Chapter 9 continued

Transcript Chapter 9 continued

Chapter 27

Money and Banking

Do you know anyone with a lot of money?

What does that mean?

Some people make a great income each year. So they probably have a lot of money.

Some people are born into families with a lot of wealth – Bill Gates’ kids are an example. They, too, probably have a lot of money. Here we want to focus on those things that we call money. But we do not focus on the income or wealth aspects. We want to see how policy dealing with money can affect the operation of the economy. 2

Overview

Here we want to study the monetary system in the US.

Monetary policy is a tool designed to get the interest rate to a level so that investment can be at a desired level. Policy makers ultimately want to have economic growth, price stability and full employment.

Reaching these goals can be influenced by Federal Reserve policy. Let’s begin our study of this material by asking what is money?

What is money?

You might say money is the dollars we have, and that is right , but more basically anything that performs the functions of money is money. The four functions of money are 1) medium of exchange, 2) Unit of account, and 3) Store of value, and 4) standard of deferred payment.

A medium of exchange means money is the thing that is readily accepted as payment for goods and services. When money is used we don’t have to barter. Barter can be a drag because of the double coincidence of wants. Without money I have to find someone who wants an econ lecture if I want to play golf. With money we force kids to take econ even though they don’t want to ;), I get money, and then I can buy golf! I spend way less time acquiring the golf when there is money!

What is money?

As a unit of account, the monetary unit(what we call the dollar) is how we state relative value. Goods and services have prices stated in terms of the monetary unit. We know the relative worth of stuff by looking at the dollar amount of the stuff.

Money is a store of value, meaning that you can use it now, or you can use it later. Other assets also act as a store of value, but money has the advantage of immediate use by a firm or a household in meeting all financial obligations.

Money is a standard of deferred payment in that when we take goods and services today, but make payment in the future, the future payment is stated in terms of the money used (in the US we take about the dollar).

Commodity money and fiat money section Commodity money is when money takes the form of something with intrinsic value. Money would have value for uses other than just money. Cigarettes in a prison would be commodity money.

I think fiat money is the money tucked into the glove compartment on that little car.  Really, fiat money (or token money) has no intrinsic value. Government says something is money and it is. Our dollars are fiat money.

M1 definition of money

In the US, the most basic definition of money is M1 = coins + paper + checkable deposits + other checkable deposits + travelers’ checks, or more basically for our purpose = currency + checkable deposits.

Checks are dollar denominated accounts at banks and other financial institutions. They are money because they are generally accepted as a medium of exchange.

Caution: 1) Credit cards are NOT money, they are loans for our purposes.

is M1 plus savings and time deposits, certificates of deposits (CD’s) and money market funds.

M2

I am not making this up, but the M2 definition of money Liquidity is a concept that refers to how fast an asset can be used to buy goods and services. Items in the M1 definition are the most liquid because these items can be used right away to buy goods and services. Items in M2 are a little less liquid because usually a check can not be written on these accounts and thus one has to spend time converting M2 items into M1 before making purchases.

In 2012 M1 added up to $2.4 trillion and M2 added up to $10.4 trillion.

What ‘backs’ our money?

A gold standard or other metal standard - meaning there can be only as much money as there is gold, or some formula amount of money per ounce of gold - may not be consistent with our desires to make trades. This is why modern economies have moved away from metal standards.

So, what backs our money?

Our money is backed by our faith that it can be readily used. We accept money because we know others will accept it from us!!

The Role of Banks

Bank as Financial Intermediary

Banks act as a “broker” between saver/lenders and spender/borrowers.

Hey, if you want, when you have income left over at the end of the month you can try to find people who might like to use your leftovers to buy something. That is a drag, so you probably put the money in the bank. (Or really you have your pay deposited and take out what you need and leave the rest in the bank.) If this is you, you are saver!

Banks have these funds from many people and after a while the banks noted that on any day most people did not want access to there funds, so the banks lends out some of the funds! Borrowers know banks make loans.

Banks are in between lenders and borrowers!!

Money Creation

Overview

In order to see how monetary policy can be used to influence economic performance (we saw fiscal policy before) we first have to look at the banking system.

We will look at some basic operations of banks. Plus we will see how the actions of people (the public), Federal Reserve (the Central Bank of the US economy) action, combined with bank operations, leads to changes in the money supply.

Remember we say that money is basically 1 - currency, and 2 - checkable deposits.

Bank Balance sheet

To understand the banking system we will look at banks from a balance sheet perspective. On a balance sheet you will find bank 1) assets 2) liabilities and net worth.

