copyright 2008 the mcgraw-hill companies 12-1 12-14 money and banking

Copyright 2008 The McGraw-Hill Companies12-1

12-14

Money andBanking


Learning objectives In this chapter students will learn:In this chapter students will learn:

A.A. About the functions of money and the components of the money supply.About the functions of money and the components of the money supply.B.B. What “backs” the money supply, making us willing to accept it as payment.What “backs” the money supply, making us willing to accept it as payment.C.C. The makeup of the Central bank and the banking system.The makeup of the Central bank and the banking system.D.D. The functions and responsibilities of the Central Bank. The functions and responsibilities of the Central Bank. E.E. Why the banking system is called a “fractional reserve” system.Why the banking system is called a “fractional reserve” system.F.F. The distinction between a bank’s actual reserves and its required reserves.The distinction between a bank’s actual reserves and its required reserves.G.G. How a bank can create money through granting loans.How a bank can create money through granting loans.H.H. About the multiple expansion of loans and money by the entire banking About the multiple expansion of loans and money by the entire banking system.system.I.I. What the monetary multiplier is and how to calculate it.What the monetary multiplier is and how to calculate it.J. J. How the equilibrium interest rate is determined in the market for money.How the equilibrium interest rate is determined in the market for money.K. K. The goals and tools of monetary policy.The goals and tools of monetary policy.L.L. About the Federal funds rate and how the Fed controls it.About the Federal funds rate and how the Fed controls it.M.M. The mechanisms by which monetary policy affects GDP and the price level.The mechanisms by which monetary policy affects GDP and the price level.N.N. The effectiveness of monetary policy and its shortcomings.The effectiveness of monetary policy and its shortcomings.


Functions of Money1.1. Medium of exchange:Medium of exchange: Money can be used for buying and Money can be used for buying and

selling goods and services. This way it:selling goods and services. This way it:– Allows the economy to escape the complications of Allows the economy to escape the complications of barterbarter– Allows the society to gain the advantages of Allows the society to gain the advantages of geographicgeographic and and humanhuman

specializationspecialization

2.2. Unit of account:Unit of account: Prices are quoted in KDs and filses. Prices are quoted in KDs and filses.– Measure of the Measure of the relative worthrelative worth of a wide variety of goods, services of a wide variety of goods, services

and resources. Just as distance is measured by meters, value is and resources. Just as distance is measured by meters, value is measured by money.measured by money.

– Price of a commodity needs only to be stated in terms of Price of a commodity needs only to be stated in terms of moneymoney, not , not in terms of other commoditiesin terms of other commodities

– It also permits to define debt obligations, taxes owed and calculate It also permits to define debt obligations, taxes owed and calculate GDPGDP


Functions of Money

3.3. Store of value:Store of value: Money allows us to transfer purchasing Money allows us to transfer purchasing power from present to future. power from present to future.

• Money is preferred as a convenient way to Money is preferred as a convenient way to store valuestore value because it is the most because it is the most liquidliquid asset. asset.

• There is a There is a negativenegative relationship between the purchasing relationship between the purchasing power of money and price level.power of money and price level.


Components of the Money Supply

• M1 (Narrow definition)M1 (Narrow definition)

1.1. CurrencyCurrency (coins and paper money) in the hands of the public (coins and paper money) in the hands of the public (this is a (this is a debtdebt on government) on government)

• CoinsCoins: the : the “small change”“small change” of money supply, they constitute a of money supply, they constitute a small percentage of M1. All coins are “small percentage of M1. All coins are “token moneytoken money”, i.e., the ”, i.e., the intrinsic or the value of metal contained in the coin is less intrinsic or the value of metal contained in the coin is less than its face value, otherwise the public will melt it downthan its face value, otherwise the public will melt it down

• Paper moneyPaper money: banknotes issued by the central bank with the : banknotes issued by the central bank with the authorization of the law (authorization of the law (legal moneylegal money).).

2.2. All checkable depositsAll checkable deposits in banks or thrift institutions (this is a in banks or thrift institutions (this is a debtdebt on commercial banks and saving institutions). on commercial banks and saving institutions). Checkable deposits are the largest component of M1. Checkable deposits are the largest component of M1.


Components of the Money Supply

Advantages of checkable deposits: Advantages of checkable deposits: • SafetySafety• ConvenienceConvenience

• Institutions that offer checkable deposits:Institutions that offer checkable deposits:- Commercial banksCommercial banks- Saving and loan associations, mutual saving banks, and credit unions. Saving and loan associations, mutual saving banks, and credit unions.

