Chapter 15: Money and Banking The functions of money: 1. Medium of exchange …usable for buying and selling goods and services Money is a social invention with which resource suppliers and producers can be paid an that can be used to buy and of the full range of items available in the market place
Chapter 15: Money and Banking The functions of money: -Medium of exchange As a medium of exchange, money allows a society to escape the complications of barter Therefore allows for geographic and human specialization
Chapter 15: Money and Banking The functions of money: 2. Unit of account Societies use monetary units (dollars in the U. S. ) as a yardstick for measuring the relative worth of a wide variety of goods, services, and resources.
Chapter 15: Money and Banking The functions of money: -Unit of account We do not need to state the price of cows in terms of corn, crayons, and cranberries…money aids rational decision making by enabling buyers and sellers to easily compare the prices of various goods, services, and resources
Chapter 15: Money and Banking The functions of money: -Unit of account Also permits us to define debt obligations, determine taxes owed, and calculate the nation’s GDP
Chapter 15: Money and Banking The functions of money: 3. Store of Value Enables people to transfer purchasing power from the present to the future…i. e. people do not usually spend all of their income on the day it is received
Chapter 15: Money and Banking The functions of money: -Store of Value But rather, people store some of their wealth as money (as opposed to cows, or mugs, or loaves of bread) in order to buy needed goods and services in the future
Chapter 15: Money and Banking The Liquidity of Money Liquidity: The ease with which an asset can be converted quickly into the most widely accepted and easily spent form of money…cash The more liquid an asset is, the faster it can be converted into cash
Chapter 31: Money and Banking The Components of the Money Supply Money is a stock of some item or group of items (unlike income, for example, which is a flow). Anything that is widely accepted as a medium of exchange can serve as money
Chapter 31: Money and Banking The Components of the Money Supply Money Definition: M 1 The narrowest definition of the U. S. money supply is called M 1. It consists of: -Currency (coins and paper money) in the hands of the public
Chapter 31: Money and Banking The Components of the Money Supply Money Definition: M 1 -All checkable deposits (all deposits in commercial banks and “thrift” or savings institutions on which checks of any size can be drawn)
Chapter 31: Money and Banking The Components of the Money Supply: M 1 Currency: Coins + Paper Money -The coins are issued by the U. S. Treasury -The paper (Federal Reserve Notes) is issued by the Federal Reserve System
Chapter 31: Money and Banking The Components of the Money Supply: M 1 The currency of the U. S. is token money…this means that the face value of any piece of currency is unrelated to its intrinsic value (The value of the physical material…metal or paper and ink…. with which the currency is constructed)
Chapter 31: Money and Banking The Components of the Money Supply: M 1 What happens if the intrinsic value is more than the face value?
Chapter 31: Money and Banking The Components of the Money Supply: M 1 Checkable Deposits The safety and convenience of checkable deposits has made this an increasingly useful option for people…. Rather than carrying around $5, 000 in cash, a check can be written
Chapter 31: Money and Banking The Components of the Money Supply: M 1 Money, M 1 = currency + checkable deposits A check can always be converted (almost immediately) into paper currency…so that is why it is part of the M 1 money supply
Chapter 31: Money and Banking The Components of the Money Supply: M 1 Money, M 1 = currency + checkable deposits We do not include currency held by the US Treasury, Fed Banks, commercial banks, or thrift institutions…. why?
Chapter 31: Money and Banking The Components of the Money Supply: M 2 Money Definition M 2: This includes M 1 monies PLUS several “nearmonies” Near-monies are certain highly liquid financial assets that do not function directly or fully as a medium of exchange but can be readily converted to currency or Check dep’s
Chapter 31: Money and Banking The Components of the Money Supply: M 2 Three Categories of M 2 1. Savings deposits, including money market deposit accounts 2. Small (less that $100, 000) time deposits Example: “CD” or certificate of deposit
Chapter 31: Money and Banking The Components of the Money Supply: M 2 Three Categories of M 2 3. Money Market Mutual Funds held by individuals: a depositor can redeem shares in a MMMF
Chapter 31: Money and Banking The Money Supply M 2 Equation Money, M 2 = M 1 + savings deposits + small time deposits (less than $100, 000)+MMMFs held by individuals
Chapter 31: Money and Banking What “Backs” the Money Supply?
