This chapter is shorter and less difficult than average. Students find most of the material very straightforward. It contains one analytically challenging topic: the process of money creation in the banking system. A good idea might be to proceed somewhat quickly through most of the chapter, spending more time on money creation in the banking system, t-accounts, and the money multiplier. The fifth edition contains more discussion of the Federal Funds rate. I’ve added some slides near the end of this PowerPoint file on the Federal Funds rate: The first covers the material in the textbook. The second slide shows time-series data on the Fed Funds rate and other key rates, to establish the importance of the Fed Funds rate. The third slide uses a supply-demand diagram of the federal funds market to show how the Fed can raise the federal funds rate using open market operations.
As in previous chapters, “g&s” = goods & services. “ Double coincidence of wants” simply means that two people have to want each other’s stuff. Students find the following example amusing: I’m an economics professor, but I’m a consumer, too. Suppose I want to go out for a beer. Under a barter system, I would have to search for a bartender that was willing to give me a beer in exchange for a lecture on economics. As you might imagine, I would have to spend a LOT of time searching. (On the plus side, this would prevent me from becoming an alcoholic.) But thanks to money, I can go directly to my favorite pub and get a cold beer; the bartender doesn’t have to want to hear my lecture, he only has to want my money.
Money is a medium of exchange. That just means you use money to buy stuff. Money is a unit of account. The price or monetary value of virtually everything is measured in the same units – dollars (in the U.S., or substitute your country’s currency if you’re located outside the U.S.). Imagine how hard it would be to plan your budget or comparison shop if sellers each used their own system of measuring prices. Money is a store of value. Money holds its value over time, so you don’t have to spend it immediately upon receiving it.
Intrinsic value means the commodity would have value even if it weren’t being used as money. In the film “The Shawshank Redemption,” prisoners use cigarettes as money. Fiat money is worthless – except as money. Yet, people are happy to accept your dollars (or euros or yen or whatever) because they know that they will be able to spend them elsewhere.
The definition of currency in the textbook does not include “(non-bank)”. I added it to avoid confusion later, when students are asked to think about what happens to the money supply when a consumer decides to deposit a $50 bill into his or her checking account.
Source: Federal Reserve, Board of Governors, Statistical Release H.6. The latest H.6 release can be found at: http://www.federalreserve.gov/releases/h6/Current/
In subsequent chapters (including the chapter immediately following this one), students will learn that the Federal Reserve’s monetary policy can have huge effects on many macroeconomic variables, like inflation, interest rates, unemployment, and even stock price indexes and exchange rates. As chair of the FOMC, Ben Bernanke is in the news quite frequently.
Segue from last slide: The Fed controls the money supply and regulates banks. Banks clearly play an important role in the money supply because bank deposits are part of the money supply (recall that M1 includes checking account deposits, and M2 also includes savings account deposits). In the interests of parsimony, I have combined the definitions of “fractional reserve banking system” and “reserves,” as shown in the first bullet point. I believe it is sufficient to convey the meaning of both terms.
Deposits are liabilities to the bank because they represent the depositors’ claims on the bank. Loans are an asset for the bank because they represent the banks’ claims on its borrowers. Reserves are an asset because they are funds available to the bank.
The notion that banks create money by making loans is a new and perhaps awkward idea for students. The following slide may help.
Students more easily accept the idea that banks create money when they see that banks do not create wealth.
Reserve requirements were introduced & defined on the slide titled “Bank Reserves,” immediately following “The Structure of the Fed.” Reserve requirements are not a good tool for monetary policy: To make the money supply grow over time, the Fed would have to continually reduce reserve requirements. This is neither possible – they cannot be reduced below 0 – nor desirable – if reserves are too low, then banks will have liquidity problems, and bank runs (discussed later in the chapter) might become fashionable again. To reduce the money supply using reserve requirements, banks wouldn’t be able to make as many loans, which would make the banking industry less profitable and could cause it to contract.
Why might banks run low on reserves? On any given day, it might turn out that depositors make higher-than-expected withdrawals, or the bank makes more loans than expected.
Indeed, the Fed is a “lender of last resort” and usually doesn’t make discount loans to banks on demand. The Fed is not in the business of giving banks cheap money to subsidize their profits.
