13-1 Money and Banks Chapter 13 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

13-1

Money and BanksChapter 13

Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

13-2

Money and Banks

• Money affects not only morals and ideals but also the way an economy works– What is money? – How is money created?– What role do banks play in the circular flow of

income and spending?

13-3

What Is Money?

• Without money, you would have to use barter to get items you want

• Barter: The direct exchange of one good for another, without the use of money

• Acquiring goods and services would be much more difficult and time-consuming

13-4

The Money Supply

• Anything that serves the following purposes can be thought of as money:– Medium of exchange: Is accepted as payment for

goods and services (and debts)– Store of value: Can be held for future purchases– Standard of value: Serves as a yardstick for

measuring the prices of goods and services

13-5

Many Types of “Money”

• In colonial America, many different things were used as mediums of exchange

• After independence, it was state-issued paper money and gold, silver, and commodities

• The National Banking Act of 1863 gave the federal government permanent authority to issue money

13-6

Modern Concepts

• Money: Anything generally accepted as a medium of exchange

• Checking accounts can and do perform the same market functions as cash

• Credit cards and online methods are popular mediums of exchange but are not money

13-7

Diversity of Bank Accounts

• There are many forms of “bank” accounts

• Some are better substitutes for cash than others– Regular checking accounts are used all the time to

pay bills or make purchases– Consumers can’t write checks on most savings

accounts or use CDs to make purchases

13-8

M1: Cash and Transactions Accounts

• Money supply: (M1) Currency held by the public, plus balances in transactions accounts

• M1 includes– Currency in circulation– Transactions account balances– Traveler’s checks

13-9

M1: Cash and Transactions Accounts

• Transactions accounts are the readiest substitutes for cash in market transactions

• Transactions account: A bank account that permits direct payment to a third party– Do not require a trip to the bank to make a special

withdrawal

13-10

M2: M1 + Savings Accounts, etc.

• M2 money supply: M1 plus balances in most savings accounts and money market mutual funds

• Savings-account balances are almost as good a substitute for cash as transaction-account balances

13-11

Composition of the Money Supply

Currency in circulation

Transactions-account balances

Savings account balances

Money market mutual funds and deposits

Traveler’s checks ($6 billion)

M2($8,223 billion)

M1 ($1,602 billion)

$1,098 billion

$5,523 billion

$776 billion$776 billion

$820 billion $820 billion

Source: Federal Reserve (January 2009 data)

13-12

Creation of Money

• Two basic principles of the money supply:– Transactions-account balances are a large portion

of our money supply– Banks can create transactions-account balances by

making loans

• Deposit creation: The creation of transactions deposits by bank lending

13-13

T Accounts

• T accounts are used to keep track of changes in reserves, deposit balances, and loans

• Assets are things of value the bank possesses– Cash held in a bank’s vaults– IOUs (loan obligations) from bank customers– Reserve credits at the Federal Reserve– Securities (bonds) purchased by the bank

13-14

T Accounts

• Liabilities are things the bank owes to others– Bank’s largest liabilities are customers’ deposits

• The books of a bank must always balance because all of its assets must belong to someone (its depositors or its owners)

13-15

• Suppose there is a single bank and you deposit $100 in coins to open a new checking account

A Monopoly Bank

University Bank Money Supply

Assets LiabilitiesCash held by the public

- $100

+ $100 in coins + $100 in depositsTransactions deposits at bank

+ $100

Change in M 0

13-16

The Initial Loan

• Now the bank loans $100 to Campus Radio station by crediting its checking account

University Bank Money Supply

Assets LiabilitiesCash held by the public

no change

+ $100 in coins

+ $100 your account balance

Transactions deposits at bank

+ $100

+ $100 in loans

+ $100 Campus Radio account

Change in M + $100

13-17

The Initial Loan

• Money has been created because checking accounts are money

• Total bank reserves have remained unchanged

• Bank reserves: Assets held by a bank to fulfill its deposit obligations

13-18

Secondary Deposits

• In a one bank system, when Campus Radio uses the loan, the proceeds of the loan are re-deposited in the same bank

• The bank continues to hold its entire reserves (your coins)

13-19

Fractional Reserves

• Bank reserves are only a fraction of total transaction deposits

• Reserve ratio: The ratio of a bank’s reserves to its total transactions deposits

bank reservesReserve ratio

total deposits

13-20

Fractional Reserves

• The Federal Reserve System requires banks to maintain some minimum reserve ratio, which limits deposit-creation lending possibilities