Chapter 31: Money and Banking What “Backs” the Money Supply? Essentially it is “backed” (guaranteed) by the government’s ability to keep the value of money relatively stable…nothing more!
Chapter 31: Money and Banking The major components of the money supply – paper money and checkable deposits – are debts, or promises to pay. In the U. S. , paper money is the circulating debt of the Federal Reserve Banks. Checkable deposits are the debts of commercial banks
Chapter 31: Money and Banking Paper currency and checkable deposits have no intrinsic value: A $5 bill is just an inscribed piece of paper…. A checkable deposit is merely a bookkeeping entry The currency is not backed by anything tangible…like gold
Chapter 31: Money and Banking Why did the government stop backing currency with gold?
Chapter 31: Money and Banking Backing the currency with gold means that the supply of money would vary with how much gold was available. By not backing the currency, the government avoids this constraint and indeed receives a key freedom: the ability to provide as much or as little money as needed to maintain the value of money and meet economic needs
Chapter 31: Money and Banking By not backing the currency, the government has given itself the ability to freely “manage” the nation’s money supply Monetary authorities attempt to provide the amount of money needed for the particular volume of business activity that will promote full employment, price-level stability, and economic growth
Chapter 31: Money and Banking So then what does give U. S. currency and checkable deposits value? That is, why can you exchange a U. S. $20 bill for goods and services, but not a $20 paper bill from the game Monopoly? There are 3 parts to answer this question
Chapter 31: Money and Banking Part 1: Acceptability Currency and checkable deposits are money because people accept them as money…we accept it as money because we are confident in our ability to exchange it for goods and services Without this confidence, money has no value
Chapter 31: Money and Banking Part 2: Legal Tender Acceptability and confidence is strengthened because the federal government has designated currency as legal tender… “This note is legal tender for all debts, public and private. ”
Chapter 31: Money and Banking Part 2: Legal Tender Note that this does not mean businesses and people are obligated to only accept cash as payment…they are legally allowed to accept noncurrency payments
Chapter 31: Money and Banking Part 3: Relative Scarcity The value of money, like the economic value of anything else, depends on its supply and demand. Money derives its value from its scarcity relative to its utility…i. e. its want-satisfying power.
Chapter 31: Money and Banking Part 3: Relative Scarcity Thus, the economy’s demand for money depends on the total dollar volume of transactions in any period plus the amount of money individuals and businesses want to hold for future transactions
Chapter 31: Money and Banking Money and Prices The purchasing power of money is the amount of goods and services a unit of money will buy. When money rapidly loses its purchasing power, it loses it role as money
Chapter 31: Money and Banking Purchasing power of the dollar: The amount a dollar will buy varies inversely with the price level. When the consumer price index (or cost-ofliving index) goes up, the value of the dollar goes down Higher prices means more dollars to purchase the goods and services desired
Chapter 31: Money and Banking Stabilizing Purchasing Power Rapidly rising price levels (rapid inflation) and the consequent erosion of the purchasing power of money typically result from imprudent economic policies. So, the government carefully monitors the money supply, the dollar value of all transactions, and the prevailing interest rates
Chapter 31: Money and Banking The Federal Reserve Banking System The “monetary authorities” in the U. S. are the members of the Board of Governors of the Federal Reserve System (the “Fed”). This board directs activities of the 12 Federal Reserve Banks, which in turn control the lending activity of the nation’s banks
Chapter 31: Money and Banking The Federal Reserve Banking System The Fed’s major goal is to control the money supply, but since checkable deposits in banks are such a large part of the money supply, an important part of its duties include maintaining stability of the banking system.
