Money, Banks, and the Federal Reserve Chapter 13 CHAPTER 1

Money, Banks, and the Federal Reserve

Chapter 13

CHAPTER

1

Money• Money

– an asset that has a unique feature: its widely accepted as a means of payment (you can use it to buy stuff)

– you can store your wealth in cash, if you desire

• Money supply – the total amount of money held by the

public

2

Two Measures of the Money Supply• M1 Money supply –

– cash in the hands of the public – checking account deposits (checkable

deposits) – travelers checks

• Cash in the hands of the public– currency and coins held by the nonbank

public – currency sitting in a bank vault or an ATM

is not part of the M1 money supply

3

The Money Supply• Checkable deposits

– demand deposits (non-interest earning checking accounts)

– other checkable deposits

• Travelers checks – specially printed checks that you can buy

from banks or other private companies

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M1 Money Supply

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Currently $2,988 billion• http://www.federalreserve.gov/releases/h6/Current/

The Money Supply• Money supply, M2 includes

– all of M1 plus– savings account deposits– money market deposits– certificates of deposit under $100,000– money market funds

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Three Functions of Money• Means of payment

– you can use it to buy stuff• Store of value

– a form in which wealth can held

• Unit of account – a common unit for measuring how much

something is worth

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Types of Money • Commodity money

– Precious metals and other valuable commodities used to buy stuff

– Important non-money use is what gave commodity money its ultimate value, called intrinsic value.

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A Brief History of the Dollar• Paper currency

– Initially, a certificate representing a certain amount of gold or silver held by a bank

– People were willing to accept paper money:• Currency could be exchanged for a valuable

commodity such as gold or silver• The issuer - either a government or a bank -

could print new money only when it acquired additional gold or silver

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A Brief History of the Dollar• Paper currency

– Today - it is no longer backed by gold or any other physical commodity

• Fiat money – Something that serves as a means of

payment by government declaration

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Financial Markets• Financial intermediary

– A business firm that specializes in channeling funds between savers and borrowers. For example, • Commercial banks• Savings and loan associations• Mutual savings banks• Credit unions• Insurance companies

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The Banking System• Depository institutions:

–Commercial banks–Savings and loan associations–Mutual savings banks–Credit unions

– are financial intermediaries– accept deposits from the general public– lend the deposits to borrowers– largest group is commercial banks

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The Banking System• Commercial banks

– a private corporation, owned by its stockholders, that provides services to the public

– Obtain funds mainly by accepting checkable deposits, savings deposits, and time deposits

– Use the funds to make business loans, mortgage loans, and consumer loans

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The Banking System• Balance sheet

– Financial statement showing assets, liabilities, and shareholders’ equity at a point in time

• Bank’s assets– Everything of value that it owns

• Bonds, loans, reserves

• Bank’s liabilities– The amounts that the bank owes

• Checking account deposits, bank borrowing

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The Balance Sheet of Mid-Size National Bank

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Question: Which items on this balance sheet are included in the M1 money supply? M2?

The Banking System• Bond

– A promise to pay back borrowed funds– It’s legal a contract– Issued by a corporation or the government

• Loan – An agreement to pay back borrowed

funds. It’s a legal contract.– Commercial and Industrial loans,

mortgage loans, consumer16

The Banking System• Reserves

– balances held at the Fed plus vault cash • Required reserves

– Minimum amount of reserves a bank must hold based on the amount of its checking account deposits

• Required Reserve Ratio or reserve requirement – currently 10%– The minimum fraction (%) of checking account

deposits that banks must hold as reserves– If less than 100% => Fractional Reserve System

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The Banking System• Excess reserves

– Reserves in excess of required reserves

• Shareholders’ equity – The difference between total assets and

total liabilities

• A balance sheet always balances

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The Federal Reserve • The Federal Reserve is the central bank

of the US.• Central bank

– A nation’s monetary authority responsible for controlling the money supply

– England: 1694– France: 1800– United States: 1913 – Canada: 1934

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The Federal Reserve System• Federal Reserve System

– 12 Federal Reserve districts

– It is not part of any branch of government• Was created by Congress - Federal Reserve

Act (1913)

• Could be eliminated by Congress if it so desired

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The United States is divided into 12 Federal Reserve districts, each with its own Federal Reserve Bank.

