Transcript Choice, Change, Challenge, and Opportunity

Ch. 10: MONEY, BANKS, AND
THE FEDERAL RESERVE
–Definition of money and functions
–History of money
–Bank functions and regulations.
–Creation of money by banking system.
–Structure of Federal Reserve System.
–Tools for Monetary Policy.
HISTORY AND ROLE OF MONEY.
• The barter economy.




No money.
Trade requires coincidence of wants
Specialization and trade fairly difficult.
Money:
 anything generally acceptable as means of
payment
 eliminates need for coincidence of wants
FUNCTIONS OF MONEY
• Medium of exchange
– unique to money
• Unit of account
– not unique to money
• Store of value
– not unique to money
– not a good store of value during inflationary
times
TYPES OF MONEY
• Commodity money
– e.g. gold, silver, tobacco
– desirable properties: durable, divisible,
portable.
• Coins
– e.g. $10 of gold in $10 gold piece
– problems: shaving or changes in the market
value of gold
• Gold standard.
– pure gold standard:
• gold coins traded as money and there is no paper
money
– gold exchange standard:
• paper money traded that is backed by gold and
TYPES OF MONEY
 Fiat money
 paper money that is not “backed” by a
commodity
 people cannot trade it for a commodity at a
fixed nominal price.
 “legal tender”
 value is based on faith in the government that
issues the currency.
 Confederate notes in Civil War.
MONEY IN U.S. HISTORY
• U.S. constitution gave Congress sole right
to "coin money and regulate value
thereof". Illegal for states to coin money.
 Bi-metallic standard initially.
• In the 1792 coin act, a $1 coin was quoted in
terms of both silver and gold.
 24.75 grains of gold =$1
 371.25 grains of silver = $1
GRESHAM’S LAW
 Greshams Law: "bad money drives out good"
 Prior to 1834, 24.75 grains of gold was worth
more than 371.25 grains of silver. Only silver
coins circulated (a "silver standard" by
default).
 After 1834, the reverse was true (a "gold
standard" by default).
 If gold coin has 10 grains and silver has 30
grains, what happens if gold price is 5 times
silver price? 2 times silver price?
 What happens to coin circulation of price of its
metal rises relative to other metals?
HISTORY OF BANKING
• Initially banks formed as “safekeeping”
institutions.
• Gradually evolved to serve several
functions:
–
–
–
–
Create liquidity
Minimize the cost of obtaining funds
Minimize the cost of monitoring borrowers
Pool risks
HISTORY OF BANKING IN U.S.
 States could not print or mint money, but
privately owned banks could if licensed by
the state government.
 Banks printed notes that were backed by
gold or silver
 easier to trade
 avoided problems with weighing
 Banks found it profitable to print more notes than
they had "reserves“ (gold/silver) for and loaned out
the extra notes.
 Fractional reserve banking was started.
 Fractional reserve banking poses
• Assets
• Reserves (gold)
• Total
100
100
Liabilities
Notes
100
100
• Banks would print notes beyond
reserves and extend loans.
• Reserves
• Loans
• Total
100
900
1000
Notes
1000
____
1000
• With “fractional reserve banking”, the banking
system
– “creates money” and lends it out.
– has only a fraction of liabilities on reserve.
– cannot satisfy customer’s demands if all want
to withdraw deposits at once.
• Source of “bank panics”.
– News that loans are not likely to be paid back,
customers will make a “run” on the bank.
– Droughts.
– Stock market crash.
• Effect of bank panic on economy?
Bank Panics and Deposit Insurance
• 7 major bank panics in the U.S. in the 1800s
– 2 in the early 1900s.
– Onset of the great depression in the
1930s, another bank panic occurred.
– In 1934, the federal government
established FDIC to help reduce spread of
bank panics.
• Deposit insurance has reduced bank panics
in the U.S.
• Problems with deposit insurance
– Incentives created for risk taking.
– The Home State experience in Ohio.
Federal Reserve System
• established in 1913 by the Federal Reserve
Act.
• first central bank of the United States
• conducts monetary policy and regulates
banks.
• aims to stabilize the macroneconomy.
Federal Reserve System
• The Structure of the Fed
– The Board of Governors
– The regional Federal Reserve banks
– The Federal Open Market Committee.
Federal Reserve System
• The Board of Governors:
– 7 members appointed by the president and
confirmed by Senate.
– terms are for 14 years and overlap so that
one position becomes vacant every 2 years.
– President appoints one member to a
(renewable) four-year term as chairman.
– Each of the 12 Federal Reserve Regional
Banks has a nine-person board of directors
and a president.
Federal Reserve System
• The District Banks:
– Monitor economic conditions within
region.
– Regulate banks within region.
– Serve as clearinghouse for checks.
– Replace currency
Federal Reserve System
• Federal Open Market Committee (FOMC)
– Main policy-making group in the Federal
Reserve System.
– members of the Board of Governors, the
president of the FRB of NY, and the 11
presidents of other regional Federal Reserve
banks of whom, on a rotating basis, 4 are
voting members.
– meets every six weeks to formulate monetary
policy.
Components of the Money Supply
• Bank reserves
– bank deposits at the Federal Reserve +
cash
• Monetary base
– currency held by the nonbank public +
bank reserves.
– M1
– currency outside banks, traveler’s checks,
and checking deposits owned by
individuals and businesses.
