Transcript Money and Banking - Villanova University

Money and Banking
What is Money?
Banking and Money Creation
Monetary Policy
The Money Market
What is Money?
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In economics we need to distinguish between:
- Income
- Wealth
- Wages
- Money
A financial asset represents claims to a future
stream of income.
Money is defined by its functions.
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Barter – transactions where goods are directly
exchanged for other goods.
The primary function of money is a medium of
exchange.
Other functions of money:
(i) Store of Value
(ii) Unit of Account
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Historically, many items have been used as
money:
(i) Stones, sea shells, wheat
(ii) Cigarettes
(iii) Gold and Silver
(iv) Coins and Paper
(v) Electronic Money
Fiat Money – money that has no intrinsic value.
National Money Supply
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Liquidity is the ease in which an asset can be
exchanged for goods and services.
Most liquid asset is money.
Rank from Liquid to Illiquid:
Cash/Checks
Saving Accounts
Bonds/Stocks
Real Estate
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Three Ways to Measure U.S. Money Supply:
(1) Currency held by public
(2) M1 = Currency + Checking Accounts
(“Demand Deposits”)
(3) M2 = M1 + Saving Accounts
(“Time Deposits”)
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Nominal Quantity of Money (M) is the face
value of money.
Real Quantity of Money is the purchasing
power of money (M/P)
Banking and Money Creation
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Where does M1 come from?
(i) Currency is created by government.
(ii) Demand deposits are created by banks.
Primary function of banks is to accept deposits
from savers and make loans to borrowers:
Depositors  Banks  Loans
Banks are businesses:
Revenue = interest from loans
Costs
= interest paid on deposits
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Fractional reserve banking – a system where
banks keep part of their deposits (D) on
“reserve” and loans out a fraction of their
deposits.
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Reserves (R) = Portion of deposits not loaned
out.
Required Reserves (RR) = Minimum amount of
reserves banks must hold as required by
government.
Required reserve ratio (rr) = fraction of deposits
required to be held in reserves.
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RR = (rr)(D)
Question: How much money can be created by
every dollar deposited into a bank?
Example: Suppose that
rr = 10%
Currency = 0  M1 = Dep
Nick deposits $100,000 into PNC Bank (“Bank 1”)
The Multiple Creation of Bank Deposits
The sequence
The running tally
Reserves
Loans
Deposits
Deposit
$100,000
Reserve
$10,000
Loan
$90,000
$10,000
$90,000
$100,000
$19,000
$171,000
$190,000
Deposit
$90,000
Reserve
$9,000
Loan
$81,000
The Multiple Creation of Bank Deposits
The sequence
The running tally
Reserves
Deposit
$81,000
Reserve
$8,100
Loan
$72,900
$19,000
Loans
$171,000
Deposits
$190,000
$27,100
$243,900
$262,900
$100,000
$900,000
$1,000,000
Deposit
$72,900
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The money multiplier (mm) is the factor which
multiplies bank reserves to get money supply:
M1 = (mm)(R)
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mm = DM1/DR
mm is also the increase in M1 for each
additional dollar of total bank reserves.
The simple money supply multiplier:
mm = 1/rr
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M1 = (1/rr)(R)
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An increase (decrease) in bank reserves leads
to a multiple expansion (contraction) of deposits
and the money supply.
Reasons why mm is too simple:
(i) Each time payment is made public does not
re-deposit 100% (they’ll hold some currency)
(ii) Banks hold excess reserves.
The “real world” mm will be < 1/rr.
The Federal Reserve and Monetary Policy
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The Federal Reserve System (Fed) is the U.S.
Central Bank.
- Created by the Federal Reserve Act of 1913.
- Independent Agency.
Functions of the Fed:
(i) Lender of Last Resorts
(ii) Regulates Banking Industry
(iii) Conducts Monetary Policy – the adjustment
of the money supply to achieve specific
goals.
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Fed is headquartered in Washington DC.
