Money and the Banking System

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Chapter objectives

• Money supply– how the banking system “creates” money– three ways the Fed can control the money supply

• Theories of money demand– a portfolio theory– a transactions theory: the Baumol-Tobin model

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A few preliminaries• Reserves (R ): the portion of deposits that banks have

not lent.

• To a bank, liabilities include deposits,assets include reserves and outstanding loans

• 100-percent-reserve banking: a system in which banks hold all deposits as reserves.

• Fractional-reserve banking: a system in which banks hold a fraction of their deposits as reserves.

• To maintain stable purchasing power of money over time, the supply of money must be controlled– Assuming a constant rate of the use of money, if

the supply of money grows more rapidly than the output of goods and services, prices will rise

– Commonly referred to as “too much money chasing too few goods”

• Production of money is under the control of the government

The Business of Banking

• The banking system is an important part of the capital market

• The banking industry consists of commercial banks, savings and loan associations, and credit unions

• Banks are profit-seeking operations which pay interest to attract checking and savings depositors

• The primary source of revenue for banks is from loans made to business investors

• The efficient allocation of investment funds is a key source of economic growth in the United States

• Commercial banks offer a wide range of services including checking and saving, making loans, etc, and are owned by stockholders

• All commercial banks operate under the Federal Reserve System

• In banking, checking, savings and CD’s are liabilities, i.e., they are an obligation by the bank to depositors to pay on demand

• Major assets to the banks are interest-earning loans and interest-earning securities such as government or private corporate bonds

• A large portion of liabilities are payable on demand– This rarely happens at one time– Therefore, to meet requirements of depositors,

banks only maintain a fraction of their total assets– Bank reserves consist of vault cash plus reserve

deposits with the Federal Reserve– This usually amounts to 10 to 20% of their total

assets

The Fractional Reserve Banking System• Banks maintain only a fraction of their deposits in

the forms of cash or other reserves– They lend out much more than they take in

• The amount of cash and other required reserves limits the banks ability to loan money and expand the money supply

• A central bank of the Federal Reserve System acts as a lender of last resort– Should all depositors attempt to withdraw their money

simultaneously, the central bank would supply the local bank enough funds to meet the demand

Increasing the money supply through the extension of loans

• A decrease in the reserves required by a bank will permit the bank to extend additional loans

• For example, banks keep a required reserve ratio (including vault currency) equal to a certain percentage of their checking accounts (i.e., demand deposits); usually around 20%

• Any money that the banks keep in reserve above this amount is called excess reserves

• Money that is in the excess reserve can be loaned out

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SCENARIO 3: Fractional-Reserve Banking

The money supply now equals $1800:

The depositor still has $1000 in demand deposits,but now the borrower holds $800 in currency.

FIRSTBANK’S balance sheet

Assets Liabilitiesdeposits $1000

Suppose banks hold 20% of deposits in reserve, making loans with the rest.

Firstbank will make $800 in loans.

reserves $1000reserves $200loans $800

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SCENARIO 3: Fractional-Reserve Banking

The money supply now equals $1800:

The depositor still has $1000 in demand deposits,but now the borrower holds $800 in currency.

FIRSTBANK’S balance sheet

Assets Liabilities

reserves $200loans $800

deposits $1000

Thus, in a fractional-reserve banking system, banks create money.

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SCENARIO 3: Fractional-Reserve Banking

• But then Secondbank will loan 80% of this deposit

• and its balance sheet will look like this:

SECONDBANK’S balance sheet

Assets Liabilities

reserves $800loans $0

deposits $800

Suppose the borrower deposits the $800 in Secondbank.

Initially, Secondbank’s balance sheet is:

reserves $160loans $640

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SCENARIO 3: Fractional-Reserve Banking

THIRDBANK’S balance sheet

Assets Liabilities

reserves $640loans $0

deposits $640

If this $640 is eventually deposited in Thirdbank,

then Thirdbank will keep 20% of it in reserve, and loan the rest out:

reserves $128loans $512

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Finding the total amount of money:Original deposit = $1000

+ Firstbank lending = $ 800+ Secondbank lending = $

640+ Thirdbank lending = $ 512+ other lending…

Total money supply = (1/rr ) $1000 where rr = ratio of reserves to deposits

In our example, rr = 0.2, so M = $5000

The monetary multiplier

• This is the multiple by which an increase in reserves will increase the money supply

• It is the ratio of required reserves to deposits or 1/r = 1/.2 = 5

• The lower the percentage of reserve requirements, the greater the potential expansion in the money supply from creating new reserves

• The fractional reserve requirement thus places a ceiling on potential money creation

• The Monetary Multiplier usually doesn’t reach full potential because:– The multiplier will be reduced if someone holds

currency, rather than depositing it in a bank– Any proportion not deposited of a total amount will

reduce all of the following transactions by a similar amount

• The multiplier will be less than its maximum potential if the bank does not loan out all of its new excess reserves– However, banks try to loan out all of their excess

reserves, with no loans, they receive no interest– The amount not loaned out is about 1% of the total

reserves of the banks

Control of Money by the Fed

• The Fed establishes reserve requirements (vault cash and deposits with the Fed) for depository institutions, including credit unions and savings and loan associations

• Banks do not need reserves against either savings or CD’s

• Lowering the required reserve ratio creates excess reserves and allows banks to extend additional loans

• This expands the money supply• Raising the reserve ratio would have the opposite

effect

• The Fed is cautious about regulating the reserve requirements (and altering the supply of money) to often because:– Changes in reserve requirements can be disruptive

of banking operations– A sudden change could require a bank to sell

securities or call in loans– It is only a very crude control; the outcome is

somewhat uncertain in terms of money supply

Open Market Operations

• The most common way the Fed controls the money supply is through the FOMC

• The Fed buys and sells U.S. securities (bonds) on the open market

• When the Fed buys bonds (through the New York Federal Reserve Bank), the money supply will expand because the bond seller will acquire money and bank reserves will increase, allowing the bank to make more loans

Open Market Operations

• Note – the Fed can purchase bonds without any money in its own account

• When the Fed sells bonds, the money supply will decrease because the buyer writes a check on a commercial bank– When the check clears, the buyers checking account and the

reserves of the bank will decline– The reduces money directly by reducing checking deposits

and indirectly by reducing the quantity of reserves available to the banking system

– This causes banks to reduce the number of loans– In summary, the Fed purchase and sale of bonds influences

the size of the monetary base

The Discount RateThe cost of borrowing from the Fed

• Banks borrow from the Fed to meet temporary shortages of reserves

• This usually happens when the banks are adjusting their loan and investment portfolio’s

• An increase in the discount rate (the interest rate on a loan from the Fed) is restrictive and is intended to ensure banks maintain some small level of excess requirements

The Discount Rate• Similarly, a decrease in the discount rate is

expansionary, encouraging banks to reduce their excess reserves to a minimum

• Because banks borrow only a very small part of their loanable funds from the Fed, an increase or decrease in the discount rate is not likely to affect the interest rate on bank loans to consumers

• Banks can also borrow from the Federal Funds Market which is composed of those commercial banks with excess reserves

• The federal funds rate and the discount rate are usually about the same – they tend to move together

• The Fed fund loans are short-term loans, sometimes only overnight

• Banks when faced with a choice would prefer to borrow from other institutions with a lower interest rate

• If none is available, they will then borrow from the Federal Funds Market

Summary of the MonetaryTools of the Federal Reserve

• There are three major tools: reserve requirements, open market operations, and the discount rate

• Reserve requirements– Expand money supply by reducing reserve

requirements– Restrict money supply by increasing reserve

requirements

Summary of the MonetaryTools of the Federal Reserve

• Open Market Operations– Expand money supply directly by buying U.S. Gov.

bonds; this will increase reserves of the banks, and allow them to make more loans

– Restrict money supply by selling U.S. Gov bonds, resulting in reduction of both the money supply and excess reserves

Summary of the MonetaryTools of the Federal Reserve

• Discount Rate– expand the money supply by lowering the

discount rate which will encourage more borrowing from the Fed• Thus, banks will reduce reserves and make more loans

– Restrict the money supply by raising the discount rate• This discourages borrowing from the Fed• Banks will make fewer loans and build up excess reserves