These are called These are called thrift institutionsthrift institutions..


Components of the Money Supply• Money Supply M2Money Supply M2

Includes M1 plus near monies (Quasi money). Includes M1 plus near monies (Quasi money).

Near or Quasi money includes:Near or Quasi money includes:

- Saving depositsSaving deposits

- Time depositsTime deposits

• Money Supply M3Money Supply M3

Includes M2 plus deposits with other non-bank financial Includes M2 plus deposits with other non-bank financial institutions. There is a minor difference between M2 and M3 institutions. There is a minor difference between M2 and M3 in Kuwait.in Kuwait.


What “backs” the money supply?• Money is essentially Money is essentially backedbacked by the government’s by the government’s abilityability to to

keep its value stable provides the backing. The government keep its value stable provides the backing. The government manages money to provide the amount needed to:manages money to provide the amount needed to:- Achieve full employmentAchieve full employment- Price level stabilityPrice level stability- Economic growthEconomic growth

• Money is debtMoney is debt; paper money is a debt of the Central Banks and checkable ; paper money is a debt of the Central Banks and checkable deposits are liabilities of banks and thrifts because depositors own them.deposits are liabilities of banks and thrifts because depositors own them.

The value of moneyThe value of money• Value of moneyValue of money arises arises notnot from its from its intrinsicintrinsic value. The central value. The central

bank will not redeem currency for any tangible assets (e.g., bank will not redeem currency for any tangible assets (e.g., gold), but its value arises from its use in gold), but its value arises from its use in exchangingexchanging for goods for goods and services. and services.

• What gives money its value:What gives money its value:1.1. acceptability:acceptability: It is acceptable as a medium of exchange.It is acceptable as a medium of exchange.


What “backs” the money supply?2.2. Legal tender:Legal tender: Currency is Currency is legal tenderlegal tender or fiat money. In or fiat money. In

general, it must be accepted in repayment of debt, but that general, it must be accepted in repayment of debt, but that doesn’t mean that private firms and government are doesn’t mean that private firms and government are mandated to accept cash; alternative means of payment may mandated to accept cash; alternative means of payment may be required. (Note that checks are not legal tender but, in fact, be required. (Note that checks are not legal tender but, in fact, are generally acceptable in exchange for goods, services, and are generally acceptable in exchange for goods, services, and resources. Legal cases have essentially determined that resources. Legal cases have essentially determined that pennies are not legal tender.)pennies are not legal tender.)

3.3. The relative scarcity of moneyThe relative scarcity of money: Compared to goods and : Compared to goods and services will allow money to retain its purchasing power.services will allow money to retain its purchasing power.


What “backs” the money supply?• Money’s purchasing power determines its value. Higher prices Money’s purchasing power determines its value. Higher prices

mean less purchasing power. mean less purchasing power. - The purchasing power of money:The purchasing power of money: is the amount a KD will buy. is the amount a KD will buy.

It varies inversely with the It varies inversely with the price levelprice level. Hence . Hence

KDKDvaluevalue = 1/P = 1/PIf price increased from 100 to 120, the value of KD will be If price increased from 100 to 120, the value of KD will be 83.33 (1/120), a 20% increase in price level lowers the value of 83.33 (1/120), a 20% increase in price level lowers the value of the dollars by 16.67%. the dollars by 16.67%.

• Inflation and acceptability:Inflation and acceptability:• Excessive inflationExcessive inflation may make money worthless and may make money worthless and

unacceptable. An extreme example of this was unacceptable. An extreme example of this was GermanGerman hyperinflationhyperinflation after World War I, which made the mark after World War I, which made the mark worth less than 1 billionth of its former value within a four-worth less than 1 billionth of its former value within a four-year period.year period.


What “backs” the money supply?• Worthless money leads to use of other currencies that are Worthless money leads to use of other currencies that are

more stable. more stable. • Worthless money may lead to barter exchange system.Worthless money may lead to barter exchange system.

Maintaining the value of moneyMaintaining the value of money• The government tries to keep supply stable with appropriate The government tries to keep supply stable with appropriate

fiscal policy.fiscal policy.• Monetary policy tries to keep money relatively scarce to Monetary policy tries to keep money relatively scarce to

maintain its purchasing power, while expanding enough to maintain its purchasing power, while expanding enough to allow the economy to grow.allow the economy to grow.