Chapter 31: Money and Banking The Federal Reserve Banking System History: Just a short time ago in the early 20 th century, congress decided that centralization and public control were both needed in order to support an efficient banking system
Chapter 31: Money and Banking The Federal Reserve Banking System History: Decentralized, unregulated banking fostered inconvenience and confusion of numerous private bank notes being used as currency… There were times of inflation because of too much money circulated and …
Chapter 31: Money and Banking The Federal Reserve Banking System History: …times of stunted growth because not enough money was being circulated There was not one single entity that was charged with creating and implementing nationally consistent banking policies
Chapter 31: Money and Banking The Federal Reserve Banking System History: Banking crises emerged and eventually caused Congress to pass the Federal Reserve Act of 1913
Chapter 31: Money and Banking The Federal Reserve Banking System The Board of Governors is the central authority of the U. S. money and banking system. The U. S. president, with the confirmation of the Senate, appoints the seven Board members for 14 year terms…one replaced every 2 years
Chapter 31: Money and Banking The Federal Reserve Banking System The Board of Governors The U. S. president selects the chairperson and vice-chairperson from among the Board members…each serving a 4 year term with the ability to be reappointed
Chapter 31: Money and Banking The Federal Reserve Banking System The 12 Federal Reserve Banks collectively serve as the nations “central bank” and function with a blend of private and public control…i. e. not totally controlled by the government but also not totally controlled by private individuals/groups
Chapter 31: Money and Banking The Federal Reserve Banking System Most nations have a single central bank (Britain’s Bank of England or Japan’s Bank of Japan). The U. S. has 12 banks whose policies are coordinated by the Fed’s Board of Governors
Chapter 31: Money and Banking The Federal Reserve Banking System These 12 banks accommodate the geographic size and economic diversity of the U. S. and the nation’s large number of commercial banks
Chapter 31: Money and Banking The Federal Reserve Banking System Whereas the Bank of England is a central, publicly controlled bank, the 12 Federal Reserve Banks of the U. S. are Quasi-Public Banks, meaning they blend private and public control
Chapter 31: Money and Banking The Federal Reserve Banking System Each Federal Reserve Bank is owned by the private commercial banks in its district (Federally chartered banks are required to purchase shares of stock in the Federal Reserve Bank in their district)
Chapter 31: Money and Banking The Federal Reserve Banking System But the Board of Governors, a government body, sets the basic policies that the Federal Reserve Banks pursue
Chapter 31: Money and Banking The Federal Reserve Banking System Additionally, unlike banks that are entirely private, the Federal Reserve Banks are not motivated by profit. Fed Banks do not compete with commercial banks because they do not deal with the general public…rather they interact with the government and commercial banks
Chapter 31: Money and Banking The Federal Reserve Banking System It is the “Bankers’ Bank”…they perform the same function for commercial banks and thrifts as those institutions perform for the public
Chapter 31: Money and Banking The Federal Reserve Banking System Just as banks and thrifts accept the deposits of and make loans to the public, so the central banks accept the deposits of and make loans to banks and thrifts
Chapter 31: Money and Banking The Federal Reserve Banking System On average these loans are around $150 million per day, but in emergency circumstances the Fed Banks become the “lender of last resort” to the banking system and can lend out as much as needed to ensure that banks and thrifts can meet their cash obligations
Chapter 31: Money and Banking The Federal Reserve Banking System The Federal Open Market Committee (FOMC) -aids the Board of Governors in conducting monetary policy and is made up of 12 individuals: -7 members of the Board of Governors -President of the New York Fed Reserve Bank -4 other Fed bank presidents rotating
Chapter 31: Money and Banking The Federal Reserve Banking System The Federal Open Market Committee (FOMC) -meets regularly to direct the purchase and sale of government securities (bills, notes, and bonds) in the open market in which such securities are bought and sold on a daily basis
Chapter 31: Money and Banking The Federal Reserve Banking System Functions of the Fed: -Issuing currency: A 1 is Boston, B 2 is NY, etc. . -Setting reserve requirements: the fractions of checking account balances that banks must maintain as currency reserves
Chapter 31: Money and Banking The Federal Reserve Banking System Functions of the Fed: -Lending Money: from time to time the Fed loans money to banks and thrifts and charges them an interest rate called the discount rate. In times of financial emergencies the Fed is also the lender of last resort
