lecture 10 money and the banking system & monetary policy

Lecture 10

Money and the Banking System

&

Monetary Policy

Overview

• Why are Banks so Heavily Regulated?• Nature of Money• How Quantity of Money is Measured• Banking System• Origins of the Money Supply• Banks & Money Creation• Why the Money Creation Multiplier is

Oversimplified• Need for Monetary Policy

Why are Banks so Heavily Regulated?

• Major “output” of banking industry is the nation’s MS --important determinant of AD.

• 1. Bank managers are paid to max shareholder value & not what is in the best interests of the economy.– Gov does not allow banks to determine MS & interest

rates strictly on profit considerations.

• 2. Concern for the safety of depositors– If banks are allowed to fail, then depositors would lose

their money whenever one went bankrupt.– “Run on a bank:” if depositors get nervous, they may all

rush to cash their accounts which causes the bank to fail. This is highly contagious! 3

Bank failures in the United States, 1915–2009

Figure 1 (a)

4

Bank failures have been less common since 1930s –until recently.

Bank failures in the United States, 1915–2009

Figure 1 (b)

5

‘09

The Nature of Money

• Barter– System of exchange where people directly

trade goods for goods without using money as an intermediate step

– Requires: “double coincidence of wants”

• Money– Greases the wheels of exchange & makes the

whole economy more productive• Dramatically reduces search costs under a barter

system

6

The Nature of Money

• What is Money?– Medium of exchange

• Standard object used in exchanging goods & services

– Unit of account• Standard unit used for quoting prices

– Store of value• Store wealth from one point in time to

another– Money is not a good hedge against inflation!

7

The Nature of Money

• What Serves as Money?– Commodity money

• An object (like cattle, stones, cigarettes, gold) used as a medium of exchange that also has substantial value in alternative uses

– Paper money = Fiat money• Decreed as money by gov & has little value

as a commodity• Maintains its value as a medium of exchange

because people have faith that the issuer will back the paper & limit its production

8

How Quantity of Money is Measured

• One measure of MS: M1– Narrowly defined– Includes coins, paper money, traveler’s checks,

conventional checking accounts, & certain other checkable deposits in banks & savings institutions

– M1 = $1,693 billion in 2009

9


• Another measure of MS: M2– Broadly defined– Includes M1 plus money market deposit

accounts, money market mutual funds, & savings accounts

– M2 = $8,524 billion in 2009– Everything in M1 is completely “liquid.”

• Liquidity refers to the ease with which an asset can be converted into cash.

10


• Credit cards are not included in MS

– How much money does your credit card represent?

• Should we count what you owe or your available credit?

• We will stick with a conventional definition of money– Coins, paper money, & checkable deposits

11

The Banking System

• Fractional reserve banking – is a system under which bankers keep as

reserves only a fraction of the funds they hold on deposit

• Features

– Bank profitability• Banks get deposits at zero interest & lend

some of them out at positive interest rates.

12

The Banking System• Features (cont.)

– Bank discretion over money supply• Create money by keeping only a fraction of

their total deposits on reserve & lending out the balance

• Bankers’ decisions on how much to hold in reserves influence the supply of money

– Exposure to bank runs• Danger of a run on the bank has induced

bankers to keep prudent reserves & lend out money carefully

The Banking System

• Banking is an inherently risky business– Safe only by cautious & prudent management– Recent events (e.g., subprime mortgage

meltdown) showed that bank managers were neither cautious nor prudent. Why?

– Caution is not the road to high profits• Max profits by keeping low reserves & earning high

interest rates on risky borrowers

– Banks need to strike a balance between the lure of profits & the need for safety

14

The Banking System

• Bank regulations

• Deposit insurance - guarantees the safety of bank deposits– FDIC

• Established in 1933 –reduced the # of bank failures• Your account is insured up to $250,000• Prevents bank runs

– Moral hazard problem• If depositors are freed from risk of loss from a failing

bank, then they will not shop around for safer banks.• People who are insured against the consequences of

risk will engage in riskier behaviors. 15

The Banking System

• Bank regulations (cont.)• Bank supervision

– Various regulatory authorities conduct periodic bank examinations

– Laws & regulations limit the kinds & qualities of assets in which banks may invest

• Reserve requirements– Minimum amount of reserves

• Proportional to volume of deposits• Not really for safety but to control the MS