CHAPTER THIRTEENCHAPTER THIRTEENMONEY CREATIONMONEY CREATION


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

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

• Three simplifying assumptions:Three simplifying assumptions:1.1. Required reserve ratio assumed to be Required reserve ratio assumed to be 20 percent20 percent. . 2.2. Initially banks have Initially banks have no excessno excess reservesreserves; they are ; they are

“loaned up.”“loaned up.”3.3. When banks have excess reserves, they loan it all to When banks have excess reserves, they loan it all to

one borrowerone borrower, who writes check for entire amount to , who writes check for entire amount to give to give to someone elsesomeone else, who deposits it at , who deposits it at another another bank.bank. The check clears against original lender. The check clears against original lender.


The Banking System

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 Monetary MultiplierMonetary Multiplier or Checkable-Deposit Monetary Multiplier or Checkable-Deposit

MultiplierMultiplier

MonetaryMultiplier =

1

Required Reserve Ratio

or in Symbols… m =1

RNew Reserves

$100$20

RequiredReserves

$80Excess

Reserves

$100Initial

Deposit

$400Bank System Lending

Money Created

GraphicExample



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

Monetary multiplier is illustrated in Table 13.2.Monetary multiplier is illustrated in Table 13.2.1.1. Formula for monetary or checkable deposit multiplier is:Formula for monetary or checkable deposit multiplier is:

Monetary multiplier = 1/required reserve ratio or m = 1/R Monetary multiplier = 1/required reserve ratio or m = 1/R or 1/.20 in our example.or 1/.20 in our example.

2.2. Maximum deposit expansion possible is equal to: excess Maximum deposit expansion possible is equal to: excess reserves reserves ×× monetary multiplier, or monetary multiplier, or



• Figure 13.1 illustrates this process.Figure 13.1 illustrates this process.• Higher reserve ratios generate lower money multipliers.Higher reserve ratios generate lower money multipliers.• a. Changing the money multiplier changes the money a. Changing the money multiplier changes the money

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

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

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


CHAPTER FOURTEEN: CHAPTER FOURTEEN: MONETARY POLICYMONETARY POLICY


The Demand for Money: Two Components

1.1. Transactions demandTransactions demand, Dt, is money kept for , Dt, is money kept for purchases and will vary directly with GDP (Figure purchases and will vary directly with GDP (Figure 14.1a).14.1a).

2.2. Asset demandAsset demand, Da, is money kept as a store of value , Da, is money kept as a store of value for later use. Asset demand varies inversely with the for later use. Asset demand varies inversely with the interest rate, since that is the price of holding idle interest rate, since that is the price of holding idle money (Figure 14.1b).money (Figure 14.1b).

3.3. Total demandTotal demand, equal quantities of money demanded , equal quantities of money demanded for assets plus that for transactions (Figure 14.1c).for assets plus that for transactions (Figure 14.1c).


Interest RatesDemand for Money and the Money Market

Ra

te o

f In

tere

st,

I p

erc

en

t

10

7.5

5

2.5

0 50 100 150 200 50 100 150 200 50 100 150 200 250 300

Amount of MoneyDemanded

(Billions of Dollars)

Amount of MoneyDemanded


Amount of MoneyDemanded and Supplied


=+

(a)TransactionsDemand forMoney, Dt

(b)Asset

Demand forMoney, Da

(c)Total

Demand forMoney, Dm

And Supply

Dt Da Dm

Sm

5


Interest RatesDemand for Money and the Money Market

50 100 150 200 250 300Amount of Money

Demanded and Supplied(Billions of Dollars)

Dm

Sm

5

Buy assets

Sell assets


The Market for Money: Interaction of Money Supply and Demand

• Key Graph 14.1c illustrates the money market. It Key Graph 14.1c illustrates the money market. It combines demand with supply of money.combines demand with supply of money.

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

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


Ra

te o

f in

tere

st,

i (p

erce

nt)

Amount of money demanded(billions of dollars)

0 50 100 150 200 250 300

10

7.5

5

2.5

0

Dm

ie

Sm

THE MONEY MARKETChanges in Money Supply

Suppose the moneysupply is decreasedfrom $200 billion, Sm,

to $150 billion Sm1.


Ra

te o

f in

tere

st,

i (p

erce

nt)


0 50 100 150 200 250 300

10

7.5

5

2.5

0

Dm

ie

Sm

A temporary shortageof money will requirethe sale of some assetsto meet the need.