Chapter 31: Money and Banking The Federal Reserve Banking System Functions of the Fed: -Providing for Check Collection: If Sue writes a check on her Miami bank to Joe who deposits it in his Dallas bank, the Fed adjusts the reserves of the two banks
Chapter 31: Money and Banking The Federal Reserve Banking System Functions of the Fed: -Acting as Fiscal Agent: The government’s tax collection, spending, and bond sales/redemption activities are all carried out using Fed’s facilities
Chapter 31: Money and Banking The Federal Reserve Banking System Functions of the Fed: -Supervising Banks: The Fed supervises the operations of banks. It makes periodic examinations to asses bank profitability, to ascertain that banks perform in accordance with the many regulations to which they are subject
Chapter 31: Money and Banking The Federal Reserve Banking System Functions of the Fed: -Supervising Banks: The Fed supervises the operations of banks. It makes periodic examinations to asses bank profitability, to ascertain that banks perform in accordance with the many regulations to which they are subject
Chapter 31: Money Creation Chapter Learning Objectives: -Why is the U. S. banking system called a “fractional reserve” system -Distinction between a bank’s actual reserves and its required reserves -How a bank can create money through granting loans
Chapter 31: Money Creation Chapter Learning Objectives: -About the multiple expansion of loans and money by the entire banking system -What the monetary multiplier is and how to calculate it
Chapter 31: Money Creation The Fractional Reserve System Most countries today have a fractional reserve banking system This means that only a portion (fraction) of checkable deposits are backed up by cash in bank vaults or deposits at the central bank
Chapter 31: Money Creation The Fractional Reserve System – History -Early traders began using gold for making transactions -This was both unsafe (i. e. people can steal your gold) and inconvenient (gold is heavy compared to its relative value)
Chapter 31: Money Creation The Fractional Reserve System – History -Gold is also inconvenient/inefficient because the weight and quality of the gold would have to be assessed every time a transaction was made -This lead to the Goldsmiths…
Chapter 31: Money Creation The Fractional Reserve System – History -Traders could deposit their gold with Goldsmiths who would store it in a vault for a fee -The trader would be given a receipt by the Goldsmith detailing how much gold was deposited
Chapter 31: Money Creation The Fractional Reserve System – History -This lead to people paying for goods and services using goldsmiths’ receipts…which is essentially one of the first paper monies
Chapter 31: Money Creation The Fractional Reserve System – History -This type of system was a 100% reserve system: Goldsmiths backed their circulating “paper money” receipts fully with the gold that was held “in reserve” in the vaults.
Chapter 31: Money Creation The Fractional Reserve System – History -Goldsmiths, however, soon realized that with the paper money circulating, less and less people started to actually demand physical receipt of the gold on a regular basis -So they were literally sitting on a pile of gold!
Chapter 31: Money Creation The Fractional Reserve System – History -By keeping careful records, Goldsmiths found that the amount of gold being deposited with them in any week or month was likely to exceed the amount that was being withdrawn -So some Goldsmiths began to issue paper receipts for gold that didn’t exactly exist
Chapter 31: Money Creation The Fractional Reserve System – History -Or in other words, paper receipts were issued in excess of the amount of gold held -Goldsmiths put these receipts into circulation by making loans to merchants, producers, and consumers…hence the bank loan is born
Chapter 31: Money Creation The Fractional Reserve System – History -For example, a merchant may borrow $10, 000 worth of gold receipts (which could now be used to exchange for goods and services) and promise to give back $10, 500 worth of gold receipts in one year
Chapter 31: Money Creation The Fractional Reserve System – History -The key is that borrowers were willing to accept loans in the form of gold receipts because the receipts were accepted as a medium of exchange in the market place
Chapter 31: Money Creation The Fractional Reserve System – History -And so the fractional reserve system (as opposed to a 100% reserve system) was born -The amount of gold in the bank vaults was actually less than the total of the money supply in terms of paper receipts in circulation
Chapter 31: Money Creation The Fractional Reserve System – History -In this way, the Goldsmiths “created” money -For example suppose the Goldsmiths have $1 million in receipts for actual gold -They then issue $1 million in receipts for loans…for gold that does not actually exist in the vaults
Chapter 31: Money Creation The Fractional Reserve System – History -Now the “money” supply in circulation is actually $2 million…or twice the value of the gold!
