Ma ch 14 banking and the money supply (1)
- 1. Banking and theMoney Supply PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
- 2. • How dobanks create money? • Why are banks called First Trust or Security National rather than Benny’s Bank or Loadsamoney? • How is the Fed both literally and figuratively a money machine? • Why are we so interested in banks, anyway? • After all, isn’t banking a business like any other, such as dry cleaning, auto washing, or home remodeling? • Why not devote a chapter to the home-remodeling business? © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2
- 3. Money Aggregates •Money aggregates –Measures of the economy’s money supply – Defined by the Fed • M1 = Narrow definition of money – Currency and coins held by nonbanking public –Checkable deposits – Traveler’s checks © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3
- 4. Money Aggregates •Checkable deposits –Bank deposits that allow the account owner to write checks to third parties – Debit cards can also access these deposits and transmit them electronically • Currency = Fiat money – Federal Reserve notes – Coins © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4
- 5. Money Aggregates •Federal Reserve notes – US Bureau of Engraving and Printing – Issued by and Liabilities of the 12 Federal Reserve banks –Two-thirds circulate abroad • Coins –Manufactured by the U.S. Mint • Sells them to the Fed at face value © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 5
- 6. Faking It •The Supernote = Counterfeit $100 note –Began circulating in 1990 – Extremely high quality • Sequential numbers • Polymer security thread – Suspected origin: North Korea • Other counterfeit money – Using copy machines, printers, computers © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 6 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
- 7. Faking It •To help combat technological improvements in counterfeiting –Redesign every 7 to 15 years –Additional colors – 3-D security images, a security thread, and a bell that shifts inside a copper colored inkwell © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 7 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
- 8. Faking It •Most popular counterfeit –Domestic: $20 note – International: $100 note • Colombia – World’s largest source of bogus American currency © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 8 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
- 9. Money Aggregates •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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 9
- 10. Exhibit 1 Measuresof the Money Supply (Week of July 9, 2012) © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 10 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
- 11. Money Aggregates •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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 11
- 12. Money Aggregates •Paying for purchases – Debit cards – increasing – Checks – decreasing – Cash transactions – becoming less important – Credit cards – will continue to fund major purchases –Smartphones as debit cards – Online payments © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 12
- 13. Exhibit 2 Popularityof U.S. Consumer Payment Systems: 2005 versus 2015 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 13 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
- 14. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 14
- 15. How Banks Work • Asymmetric information – A situation in which one side of the market has more reliable information than the other side • Diversification – Develop a diversified portfolio of assets • Rather than lending funds to a single borrower –Reduce the risk to each individual saver © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 15
- 16. 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 the bank – Physical property – Financial claim – Stock in district Fed • Liabilities: owed by the bank © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 16
- 17. Exhibit 3 HomeBank’s Balance Sheet © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 17 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
- 18. Exhibit 4 HomeBank’s Balance Sheet after $1,000,000 Deposit into Checking Account © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 18 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
- 19. Reserve Accounts •Required reserve – Dollar amount that must be held in reserve –Required by Fed • Required reserve ratio – Percentage of checkable deposits (10%) • Must be held in reserve © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 19
- 20. Reserve Accounts •Reserves – Cash in bank’s vault –Deposits at the Fed • Excess reserves –Bank reserves exceeding required reserves –Can be used to make loans or to purchase interest-bearing assets © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 20
- 21. Liquidity Versus Profitability • Liquidity – Ease to convert assets into cash – Safety • Profitability – Hold more profitable assets • The objectives of liquidity and profitability are at odds © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 21
- 22. Liquidity Versus Profitability • Federal funds market –Day-to-day lending and borrowing –Among banks – Interbank market for reserves on account at the Fed – Interest rate: federal funds rate © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 22
- 23. Liquidity Versus Profitability • Federal funds rate – Interest rate charged in the federal funds market – Interest rate banks charge one another for overnight borrowing – The Fed’s target interest rate © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 23
- 24. How Banks CreateMoney • Creating money through excess reserves –Round one • Fed buys $1,000 US government bond – Creates reserves • Money supply: +$1,000 • Required reserves: +$100 • Excess reserves: +$900 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 24