– M2
– M1 plus time deposits, savings deposits,
How do banks create money?
 Suppose that there is $100 million of cash and
no bank system.
 A bank now begins and $90 million of cash is
deposited in the bank in exchange for checking
account (demand deposit) balances.
 The bank’s owners invest $5 million in plant and
equipment and thus have $5 million of owner’s
equity. The bank’s balance sheet is now:
How do banks create money?
The balance sheet
Assets
Liabilities
Cash
90 m.
Demand
deposits
90 m.
Plant &
equipment
5 m.
Owner’s equity
5 m.
Total assets
95 m.
Total Liabilities
95 m.
Note: The balance sheet requires that total assets
equal total liabilities.
How do banks create money?
 Fed sets a reserve ratio (let’s suppose it’s 25%).
Implying bank must have 25% of it’s demand
deposits on reserve.
 Reserves = cash + deposits at Fed.
 Bank can increase demand deposits by creating
new loans to customers until it no longer has any
excess reserves.
 required reserves = rr * demand deposits
 Maximum demand deposits = (1/rr) * reserves
How do banks create money?
The balance sheet
Assets
Liabilities
Cash
90 m.
Demand deposits
90m360
m.
Loans
0270 m
Owner’s equity
5 m.
Plant & equipment
5 m.
Total assets
95m365
m.
Total Liabilities
95m365
m.
Note: The bank system created $270 million of additional
money by creating new demand deposits for borrowers
(loans). This assumes that none of the new loans/demand
deposits are withdrawn as cash.
How Banks Create Money
• Deposits lead to a multiplier effect on M1 as
banks convert a $1 deposit into several dollars
of demand deposits.
• To illustrate, assume rr=25%
– A new deposit of $100,000 is made.
– The bank keeps $25,000 in reserve and lends
$75,000.
– This loan is credited to someone’s bank
deposit.
– The person spends the deposit and another
bank now has $75,000 of extra deposits.
– This bank keeps $18,750 on reserve and
How Banks Create Money
– The process
continues and
keeps
repeating with
smaller and
smaller loans
at each
“round.”
How do banks create money?
• Summary of money creation process.
• monetary base = nonbank cash + bank reserves
• M1
= nonbank cash + demand
dep.
• DDmax
= (1/rr)* bank reserves
• The Fed controls the money supply through
its control over the monetary base and the
deposit multiplier (1/rr).
Fed Tools
• Open market operations.
– The Fed buys (sells) government securities in
the open market to increase (decrease) the
money supply.
• Discount window lending.
– The Fed loans reserves to member banks and
charges the discount rate.
• Reserve requirements.
– The Fed sets the required reserve ratio.
– Rarely used.
OPEN MARKET OPERATIONS.
• If the Fed wants to increase the amount
of bank reserves
– buy government securities from member
banks
– banks give up government bonds and
receive deposit at the Fed or cash.
• By buying government securities
– Fed created new reserves that multiply into
new loans and demand deposits
(remember the deposit multiplier).
• If the Fed sold government securities,
reserves and M1 would decrease.
DISCOUNT WINDOW LENDING.
• The Fed lends banks reserves at the
“discount rate”.
– The higher the discount rate, the less likely banks are to borrow
reserves to increase the money supply.
• The federal funds rate is the interest rate
that banks charge each other for a loan of
reserves.
– The federal funds rate tracks the discount rate fairly closely.
• If the Fed wants to increase reserves in the
sytem, it would lower the discount rate.
THE RESERVE REQUIREMENT.
• If the Fed increases the reserve
requirement
– the deposit multiplier (1/rr) falls
– the amount of demand deposits that banks
can create for a given amount of reserves is
reduced.
– [Note: you may ignore the “money multiplier”
discussed in text. Focus only on “deposit
multiplier”]
OTHER FACTORS INFLUENCING THE MONEY SUPPLY
• The amount of cash people choose to hold
– Cash in bank multiplies
– Cash outside bank does not.
• The type of deposits people make.
– the reserve requirement is higher on demand
deposits (about 3%) than on certificates of
deposit.
– If people switch between different types of
accounts, the “average” reserve requirement
and money multiplier will change.
Changes in the money supply
The balance sheet
COB=$10m; rr=25%
Assets
Liabilities
Cash
90 m.
Demand deposits
360 m.
Loans
270 m
Owner’s equity
5 m.
Plant & equipment
5 m.
Total assets
365 m.
Total Liabilities
365 m.
Suppose the Fed purchases $10 m. of government securities.
What is the effect on:
Loans
Demand deposits
M1
Changes in the money supply
The balance sheet
COB=$10m; rr=25%
Assets
Liabilities
Cash
90 m.
Demand deposits
360 m.
Loans
270 m
Owner’s equity
5 m.
Plant & equipment
5 m.
Total assets
365 m.
Total Liabilities
365 m.
Suppose the public withdraws $10m. Of DD as cash. What
is the effect on:
Loans
Demand deposits
M1
Changes in the money supply
The balance sheet
COB=$10m; rr=25%
Assets
Liabilities
Cash
90 m.
Demand deposits
360 m.
Loans
270 m
Owner’s equity
5 m.
Plant & equipment
5 m.
Total assets
365 m.
Total Liabilities
365 m.
Suppose the Fed reduces the rr to 20% What is the effect on:
Loans
Demand deposits
M1