28 Money and the Banking System [Money] is a machine for doing quickly and commodiously what would be done, though less quickly and commodiously, without.

28

Money and the Banking System

[Money] is a machine for doing quickly and

commodiously what would be done, though less quickly and commodiously, without it.

JOHN STUART MILL

● The Nature of Money● How the Quantity of Money is Measured● The Banking System● The Origins of the Money Supply● Banks and Money Creation● Why the Deposit Creation Formula Is

Oversimplified● The Need for Monetary Policy

● The Nature of Money● How the Quantity of Money is Measured● The Banking System● The Origins of the Money Supply● Banks and Money Creation● Why the Deposit Creation Formula Is

Oversimplified● The Need for Monetary Policy

ContentsContents

Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

● Barter versus Monetary Exchange♦ A barter system (with no money) would be

awkward and extremely inefficient.

♦ Money greases the wheels of exchange and, thus, makes the whole economy more productive.

● Barter versus Monetary Exchange♦ A barter system (with no money) would be

awkward and extremely inefficient.

♦ Money greases the wheels of exchange and, thus, makes the whole economy more productive.

The Nature of MoneyThe Nature of Money



● The Conceptual Definition of Money♦ The functions of money:

■Medium of exchange■Unit of account■Store of value

♦ Money = whatever serves as the medium of exchange

● The Conceptual Definition of Money♦ The functions of money:

■Medium of exchange■Unit of account■Store of value

♦ Money = whatever serves as the medium of exchange


● What Serves as Money?♦ Societies have gradually moved from the use

of commodity monies to the use of money that has no commodity backing at all.

● What Serves as Money?♦ Societies have gradually moved from the use

of commodity monies to the use of money that has no commodity backing at all.



● There is no single, obvious place to draw the line between “money” and “near money.”

● M1 = coins and paper money in circulation, plus checkable deposits

● M2 = M1 + money market deposit accounts, money market mutual funds, and savings accounts

● There is no single, obvious place to draw the line between “money” and “near money.”

● M1 = coins and paper money in circulation, plus checkable deposits

● M2 = M1 + money market deposit accounts, money market mutual funds, and savings accounts

How the Quantity of Money is MeasuredHow the Quantity of Money is Measured

FIGURE 28-2 Two Definitions of the Money Supply, February 2002

FIGURE 28-2 Two Definitions of the Money Supply, February 2002


M2 = $5500 billion

M1 = $1183 billion

Money market mutual funds $972 billion

Savings deposits

$3345 billion

M1 $1183 billion

Checking deposits in commercial banks $324 billion

Other checkable deposits $268 billion

Currency outside banks $591 billion


● How Banking Began♦ Fractional reserve banking began when

goldsmiths realized they could profitably lend out a portion of the gold that had been deposited with them for safekeeping.

● How Banking Began♦ Fractional reserve banking began when

goldsmiths realized they could profitably lend out a portion of the gold that had been deposited with them for safekeeping.

The Banking SystemThe Banking System



● How Banking Began♦ Three important features of the fractional

reserve banking system: ■Bank profitability■Banks discretion over the money supply■Exposure to bank runs

● How Banking Began♦ Three important features of the fractional

reserve banking system: ■Bank profitability■Banks discretion over the money supply■Exposure to bank runs



● Principles of Bank Management: Profits versus Safety♦ To make a profit, a banker must take risks.

♦ But because the business is risky, the same banker must also emphasize safety.

♦ The heart of banking is to be torn between the two principles.

● Principles of Bank Management: Profits versus Safety♦ To make a profit, a banker must take risks.

♦ But because the business is risky, the same banker must also emphasize safety.

♦ The heart of banking is to be torn between the two principles.

FIGURE 28-1 Bank Failures in the United States, 1915-2000

FIGURE 28-1 Bank Failures in the United States, 1915-2000


'00 '95

'00 '95

Nu

mb

er o

f B

ank

Fai

lure

s

1985 1975 1965 1955 1945 1935

40

80

120

160

200

0

Great Depression begins

FDIC established

Nu

mb

er o

f B

ank

Fai

lure

s

Year

2,200

2,000

1,800

1,600

1,400

1,200

1,000

800

600

400

200

0 1990 1985 1980 1975 1970 1965 1960 1955 1950 1945 1940 1935 1930 1925 1920 1915



● Bank Regulation♦ Deposit Insurance

■The Federal Deposit Insurance Corporation insures people’s deposits at banks.

♦ Bank Supervision ■Ensures banks take only sensible, defensible risks ■Controls the money supply

♦ Reserve Requirements ■Helps control the money supply

● Bank Regulation♦ Deposit Insurance

■The Federal Deposit Insurance Corporation insures people’s deposits at banks.

♦ Bank Supervision ■Ensures banks take only sensible, defensible risks ■Controls the money supply

♦ Reserve Requirements ■Helps control the money supply


● How Bankers Keep Books♦ Banks keep balance sheets

■Assets = liabilities + net worth

♦ Assets include: ■Reserves■Loans

♦ Liabilities include: ■Deposits owed to customers.