- 25. Exhibit 5 Changesin Home Bank’s Balance Sheet after the Fed Buys a $1,000 Bond from Securities Dealer © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 25 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
- 26. How Banks CreateMoney • Creating money through excess reserves –Round two • $900 loan • Money supply: +$900 • Required reserves: +$90 • Excess reserves: +$810 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 26
- 27. Exhibit 6 Changesin Home Bank’s Balance Sheet after Lending $900 to You © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 27 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
- 28. How Banks CreateMoney • Creating money through excess reserves –Round three • $810 loan • Money supply: +$810 • Required reserves: +$81 • Excess reserves: +$729 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 28
- 29. Exhibit 7 Changesin Merchants Trust’s Balance Sheet after Lending $810 to English Major © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 29 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
- 30. How Banks CreateMoney • 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 30
- 31. How Banks CreateMoney • 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 31
- 32. Exhibit 8 Summaryof the Money Creation Resulting from the Fed’s Purchase of $1,000 U.S. Government Bond © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 32 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
- 33. Reserve Requirements •Assumptions – No bank holds excess reserves – Borrowed funds don’t sit idle – People don’t want to hold more cash • Change in the money supply = Change in fresh reserves ˣ 1/r –Required reserve ratio = r – Simple money multiplier = 1/r © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 33
- 34. Reserve Requirements •Money multiplier – The multiple by which the money supply changes • As a result of a change in fresh reserves in the banking system • Simple money multiplier, 1/r – Reciprocal of the required reserve ratio –Maximum multiple of fresh reserves by which the money supply can increase © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 34
- 35. Reserve Requirements •Excess reserves – Fuel the deposit expansion process – A higher reserve requirement • Drains this fuel from the banking system • Reducing the amount of new money that can be created © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 35
- 36. Limitations of MoneyExpansion • Leakages from expansion –Smaller money multiplier – Cash – preferred to checking accounts • People hold money • Fewer excess reserves © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 36
- 37. Multiple Contraction •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 ˣ 1/r © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 37
- 38. The Fed’s Toolsof Monetary Control • Open-market operations – Buy / sell US government bonds • The discount rate – Interest rate, the Fed – For loans made to banks • The required reserve ratio – Minimum fraction of reserves © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 38
- 39. Open-Market Operations •Increase money supply – The Fed buys US bonds • Open-market purchase • Reduce money supply – The Fed sells US bonds • Open-market sale • Tool of choice for the Fed – Influences bank reserves – Influences federal funds rate © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 39
- 40. The Discount Rate • Discount rate – Interest rate charged by the Fed – Loans to banks • Bank borrow ‘Discount window’ – Satisfy reserve requirements • The Fed – Lender of last resort © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 40
- 41. The Discount Rate • Discount rates – Primary discount rate – Secondary discount rate • Signal to financial markets –Monetary policy • Emergency tool – Injecting liquidity © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 41
- 42. Reserve Requirements •Reserve requirements –Regulations regarding the minimum amount of reserves that banks must hold to back up deposits – Determine how much money the banking system can create with each dollar of fresh reserves • Disruptive to the banking system © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 42
- 43. Coping with FinancialCrisis • Regulation of financial markets – Prevents major disruptions and financial panics – Sufficient liquidity in the financial system • 2007 and 2008 – Discount rate from 6.25% to 0.5% • Encouraged banks to borrow from the Fed © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 43
- 44. Coping with FinancialCrisis • To help banks improve - balance sheets – Interest on bank reserves held at the Fed • To keep mortgage rates low – Invested more than a $1 trillion in mortgage-backed securities • Prevent the insurance giant AIG from collapsing – Invested more than $90 billion in the company © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 44
- 45. The Fed isa Money Machine • Assets (most earn interest) –Mortgage-baked securities (30%) – U.S. government securities (60%) • From open-market operations – Foreign currencies • Liabilities – Federal Reserve notes outstanding (40%) • U.S. currency – Reserves © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 45
- 46. The Fed isa Money Machine • The Fed is a money machine –Supplies Federal Reserve notes –Main assets: earns interest –Main liability: no interest payment – Earns revenue from discount lending to banks and from other services it provides banks © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 46
- 47. The Fed isa Money Machine • The Fed’s payments – Its operating costs – A small amount of interest on bank reserves at the Fed –6% dividend to the member banks – Any remaining income: to the federal government (U.S. Treasury) • $77 billion in 2011 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 47
- 48. Exhibit 9 FederalReserve Bank Balance Sheet as of July 11, 2012 (Billions) © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 48 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.