Chapter 31: Money Creation The Fractional Reserve System So two important characteristics can be highlighted from this history: 1. Banks can “create” money through lending 2. Banks operating on the basis of fractional reserves are vulnerable to “panics” or “runs”
Chapter 31: Money Creation Creating Money: Goldsmiths created money when they made loans by giving borrowers paper money that was not fully backed by gold reserves. The quantity of such money depended on the amount of reserves they deemed prudent to have available
Chapter 31: Money Creation Creating Money: The smaller the amount of reserves thought necessary, the larger the amount of paper money the goldsmiths could create
Chapter 31: Money Creation Creating Money: Today, money is no longer backed but gold, but currency (paper money) itself serves as bank reserves So, the creation of checkable deposit money banks is limited by the amount of currency reserves that banks are required to keep
Chapter 31: Money Creation Vulnerability of Fractional Reserve Systems: A Goldsmith who issued paper money that valued twice the amount of gold he had in reserves would not be able to pay every receipt holder in the event they all simultaneously showed up at his door to collect their gold
Chapter 31: Money Creation Vulnerability of Fractional Reserve Systems: This has actually happened and has ruined many European and U. S. banks (the great depression)
Chapter 31: Money Creation Vulnerability of Fractional Reserve Systems: Historically, however, a bank panic is unlikely if the banker’s reserve and lending policies are prudent. Still, bank industries are highly regulated by the federal government to help prevent such economically catastrophic events.
Chapter 31: Money Creation Vulnerability of Fractional Reserve Systems: In the U. S. , we have a system of deposit insurance…whereby deposits are guaranteed safe by federal agencies (for example the FDIC)
Chapter 31: Money Creation Understanding the Modern Fractional System Let’s first look at an example of a single commercial bank. Commercial banks’ balance sheets look something like this (simplified): Assets = liabilities + net worth
Chapter 31: Money Creation Understanding the Modern Fractional System Now consider that a business man decides to open a bank in a small town in Nebraska. To do so, he acquires a national charter from the federal government and then finds investors to whom he sells $250, 000 worth of stock
Chapter 31: Money Creation Understanding the Modern Fractional System This businessman has now raised enough initial capital and the bank exists…on paper Currently, the bank has $250, 000 of cash on hand $250, 000 worth of stock shares outstanding
Chapter 31: Money Creation Understanding the Modern Fractional System The cash is an asset for the bank (cash held by banks is commonly called vault cash or till money), whereas the shares of stock constitute the net worth of the bank… Assets = liabilities + net worth $250, 000 = $0 + $250, 000
Chapter 31: Money Creation Understanding the Modern Fractional System The bank now must create a physical establishment with which to do business…this means acquiring physical property and equipment… Suppose the bank directors decide to purchase a building for $220, 000 and pay for office equipment totaling $20, 000
Chapter 31: Money Creation Understanding the Modern Fractional System Now the balance sheet is slightly more complex:
Chapter 31: Money Creation Understanding the Modern Fractional System Now the bank is ready to open for business. Banks have two basic functions: (1) Accept deposits of money and (2) make loans Suppose then, that this bank opens its doors and initially accepts $100, 000 in deposits
Chapter 31: Money Creation Understanding the Modern Fractional System There are two things to keep in mind here: A bank accepts a deposit in the form of “cash, ” which means that bank has cash…an asset However, the person depositing that cash is the true owner and can take it back at any time
Chapter 31: Money Creation Understanding the Modern Fractional System There are two things to keep in mind here: So the deposit is a liability for the bank Cash: Asset Deposit: Liability
Chapter 31: Money Creation Understanding the Modern Fractional System Now the balance sheet reads:
