Chapter 11

Bank Assets and Liabilities: The Relative Magnitudes

Figure 11.3 shows the relative magnitudes of the banks' assets and liabilities—deposits and other borrowing—in 2011. After performing their profit-versus-risk balancing acts, the banks kept 13 percent of total assets in reserves, placed another 13 percent in liquid assets, 21 percent in securities, and 53 percent in loans. Checkable deposits (part of M1) were 8 percent of total funds. Another 51 percent of total funds were savings deposits and small time deposits (part of M2).

Barter

The direct exchange of goods and services for other goods and services, which requires a double coincidence of wants.

The word "fiat" is

Used to describe today's money because it is money set by law.

For a commodity or token to be money it must

be accepted in exchange for all other goods and services.

Whenever somebody deposits a check from bank A into a checkable deposit at bank B, bank A's reserves ________ and bank B's reserves ________

decrease; increase

Banks earn a profit by

making loans at a higher interest rate than the rates that they offer on their deposits.

All of the following are elements in the structure of the Fed EXCEPT the

Executive Council to the Governor.

Assume the desired reserve ratio is 10 percent, banks loan all excess reserves and the currency drain is zero. If the Fed sells $100 million of U.S. government securities to Boise Bank, the monetary base increases by

$100 million. See pages 281 - 284 for explanation.

Suppose the desired reserve ratio is 10 percent. If Urban Bank has total deposits of $1000 and total assets of $10,000, the amount of desired reserves is

$100.00

CHAPTER SUMMARY Key Points

1 Define money and describe its functions. -Money is anything that serves as a generally accepted means of payment. -Money functions as a medium of exchange, unit of account, and store of value. -M1 consists of currency held by individuals and businesses, travelers' checks, and checkable deposits owned by individuals and businesses. -M2 consists of M1 plus savings deposits, small time deposits, and money market funds. 2 Describe the functions of banks. -The deposits of commercial banks and thrift institutions are money. -Banks borrow short term and lend long term and make a profit on the spread between the interest rates that they pay and receive. 3 Describe the functions of the Federal Reserve System (the Fed). -The Federal Reserve is the central bank of the United States. - The Fed influences the economy by setting the required reserve ratio for banks, by setting the discount rate, by open market operations, and by taking extraordinary measures in a financial crisis. 4 Explain how the banking system creates money and how the Fed controls the quantity of money. - Banks create money by making loans. -The maximum quantity of deposits the banks can create is limited by the monetary base, the banks' desired reserves, and desired currency holding. -When the Fed buys securities in an open market operation, it creates bank reserves. When the Fed sells securities in an open market operation, it destroys bank reserves. -An open market operation has a multiplier effect on the quantity of money.

When the Fed sells $100 million of securities to AIG, three things happen:

1. AIG has $100 million more in securities, and the Fed has $100 million less in securities. 2. AIG pays for the securities with a check for $100 million drawn on its deposit account at the Manhattan Commercial Bank. 3. The Fed collects payment of this check from the Manhattan Commercial Bank by decreasing its reserves by $100 million.

Which of the following is NOT a thrift institution?

A COMMERCIAL BANK

What is a bank's balancing act?

A bank makes a profit by borrowing from depositors at a low interest rate and lending at a higher interest rate. The bank must hold enough reserves to meet depositors' withdrawals. The bank's balancing act is to balance the risk of loans (profits for stockholders) against the security for depositors.

Excess reserves

A bank's actual reserves minus its desired reserves. A bank's excess reserves are its actual reserves minus its desired reserves. When the banking system as a whole has excess reserves, banks can create money by making new loans. When the banking system as a whole is short of reserves, banks must destroy money by decreasing the quantity of loans.

Desired Reserves

A bank's desired reserves are the reserves that the bank chooses to hold. The desired reserve ratio is the ratio of reserves to deposits that a bank wants to hold. This ratio exceeds the required reserve ratio by an amount that the banks determine to be prudent on the basis of their daily business requirements. A bank's actual reserve ratio changes when its customers make a deposit or a withdrawal. If a bank's customer makes a deposit, reserves and deposits increase by the same amount, so the bank's reserve ratio increases. Similarly, if a bank's customer makes a withdrawal, reserves and deposits decrease by the same amount, so the bank's reserve ratio decreases.

Reserves

A bank's reserves consist of currency in its vaults plus the balance on its reserve account at a Federal Reserve Bank. The currency in a bank's vaults is a reserve to meet its depositors' withdrawals. Your bank must replenish currency in its ATM every time you and your friends have raided it for cash for a midnight pizza.

The Federal Reserve System (the Fed) is the central bank of the United States.

A central bank is a public authority that provides banking services to banks and governments and regulates financial institutions and markets. A central bank does not provide banking services to businesses and individual citizens. Its only customers are banks such as Bank of America and Citibank and the U.S. government. The Fed's main task is to regulate the interest rate and quantity of money to achieve low and predictable inflation and sustained economic expansion.

Checks

A check is not money. It is an instruction to a bank to make a payment. The easiest way to see why a check is not money is to think about how the quantity of money you own changes if you write a check. You don't suddenly have more money because you've written a check to pay a bill. Your money is your bank deposit, not the value of the checks you've written.

Bank Deposits

A commercial bank accepts three broad types of deposits: checkable deposits, savings deposits, and time deposits. A bank pays a low interest rate (sometimes zero) on checkable deposits, and it pays the highest interest rate on time deposits.

Commercial Banks

A commercial bank is a firm that is chartered by the Comptroller of the Currency in the U.S. Treasury (or by a state agency) to accept deposits and make loans.

