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Chapter 15 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 1
ECON
Designed byAmy McGuire, B-books, Ltd.
McEachern 2010-2011
15
CHAPTERBanking and the Money Supply
Macro
Chapter 15 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 2
Money Aggregates
LO1
Money aggregates Measure of money supply Defined by the Fed
M1 = Narrow definition of money Currency (including coins)
Nonbanking public Checkable deposits
Bank deposits Write checks to third parties
Traveler’s checks
Chapter 15 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 3
Money Aggregates
LO1
Currency = Fiat money Federal Reserve Notes
U.S. Bureau of Engraving and Printing
Issued by & Liabilities of 12 Federal Reserve Banks
60% - abroad Coins
U.S. Mint
Chapter 15 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 4
Money Aggregates
LO1
M2 = Broader definition of money M1 Savings deposits
Earn interest; no specific maturity date Small-denomination time deposits
Certificates of deposits, CDs Earn interest; specific maturity date
Money market mutual fund accounts Restrictions
Chapter 15 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 5
LO1
Measures of the Money Supply (February 2009)
Exhibit 1
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Money Aggregates
LO1
Credit cards Loan from the card issuer Repay later Dispute a charge Not part of money supply
Debit cards From checking account Part of M1
Chapter 15 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 7
How Banks Work
Banks earn profit Attract deposits from savers Lend to borrowers
Banks are financial intermediaries Reduce transaction costs Cope with asymmetric
information Reduce risk through
diversification
LO2
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Starting a Bank
Home Bank – obtains a charter Net worth = Owner’s equity
Shares of stock in the bank Balance sheet
Assets = Liabilities + Net worth Asset – owned by bank
Physical property Financial claim Stock in district Fed
Liabilities – owned by bank
LO2
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LO2
Home Bank’s Balance Sheet
Exhibit 2
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Home Bank’s Balance Sheet After $1,000,000 Deposit Into Checking Account
LO2 Exhibit 3
Chapter 15 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 11
Reserve Accounts
Required reserve Dollar amount
Must be held in reserve Required by Fed
Required reserve ratio Percentage of checkable deposits (10%)
Must be held in reserve Reserves (Earn no interest)
Cash in bank’s vault Deposits at the Fed
Excess reserves
LO2
Chapter 15 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 12
Liquidity vs. Profitability
Liquidity Ease to convert assets into cash Safety
Profitability Federal funds markets
Day-to-day lending and borrowing
Among banks Excess reserves on account at
the Fed Interest: federal funds rate
LO2
Chapter 15 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 13
How Banks Create Money
LO3
Creating money through excess reserves– Round one
• Fed buys $1,000 U.S. government bond
– Creates reserves• Money supply: +$1,000• Required reserves: +$100• Excess reserves: +$900
Chapter 15 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 14
Changes in Home Bank’s Balance Sheet After Fed Buys a $1,000 Bond from Securities
Dealer
LO3 Exhibit 4
Chapter 15 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 15
How Banks Create Money
LO3
Creating money through excess reserves– Round two
• $900 loan• Money supply: +$900• Required reserves: +$90• Excess reserves: +$810
Chapter 15 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 16
Changes in Home Bank’s Balance Sheet After Lending $900 to You
LO3 Exhibit 5
Chapter 15 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 17
How Banks Create Money
LO3
Creating money through excess reserves– Round three
• $810 loan• Money supply: +$810• Required reserves: +$81• Excess reserves: +$729
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Changes in Merchants Trust’s Balance Sheet After Lending $810 to English Major
LO3 Exhibit 6
Chapter 15 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 19
How Banks Create Money
LO3
Creating money through excess reserves– Round four and beyond
• Excess reserves – new loans• Required reserves: +10% of new
checkable deposits– Excess reserve – maximum amount
for loans– Money supply expansion
Chapter 15 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 20
How Banks Create Money
LO3
Creating money through excess reserves A summary of rounds
– Fed: $1,000 injection in fresh reserves– Increased excess reserves– Money supply increase: Up to $10,000
• Checkable deposits– Banking system
• Eliminates excess reserves– Expand money supply
Chapter 15 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 21
Summary of the Money Creation Resulting from the Fed’s Purchase of
$1,000 U.S. Government Bond
LO3 Exhibit 7
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Reserve Requirements & Money Expansion
LO3
Assumptions– No bank holds excess
reserves– Borrowed funds don’t
sit idle– People don’t want to
hold more cash
Chapter 15 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 23
Reserve Requirements & Money Expansion
LO3
Required reserve ratio = r Money multiplier Simple money multiplier = 1/r Change in the money supply = Change in
fresh reserves × 1/r
Chapter 15 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 24
Limitations of Money Expansion
LO3
Leakages from expansion– Smaller money multiplier– Cash – preferred to checking accounts
• People hold money• Fewer excess reserves
Chapter 15 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 25
Multiple Contraction ofMoney Supply
LO3
The Fed sells a $1,000 bond– Money supply: -$1,000– Required reserves: -$900– Recall loans– Money supply: -$900– Required reserves: -$810– Maximum effect
• Decrease money supply = Original decrease in reserve requirements × 1/r
Chapter 15 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 26
The Fed’s Tools of Monetary Control
LO4
Open-market operations– Buy/sell U.S. government bonds
The discount rate– Interest rate, the Fed– For loans made to banks
The required reserve ratio– Minimum fraction of reserves
Chapter 15 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 27
Open-Market Operations
LO4
Increase money supply– The Fed buys U.S. bonds
• Open-market purchase Reduce money supply
– The Fed sells U.S. bonds• Open-market sale
Chapter 15 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 28
Open-Market Operations
LO4
Tool of choice for the Fed Influences bank reserves Influences federal funds rate
– Interest rate– Borrowing among banks– Of excess reserves at the
Fed
Chapter 15 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 29
The Discount Rate
LO4
Discount rate– Interest rate charged by the Fed– Loans to banks
Bank borrow ‘Discount window’– Satisfy reserve requirements
The Fed– Lender of last resort
Chapter 15 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 30
The Discount Rate
LO4
Primary discount rate Secondary discount rate Signal to financial markets
– Monetary policy Emergency tool
– Injecting liquidity
Chapter 15 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 31
Reserve Requirements
LO4
Required reserve ratio Money creation for each dollar of
fresh reserves Disruptive
– Banking system
Chapter 15 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 32
Coping with Financial Crisis
LO4
Regulation of financial markets Prevents major disruptions and
financial panics Sufficient liquidity
– Financial system
Chapter 15 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 33
The Fed Is a Money Machine
LO4
Assets– U.S. government bonds, 24%
– Earns interest Liabilities
– Federal Reserve notes, 43%– Fed pays no interest
The Fed is a money machine– Supplies Federal Reserve notes– Main asset: earns interest– Main liability: no interest payment
Chapter 15 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 34
Federal Reserve Bank Balance Sheet as of April 1, 2009 (Billions)
LO4 Exhibit 8