Chapter 31: Money Creation Understanding the Modern Fractional System So at this point recognize that no extra money has been created in the economy…the money available to the bank has increased, but only because depositors supplied them with existing currency
Chapter 31: Money Creation Understanding the Modern Fractional System Next, all commercial banks that provide checkable deposits must by law keep required reserves…which are an amount of funds equal to a specified percentage of the bank’s own deposit liabilities These reserves are in the form of deposits with a Federal Reserve Bank
Chapter 31: Money Creation Understanding the Modern Fractional System So, for example suppose this new bank opened in Hammond, IN…the Federal Reserve Bank for Northern Indiana is the Chicago Federal Reserve Bank, so this new bank must deposit a percentage of its own deposit liabilities in the Chicago bank
Chapter 31: Money Creation Understanding the Modern Fractional System The formula used to compute the reserve ratio is:
Chapter 31: Money Creation Understanding the Modern Fractional System So for example, if the Hammond Bank has accepted $100, 000 is deposits from the public, and the reserve ratio requirement is 10%, then this bank must deposit $10, 000 in the Federal Reserve Bank of Chicago…for 20%, then $20, 000…etc…
Chapter 31: Money Creation Understanding the Modern Fractional System The Fed has the authority to establish and vary the reserve ratio within limits legislated by Congress. . Currently, the first $9. 3 million deposited in a commercial bank is exempt from reserve requirements
Chapter 31: Money Creation Understanding the Modern Fractional System For $9. 3 – $43. 9 million there is a 3% reserve requirement Over $43. 9 million is a 10% reserve requirement
Chapter 31: Money Creation Understanding the Modern Fractional System Suppose for our Hammond Bank, there is a 20% reserve requirement in place by the Chicago Fed Bank… So, to comply with federal law, the Hammond bank deposits $20, 000 of the $100, 000 in the Fed Bank of Chicago
Chapter 31: Money Creation Understanding the Modern Fractional System However, suppose also that Hammond Bank is confident that its checkable deposits will grow, and to account for this it preemptively sends an additional $90, 000 to the Fed in Chicago. Thus, Hammond Bank has deposited $110, 000 in total with the Chicago Fed
Chapter 31: Money Creation Understanding the Modern Fractional System The balance sheet:
Chapter 31: Money Creation Understanding the Modern Fractional System Suppose now that business is operating, and one of the depositors, Fred, of Hammond Bank writes a check for $50, 000 to pay for his car mechanic business He writes this check to Auto. Fix Extreme, a company that builds oil change stations for mechanics
Chapter 31: Money Creation Understanding the Modern Fractional System Auto. Fix Extreme is a business that has its own bank, called Whiting Bank. So the process goes like this: Fred writes a check for $50, 000 to Auto. Fix deposits the $50, 000 into Whiting Bank
Chapter 31: Money Creation Understanding the Modern Fractional System Whiting Bank sends this check to the Chicago Fed Bank…this check is a claim against the assets of Hammond Bank So the Chicago Fed bank increases the reserves of Whiting Bank by $50, 000 and decreases the reserves of Hammond Bank by $50, 000
Chapter 31: Money Creation Understanding the Modern Fractional System The Chicago Fed sends this check to Hammond Bank, and for the first time Hammond Bank learns about this check being written. So it decreases the deposit account balance of Fred by $50, 000 and sees that this has also resulted in a $50, 000 decline in reserves at the Chicago Fed
Chapter 31: Money Creation Understanding the Modern Fractional System The Hammond Bank has reduced its assets and liabilities by $50, 000 The Chicago Fed bank has not gained or lost reserves, but merely transferred ownership of reserves from Hammond Bank to Whiting Bank
Chapter 31: Money Creation Understanding the Modern Fractional System
Chapter 31: Money Creation Understanding the Modern Fractional System So, now that deposits are understood, how does a bank “create money” through loans? Suppose that Jane’s Coffee Shop in Hammond wants to expand business by buying and incorporating the next door office space into more restaurant space