The prime rate (the rate banks charge on loans to their best customers) and the 3-month Treasury Bill rate are very highly correlated with the Fed Funds rate. The mortgage rate shown is the 30-year fixed rate. It is less correlated with the Federal Funds rate, but this is to be expected: Fed Funds are overnight loans between banks, while mortgages are 30-year loans to consumers. source: FRED database http://research.stlouisfed.org/fred2/
This graph is not in the textbook, so it is not supported with material in the study guide or test bank. Therefore, you may wish to omit this slide from your presentation. But I hope you will consider keeping it. It is uses a simple supply-demand diagram to illustrate something described verbally in the text: how the Federal Reserve targets the federal funds rate. The demand for federal funds comes from banks that find themselves with insufficient reserves, perhaps because they made too many loans or had higher-than-expected withdrawals. The supply of federal funds comes from banks that find themselves with more reserves than they want, perhaps because they had lower-than-expected withdrawals or because few customers took out loans. The federal funds rate adjusts to balance the supply of and demand for federal funds. The Federal Reserve can use OMOs to target the fed funds rate. Whenever the rate starts to fall below the Fed’s target, the Fed sells government bonds in the open market in order to pull reserves out of the banking system, which raises the rate as shown in this diagram. If the rate rises above the Fed’s target, the Fed buys govt bonds in the open market, injecting reserves into the banking system, and pushing the rate down. For the Fed, OMOs are quick, easy, and effective, so the Fed can keep the fed funds rate very close to the target.
In this chapter,In this chapter,look for the answers to these questions:look for the answers to these questions: What assets are considered “money”? What arethe functions of money? The types of money? What is the Federal Reserve? What role do banks play in the monetary system?How do banks “create money”? How does the Federal Reserve control the moneysupply?2
THE MONETARY SYSTEM 3What Money Is and Why It’s Important Without money, trade would require barter,the exchange of one good or service for another. Every transaction would require a doublecoincidence of wants – the unlikely occurrencethat two people each have a good the other wants. Most people would have to spend time searching forothers to trade with – a huge waste of resources. This searching is unnecessary with money,the set of assets that people regularly use to buyg&s from other people.
THE MONETARY SYSTEM 4The 3 Functions of Money Medium of exchange: an item buyers give tosellers when they want to purchase g&s Unit of account: the yardstick people use topost prices and record debts Store of value: an item people can use totransfer purchasing power from the present tothe future
THE MONETARY SYSTEM 5The 2 Kinds of MoneyCommodity money:takes the form of a commoditywith intrinsic valueExamples: gold coins,cigarettes in POW campsFiat money:money without intrinsic value,used as money because ofgovt decreeExample: the U.S. dollar
THE MONETARY SYSTEM 6The Money Supply The money supply (or money stock):the quantity of money available in the economy What assets should be considered part of themoney supply? Two candidates: Currency: the paper bills and coins in thehands of the (non-bank) public Demand deposits: balances in bank accountsthat depositors can access on demand bywriting a check
THE MONETARY SYSTEM 7Measures of the U.S. Money Supply M1: currency, demand deposits,traveler’s checks, and other checkable deposits.M1 = $1.4 trillion (June 2008) M2: everything in M1 plus savings deposits,small time deposits, money market mutual funds,and a few minor categories.M2 = $7.7 trillion (June 2008)The distinction between M1 and M2The distinction between M1 and M2will usually not matter when we talk aboutwill usually not matter when we talk about“the money supply” in this course.“the money supply” in this course.
THE MONETARY SYSTEM 8Central Banks & Monetary Policy Central bank: an institution that oversees thebanking system and regulates the money supply Monetary policy: the setting of the moneysupply by policymakers in the central bank Federal Reserve (Fed): the central bank of theU.S.
THE MONETARY SYSTEM 9The Structure of the FedThe Federal Reserve Systemconsists of: Board of Governors(7 members),located in Washington, DC 12 regional Fed banks,located around the U.S. Federal Open MarketCommittee (FOMC),includes the Bd of Govs andpresidents of some of the regional Fed banksThe FOMC decides monetary policy.Ben S. BernankeChair of FOMC,Feb 2006 – present
THE MONETARY SYSTEM 10Bank Reserves In a fractional reserve banking system,banks keep a fraction of deposits as reservesand use the rest to make loans. The Fed establishes reserve requirements,regulations on the minimum amount of reservesthat banks must hold against deposits. Banks may hold more than this minimum amountif they choose. The reserve ratio, R= fraction of deposits that banks hold as reserves= total reserves as a percentage of total deposits
THE MONETARY SYSTEM 11Bank T-account T-account: a simplified accounting statementthat shows a bank’s assets & liabilities. Example: FIRST NATIONAL BANKAssets LiabilitiesReserves $ 10Loans $ 90Deposits $100 Banks’ liabilities include deposits,assets include loans & reserves. In this example, notice that R = $10/$100 = 10%.
THE MONETARY SYSTEM 12Banks and the Money Supply: An ExampleSuppose $100 of currency is in circulation.To determine banks’ impact on money supply,we calculate the money supply in 3 different cases:1. No banking system2. 100% reserve banking system:banks hold 100% of deposits as reserves,make no loans3. Fractional reserve banking system
THE MONETARY SYSTEM 13Banks and the Money Supply: An ExampleCASE 1: No banking systemPublic holds the $100 as currency.Money supply = $100.
THE MONETARY SYSTEM 14Banks and the Money Supply: An ExampleCASE 2: 100% reserve banking systemPublic deposits the $100 at First National Bank (FNB).FIRST NATIONAL BANKAssets LiabilitiesReserves $100Loans $ 0Deposits $100FNB holds100% ofdepositas reserves:Money supply= currency + deposits = $0 + $100 = $100In a 100% reserve banking system,banks do not affect size of money supply.
THE MONETARY SYSTEM 15Banks and the Money Supply: An ExampleCASE 3: Fractional reserve banking systemMoney supply = $190 (!!!)Depositors have $100 in deposits,Borrowers have $90 in currency.FIRST NATIONAL BANKAssets LiabilitiesReserves $100Loans $ 0Deposits $100Suppose R = 10%. FNB loans all but 10%of the deposit:1090
THE MONETARY SYSTEM 16Banks and the Money Supply: An ExampleHow did the money supply suddenly grow?When banks make loans, they create money.The borrower gets $90 in currency (an asset counted in themoney supply) $90 in new debt (a liability)CASE 3: Fractional reserve banking systemA fractional reserve banking systemcreates money, but not wealth.
THE MONETARY SYSTEM 17Banks and the Money Supply: An ExampleCASE 3: Fractional reserve banking systemIf R = 10% for SNB, it will loan all but 10% of thedeposit.SECOND NATIONAL BANKAssets LiabilitiesReserves $ 90Loans $ 0Deposits $ 90Suppose borrower deposits the $90 at SecondNational Bank (SNB).Initially, SNB’sT-accountlooks like this:981
THE MONETARY SYSTEM 18Banks and the Money Supply: An ExampleCASE 3: Fractional reserve banking systemIf R = 10% for TNB, it will loan all but 10% of thedeposit.THIRD NATIONAL BANKAssets LiabilitiesReserves $ 81Loans $ 0Deposits $ 81The borrower deposits the $81 at Third NationalBank (TNB).Initially, TNB’sT-accountlooks like this:$ 8.10$72.90
THE MONETARY SYSTEM 19Banks and the Money Supply: An ExampleCASE 3: Fractional reserve banking systemThe process continues, and money is created witheach new loan.Original deposit =FNB lending =SNB lending =TNB lending =...$ 100.00$ 90.00$ 81.00$ 72.90...Total money supply = $1000.00In thisexample,$100 ofreservesgenerates$1000 ofmoney.In thisexample,$100 ofreservesgenerates$1000 ofmoney.
THE MONETARY SYSTEM 20The Money Multiplier Money multiplier: the amount of money thebanking system generates with each dollar ofreserves The money multiplier equals 1/R. In our example,R = 10%money multiplier = 1/R = 10$100 of reserves creates $1000 of money
A C T I V E L E A R N I N GA C T I V E L E A R N I N G 11Banks and the money supplyBanks and the money supply21While cleaning your apartment, you look under thesofa cushion find a $50 bill (and a half-eaten taco).You deposit the bill in your checking account.The Fed’s reserve requirement is 20% of deposits.A. What is the maximum amount that themoney supply could increase?B. What is the minimum amount that themoney supply could increase?
A C T I V E L E A R N I N GA C T I V E L E A R N I N G 11AnswersAnswers22If banks hold no excess reserves, thenmoney multiplier = 1/R = 1/0.2 = 5The maximum possible increase in deposits is5 x $50 = $250But money supply also includes currency,which falls by $50.Hence, max increase in money supply = $200.You deposit $50 in your checking account.A. What is the maximum amount that themoney supply could increase?
A C T I V E L E A R N I N GA C T I V E L E A R N I N G 11AnswersAnswers23Answer: $0If your bank makes no loans from your deposit,currency falls by $50, deposits increase by $50,money supply does not change.You deposit $50 in your checking account.A. What is the maximum amount that themoney supply could increase?Answer: $200B. What is the minimum amount that themoney supply could increase?
