Money and the Banking System Ch. 13
The Fed's quantitative easing policies during 2008-2013 expanded the monetary base from
$828 billion in the second quarter of 2008 to $3.67 trillion in December 2013.
The Changing Nature of Money in Recent Decades • Widespread use of the dollar abroad:
At least one-half and perhaps as much as two-thirds of U.S. dollar currency is held abroad. These dollars are included in the M1 money supply even though they are not circulating in the U.S..
The Changing Nature of Money in Recent Decades • Money Market Mutual Funds:
In the 1990s, many depositors shifted funds from interest earning checking accounts to money market mutual funds (MMMF). Because MMMFs are not included in M1 this further reduced the comparability of the M1 figures across time periods.
The Changing Nature of Money in Recent Decades • Substitution of electronic payments for checks and cash:
Increased use of debit cards & various forms of electronic money have reduced the demand for currency. Like other changes in the nature of money, these innovations have reduced the reliability of the money supply figures as an indicator of monetary policy.
Quantitative Easing
Increases in the Fed's asset holdings reflect expansionary monetary policy - "quantitative easing."
Longer-Term Loans Extended by the Fed
Like the discount rate loans, these new types of loans inject additional reserves into the banking system and thereby exert an expansionary impact on the money supply.
A unit of account:
Money is a unit of measurement used by people to post prices and keep track of revenues and costs
A store of value:
Money is an asset that allows people to transfer purchasing power from one period to another.
A medium of exchange:
Money is an asset used to buy and sell goods and services.
Quantitative easing (QE):
QE1: Fed assets ballooned from $923 billion in mid-2008 to $2.1 trillion in mid-2009. • QE2: As the economy remained sluggish, the Fed instituted a second round of quantitative easing. Between late-2010 and mid-2011, Fed assets increased another half trillion dollars. • QE3: Beginning in late 2012, the Fed began purchasing Treasury and mortgage backed securities at a rate of $85 billion per month.
4 Tools Fed Uses to Control Money Supply
The Fed has 4 major tools it can use to control the money supply: • Reserve requirements • Open market operations • Extension of Loans • Interest paid on bank reserves
The Federal Reserve info
The Federal Reserve (the Fed), created in 1913, is the central bank for the United States. •In short, the Federal Reserve is responsible for the conduct of U.S. monetary policy.
What does The Federal Reserve responsible for?
The Federal Reserve is responsible for the creation of a stable monetary climate for the entire U.S. economy. •It controls the money supply of the U.S., •serves as a "banker's bank" or "bank of last resort" for U.S. banks, and, •regulates the banking sector.
Controlling the Money Supply: Extension of Loans by the Fed DISCOUNT RATE
The discount rate is the interest rate the Fed charges banks for short-term loans needed to meet reserve requirements.
The Changing Nature of Money in Recent Decades • Interest earning checking accounts:
The introduction of interest earning checking accounts in early 1980s reduced the opportunity cost of holding checking deposits and thereby changed the nature of the M1 money supply.
Why is Money Valuable?
The main thing that makes money valuable is the same thing that generates value for other commodities: •the demand (for money) relative to its supply. •People demand money because it reduces the cost of exchange. •If the purchasing power of money is to remain stable over time, its supply must be limited. •When the supply of money grows rapidly relative to goods and services, its purchasing power will fall.
The Monetary Base
The monetary base is equal to the currency in circulation plus the reserves of commercial banks (vault cash & reserves held at the Fed).
Controlling the Money Supply: Interest Rate Fed Pays on Reserves
The payment of interest on reserves provides the Fed with another tool it can use to control the money supply.
The Business of Banking Banks play a central role in the capital market (the loanable funds market):
They help bring together people who want to save for the future with those who want to borrow for current investment.
How the Money Supply is Measured
Two basic measurements of the money supply are M1 and M2.
Under a fractional reserve system
an increase in deposits will provide the bank with excess reserves and place it in a position to extend additional loans, and thereby expand the money supply.
What is Money?
anything that serves as a medium of exchange, a unit of account, and a store of value
Open market operations
buying and selling of U.S. government securities (and other assets) in the open market
Fractional Reserve Banking: Excess reserves
can be used to extend new loans and make new investments.
Extension of Loans
control of loan volume to banks and other financial institutions
The U.S. banking system is a what kind of banking system?
fractional reserve system
The monetary base is important because
it provides the foundation for the money supply.
In contrast, if the Fed wants to reduce the money supply,
it will increase the interest rate paid banks on excess reserves. This will provide them with an incentive to hold more reserves, which will reduce the money supply.
If the Fed wants banks to extend more loans and thereby expand the money supply,
it will set the interest rate it pays on excess reserves very low, possibly even zero.
Conversely, a lower discount rate will
make it cheaper for banks to borrow from the Fed and exert an expansionary impact on the supply of money.
While media often focuses on the Fed's target fed funds rate,
open market operations are used to control this interest rate.
Other things constant, an increase in the discount rate will
reduce borrowing from the Fed and thereby exert a restrictive impact on the money supply.