Chapter 31: Money Creation Understanding the Modern Fractional System This will involve paying for the demolition and construction, as well as any lost business due closures resulting from the renovation/addition To finance this endeavor, Jane decides to borrow money from Hammond Bank
Chapter 31: Money Creation Understanding the Modern Fractional System Suppose that the loan officers at Hammond Bank know and trust Jane’s ability as a coffee shop owner, and believe that her proposed expansion will be a profitable one So, they decide that loaning Jane the money is a wise investment
Chapter 31: Money Creation Understanding the Modern Fractional System After consulting a construction company, Jane decides that the project will cost $50, 000, and so Hammond Bank authorizes that $50, 000 be added to her deposit account Now the bank’s balance sheet looks like:
Chapter 31: Money Creation Understanding the Modern Fractional System
Chapter 31: Money Creation Understanding the Modern Fractional System So notice what happened here…Jane did not have any money to start with, but now has $50, 000…which was given to her by the bank
Chapter 31: Money Creation Understanding the Modern Fractional System
Chapter 31: Money Creation Understanding the Modern Fractional System So Jane has just promised to pay the bank money back…and the bank created a book entry to monetize that promise (or IOU)
Chapter 31: Money Creation Understanding the Modern Fractional System However, by creating this type of demand deposit account for Jane, the bank must be careful to understand how often funds will be withdrawn…For example, a business expense like this is not likely to sit in a bank account, but will most likely go to pay for the construction costs
Chapter 31: Money Creation Understanding the Modern Fractional System So until Jane’s expansion is done and she is accepting a higher volume of customers, Hammond Bank should expect that the $50, 000 loaned to Jane will not be available to the bank as reserves
Chapter 31: Money Creation Understanding the Modern Fractional System So suppose that Jane hires Acme Construction to perform the building work, and she writes them a check for $50, 000. Acme Construction banks with First National Indiana Bank, and so deposits this check in that bank.
Chapter 31: Money Creation Understanding the Modern Fractional System Now, the same as before, the check is sent over to the Chicago Fed and there is a claim against the reserve funds of Hammond Bank for $50, 000…which needs to be transferred to First National Indiana’s account with the Fed.
Chapter 31: Money Creation Understanding the Modern Fractional System Now, examine the balance sheet
Chapter 31: Money Creation Understanding the Modern Fractional System At this point, Hammond Bank has exhausted almost all of its reserve shares at the Federal Reserve Bank of Chicago: $50, 000 for Fred, $50, 000 for Jane = $100, 000 reserves transferred to other banks Original Reserves: $110, 000
Chapter 31: Money Creation Understanding the Modern Fractional System Remaining Reserves: $10, 000 Current required reserves given balance sheet: 20% of $50, 000 (checkable deposits) is $10, 000 So no excess reserves at this point…
Chapter 31: Money Creation Understanding the Modern Fractional System This means that without additional checkable deposits given to Hammond Bank, the bank can no longer make loans…. it is “fully loaded up”
Chapter 31: Money Creation Understanding the Modern Fractional System At this point, take a moment to understand why the Federal Reserve Banks require commercial banks to keep reserves at the Fed Banks… It is not really for protection against runs on the bank…why?
Chapter 31: Money Creation Understanding the Modern Fractional System Instead it is a way to control how much banks are lending…if the Fed sets reserves very high (say 70 -80%) then there is not much left over for commercial banks to use for lending
Chapter 31: Money Creation Understanding the Modern Fractional System On the other hand, a low reserve level (010%) allows banks a lot of freedom when deciding to make loans… So if the government wants to slow down lending, just raise the reserve requirements!
