Banking and the Money supply

BANKING AND THE MONEY SUPPLY

•Monetary aggregates•Checkable deposits•Balance sheets•Money creation•Money multiplier•Tools of the Fed

MONETARY AGGREGATES

These are measures of the money supply. We add

together all assets that are liquid enough to be classified

as money

M1The narrow measure of the money supply; includes only the most liquid assets

M1 equals Currency and coin in circulationPlus: Checkable depositsPlus: Travelers’ checks

About 60 percent of Federal Reserve

notes now circulate abroad

M2 A broader measure of the money supply favored by many economists.

M2 equals

M1Plus: Miscellaneous near moniesPlus: Small denomination time depositsPlus: Savings depositsPlus: Money market deposit accounts

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Measures of the money supply (July 2007)

HOW BANKS WORKBy bringing together both sides of the money market , banks serve as intermediaries or go-betweens. Banks reduce the transactions costs of channeling saving to creditworthy borrowers.

•Coping with asymmetric information.•Reducing risk through diversification.

STARTING A BANK

To start a bank we must obtain a charter from a state government

or from the Federal Reserve

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Home Bank’s balance sheet

Assets Liabilities Building and furnitureStock in district Fed

$450,00050,000

Net worth $500,000

Total $500,000 Total $500,000

Note that:

Assets = Liabilities + Net Worth

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Home Bank’s balance sheet after $1,000,000 deposit into checking account

Assets Liabilities CashBuilding and furnitureStock in district Fed

$1,000,000450,000

50,000

Checkable depositsNet worth

$1,000,000500,000

Total $1,500,000 Total $1,500,000

Remember that deposits are an asset for depositors but a liability for the bank.

RESERVE REQUIREMENTSBanks must maintain a reserve account at the regional Federal Reserve bank

•Required reserves: The dollar amount of reserves a bank is required to hold as cash in vault or on account at the Fed.•Required reserve ratio: The ratio of reserves to deposits that banks by regulation are obligated to hold.•Excess reserves: Bank reserves exceeding required reserves

LIQUIDITY VERSUS PROFITABILITY

Banks must be ready for customers’ withdrawals, so

liquid bank assets are desirable. At the same time,

less liquid assets such as commercial and real estate loans are more profitable.

BANKS CREATE MONEY!!

•Banks create money when they make loans and credit the accounts of loan recipients.•Money creation (lending) is limited by banks’ holdings of excess reserves. •Reserve do not earn interest; hence banks seek to minimize reserve holdings

ILLUSTRATING THE EFFECTS OF FED OPEN MARKET OPERATIONS

Suppose the Fed pays $1,000 to a securities dealer for a bond. The

transaction is handled by the dealer’s bank—Home

Bank

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Changes in Home Bank’s balance sheet after Fed buys a $1,000 bond from Securities dealer

Assets Liabilities Reserves at Fed +$1,000 Checkable deposits +$1,000

oThe Fed credits home Bank’s reserve account by $1,000.oHome Banks’ liabilities increase by $1,000.

LET’S MAKE A LOAN!Assume the legal reserve ratio is .10 or 10 percent.

The preceding transaction will create a $900 excess reserve for Home Bank. Loans and

deposits can be expanded by that

amount.

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Round 2: Changes in Home Bank’s balance sheet after lending $900 to you

Assets Liabilities Loans +$900 Checkable deposits +$900

Thus the money supply initially increases by $900 as a result of this loan.

CHECKING AWAY THE LOAN

1. Suppose you write a $900 check to your university to pay fees.

2. Your university deposits the check into its account at Merchants Trust bank.

3. When the check clears, the Fed debits Home Banks’ reserve account for $900 and credits Merchant Bank’s reserve account for $900.

4. Thus the transaction creates a $810 excess reserve for MerchantsTrust.

MERCHANTS TRUST MAKES A LOANMerchants Trust makes a $810 loan

to an English major starting an online note-taking service called “Note

This.”

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Round 3: Changes in Merchants Trust’s balance sheet after lending $810 to English Major

Assets Liabilities Loans +$810 Checkable deposits +$810

Note that as a result of this loan the money supply has increased by $810.

CHECKING AWAY THE LOAN: PART 2

1. The English major writes an $810 check to the college bookstore.

2. The college bookstore deposits the $810 check into its account at Fidelity Bank

3. When the check clears, the Fed debits Merchant Trust’s reserve account for $810 and credits Fidelity Bank’s reserve account for $810.

4. Thus the transaction creates a $729 excess reserve for Fidelity Bank.

Fidelity Bank is now positioned to make loans totaling $729

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Summary of money creation resulting from Fed’s purchase of $1,000 US Government Bond

Bank

(1)Increase in CheckableDeposits

(2)Increase in

RequiredReserves

(3) Increase in

Loans=(1)-(2)

1. Home Bank2. Merchants Trust 3. Fidelity Bank All remaining rounds

$1,000 900 810

7,290

$100 90 81

729

$900 810 729

6,561 Totals $10,000 $1,000 $9,000

SIMPLE MONEY MULTIPLIER

The multiple by which the money supply changes as a result of a fresh change in fresh reserves of the banking system.

Change in the money supply = change in fresh reserves x 1/r

Where r is the required reserve ratio Simple money multiplier

In our case:

Change in the money supply = $900 x 1/.10 = (4900)(10)= 9,000

FED OPEN MARKET OPERATIONSHAVE POWERFUL EFFECTS

It should be clear now that when Fed buys

government securities in large quantities, there are strong effects in terms of bank excess reserves and

lending capacity.

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Federal Reserve Bank balance sheet as of August 22, 2007 (billions)

Assets Liabilities

US Treasury securitiesForeign currenciesBank buildingsDiscount loans to depository institutionsOther assets

$789.936.9

2.1

2.335.9

Federal Reserve notes outstandingDepository institutions reservesUS Treasury balanceOther liabilitiesNet Worth

$774.513.1

5.339.534.4

Total $866.8 Total $866.8