The Required Reserve Ratio of Banking Institutions
reserve requirement for CHECKING ACCOUNTS 0-$12.4 million = 0% $12.4-$79.5 m = 3% >$79.5 m = 10%
Reserve requirements
setting the fraction of assets banks must hold as reserves (vault cash or deposits with the Fed), against their checking deposits
Interest paid on bank reserves
setting the interest rate paid banks on reserves held at the fed
Announcements after the regular meetings of the Federal Open Market Committee often focus on
the Fed's target for the fed funds rate.
The currency in circulation contributes directly to the money supply,
while the bank reserves provide the underpinnings for checking deposits.
The Business of Banking Banks are profit-seeking institutions:
• Banks accept deposits and use part of them to extend loans and make investments. Income from these activities is their major source of revenue.
Fractional Reserve Banking
• Banks are required to maintain only a fraction of their assets as reserves against their customers' deposits (required reserves). • Vault cash and deposits held with the Federal Reserve count as reserves.
Controlling the Money Supply: Extension of Loans by the Fed
• Historically, member banks have borrowed from the Fed, primarily to meet temporary shortages of reserves.
The components of M2 (a broader measure of money) includes:
• M1, • savings, • time deposits, and, • money market mutual funds.
Controlling the Money Supply: Open Market Operations
• Open Market Operations: the buying and selling of U.S. Treasury bonds and other financial assets by the Fed • This is the primary tool used by the Federal Reserve to control the money supply. • Note: the U.S. Treasury bonds held by the Fed are part of the national debt.
Controlling the Money Supply: Setting Reserve Requirements
• Reserve requirements: The fraction banks must hold as reserves (vault cash and deposits with the Fed) against their checking deposits. • When the Fed lowers the required reserve ratio, it creates additional excess reserves, encouraging banks to extend additional loans, and expanding the money supply. • Raising the reserve requirements has the opposite effect.
Controlling the Federal Funds Rate
• The Fed controls the federal funds rate through open market operations. • The Fed can reduce the fed funds rate by buying bonds, which will inject additional reserves into the banking system. • The Fed can increase the fed funds rate by selling bonds, which drains reserves from the banking system.
Discount Rate and Federal Funds Rate:
• The discount rate is closely related to the interest rate in the federal funds market, a private loanable funds market where banks with excess reserves extend short-term loans to other banks trying to meet their reserve requirements. • The interest rate in this market (in the federal fund market) is called the federal funds rate.
Open Market Operations: When the Fed sells bonds the money supply contracts because:
• bond buyers exchange money for bonds • bank reserves decline, causing them to extend fewer loans
Open Market Operations: When the Fed buys bonds the money supply expands, as:
• bond sellers acquire money (check from the fed) • bank reserves increase, placing banks in a position to expand the money supply through the extension of additional loans
The Business of Banking The banking industry includes:
• commercial banks, • savings & loans, and, • credit unions.
The components of M1 are:
• currency, • checking deposits (including demand deposits and interest-earning checking deposits), and, • traveler's checks.
The Functions of the Fed and Treasury THE U.S. TREASURY:
• is concerned with the finance of federal expenditures • issues bonds to the general public to finance the budget deficits of the federal government • does not determine the money supply
The Functions of the Fed and Treasury THE FEDERAL RESERVE:
• is concerned with the monetary climate of the economy • does not issue bonds • is responsible for the control of the money supply and the conduct of monetary policy
The Functions of Commercial Banking Institutions
•Banks provide services and pay interest to attract checking, savings, and time deposits (liabilities). •Most of these deposits are invested and loaned out, providing interest income for the bank. •Banks hold a portion of their assets as reserves (either as cash or deposits with the Fed) to meet their daily obligations toward their depositors.
Why Didn't the Banks Use the Excess Reserves to Extend Loans?
•Because of the recession and sluggish growth, the demand for loans was weak. •The Fed pushed the interest rate on Treasury bills and other short-term loans to near zero. •There was considerable uncertainty about the future and therefore banks were reluctant to make long-term commitments.
Credit Cards versus Money
•Money is an asset. •The use of a credit card is merely a convenient way to arrange for a loan. •Credit card balances are a liability. •Thus, credit card purchases are not money.
The Changing Nature of Money
•Recent financial innovations and structural changes have changed the nature of money and reduced the reliability of money growth figures as an indicator of monetary policy.
The Independence of the Fed
•The independence of the Federal Reserve system is designed to strengthen the ability of the Fed to pursue monetary policy in a stabilizing manner.
How Banks Create Money by Extending Loans
•The lower the percentage of the reserve requirement, the greater the potential expansion in the money supply resulting from the creation of new reserves. •The fractional reserve requirement places a ceiling on potential money creation from new reserves.
How Banks Create Money by Extending Loans: Actual deposit multiplier will be less than the potential because
•some persons will hold currency rather than bank deposits, and, •some banks may not use all their excess reserves to extend loans.
Fed independence stems from:
•the lengthy terms for the individual members of the Board of Governors (14 years), and, •the fact that the Fed's revenues are derived from interest on the bonds that it holds rather than allocations from Congress.