Chapter 31: Money Creation Understanding the Modern Fractional System Another way that a commercial bank can create money is to buy government securities from the public…
Chapter 31: Money Creation Understanding the Modern Fractional System Suppose we are bank to a bank balance sheet for Hammond Bank that looks like:
Chapter 31: Money Creation Understanding the Modern Fractional System So instead of making a $50, 000 loan to Jane for her Coffee Shop, the bank buys $50, 000 in government securities (government securities are things like T-Bonds, T-Bills, T-Notes…i. e. government debt)…so rather than lending to Jane, the bank lends to the government
Chapter 31: Money Creation Understanding the Modern Fractional System So currently, checkable deposits are up by $50, 000 from before, and the new section of assets, Securities, shows a positive balance of $50, 000
Chapter 31: Money Creation Understanding the Modern Fractional System Much the same way as the loan to Jane, the securities broker that took payment for the $50, 000 of government securities will deposit a check drawn on Hammond Bank, and again the Reserves and Checkable Deposits will adjust downward
Chapter 31: Money Creation The Money Multiplier: How it works So this is how things work for a single bank, but what if we start to include the flow of loans, reserves, and checkable deposits between multiple banks?
Chapter 31: Money Creation The Money Multiplier: How it works Consider an example: Tom decides to clean out his old coat closet and finds a $100 bill in the pocket of a jacket he has not worn in 10 years. He then deposits this $100 in his checking account with Bank 1
Chapter 31: Money Creation The Money Multiplier: How it works Consider the initial changes to Bank 1’s balance sheet… + $100 checkable deposits = $20 reserve requirement and $80 excess reserves
Chapter 31: Money Creation The Money Multiplier: How it works Recall that the bank is allowed to only loan out its excess reserves, so Bank 1 is authorized to make a loan for $80
Chapter 31: Money Creation The Money Multiplier: How it works Suppose this loan of $80 goes to Jim, meaning that the bank now has +$80 of loans in the assets column and +$80 of checkable deposits in the liabilities column
Chapter 31: Money Creation The Money Multiplier: How it works Now Jim uses that loan and writes a check to Dave for $80. Bank 1 loses the checkable deposits of $80 as well as the excess reserve of $80… Thus, Bank 1 is left with its minimum reserve requirement ($20) and can no longer loan out
Chapter 31: Money Creation The Money Multiplier: How it works However, Dave receives the check for $80 and then deposits that in his bank, Bank 2, which now becomes a part of that bank’s checkable deposit liabilities as well as reserve assets.
Chapter 31: Money Creation The Money Multiplier: How it works Because the reserve requirement is set to 20%, Bank 2 is lawfully required to keep $16 as reserves, but the remaining $64 is excess reserves that can be lent out… Repeat the process…
Chapter 31: Money Creation The Money Multiplier: How it works $64 deposited in Bank 3…Bank 2 reduced to $16 reserve requirement and no more lending Bank 3 required to keep 20% of $64 and can loan out the rest…. $12. 80 in reserves and $51. 20 in loanable funds…. etc…
Chapter 31: Money Creation The Money Multiplier: How it works Following this through to completion, we can track the expansion of the money supply through the commercial banking system…
Chapter 31: Money Creation
Chapter 31: Money Creation The Money Multiplier: How it works So this means that by Tom finding $100 in his coat pocket and depositing it in the bank, the money supply should actually increase by $400 through commercial bank lending practices
Chapter 31: Money Creation The Money Multiplier: How it works And as to be expected, there is a formula that can be used to quickly and simply determine how much money can be “created” using this process… It is called the Money Multiplier
Chapter 31: Money Creation
Chapter 31: Money Creation The Money Multiplier: How it works So in this equation, m, is the max amount of new checkable deposit money that can be created by a single dollar of excess reserves, given the value of R (the reserve requirement rate)
Chapter 31: Money Creation The Money Multiplier: How it works We can then use the following formula to determine how much extra money is created: Checkable Deposit Creation = Excess reserves X money multiplier
Chapter 31: Money Creation The Money Multiplier: How it works Using our example of Tom finding $100…with a reserve requirement of $20, there are $80 in excess reserves Money Multiplier = 1/. 2 = 1/(1/5) = 5 Extra money = $80 * 5 = $400
Chapter 31: Money Creation The Money Multiplier: How it works
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