● How Bankers Keep Books♦ Banks keep balance sheets

■Assets = liabilities + net worth

♦ Assets include: ■Reserves■Loans

♦ Liabilities include: ■Deposits owed to customers.

The Origins of the Money SupplyThe Origins of the Money Supply

TABLE 28-1 Balance Sheet of Bank-a-mythica, Dec. 31, 2001

TABLE 28-1 Balance Sheet of Bank-a-mythica, Dec. 31, 2001



Banks and Money CreationBanks and Money Creation

● The Limits to Money Creation by a Single Bank♦ Banks can lend money in their vault that is

above the minimum required reserve ratio.

♦ In doing so, they create new money.

● The Limits to Money Creation by a Single Bank♦ Banks can lend money in their vault that is

above the minimum required reserve ratio.

♦ In doing so, they create new money.

TABLE 28-2 Bank-a-mythica’s Balance Sheet, Jan. 2, 2002

TABLE 28-2 Bank-a-mythica’s Balance Sheet, Jan. 2, 2002


TABLE 28-3 Bank-a-mythica’s Balance Sheet, Jan. 3-6, 2002








● Multiple Money Creation by a Series of Banks♦ When all banks make loans with funds they

have that are above the required reserve ratio, the society’s money supply expands.

● Multiple Money Creation by a Series of Banks♦ When all banks make loans with funds they

have that are above the required reserve ratio, the society’s money supply expands.



● Multiple Money Creation by a Series of Banks deposits = (1/m) x reserves

■Assumes banks keep the minimum reserve ratio, m■Assumes all new money held in the form of

deposits■Oversimplified deposit multiplier formula

● Multiple Money Creation by a Series of Banks deposits = (1/m) x reserves

■Assumes banks keep the minimum reserve ratio, m■Assumes all new money held in the form of

deposits■Oversimplified deposit multiplier formula

TABLE 28-5 Changes in First National Bank’s Balance Sheet

TABLE 28-5 Changes in First National Bank’s Balance Sheet


TABLE 28-6 Changes in Second National Bank’s Balance Sheet

TABLE 28-6 Changes in Second National Bank’s Balance Sheet


FIGURE 28-3 The Chain of Multiple Deposit Creation

FIGURE 28-3 The Chain of Multiple Deposit Creation


•

•

•

$400,000

$268,928

$236,160

$195,200

$144,000

(3)

$80,000

Loans

•

•

•

$100,000

•

•

•

$500,000

$336,160

$295,200

$244,000

$180,000

Running Sums

(2)

$100,000

Deposits

$67,232

$59,040

$48,800

$36,000

(1)

$20,000

Reserves

And so on . . .

$40,960 deposit

$32,768 lent out $8,192 on reserve

$51,200 deposit


$64,000 deposit


$80,000 deposit


$100,000 deposit




● The Process in Reverse: Multiple Contractions of the Money Supply♦ Deposits, and with them the money supply,

contract when reserves are reduced.■Banks reduce their loan commitments.■Calculation of the contraction in the money supply

utilizes the same formula as for money expansion.

● The Process in Reverse: Multiple Contractions of the Money Supply♦ Deposits, and with them the money supply,

contract when reserves are reduced.■Banks reduce their loan commitments.■Calculation of the contraction in the money supply

utilizes the same formula as for money expansion.

TABLE 28-7 Changes in Balance Sheet of Bank-a-mythica

TABLE 28-7 Changes in Balance Sheet of Bank-a-mythica


TABLE 28-8 Changes, Balance Sheet of First National Bank

TABLE 28-8 Changes, Balance Sheet of First National Bank



● Individuals hold some portion of additions to their money in the form of cash.

● Banks sometimes hold reserves above the required minimum.

● Individuals hold some portion of additions to their money in the form of cash.

● Banks sometimes hold reserves above the required minimum.

Why the Deposit Creation Formula Is OversimplifiedWhy the Deposit Creation Formula Is Oversimplified


The Need for Monetary PolicyThe Need for Monetary Policy

● Left uncontrolled, banks would: ♦ Reduce the money supply in a recession♦ Increase the money supply during boom

periods

● Changes in the money supply would exacerbate the business cycle.

● One reason for monetary policy, therefore, is to prevent this behavior on the part of banks.

● Left uncontrolled, banks would: ♦ Reduce the money supply in a recession♦ Increase the money supply during boom

periods

● Changes in the money supply would exacerbate the business cycle.

● One reason for monetary policy, therefore, is to prevent this behavior on the part of banks.

28 Money and the Banking System [Money] is a machine for doing quickly and commodiously what would be done, though less quickly and commodiously, without.

Documents

banking system money

money creation

use of money

quantity of money

functions of money

paper money

money greases

nature of money slide