THE MONETARY SYSTEM 24The Fed’s 3 Tools of Monetary Control1. Open-Market Operations (OMOs): the purchaseand sale of U.S. government bonds by the Fed. To increase money supply, Fed buys govt bonds,paying with new dollars.…which are deposited in banks, increasing reserves…which banks use to make loans, causing themoney supply to expand. To reduce money supply, Fed sells govt bonds,taking dollars out of circulation, and the processworks in reverse.
THE MONETARY SYSTEM 25The Fed’s 3 Tools of Monetary Control1. Open-Market Operations (OMOs): the purchaseand sale of U.S. government bonds by the Fed. OMOs are easy to conduct, and are the Fed’smonetary policy tool of choice.
THE MONETARY SYSTEM 26The Fed’s 3 Tools of Monetary Control2. Reserve Requirements (RR):affect how much money banks can create bymaking loans. To increase money supply, Fed reduces RR.Banks make more loans from each dollar of reserves,which increases money multiplier and money supply. To reduce money supply, Fed raises RR,and the process works in reverse. Fed rarely uses reserve requirements to controlmoney supply: Frequent changes would disruptbanking.
THE MONETARY SYSTEM 27The Fed’s 3 Tools of Monetary Control3. The Discount Rate:the interest rate on loans the Fed makes to banks When banks are running low on reserves,they may borrow reserves from the Fed. To increase money supply,Fed can lower discount rate, which encouragesbanks to borrow more reserves from Fed. Banks can then make more loans, which increasesthe money supply. To reduce money supply, Fed can raise discount rate.
THE MONETARY SYSTEM 28The Fed’s 3 Tools of Monetary Control3. The Discount Rate:the interest rate on loans the Fed makes to banks The Fed uses discount lending to provide extraliquidity when financial institutions are in trouble,e.g. after the Oct. 1987 stock market crash. If no crisis, Fed rarely uses discount lending –Fed is a “lender of last resort.”
THE MONETARY SYSTEM 29The Federal Funds Rate On any given day, banks with insufficient reservescan borrow from banks with excess reserves. The interest rate on these loans is the federalfunds rate. The FOMC uses OMOs to target the fed fundsrate. Many interest rates are highly correlated,so changes in the fed funds rate cause changes inother rates and have a big impact in the economy.
The Fed Funds Rate and Other Rates, 1970-2008(%)051015201970 1975 1980 1985 1990 1995 2000 2005Fed fundsprime3-month Tbillmortgage
THE MONETARY SYSTEM 31Monetary Policy and the Fed Funds RateTo raise fed fundsrate, Fed sellsgovt bonds (OMO).This removesreserves from thebanking system,reduces supply offederal funds,causes rf to rise.rfFD1S23.75%F2S1F13.50%The FederalFunds marketFederalfunds rateQuantity offederal funds
THE MONETARY SYSTEM 32Problems Controlling the Money Supply If households hold more of their money ascurrency, banks have fewer reserves,make fewer loans, and money supply falls. If banks hold more reserves than required,they make fewer loans, and money supply falls. Yet, Fed can compensate for householdand bank behavior to retain fairly precise controlover the money supply.
THE MONETARY SYSTEM 33Bank Runs and the Money Supply A run on banks:When people suspect their banks are in trouble,they may “run” to the bank to withdraw their funds,holding more currency and less deposits. Under fractional-reserve banking, banks don’thave enough reserves to pay off ALL depositors,hence banks may have to close. Also, banks may make fewer loans and hold morereserves to satisfy depositors. These events increase R, reverse the process ofmoney creation, cause money supply to fall.
THE MONETARY SYSTEM 34Bank Runs and the Money Supply During 1929-1933, a wave of bank runs andbank closings caused money supply to fall 28%. Many economists believe this contributed to theseverity of the Great Depression. Since then, federal deposit insurance has helpedprevent bank runs in the U.S. In the U.K., though, Northern Rock bankexperienced a classic bank run in 2007 and waseventually taken over by the British government.
CHAPTER SUMMARYCHAPTER SUMMARY Money includes currency and various types ofbank deposits. The Federal Reserve is the central bank of theU.S., is responsible for regulating the monetarysystem. The Fed controls the money supply mainlythrough open-market operations. Purchasinggovt bonds increases the money supply, sellinggovt bonds decreases it.35
CHAPTER SUMMARYCHAPTER SUMMARY In a fractional reserve banking system, bankscreate money when they make loans. Bankreserves have a multiplier effect on the moneysupply.36