Consists of
(i) Board of Governors
(ii) 12 regional Fed Banks (including Philly)
(iii) Federal Open Market Committee (FOMC)
 The Chairman of the Fed is often called the
“second most powerful person in country”.
Currently Ben Bernanke.
 The Fed Chairman
(i) Sets the agenda for the FOMC
(ii) Point of contact between Fed and President
and Congress.
The Federal Reserve System
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Two ways Fed affects money supply:
(1) Bank reserves:
 R  M1 and DM1  (mm)DR
(2) money multiplier:  mm M 1
Three tools of monetary policy:
(1) Required reserve ratio:
 rr   mm   M1
(2) Discount rate (d) is the interest rate that
banks pay for borrowing from Fed:
 d   R   M1
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Open Market Operations (OMO) – the Fed purchase/
sale of government bonds to/from public.
Sells Bonds
 public pays by writing check to Fed
(open market sale)
 dec R
 decrease M1
Buys Bonds
 Fed pay by writing check to public
(open market purchase) check is deposited into bank
 inc R
 increase in M1
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Expansionary monetary policy  increase M1
Contractionary monetary policy  decrease M1
Why would the Fed use monetary policy to
change M1?
Money Supply Curve
MS = real money supply (purchasing power)
Three factors determine MS:
(i) Banks (loans)
(ii) Public (deposits)
(ii) Federal Reserve (monetary policy)
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How is MS affected by interest rates (r)?
r   opportunity cost of excess reserve
  bank willingness to make loans
  MS
 The money supply (MS) curve shows the
positive relationship between r and MS.
(i) change in r  movement along MS curve
(ii) Expansionary monetary policy  right
Contractionary monetary policy  left
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Money Demand
 A financial asset represents a claim to a future
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stream of payments (Bank account, bonds,
stocks)
Financial assets have less liquidity than money.
They have
(i) higher rate of return
(ii) more risk
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Money or Asset Markets – markets where
money and financial assets are exchanged.
Question: How much money do you demand?
The demand for money is the demand for M1 as
an alternative to other financial assets:
Money is demanded for liquidity
Other assets offer interest payments
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Factors which determine real money demand
(MD):
(1) Real Income (Y or GDP): positive effect
(2) Interest Rates (r): negative effect
(3) Other factors (risk, inflation)
The money demand (MD) curve shows the
inverse relationship between MD and r.
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Changes in r  movement along MD curve
Other factors:
An increase (decrease) in Y  shifts MD curve
right (left).
Money Demand and Bonds
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A bond is an agreement (IOU) which
promises the holder (lender) a payment by
issuer (borrower).
Bonds can be bought/sold in markets.
Consider a simple portfolio choice of bonds
versus money.
Example:
I borrow $100 from Nick at r = 10%.
Price = Pb = $100.
I issue Nick a bond that says “$110 payable to
issuer at maturity date.” This is its face value.
 If Nick holds onto the bond until the “maturity
date,” then it’s the same as a traditional loan.
 Nick has to sell bond to Lisa.
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(i) Suppose Pb has increased to $105. Great
deal for Nick! Nicole spent $105 and will get
paid $110  r = (110 - 105)/105 = 5%.
(ii) Suppose Pb fallen to $95. Nick looses!
Nicole spends $95 and will get $110  r =
(110-95)/95 = 15%.
There is a negative relationship between the
price of bonds and it’s interest rate (yield).
 Interest rates and money demand:
 r  Pb  demandfor bonds
 moneydemand
Equilibrium and Monetary Policy
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In the money market, “price” is the interest rate
(time value of money).
Equilibrium
 MD = MS = M*
 r = r*
Market interest rates are determined in money
markets:
* The Fed does not “set” interest rates on your
bank account.
* The Fed can influence the interest rate by it’s
ability to shift MS curve.
Short-Term Interest Rates
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Expansionary monetary policy:
 shifts MS right
 Decreases r
Contractionary monetary policy
 shifts MS left
 Increases r.
Money and Interest Rates