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  • 1. Economics for Journalists Week 9: The Banking System Jeffrey TimmermansMonday, 26 March, 12
  • 2. Review: Monetary PolicyMonday, 26 March, 12
  • 3. Monetary policy ✤ Now, typically the domain of central banks ✤ In most developed countries, central banks control interest rates and money supply independently ✤ Both interest rates and money supply are closely linkedMonday, 26 March, 12
  • 4. Central banks & money supply ✤ Central banks have three main ways to influence the supply of money in an economy ✤ Directly increasing/decreasing money supply by selling/buying government bonds (U.S., Europe, Japan) ✤ Raising/lowering deposit & lending rates (China) ✤ Changing commercial banks’ reserve ratio (China)Monday, 26 March, 12
  • 5. Interest rates ✤ Most countries have a “base” interest rate, upon which all other domestic rates (deposit rates, mortgage rates) depend ✤ Typically, these are target rates for overnight loans between banks ✤ Fed funds target rate in U.S. (zero-0.25%) ✤ Overnight call rate in Japan (0.10%)Monday, 26 March, 12
  • 6. Impact of interest rate adjustments/open-market ops Open-market Money supply All interest rates PURCHASES UP DOWN Open-market Money supply All interest rates SALES DOWN UPMonday, 26 March, 12
  • 7. Money SupplyMonday, 26 March, 12
  • 8. Measuring the money supply ✤ M1: Currency + Demand Deposits + Traveler’s Checks + Other Checkable Deposits ✤ M2: M1 + Savings Deposits + Retail Money Market Mutual FundsMonday, 26 March, 12
  • 9. U.S. Money Supply February 2010 (provisional) billions of 9,000 U.S. dollars Money Mkt Funds Time Deposits 6,750 Savings 4,500 Deposits 2,250 M1 Currency 0 M1 M2 Source: U.S. Federal ReserveMonday, 26 March, 12
  • 10. The Banking SystemMonday, 26 March, 12
  • 11. Role of the banking system ✤ To channel individuals’ savings to others who want to borrow money ✤ To serve as a financial intermediaryMonday, 26 March, 12
  • 12. The Banking System Prime rate Home/car Commercial Bank Loans Interbank Commercial rate Bank Interbank Commercial market Bank Deposits Commercial Deposit rate Home/car Bank Loans Finance Open- Discount Business Company Market window loans Ops Discount rate Commercial lending rate Money Central Market Fund Commercial Bank PaperMonday, 26 March, 12
  • 13. Key interest rates ✤ Interbank rates Low ✤ Overnight, 1-wk, 1-mth, 3-mth ✤ Deposit rates ✤ Overnight, 1-wk, 1-mth, 3-mth ✤ Commercial lending rate High ✤ Prime (lending) rateMonday, 26 March, 12
  • 14. Structure of the Banking System ✤ The central bank sets a target rate for overnight lending by banks ✤ Commercial banks borrow from each other to meet short-term needs in the interbank market ✤ Commercial banks take deposits from individuals and lend out some of those deposits ✤ Corporations issue short-term debt in form of commercial paper, which is purchased by banks & money-market fundsMonday, 26 March, 12
  • 15. The “Shadow Banking System” ✤ Any non-bank financial institution that is subject to less oversight than traditional lenders like commercial banks ✤ Finance companies ✤ Money-market funds ✤ Hedge fundsMonday, 26 March, 12
  • 16. Interbank rates ✤ H.K.: Hong Kong Interbank Offer Rate (Hibor) ✤ U.K.: London Interbank Offer Rate (Libor) ✤ Fed sets Fed Funds target rate; supply/demand determine Hibor & Libor ✤ Banks’ other lending rates often based on local interbank rateMonday, 26 March, 12
  • 17. Commercial Banks ✤ Take deposits ✤ Make loans ✤ Deposits are banks’ liabilities ✤ Loans (& reserves) are assets ✤ Pay depositors interest (deposit rate) ✤ Banks keep some reserves, lend out the rest ✤ Earn interest from borrowersMonday, 26 March, 12
  • 18. Reserve Ratio ✤ Typically set by the central bank ✤ Indicates the percentage of deposits a bank must keep as reserves ✤ In U.S., reserve ratio is now 10% for deposits above $55.2 million ✤ An increase in the reserve ratio forces banks to curtail lending, a decrease leads to more lending and an expansion of the money supplyMonday, 26 March, 12
  • 19. Jeff’s Bank (100% reserve ratio) Assets Liabilities Reserves $100 Deposits $100Monday, 26 March, 12
  • 20. Jeff’s Bank (10% reserve ratio) Assets Liabilities Reserves $10 Deposits $100 Loans $90Monday, 26 March, 12
  • 21. The Money Multiplier 1 reserve ratioMonday, 26 March, 12
  • 22. How the multiplier works Original deposit $100 Jeff’s Bank lending $90 (.9 x $100) Masato’s Bank lending $81 (.9 x $90) Wylie’s Bank lending $72.90 (.9 x $81) etc. etc. Total money supply $1,000Monday, 26 March, 12

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