Sm1

THE MONEY MARKET


Ra

te o

f in

tere

st,

i (p

erce

nt)


0 50 100 150 200 250 300

10

7.5

5

2.5

0

Dm

ie

Sm

THE MONEY MARKET

Suppose the moneysupply is increasedfrom $200 billion, Sm,

to $250 billion Sm2.


Ra

te o

f in

tere

st,

i (p

erce

nt)


0 50 100 150 200 250 300

10

7.5

5

2.5

0

Dm

ie

Sm Sm2

THE MONEY MARKET

A temporary surplusof money will requirethe purchase of someassets to meet the de-sired level of liquidity.


The Central Bank has Three Major “Tools” of Monetary Policy

1. Open‑market operations1. Open‑market operations refer to the central bank buying and selling of refer to the central bank buying and selling of government bonds.government bonds.

• Buying securities will increase bank reserves and the money supply (see Buying securities will increase bank reserves and the money supply (see Figure 14.2).Figure 14.2).

a.a. If the central bank buys directly from banks, then bank reserves go up If the central bank buys directly from banks, then bank reserves go up by the value of the securities sold to the central bank, Banks’ lending by the value of the securities sold to the central bank, Banks’ lending ability rises with new excess reserves. Money supply rises directly with ability rises with new excess reserves. Money supply rises directly with increased deposits by the public.increased deposits by the public.

b.b. b. If the central bank buys from the general public, people receive b. If the central bank buys from the general public, people receive checks from the central bank and then deposit the checks at their bank. checks from the central bank and then deposit the checks at their bank. Bank customer deposits rise and therefore bank reserves rise by the Bank customer deposits rise and therefore bank reserves rise by the same amount. same amount.

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


Tools of Monetary Policy

New Reserves$1000


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

Fed Buys $1,000 Bond from a Commercial Bank. RRR = 20%.

$1000Excess

Reserves


Tools of Monetary Policy

Check is DepositedNew Reserves

$1000

Total Increase in the Money Supply, ($5000)

Fed Buys $1,000 Bond from the Public. RRR = 20%.

$200RequiredReserves

$800Excess

Reserves

$1000Initial

CheckableDeposit



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

• RaisingRaising the reserve ratio increases required reserves and the reserve ratio increases required reserves and shrinks excess reserves. Loss of excess reserves shrinks banks’ shrinks excess reserves. Loss of excess reserves shrinks banks’ lending ability and the potential money supply by a multiple lending ability and the potential money supply by a multiple amount of the change in excess reserves.amount of the change in excess reserves.

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

• Changing the reserve ratio has two effects.Changing the reserve ratio has two effects.

a.a. It affects the size of excess reserves.It affects the size of excess reserves.

b.b. It changes the size of the monetary multiplier. For example, if It changes the size of the monetary multiplier. For example, if ratio is raised from 10 percent to 20 percent, the multiplier ratio is raised from 10 percent to 20 percent, the multiplier falls from 10 to 5.falls from 10 to 5.


3.3. The third “tool” is the discount rateThe third “tool” is the discount rate, which is the interest rate , which is the interest rate that the central bank charges to commercial banks that borrow that the central bank charges to commercial banks that borrow from the central bank.from the central bank.

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

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


Monetary Policy

10

8

6

0

Ra

te o

f In

tere

st,

i (

Pe

rce

nt)

Amount of MoneyDemanded and Supplied


Amount of Investment, I(Billions of Dollars)

Pri

ce

Le

ve

l

Real Domestic Product, 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)Investment

Demand

(c)Equilibrium Real

GDP and thePrice Level

Monetary Policy and Equilibrium GDP

AS


Monetary PolicyExpansionary Monetary PolicyProblem: Unemployment and Recession

Fed Buys Bonds, Lowers ReserveRatio, or Lowers the Discount Rate

Excess Reserves Increase

Money Supply Rises

Interest Rate Falls

Investment Spending Increases

Aggregate Demand Increases

Real GDP Rises

CA

US

E-E

FF

EC

T C

HA

IN


Monetary PolicyRestrictive Monetary PolicyProblem: Inflation

Fed Sells Bonds, Increases ReserveRatio, or Increases the Discount Rate

Excess Reserves Decrease

Money Supply Falls

Interest Rate Rises

Investment Spending Decreases

Aggregate Demand Decreases

Inflation Declines

CA

US

E-E

FF

EC

T C

HA

IN

copyright 2008 the mcgraw-hill companies 12-1 12-14 money and banking

Documents