Transcript Money, Banking, and the Federal Reserve System

Money, Banking, and the Federal Reserve
System
Keys Issues:
What is money and why does money make economies more efficient?
 Define money and describe its functions
What determines the amount of money in the economy?
 Explain the economic functions of banks and other depository
institutions and describe how they are regulated
 Explain how banks create money
 Describe the structure of the Federal Reserve System (the Fed), and
the tools used by the Fed to conduct monetary policy
 Explain what an open market operation is, how it works, and how it
changes the quantity of money
How do changes in the quantity of money influence the
macroeconomy? (Later)
What is Money?
Money is any commodity or token that is generally
acceptable as a medium of exchange.
Money has three other functions:
 Means of Payment
 Unit of account
 Store of value
What is Money?
Medium of Exchange
A medium of exchange is an object that is generally
accepted in exchange for goods and services.
In the absence of money, people would need to exchange
goods and services directly, which is called barter.
Barter requires a double coincidence of wants, which is
rare, so barter is costly.
Unit of Account
A unit of account is an agreed measure for stating the
prices of goods and services.
What is Money?
Store of Value
As a store of value, money can be held for a time and later
exchanged for goods and services.
Means of Payment
A means of payment is a method of settling a debt.
What is Money?
Money in the United States Today
Money in the United States consists of
 Currency
 Deposits at banks and other depository institutions
Currency is the general term for bills and coins.
What is Money?
The two main official measures of money in the United
States are M1 and M2.
M1 consists of currency outside banks, traveler’s checks,
and checking deposits owned by individuals and
businesses.
M2 consists of M1 plus time deposits, savings deposits,
and money market mutual funds and other deposits.
What is Money?
Figure 10.1 illustrates the
composition of these two
measures in 2001 and
shows the relative
magnitudes of the
components of money.
What is Money?
The items in M1 clearly meet the definition of money; the
items in M2 do not do so quite so clearly but still are quite
liquid.
Liquidity is the property of being instantly convertible into
a means of payment with little loss of value.
Checkable deposits are money, but checks are not–
checks are instructions to banks to transfer money.
Credit cards are not money. Credit cards enable the holder
to obtain a loan quickly, but the loan must be repaid with
money.
Depository Institutions
A depository institution is a firm that accepts deposits
from households and firms and uses the deposits to make
loans to other households and firms.
The deposits of three types of depository institution make
up the nation’s money:
 Commercial banks
 Thrift institutions
 Money market mutual funds
Depository Institutions
Commercial Banks
A commercial bank is a private firm that is licensed to
receive deposits and make loans.
A commercial bank’s balance sheet summarizes its
business and lists the bank’s assets, liabilities, and net
worth.
The objective of a commercial bank is to maximize the net
worth of its stockholders.
Depository Institutions
Thrift Institutions
The thrift institutions are
 Savings and loan associations
 Savings banks
 Credit unions.
Depository Institutions
A savings and loan association (S&L) is a depository
institution that accepts checking and savings deposits and
that make personal, commercial, and home-purchase
loans.
A savings bank is a depository institution owned by its
depositors that accepts savings deposits and makes
mainly mortgage loans.
A credit union is a depository institution owned by its
depositors that accepts savings deposits and makes
consumer loans.
Depository Institutions
Money Market Mutual Funds
A money market fund is a fund operated by a financial
institution that sells shares in the fund and uses the
proceeds to buy liquid assets such as U.S. Treasury bills.
Depository Institutions
The Economic Functions of Depository Institutions
Depository institutions make a profit from the spread
between the interest rate they pay on their deposits and
the interest rate they charge on their loans.
This spread exists because depository institutions
 Create liquidity
 Minimize the cost of obtaining funds
 Minimize the cost of monitoring borrowers
 Pool risk
Depository Institutions
To achieve its objective, a bank makes risky loans at an
interest rate higher than that paid on deposits.
But the banks must balance profit and prudence; loans
generate profit, but depositors must be able to obtain their
funds when they want them.
So banks divide their funds into two parts: reserves and
loans.
Reserves are the cash in a bank’s vault and deposits at
Federal Reserve Banks.
Bank lending takes the form of liquid assets, investment
securities, and loans.
Financial Regulation, Deregulation, and
Innovation
Deposits at banks, S&Ls, savings banks, and credit unions
are insured by the Federal Deposit Insurance Corporation
(FDIC).
This insurance guarantees deposits in amounts of up to
$100,000 per depositor.
This guarantee gives depository institutions the incentive
to make risky loans because the depositors believe their
funds to be perfectly safe; because of this incentive
balance sheet regulations have been established.
How Banks Create Money
Reserves: Actual and Required
The fraction of a bank’s total deposits held as reserves is
the reserve ratio.
The required reserve ratio is the fraction that banks are
required, by regulation, to keep as reserves. Required
reserves are the total amount of reserves that banks are
required to keep.
Excess reserves equal actual reserves minus required
reserves.
How Banks Create Money
Creating Deposits by Making Loans
To see how banks create deposits by making loans,
suppose the required reserve ratio is 25 percent.
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 lends $56,250.
How Banks Create Money
The process continues and keeps
repeating with smaller and smaller loans at
each “round.”
Figure 10.2 illustrates the money creation
process.