The Geography of the Federal Reserve System

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Structure of The Federal Reserve System • Board of Governors

–Seven members• Appointed by the president

–Confirmed by the Senate–For a 14-year term

–Chairman • One of the seven governors

– Appointed by the president – Approved by with Senate – 4-year term

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• http://www.federalreserve.gov/aboutthefed/default.htm

Structure of The Federal Reserve System

• 12 Federal Reserve Banks– Each is supervised by nine directors

• Three - appointed by the Board of Governors• Six - elected by private commercial banks

– Each has a president• Chosen by the directors

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Structure of the Federal Reserve System

• Federal Open Market Committee (FOMC) – a committee of Federal Reserve officials

that establishes U.S. monetary policy– includes all seven governors of the Fed– plus five of the twelve bank presidents

• Discount rate – Banks can borrow from the Fed– The discount rate is the interest rate the

Fed charges on loans to banks24

The Federal Reserve System - Structure

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The Federal Reserve System• The functions of the Fed

– Supervising and regulating banks– Acting as a “bank for banks”– Issuing paper currency– Check clearing– Guiding the macro economy (Monetary

Policy)– Dealing with financial crises

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Monetary Policy and the Money Supply• Open market operations

– Purchases or sales of bonds by the Federal Reserve System

– The primary way the Fed increases or decreases the money supply

• Open market purchase– Fed buys government bonds– Money supply increases

• Open market sale– Fed sells government bonds– Money supply decreases

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Monetary Policy and the Money Supply• We make the following assumptions

– Banks never hold excess reserves

– Households and businesses do not withdraw or deposit cash

– Required Reserve Ratio or Reserve

Requirement is 10% (0.1)• For each $1,000 increase in checking account

deposits at a bank, its reserves must rise by $100

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Open Market Purchase• What happens when the Fed purchases

government bonds– Suppose the Fed buys $100,000 worth of

bonds from Acme Bond Company

– Acme has a checking account with Mid-Size National Bank and deposits $100,000

– 3 players: The Fed, Acme Bond Company and Mid-size bank.

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Open market Purchase - Fed buys $100,000 worth of bonds from Acme Bond Company

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Assets Liab + NW Assets Liab + NW Assets Liab + NWBonds +$100,000 Reserves +$100,000 Bonds -$100,000 Total Reserves $100,000 Check Deposit +$100,000

Check Deposit +$100,000 Required +$10,000Excess +$90,000

Federal Reserve Acme Bond Mid-Size Bank

• Acme sends bonds to the Fed• Fed give Acme check for $100,000• Acme deposits check in bank• Bank sends check to Fed• Fed gives bank reserves

Open Market Purchase• Mid-Size National Bank now has:

• $100,000 in reserves • $10,000 required reserves (10% reserve requirement)• $90,000 excess reserves

• Result:– The Fed injected $100,000 in reserves into

the banking system

– Important ! The money supply also increased by $100,000 (checking accounts)

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The Fed and the Money Supply

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• Mid-Size National Bank now has $90,000 excess reserves to lend.

• Mid-Size National bank lends $90,000 to Paula so she can buy new equipment for her pizza business (or maybe a new BMW)

• The bank gives Paula a check for $90,000.

Mid- Size National bank lends $90,000 to Paula

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• Paula deposits the check in her checking account at Second Bank

Assets Liab + NW Assets Liab + NWTotal Reserves $100,000 Check Deposit +$100,000 Total Reserves $90,000 Check Deposit +$90,000Required +$10,000 Required +$9,000Excess +$0 Excess +$81,000Loan to Paula $90,000

Second BankMid-Size Bank

• The check clears – which means Second Bank sends Paula’s check to the Fed to collect $90,000 from Mid-size bank.

• $90,000 in reserves are transferred from Mid-Size bank to Second Bank.

The Fed and the Money Supply• Second Bank

– $90,000 checking account deposit– $9,000 required reserve– $81,000 excess reserves– Lends out the excess reserves

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Effects of a $100,000 Open Market Purchase

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Open Market Purchase increases the Money Supply

The Fed and the Money Supply• https://search.yahoo.com/search;_

ylt=An1V836MMJqFEbBKxnsyDLibvZx4?fr=yfp-t-315-s&toggle=1&fp=1&cop=mss&ei=UTF-8&p=h%26r%20block%20commercials%202015

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The Fed and the Money Supply• Open market sale

– Fed sells government bonds– Money supply decreases

• The Fed sells $100,000 government bonds to Acme Bond– Acme will pay with a $100,000 check

drawn on its account at Mid-Size Bank

37

The Fed and the Money Supply• Changes in Mid-Size National Bank’s

balance sheet

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• Mid-Size National Bank– Total reserves decreased by $100,000– Required reserves decreased by $10,000– Deficient reserves $90,000– “Calling in” loans: $90,000

The Fed and the Money Supply• Changes in Mid-Size’s balance sheet

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Summary of Open Market Operation

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•Open market purchase• Fed buys government bonds• Reserves in the banking system increase

• Money supply increases•Open market sale• Fed sells government bonds• Reserves in the banking system decrease

• Money supply decreases

The Fed and the Money Supply• Other Fed actions that change the money

supply– Changes in the required reserve ratio– Changes in the discount rate– Changes in the interest rate on reserves

• Tools of monetary policy:– Open market operations– Changes in the required reserve ratio– Changes in the discount rate– Changes in the interest rate on reserves

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Change in the Required Reserve Ratio

• Lower the required reserve ratio– Increase in money supply

• Increase the required reserve ratio– Decrease in money supply

• Very Powerful Tool - seldom used

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CHANGE IN THE REQUIRED RESERVE RATIOA Decrease in the Required Reserve Ratio from 20 Percent to 12.5 Percent Increases the Supply of Money (All Figures in Billions of Dollars)

PANEL 1: REQUIRED RESERVE RATIO = 20%

Federal Reserve Commercial Banks

Assets Liabilities Assets Liabilities

Government $200 $100 Reserves Reserves $100 $500 Deposits

securities $100 Currency Loans $400

Note: Money supply (M1) = Currency + Deposits = $600.