The Origins of the Money Supply• Asset of a bank: item of value that is owned by the

bank (e.g., bank building or loan) • Liability of a bank: item of value that the bank

owes (e.g., your bank balance)• Balance sheet: is an accounting statement

• Left side: lists values of all assets• Right side: values of all liabilities & net worth

– Net worth = value of assets – value of liabilities– Assets = Liabilities + Net worth

17

Balance sheet of Bank-a-mythica,

December 31, 2007

Table 1

18

Assets Liabilities and Net Worth

AssetsReservesLoans outstandingTotalAddendum: Bank ReservesActual reservesRequired reservesExcess reserves

$1,000,000$4,500,000$5,500,500

$1,000,000$1,000,000 0

LiabilitiesChecking deposits

Net WorthStockholder’s equityTotal

$5,000,000

$500,000 $5,500,000

Example of a balance sheet. Bank has only two kinds of assets: $1M in cash reserves & $4.5M in outstanding loans. One kind of liability: $5M in checking deposits. Net worth = total assets – total liabilities = $500,000.

Banks and Money Creation

• Our goal is to understand the process of deposit creation.– Fractional reserve banking system can turn $1

of bank reserves into several dollars of bank deposits

• Excess reserves– Any reserves held in excess of the legal

minimum– Earn no interest so banks typically want to keep

excess reserves at zero

19

Changes in Bank-a-mythica’s balance sheet,

January 2, 2008

Table 2

20


Reserves Addendum: Changes in ReservesActual reservesRequired reservesExcess reserves

+$100,000

+$100,000+$ 20,000 +$ 80,000

Checking deposits +$100,000

Eccentric widower deposits $100,000 in cash into a checking deposit. The bank has $100,000 more in cash reserves & in checking deposits. Assuming the required reserve ratio is 20%, the bank now has excess reserves of $80,000.


January 3–6, 2008

Table 3

21


Loans outstandingReserves Addendum: Changes in ReservesActual reservesRequired reservesExcess reserves

+$80,000-$80,000

-$80,000

No change-$80,000

No change

Bank earns 0% interest on the excess reserves, so it will make a loan of $80,000 to Hard-Pressed Construction Co. Loans rise by $80,000 & cash reserves fall by $80,000.


January 2–6, 2008

Table 4

22


ReservesLoans outstanding Addendum: Changes in ReservesActual reservesRequired reservesExcess reserves

+$20,000+$80,000

+$20,000+$20,000 No change


Combine Tables 2 & 3 to show the bank’s transactions. Checking deposits are up by $100,000, reserves are up by $20,000, loans are up by $80,000.

Money creation has begun! $100,000 in cash deposits has turned into $100,000 in checking deposits + $80,000 loan (which was probably deposited in another bank by Hard-Pressed). So the original $100,000 deposit is now $180,000.

Changes in First National Bank’s balance sheet

Table 5

23



+$16,000+$64,000

+$16,000+$16,000 No change


Hard-Pressed banks at First National & deposits the $80,000 loan from BAM. First National’s reserves rise by $80,000 & it loans out the excess reserves of $64,000 to Al’s Auto Shop.

Now $244,000 worth of money is circulating = $100,000 initial deposit + $80,000 (loan & deposit of Hard-Pressed) + $64,000 (loan & presumed deposit of Al).

Changes in Second National Bank’s balance sheet

Table 6

24



+$12,800+$51,200

+$12,800+$12,800 No change


Al deposits the $64,000 loan from FN to his bank, Second National. Second National now has $51,200 in excess reserves which it will loan out. And the money creation process continues…


• Assumptions of our money creation process– Each bank holds exactly 20% required reserves– Each loan recipient re-deposits proceeds in the

next bank

• Sum of infinite geometric progression

25

where R = 0.80

$100,000 + $80,000 + $64,000 + $51,200 + …

= $100,000 X 1/(1 – 0.80) = $100,000/(0.20) = $500,000

RRRR

11

...1 32

Figure 2. Chain of Multiple Deposit Creation

26

The initial deposit of $100,000 in cash is eventually absorbed in bank reserves (col. 1), leading to a total of $500,000 in new deposits (col. 2), & $400,000 in new loans (col. 3). Money supply rises by $400,000 because the nonbank public holds $100,000 less in currency & $500,000 more in checking deposits.


• Reserve ratio = m– R = 1-m– Deposits expand by 1/m of each $1 of new

reserves that are injected into the system

• Oversimplified money multiplier formula– ∆MS = (1/m) x ∆reserves

• Our example: ∆reserves = $100,000 x 1/0.20 = $500,000 but $500,000 is not the ∆MS because money includes both checking deposits & cash –which increases by only $400,000. There are $500,000 in new deposits but $100,000 less in cash.

27

Banks and Money Creation• Multiple contractions of MS

– Deposit destruction shown in Tables 7 & 8• Now the eccentric widower withdrawals $100,000

from his checking deposit at BAM & places it under his mattress.

• Decrease BAM’s reserves by $100,000– BAM needs $80,000 to meet its reserve requirement

• As outstanding loans are paid off it would cease granting new loans until the $80,000 is acquired

• Where did the borrowers get this $80,000? – Probably by making withdrawals from other banks

28


• Assume funds came from FNB which now loses $80,000 in deposits & $80,000 in reserves.

• It is now short $64,000 in reserves & must reduce its loan commitments by $64,000 as shown in Table 8.

• This reaction causes some other bank to suffer a loss of reserves & deposits of $64,000 & the whole process repeats.

• Overall, process looks like Figure 2 but with minus signs.– Deposits shrink by $500,000; loans fall by $400,000;

bank reserves fall by $100,000; & M1 falls by $400,000.

Changes in the balance sheet of Bank-a-mythica

Table 7

30

(a)


Reserves Addendum: Changes in ReservesActual reservesRequired reservesExcess reserves

-$100,000

-$100,000-$20,000 -

$80,000

Checking deposits -$100,000

(b)


Reserves Loans outstanding

Addendum: Changes in ReservesActual reservesRequired reservesExcess reserves

+$80,000-$80,000

+$80,000

No change+$80,000

No change

Changes in the balance sheet of First National Bank

Table 8

31

(a)


Reserves


-$80,000

-$80,000-$16,000 -

$64,000

Checking deposits -$80,000

(b)


Reserves Loans outstanding


+$64,000-$64,000

+$64,000

No change+$64,000

No change

Money-Creation Formula Is Oversimplified

• Oversimplified money multiplier is only accurate under very particular circumstances:

1. Every recipient of cash must redeposit the cash into another bank rather than hold it.

2. Every bank must hold reserves no larger than the legal minimum.

32

Money-Creation Formula Is Oversimplified

• If individuals & firms hold more cash, the multiple expansion of bank deposits is curtailed because fewer dollars of cash will be available for use as reserves to support checking deposits. So the MS will be smaller.

• If banks wish to keep excess reserves, the multiple expansion of bank deposits will be limited. A given amount of cash will support a smaller MS than would be the case if banks held no excess reserves.

33

The Need for Monetary Policy

• During a recession– Banks would reduce MS by increasing their

excess reserves & refusing to lend to less creditworthy applicants

• Tight credit deepens a recession• Need government intervention• During Great Depression, MS contracted violently

because banks held excess reserves rather than making loans that might not be repaid.

34

The Need for Monetary Policy

• During an economic boom– Banks would expand MS by keeping reserves at

a minimum & lending to firms when AD and profits are high

• Adds undesirable momentum to the economy & paves the way for inflation

• Need government intervention

35

Managing Aggregate Demand:

Monetary Policy

Overview

• Money & Income• Federal Reserve System• Open Market Operations• Other Methods of Monetary Control• How Monetary Policy Works• Money & the Price Level

Money and Income: Difference

• Money– At one point in time

• How much money do you have right now?• E.g., money stock (M1)

• Income– Over a period of time

• What is your income? (per month or per year)• E.g., nominal GDP per year

• Examine how interest rates and stock of money influence rate at which people earn income –or how monetary policy affects GDP

38

The Federal Reserve System

• Federal Reserve System “The Fed”– U.S. central bank

• Bank for banks

– Created in 1907• After four severe banking panics (1873-1907)

– 12 central banks• Each is a corporation whose stockholders are

member banks

– Immense profits go to U.S. Treasury

39


• (7 member) Board of Governors– Appointed by U.S. President

• Chairman serves a 4-year term• Most powerful central banker in the world

– Advice & consent of Senate

• The Fed– Independent

• Makes decisions without political interference

– Sets monetary policy

40


• Federal Open Market Committee (FOMC)– Determines short-term interest rates & size of

U.S. MS

– 12 voting members• 7 governors of the Fed• President of the NY Fed

• 4 (of remaining 11) district bank presidents – Meets 8 times a year in Washington– Very limited access to meetings; no press– Decisions are announced at the meeting’s end

41

Implementing Monetary Policy• Fed normally relies on open-market operations

to control interest rates– Fed’s purchase or sale of gov securities

• Open market operations either give banks more reserves or take reserves away from them, thereby triggering a multiple expansion in MS

• To see how open-market operations affect interest rates, we need to understand the market for bank reserves

42

Implementing Monetary Policy

• Market for bank reserves– (upward-sloping) Supply curve

• Fed decides how many dollars of reserves to supply– ∆Fed policy shifts the S curve

– (downward-sloping) Demand curve• Banks are required to hold reserves

– Required reserve ratio (m) = 0.10 in U.S.

• Reflects the demand for bank deposits– People hold bank deposits to conduct transactions

» GDP reflects the number of transactions & P level reflects the average price per transaction

– ∆GDP or ∆P level will shift the D curve

43

The market for bank reserves

Figure 1

44

Quantity of Bank Reserves

Inte

rest

Rat

e

S

SD

D

E

For given

Fed policy

For given

Y and P

∆Fed policy will shift the S curve

∆GDP or ∆P level will shift the D curve


• Market for bank reserves– Interest rate in Fig. 1 is the federal funds rate

• Interest rate that banks pay/receive when they borrow reserves from one another

– Banks lend or borrow from one another to maintain a desired level of reserves

– D (S) for reserves slopes downward (upward) because as interest rates rise borrowing (lending) becomes more expensive (attractive)

45

The effects of an open-market purchase

Figure 2

46

Quantity of Bank Reserves

Inte

rest

Rat

e

S0

S0

D

D

S1

S1

E

A

If Fed wants to lower federal funds rate, it provides additional reserves by purchasing T-Bills from banks. This shifts S curve outward.


• Table 1 shows the bookkeeping behind the Fed’s open-market purchase of $100m worth of T-Bills.

• Fed makes payment by giving banks $100m in new reserves.– These reserves are liabilities of Fed & assets of

banks.– Bank deposits have not increased so required

reserves are unchanged but actual reserves are $100m higher.

• Now banks have $100m in excess reserves.47

Effects of an open-market purchase of gov securities on the balance sheets of banks and the Fed

Table 1

48

Banks

Assets Liabilities

Federal Reserve System

Assets Liabilities

Reserves +$100 million

U.S. government

securities -$100 million

Addendum: Changes

in Reserves

Actual Reserves

+$100 million

Required Reserves

No Change

Excess Reserves

+$100 million

U.S. government

securities +$100 million

Bank Reserves

+$100 million

Bank gets Reserves

Fed gets securities


• Additional bank reserves can support a multiple expansion of MS.– Banks lend to rid themselves of excess

reserves.– Estimate ultimate ↑MS = $100m ∕ “m” = $500m

• If m = 0.20

• Difficult to estimate ultimate ↑MS because– People may want to hold more cash– Banks may want to hold excess reserves

• Oversimplified money multiplier assumes that neither is true.

49

Implementing Monetary Policy• Fed controls the federal funds rate directly by

buying just the right volume of securities.• Consider the case when Fed wants to increase

interest rates (contractionary monetary policy)– Fed sells T-Bills in the open market– Banks pay with reserves

• They draw down on their deposits at the Fed

– Banks acquire reserves by curtailing their lending

– Multiple contraction process ensues

50

Implementing Monetary Policy• Bond Prices & Interest Rates

– always move in the opposite direction

• Bonds (e.g., T-Bills) pay a fixed number of dollars of interest per year.– E.g., Bond pays $60/year. If P = $1,000 → interest

rate = 6%. If P = $1,200 → interest rate = 5%

– If ↑P of bond → ↓interest rate and vice versa.

51

Open-market purchases and treasury bill prices

Figure 3

52

Quantity of Treasury Bills

Pric

e of

a T

reas

ury

Bill

S0

S0

D

D

S1

S1

P0

P1A

B

Expansionary Monetary Policy: Fed buys T-Bills and S shifts in as number of T-Bills available to private investors falls. Price of T-Bills rises which lowers the interest rate.

Figure 3 is another way to understand how Fed open-market operations influence interest rates.