Using a mechanism called a t-account, we have assets on the left and liabilities and net worth on the right. In general assets = liabilities +NW, but we will focus on changes, not totals.

assets liabilities + NW 14

examples of assets and liabilities

Some assets we will talk about are 1) reserves of the bank(BR) 2) loans the bank has made(L) For now we will mention the liability called 1) checkable deposits or demand deposits(D) Note: remember we said money or M1=currency (CU) + checkable deposits (D). By currency, we mean the funds in the hands of the nonbank public. Let’s look at some examples of bank operations.

currency deposits

A BR +100 L+NW D+100 Say you have $100 in currency and you put it into your checking account. The bank now has a liability -> it owes you $100. But it also has what are called reserves, in this case the currency you brought in is put in the bank vault.

Note the currency in the vault is not in the hands of the nonbank public, so is not money, but now reserves of the bank. In this example the money supply was not changed, but transformed from currency to checkable deposits.

Let’s ponder some more what we just had on the last screen. When people hold these bills the bills are called money.

When people put the bills into their checking account the people still have money, but now in the form of checking account balances. The bank then has the bills and the bills are then called reserves!

A BR -100 L+NW D -100

currency withdrawal

Say you want $100 in currency from your checking account. The bank no longer has a liability and it loses an equal amount of reserves, in this case from the bank vault.

In this example the money supply was not changed, but transformed from checkable deposits to currency.

Imagine the economy is just starting its use of money. Say the Federal Reserve (FED), the central bank in the US, has some guys fly around in a helicopter and they drop 100 single dollar bills over the land where people live. At this point the money supply would be $100 and made up of only currency.

If people just used these bills and never put money in a bank, then the money supply would stay at $100 unless the FED put more money in or took money out of the system.

A few potential problems of holding money only in the form of currency is that it may be lost, or it could be stolen. Because of this (and a few other things we do not need to worry about here ) folks put their money into a bank.

For now let’s assume people do not want to hold any currency. So, they put all $100 into a checking account.

A BR 100

All currency is deposited into

L+NW D 100

banks

At this point the money supply is still only $100 but is now made up of checking account balances. Banks customers as a group usually do not want all of their deposits back on a certain day. As an example, maybe on every dollar customers have in a bank they only want to write checks worth 5 cents on a given day.

What I am trying to express here is that banks have noticed that customers as a group only take out a fraction of their deposits on a given day.

Let’s note a few ideas.

Bank reserves are held because the bank has to be able to give you these bills if you so desire (and you have balances in your account – otherwise they try to put you in jail;).

Bank reserves do not earn the bank any interest (well, very little when the rules where changed after the late 2000’s), but there is the gain of keeping customers happy by being able to give out bills when desired.

Banks have noticed that at any point in time depositors do not want all their money to be transformed back from checking account balances to currency.

With these three things in mind banks have discovered that they can lend out some of the bank reserves and then interest can be charged on the loan.

By remembering what I have here you can score some points on the next few assignments and the final exam.

If banks always kept all the reserves in the bank, we would have a 100% reserve banking systems.

When banks lend some of the reserves and thus only keep a fraction of its reserves the banking system becomes a

fractional reserve banking system.

Let’s assume banks desire to keep in reserve 20% of the deposits obtained. This means the banks will lend out the rest. Also remember we said the public does not want to hold currency at this time.

Let’s next see what happens in the banking system when bank loans are made.

I have plus signs and minus signs to denote changes in these amounts.

A L+NW

Bank loan

BR +100 D +100 A L + 80 D +80 A L + NW BR -80 A L+NW BR +20 L +80 D -80 D +100 At the top you see what the banking system looks like when the public deposits the $100.

Next you see how the loan is made. Since the bank wants to hold 20% of deposits as reserves it loans 80 by creating an asset called loans and adds to checkable deposits for the person who gets the loan.

The third point is the person with the loan spends the money and the bank loses an equal amount of reserves.

At the bottom here you see the final position for the bank. The 100 in new deposits will support 80 in loans.

Bank loan is money creation

At any point in time the bank can only lend out what

it has in excess reserve. The bank notes what is excess over a period of time. The bank we saw before had excess reserves of 80 and lent out 80.

Once a bank loan is made, a process is started in the economy and the process culminates in a multiple expansion of the money supply. Multiple here means more than the amount that occurred at first.

Let’s now turn to the process of multiple deposit

expansion.

A BR +80 L+NW D +80 A L + 64 D +64 A L + NW BR -64 D -64 A L+NW BR +16 L +64 D +80

Round 2

The person who obtained the first loan bought something. The seller of that stuff gets the check and deposits it in their bank. We see that first here.

Next you see that since the bank wants to only hold 20% of deposits as reserves it loans .8(80) = 64 by creating an asset called loans and adds to checkable deposits for the person who gets the loan.

The third point is the person with the loan spends the money and the bank loses an equal amount of reserves.

At the bottom here you see the final position for the bank. The 80 in new deposits will support 64 in loans.

Before I move on to more of the story, note what happened on the previous screen.

1) In the banking system an aditional 80 dollars in checking account balances occurred because someone was able to get a loan.

2) The bank added to the first round by making another $64 in loans.

3) At the end of the day the bank has looked at its new deposits, evaluated what it wants to hold on to as reserves and lends out the rest.

Another round of lending can still occur – let’s see that next.

A BR +64 L+NW D +64 A L + 51.20

D +51.20

A L + NW BR -51.20

D -51.20

A L+NW BR +12.80

L +51.20

D +64

Round 3

loan bought something. The seller of that stuff gets the check and deposits it in the bank. We see that first here.

Next you see that since the bank wants to only hold 20% of deposits as reserves it loans .8(64) = 51.20 by creating an asset called loans and adds to checkable deposits for the person who gets the loan.

The third point is the person with the loan spends the money and the bank loses an equal amount of reserves.

At the bottom here you see the final position for the bank. The 64 in new deposits will support 51.20 in loans.

Multiple deposit expansion

Let’s review again. The first bank received 100 in new deposits and since it only needs to keep 20% (because most folks don’t want all their funds on any one day) it lent out 80. This ended up in another bank because the person who got the loan didn’t

want to take the money home, throw it on the floor, and roll in the

cash (would you do that?). The person wanted to spend it! That spending meant someone else sold some goods and got a check to put in their bank. That bank evaluated its position and made a loan…… DO you see a pattern here? Note each successive loan is for a smaller amount than the previous loan.

Begin Round 1 BR +100 D +100 BR +20 Round D +100 BR +16 Round 3 D +80 BR+12.80

D +64 L +80 L +64 L +51.20

Bit of a review again – bring the last few slides together. On this slide you see the beginning when 100 in cash was put in the bank. Then I show three rounds in the final position of each round, but more will occur.

Recall that money is made up of currency and checkable deposits. The beginning and round 1 is the first bank involved. While there is 100 more in checking there is 100 less in cash in the hands of the non-bank public. This means no change in the money supply. But rounds 2, 3 and on have new deposits that are new additions to the money supply. On the next slide I show some math, but you only need to have the end result of that math.

New money from the lending process here 80 + 64 + 52.10 + … = 80(1 + .8 + .8

2 line) + …) (math folks help us get to the next = 80[1/(1 - .8)] (wow, look at that!) = 80(1/0.2) = 80(5) = 400 amount of excess reserves in the system when cash was put in the bank. The 5 is the money multiplier (It is similar to the multiplier we saw back with aggregate demand). Note the 5 is from 1/0.2, where the 0.2 is the 20% banks like to hold in reserve to meet the needs of its depositors. These two items make up the money multiplier. 30

Required reserves

Hey, you want to know something? Well, listen up! The 20% I mentioned that banks want to hold to meet the needs of the depositors is too high a number. Many banks would really only need to keep way less than 20%. Moreover, some banks would like to earn more money and they might hold less than they really need.

The Federal Reserve system has a rule banks must follow so that they don’t have too few reserves. The rule is called reserve requirements. The Fed sets, and does change from time to time, the minimum reserve required amount banks must hold to meet the amount of checking account balances that are in the bank. 31

Required reserves

If the reserve requirement is 20% banks have to have in reserves (BR) 20% of the checking account balances. So if D = 100, BR must be no lower than 20. If D = 500, BR must be no lower than 100.

For the most part, we will assume in class that whatever the Fed sets as the reserve requirement will be the target banks shoot for.

So, if the reserve requirement is 20% the money multiplier is 5.

If the reserve requirement is 10% the money multiplier is 10.

Summary 1) FED dropped 100 single dollar bills on public for a money supply of $100, 2) Public put all money in the bank in checking accounts, for a money supply still of $100, 3) Banks only desired to hold reserves equaling 20% (because we now see that is what the FED set) of deposits and they lent out the rest.

4) After many rounds of lending bank deposits end up at $400 of additional checking account balances in addition to the $100 start.

5) The 100 of new bank reserves ends up supporting a money supply of 500, the 400 of new deposits from the lending process and the initial 100 Fed dropped, but transferred to checking by public. 33