PANEL 2: REQUIRED RESERVE RATIO = 12.5%

Federal Reserve Commercial Banks

Assets Liabilities Assets Liabilities

Government $200 $100 Reserves Reserves $100 $800 Deposits

securities $100 Currency Loans(+ $300)

$700 (+ $300)

Note: Money supply (M1) = Currency + Deposits = $900.

The Fed and the Money Supply• Changes in the discount rate

– Lower discount rate• Encourages banks to borrow reserves• Increase the money supply

– Increase the discount rate• Discourage banks from borrowing• Decrease the money supply

• Not a powerful tool - Banks are hesitant to borrow from the Fed

- Little effect on bank borrowing, bank reserves, or the money supply

44

The Fed and the Money Supply• Changes in the interest rate on reserves

– The Fed began paying interest on reserves (IOR) in 2008• Reduced bank’s opportunity cost of holding

reserves

– If the Fed lowers the IOR rate• The opportunity cost of holding excess

reserves rises• Encourage bank lending• Increase the money supply

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Banking Panics• Fractional reserve system

– a system in which banks hold only a fraction of their deposit liabilities as reserves (10% in the U.S.)

Assets Liabilities

Reserves $100 Deposits $1,000

Loans $900

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• Insolvent– banks become insolvent when total

assets are less than its total liabilities

• Bank failure– when an insolvent bank goes out of

business

Banking Panics

The Balance Sheet of Mid-Size National Bank

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Equity Ratio = Equity / Assets

In this case = $125 /$1,000 = .125 or 12.5%

Suppose Borrows Fail to Repay $150 million in Loans loansBecome Insolvent

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Total Assets = $850 million; Total Liabilities = $875

Total Assets – Total Liabilities = $850 – 875 = $-25

The bank is insolvent

15% of assets are bad

Bad Loans Cause Mid-Size Bank to Become Insolvent

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If the bank had $150 million in equity (15%) or more, it would not be insolvent

Lehman Brothers equity ratio was 3% when it failed.

15% of assets are bad

Banking Panics• Run on the bank (Bank run)

– an attempt by a lot of a bank’s depositors to withdraw their funds

• Banking panic – depositors attempt to withdraw funds from

many banks simultaneously– forces many banks to “close their doors”

(unable to honor their depositors’ requests for funds) • Even if they were solvent

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During the Great Depression a large number of banks failed. The creation of the Federal Deposit Insurance Corporation in 1933 strengthened faith in the stability of the banking system. Even during the financial crisis of 2008–2009, bank failures were far fewer than in the 1930s.

Bank Failures in the United States, 1921–2011

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FDIC created in 1933

About 10,000 banks (1/3 of banks in the US) failed

during the Great Depression

Banking Panics• Largely eliminated after 1933

• Federal Reserve – learned important lesson during the Great Depression - ready to lend to banks more quickly in a crisis

• Federal Deposit Insurance Corporation: reimburse those who lose their deposits

• Increased government regulation of banks

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Bank Regulation• Continuous monitoring of bank financial

condition with a focus on the shareholders’ equity (called bank capital)

• Legal capital requirements: • Banks must hold a percentage of their assets as

equity (bank capital, 5% to 8%)• Dr. Neri does not believe the percentage is high

enough. • High equity encourages banks to lend

responsibly because the owner’s loose if lend recklessly.

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Bank Regulation• Bank Capital

– another name for shareholders’ equity in a bank

• Capital ratio (equity ratio)– A bank’s capital (shareholder equity) as a

percentage of its total assets

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𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓 𝒆𝒒𝒖𝒊𝒕𝒚𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔

Bank Regulation• Why require higher capital ratios

– Greater incentives to avoid risky loans• Reduces the likelihood of bank failures that

pass losses onto non-owners

– Some argue (the banks, duh!) this reduces the amount of interest-earning assets a bank can hold for each dollar of capital that the owners have invested• Reduces the rate of return to the bank’s

owners• Discourages people from forming or investing

in banks ( I don’t believe this)56

Banking Panics• Look at the slide on bank failures. What

happened in the 1980s and 90s? – many undercapitalized banks, not enough

equity– many without FDIC insurance

• Poorly regulated – banks made bad loans and had low capital ratio

• Reminder of the need for deposit insurance and high capital requirements.

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