• Open-market purchase of T-Bills (expansionary monetary policy)– ↑MS → ↑P of T-bills → ↓interest rates

• Open-market sale of T-Bills (contractionary monetary policy)– ↓MS → ↓ P of T-bills → ↑interest rates

53

Other Methods of Monetary Control• Fed is a “lender of last resort”

– Occurred in summer & fall of 2007 when financial crisis made banks wary of lending

– In 2008, Fed also began lending to securities firms –not done since 1930s

• In Table 2, Fed loans $5m to a bank – Expands (actual & excess) reserves by $5m, which

should lead to an expansion of the MS

• Discount rate is the interest rate Fed charges on loans to banks– Fed can ↓discount rate to encourage banks to have

more reserves (occurred in 2007 & 2008)

54

Balance sheet changes for borrowing from the Fed

Table 2

55

Banks

Assets Liabilities

Federal Reserve System

Assets Liabilities

Reserves

+$5 million

Loan from

Fed +$5 million

Addendum:

Changes in

Reserves

Actual Reserves

+$5 million

Required

Reserves

No Change

Excess Reserves

+$5 million

Loan to

Bank +$5 million

Bank Reserves

+$5 million

And the proceeds are credited

to its reserve account

Bank borrows $5 million

Other Methods of Monetary Control

• Minimum required reserve ratio• Decrease m

– Increase banks’ excess reserves → money expansion– Lower the D for reserves & thereby lower interest rates

• Increase m– Decrease banks’ reserves → money contraction– Raise the D for reserves & thereby raise interest rates

• “m” has been 10% since 1992– Infrequently used by Fed as a policy tool

56

How Monetary Policy Works

• Expansionary monetary policy1. Open-market purchase of T-Bills

2. Lower discount rate

3. Lower required reserve ratio

• Contractionary monetary policy1. Open-market sale of T-Bills

2. Raise discount rate

3. Raise required reserve ratio• **Fed primarily uses open-market transactions

to conduct monetary policy**

57

The effects of monetary policy on interest rates

Figure 4

58

Bank Reserves

Inte

rest

Rat

e

S0

S0D

D

S1

S1

E

A

(a)

Expansionary Monetary Policy

Bank Reserves

Inte

rest

Rat

e

S0

S0

D

D

S2

S2

E

B

(b)

Contractionary Monetary Policy


• Recall: AD: total exp = C + I + G + (X-IM)

• Most sensitive components of AD to monetary policy:– Investments are largely financed through

borrowing, so interest rates (r) impact the cost of investments

• ↑r → ↓I• ↓r → ↑I

– Net exports• ↑r → ↑$ → ↓(X-IM) • ↓r → ↓$ → ↑(X-IM)

59

The effect of interest rates on total expenditure

Figure 5

60Real GDP

Rea

l Exp

endi

ture

45°

C+I+G+(X-IM)

C+I+G+(X-IM)

(lower interest rate)

C+I+G+(X-IM)

(higher interest rate)


• Expansionary monetary policy– Lowers r → Encourages I → higher total

spending → shifts expenditure schedule up → multiplier effect on AD → raises GDP

61

GDPIMXGIC 43

321

)(

Ir and M

Policy

Reserve Federal

The effect of expansionary monetary policy on total expenditure

Figure 6

62

Rea

l Exp

endi

ture

45°

C+I1+G+(X-IM)

C+I0+G+(X-IM)

E0

E1

6,5006,0000

Real GDP

5,500 7,000


• Effect of monetary policy on AD– Depends on

• Sensitivity of interest rates to open-market operations

• Responsiveness of investment spending to the interest rate

• Size of basic expenditure multiplier

63

Money & Price Level in Keynesian Model

• Expansionary monetary policy

– Increases quantity of AD• At any given price level

– Causes some inflation• Depends on slope of AS curve

64

PYIMXGIC and

Ir and MPolicy

Reserve Federal

43

321

)(

Inflationary effects of expansionary monetary policy

Figure 7

65

Pric

e Le

vel

0

Real GDP

6,4006,000

S

S

D0

D0

100

E103

D1

D1

B$500 billion Expansionary

monetary policy causes some inflation. But how much depends on the slope of AS.

Money & Price Level in Keynesian Model

• Why does AD curve slope downward? – Higher price level

• Reduces purchasing power of money fixed assets & thereby lowers C

• Depress X & Stimulate IM• Increases the quantity of bank deposits

demanded – D for bank reserves shifts outward → increases

federal funds rate → higher interest rate → discourages I → lowers aggregate quantity demanded

66

The effect of a higher price level on the market for bank reserves

Figure 8

67

Bank Reserves

Inte

rest

Rat

e

S

S D0

D0

D1

D1

Effect of a

higher P

E1

E0

At higher P levels, the quantity of bank reserves demanded is greater. Thus, higher prices lead to higher interest rates.

lecture 10 money and the banking system & monetary policy

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