assets Liabilities

Securities $160 $100 Reserves(+ $20)

Reserves(+ $20)

$100 $500 Deposits(+ $300)

Loans $20 $80 Currency Loans(+ $100)

$420 $20 Amount owed to Fed (+ $20)

Note: Money supply (M1) = Currency + Deposits = $580.

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Open Market Operations

Open market operations is the purchase and sale by the Fed of government securities in the open market; a tool used to expand or contract the amount of reserves in the system and thus the money supply.

Open market operations is by far the most significant tool of the Fed for controlling the supply of money.

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The Mechanics ofOpen Market Operations

Open Market Operations (The Numbers in Parentheses in Panels 2 and 3 Show the Differences Between Those Panels and Panel 1. All Figures in Billions of Dollars)

PANEL 1Federal Reserve Commercial Banks Jane Q. Public

Assets Liabilities Assets Liabilities Assets LiabilitiesSecurities $100 $20 Reserves Reserves $20 $100 Deposits Deposits $5 $0 Debts

$80 Currency Loans $80 $5 Net WorthNote: Money supply (M1) = Currency + Deposits = $180.

PANEL 2Federal Reserve Commercial Banks Jane Q. Public

Assets Liabilities Assets Liabilities Assets LiabilitiesSecurities(− $5)

$95 $15 Reserves (− $5)

Reserves (− $5)

$15 $95 Deposits (− $5)

Deposits (− $5)

$0 $0 Debts

$80 Currency Loans $80 Securities(+ $5)

$5 $5 Net Worth

Note: Money supply (M1) = Currency + Deposits = $175.

PANEL 3Federal Reserve Commercial Banks Jane Q. Public

Assets Liabilities Assets Liabilities Assets Liabilities

Securities(− $5)

$95 $15 Reserves (− $5)

Reserves (− $5)

$15 $75 Deposits (− $25)

Deposits (− $5)

$0 $0 Debts

$80 Currency Loans(− $20)

$60 Securities(+ $5)

$5 $5 Net Worth

Note: Money supply (M1) = Currency + Deposits = $155.

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Open Market Operations

An open market purchase of securities by the Fed results in an increase in reserves and an increase in the supply of money by an amount equal to the money multiplier times the change in reserves.

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Open Market Operations

An open market sale of securities by the Fed results in a decrease in reserves and a decrease in the supply of money by an amount equal to the money multiplier times the change in reserves.

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Open Market Operations

Open market operations are the Fed’s preferred means of controlling the money supply because:

they can be used with some precision,

are extremely flexible, and

are fairly predictable.

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The Supply Curve for Money

Through open market operations, the Fed can have the money supply be whatever value it wants.

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