• Required reserves: The minimum amount of reserves a bank is required to hold

Required required totalreserves reserve ratio deposits

13-21

A Multibank World

• The ability of banks to make loans depends on access to excess reserves

• Excess reserves: Bank reserves in excess of required reserves

Excess total requiredreserves reserves reserves

13-22

Excess Reserves

• So long as a bank has excess reserves, it can make loans– Example: If a bank has $100 in reserves and is

required to hold $20, it can lend out excess reserves of $80

13-23

Changes in the Money Supply

• In making a loan, the bank automatically increases the total money supply

• Money effectively appears out of thin air

• The creation of transaction deposits via new loans is the same as creating money

13-24

Assets Liabilities

University Bank

Required Reserves $20

Excess Reserves $80

Youraccount $100

Total Assets $100

Total Liabilities $100

Assets Liabilities

Eternal Savings

Total Assets Total Liabilities

Deposit Creation

13-25

Deposit Creation

Assets Liabilities

University Bank

Required Reserves $36Excess Reserves $64Loans $80

Youraccount $100

Campus Radio account $ 80

Total Assets $180

Total Liabilities $180

Assets Liabilities

Eternal Savings

Total Assets Total Liabilities

13-26

Deposit Creation

Assets Liabilities

University Bank

Required Reserves $20Excess Reserves $ 0Loans $80

Youraccount $100

Campus Radio account $ 0

Total Assets $100

Total Liabilities $100

Assets Liabilities

Eternal Savings

Required Reserves $16Required Reserves $64

Atlas Antenna account $80

Total Assets $80

Total Liabilities $90

13-27

Deposit Creation

Assets Liabilities

University Bank

Required Reserves $20Excess Reserves $ 0Loans $80

Youraccount $100

Campus Radio account $ 0

Total Assets $100

Total Liabilities $100

Assets Liabilities

Eternal Savings

Required Reserves $29Required Reserves $51 Loans $64

Atlas Antenna account $80Herman’sHardwareaccount $64

Total Assets $144

Total Liabilities $144

13-28

The Money Multiplier

• In a multi-bank system, loans created by one bank invariably end up as reserves in another bank, which can then lend their excess reserves

• This process can theoretically continue until all banks have zero excess reserves (no more loans can be made)

13-29

The Money Multiplier

• Money multiplier: The number of deposit (loan) dollars that the banking system can create from $1 of excess reserves

1

Money multiplier

required reserve ratio

13-30

The Money Multiplier

• Required reserves represent leakage from the flow of money, since they cannot be used to create new loans

• Excess reserves can be used for new loans

13-31

The Money Multiplier Process

Required reserves

Excess reserves

Leakage into

The public

13-32

Excess Reserves as Lending Power

• Each bank may lend an amount equal to its excess reserves and no more

• The banking system can increase the volume of loans by the amount of excess reserves multiplied by the money multiplier

Excess reserves money potentialof banking system multiplier deposit creation

13-33

The Money Multiplier at Work

Original deposit = $ 100.00

Bank A loans: = $ 80.00 [=0.8 x $100.00]

Bank B loans = $ 64.00 [=0.8 x $80.00]

Bank C loans = $ 51.20 [=0.8 x $64.00]

Total money supply

= $ 500.00

13-34

Banks and the Circular Flow

• Banks perform two essential functions for the macro economy:– Banks transfer money from savers to spenders by

lending funds (reserves) held on deposit– The banking system creates additional money by

making loans in excess of total reserves

13-35

Banks in the Circular Flow

Lo

ans

Lo

ans

Factor markets

Product markets

Business firms

Consumers

BANKS

Sav

ing

Investment expenditures

Sales receipts

Wages, dividends, etc.

IncomeDomestic consumption

13-36

Financing Injections

• Consumer saving is a leakage, but a substantial portion is deposited in banks

• Bank deposits can be used to make loans, returning purchasing power to the circular flow

• The banking system can create any desired level of money supply if allowed to expand or reduce loan activity at will

13-37

Constraints on Deposit Creation

• Four major constraints on deposit creation:– Deposits– Willingness to Lend– Willingness to Borrow– Regulation

13-38

When Banks Fail

• In the past, “runs” of depositors rushing to withdraw their funds created panics

• Banks closed, wiping out customer deposits, curtailing lending, and often pushing the economy into recession

• In the early part of the Great Depression over 9,000 banks failed

13-39

When Banks Fail

• FDIC and FSLIC were created by Congress to ensure depositors their money was safe and eliminate motivation for bank runs

• In 2008, the U.S. was hit with another banking crisis

• Hundreds of billions of government dollars were pumped into the banking system

13-40

Money and BanksEnd of Chapter 13

Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin