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Chapter 25

The Banking System and the Money Supply

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What Counts as Money

• Definition of Money Money is an asset that is widely accepted as a means of payment.

• Only assets—things of value that people own—can be considered as money.

– Can credit cards be considered as money?• Only things that are widely acceptable as a means of payment are

regarded as money.– Can stocks or bonds be considered as money?

• Money has two useful functions– Provides a unit of account

• Standardized way of measuring value of things that are traded.– Serves as store of value

• One of several ways in which households can hold their wealth.

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Measuring the Money Supply

• Money Supply– Total amount of money held by the public

• Governments use different measures of the money supply.– Each measure includes a selection of assets that are widely

acceptable as a means of payment and are relatively liquid.• An asset is considered liquid if it can be converted to cash quickly and

at little cost.– So, an illiquid asset can be converted to cash only after a delay, or at

considerable cost.

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Assets and Their Liquidity

• Most liquid asset is cash in the hands of the public.• Next in line are asset categories of about equal liquidity.

– Demand deposits (Checking accounts)– Other checkable accounts– Travelers checks

• Then, savings-type accounts– less liquid than checking-type accounts, since they do not allow

you to write checks.• Next on the list are deposits in retail money market mutual

funds.– Time deposits (called certificates of deposit, or CDs)

• Require you to keep your money in the bank for a specified period of time (usually six months or longer)

– Impose an interest penalty if you withdraw early

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Figure 1: Monetary Assets and Their Liquidity (July 14, 2003)

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M1 And M2

• Standard measure of money stock (supply) is M1– Sum of the first four assets in our list

• M1 = cash in the hands of the public + demand deposits + other checking account deposits + travelers checks

– When economists or government officials speak about “money supply,” they usually mean M1

• Another common measure of money supply, M2, adds some other types of assets to M1– M2 = M1 + savings-type accounts + retail MMMF

balances + small denomination time deposits

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M1 And M2

• We will assume money supply consists of just two components.– Cash in the hands of the public and demand deposits

• Our definition of the money supply corresponds closely to liquid assets that our national monetary authority—the Federal Reserve—can control.

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The Banking System: Financial Intermediaries

• What are banks?– Financial intermediaries—business firms that specialize in

• Collecting loanable funds from households and firms whose revenues exceed their expenditures.

• Channeling those funds to households and firms (and sometimes the government) whose expenditures exceed revenues.

• Intermediaries must earn a profit for providing brokering services.– By charging a higher interest rate on funds they lend than the rate

they pay to depositors.

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A Bank’s Balance Sheet

• A balance sheet is a financial statement that provides information about financial conditions of a bank at a particular point in time.– On one side, a bank’s assets are listed

• Everything of value that it owns– Bonds– Loans– Vault cash– Account with the Federal Reserve

– On the other side, the bank’s liabilities are listed• Amounts it owes

– Deposits

– Net worth = Total assets – Total liabilities

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A Bank’s Balance Sheet

• Explanations for vault cash and accounts with Federal Reserve– On any given day, some of the bank’s customers might want to

withdraw more cash than other customers are depositing.– Banks are required by law to hold reserves.

• Sum of cash in vault and accounts with Federal Reserve

• Required reserve ratio tells banks the fraction of their checking accounts that they must hold as required reserves.– Set by Federal Reserve

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Figure 2: The Geography of the Federal Reserve System

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Figure 3: The Structure of the Federal Reserve System

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The Federal Open Market Committee

• Federal Open Market Committee (FOMC)– A committee of Federal Reserve officials that establishes U.S.

monetary policy.

• Consists of all 7 governors of Fed, along with 5 of the 12 district bank presidents.

• Not even President of United States knows details behind the decisions, or what FOMC actually discussed at its meeting, until summary of meeting is finally released.– The FOMC exerts control over nation’s money supply by buying

and selling bonds in public (“open”) bond market.

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The Fed and the Money Supply

• Suppose Fed wants to change nation’s money supply– It buys or sells government bonds to bond dealers, banks, or other

financial institutions.• Actions are called open market operations

• We’ll make two special assumptions to keep our analysis of open market operations simple for now.– Households and business are satisfied holding the amount of cash

they are currently holding• Any additional funds they might acquire are deposited in their checking

accounts..• Any decrease in their funds comes from their checking accounts.

– Banks never hold reserves in excess of those legally required by law.

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How the Fed Increases the Money Supply

• To increase money supply, Fed will buy government bonds.– Called an open market purchase

• Suppose, by writing a check, Fed buys $1,000 bond from Lehman Brothers, which deposits the total into its checking account.– Two important things have happened

• Fed has injected reserve into banking system.• Money supply has increased.

– Demand deposits have increased by $1,000 and demand deposits are part of money supply (for instance, M1).

– Lehman Brothers’ bank now has excess reserves» Reserves in excess of required reserves» If required reserve ratio is 10%, bank has excess reserves of $900 to

lend» Demand deposits increase each time a bank lends out excess reserves.

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The Demand Deposit Multiplier

• How much will demand deposits increase in total?– Each bank creates less in demand deposits than the bank before– In each round, a bank lends 90% of deposit it received– So, the total increase in demand deposits is

• Whatever the injection of reserves, demand deposits will increase by a factor of 10, so we can write– ΔDD = 10 x reserve injection

7298109001000 DD S o , 32 9.010009.001009.010001000 DD 32 9.00.90.911000

10000

101000

Ratio Reserve Required

1

9.01

11000

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The Demand Deposit Multiplier

• For any value of required reserve ratio (RRR), formula for demand deposit multiplier is 1/RRR.

• Using general formula for demand deposit multiplier, can restate what happens when Fed injects reserves into banking system as follows– ΔDD = (1 / RRR) x ΔReserves

• With the assumption that the amount of cash in the hands of the public (the other component of the money supply) does not change, we can also write– ΔMoney Supply = (1 / RRR) x ΔReserves

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How the Fed Decreases the Money Supply

• Just as Fed can decrease money supply by selling government bonds.

• An open market sale

• Banks have to call in loans in order to meet the required reserve amount with Fed.

• Process of calling in loans will involve many banks.– Each time a bank calls in a loan, demand deposits are destroyed.– Total decline in demand deposits will be a multiple of initial

withdrawal of reserves.– Using demand deposit multiplier—1/(RRR), we can calculate the

decrease in money supply with the same formula.• ΔDD = (1/RRR) x Δreserves• This time, the change in reserve is negative.

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Some Important Provisos About the Demand Deposit Multiplier

• Although process of money creation and destruction as we’ve described it illustrates the basic ideas, formula for demand deposit multiplier—1/RRR—is oversimplified.– In reality, multiplier is likely to be smaller than formula suggests,

for two reasons:• We’ve assumed that as money supply changes, public does

not change its holdings of cash.• We’ve assumed that banks will always lend out all of their

excess reserves.

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Other Tools for Controlling the Money Supply

• There are two other tools Fed can use to increase or decrease money supply.– Changes in required reserve ratio– Changes in discount rate

• Changes in either required reserve ratio or discount rate could set off the process of deposit creation or deposit destruction in much the same way outlined in this chapter.– In reality, neither of these policy tools is used very often.