Credit Cards

A credit card is not money. It is a special type of ID card that gets you an instant loan. Suppose that you use your credit card to buy a textbook. You sign or enter your PIN and leave the store with your book. The book may be in your possession, but you've not yet paid for it. You've taken a loan from the bank that issued your credit card. Your credit card issuer pays the bookstore and you eventually get your credit card bill, which you pay using money.

Debit Cards

A debit card works like a paper check, only faster. And just as a check isn't money, neither is a debit card. To see why a debit card works like a check, think about what happens if you use your debit card to buy your textbook. When the sales clerk swipes your card in the bookstore, the computer in the bookstore's bank gets a message: Take $100 from your account and put it in the account of the bookstore. The transaction is done in a flash. But again, the bank deposits are the money and the debit card is the tool that causes money to move from you to the bookstore.

Means of Payment

A means of payment is a method of settling a debt. When a payment has been made, the deal is complete. Suppose that Gus buys a car from his friend Ann. Gus doesn't have enough money to pay for the car right now, but he will have enough three months from now, when he gets paid. Ann agrees that Gus may pay for the car in three months' time. Gus buys the car with a loan from Ann and then pays off the loan. The loan isn't money. Money is what Gus uses to pay off the loan.

Medium of Exchange

A medium of exchange is an object that is generally accepted in return for goods and services. Money is a medium of exchange. Without money, you would have to exchange goods and services directly for other goods and services—an exchange called barter. Barter requires a double coincidence of wants. For example, if you want a soda and have only a paperback novel to offer in exchange for it, you must find someone who is selling soda and who also wants your paperback novel. Money guarantees that there is a double coincidence of wants because people with something to sell will always accept money in exchange for it. Money acts as a lubricant that smoothes the mechanism of exchange. Money enables you to specialize in the activity in which you have a comparative advantage instead of searching for a double coincidence of wants.

Money Market Funds

A money market fund is a financial institution that obtains funds by selling shares and uses these funds to buy assets such as U.S. Treasury bills. Money market fund shares act like bank deposits. Shareholders can write checks on their money market fund accounts, but there are restrictions on most of these accounts. For example, the minimum deposit accepted might be $2,500 and the smallest check a depositor is permitted to write might be $500.

Unit of Account

A unit of account is an agreed-upon measure for stating the prices of goods and services. To get the most out of your budget, you have to figure out whether going to a rock concert is worth its opportunity cost. But that cost is not dollars and cents. It is the number of movies, cappuccinos, ice-cream cones, or sticks of gum that you must give up to attend the concert. It's easy to do such calculations when all these goods have prices in terms of dollars and cents (see Table 11.1). If a rock concert costs $64 and a movie costs $8, you know right away that going to the concert costs you 8 movies. If a cappuccino costs $4, going to the concert costs 16 cappuccinos. You need only one calculation to figure out the opportunity cost of any pair of goods and services. For example, the opportunity cost of the rock concert is 128 sticks of gum ($64 ÷ 50¢ = 128 sticks of gum).

The Nonbank Public Sells When the Fed buys $100 million of securities from AIG, three things happen: 1. AIG has $100 million less in securities, and the Fed has $100 million more in securities. 2. The Fed pays for the securities with a check for $100 million drawn on itself, which AIG deposits in its account at the Manhattan Commercial Bank. 3. The Manhattan Commercial Bank collects payment of this check from the Fed, and the Manhattan Commercial Bank's reserves increase by $100 million.

AIG has the same total assets as before, but their composition has changed. It now has more money and fewer securities. The Manhattan Commercial Bank's reserves increase, and so do its deposits—both by $100 million. Because bank reserves and deposits have increased by the same amount, the bank has excess reserves, which it can use to make loans. When it makes loans, the quantity of money increases.

Which of the following is a tool the Federal Reserve System can use to regulate the quantity of money? i. changing the discount rate ii. conducting open market operations iii. changing the required reserve ratio *

ALL THREE

E-Checks

An electronic check (or e-check) is an electronic equivalent of a paper check. A group of more than 90 banks and other financial institutions have formed the Financial Services Technology Consortium to collaborate on developing the electronic check. Bank of Internet USA offers an Internet e-check system via e-mail. Like a paper check, an e-check is not money. The deposit transferred is money. You now know that checks, credit cards and debit cards, and e-checks are not money, but one new information-age money is gradually emerging—e-cash.

Open Market Operations

An open market operation is the purchase or sale of government securities—U.S. Treasury bills and bonds—by the Federal Reserve in the open market. When the Fed conducts an open market operation, it makes a transaction with a bank or some other business but it does not transact with the federal government. The New York Fed conducts the Fed's open market operations.

Store of Value

Any commodity or token that can be held and exchanged later for goods and services is called a store of value. Money acts as a store of value. If it did not, it would not be accepted in exchange for goods and services. The more stable the value of a commodity or token, the better it can act as a store of value and the more useful it is as money. No store of value is completely stable. The value of a physical object, such as a house, a car, or a work of art, fluctuates over time. The value of the commodities and tokens that we use as money also fluctuates, and when there is inflation, money persistently falls in value.

How do banks create new deposits by making loans, and what factors limit the amount of deposits and loans that they can create?

Banks can make loans when they have excess reserves. When a bank makes a loan, it creates a new deposit for the person who receives the loan. The amount of deposits created (loans made) is limited by the banks' excess reserves, its desired reserve ratio, and the currency drain ratio.

REGULATING THE QUANTITY OF MONEY

Banks create money, but this doesn't mean that they have smoke-filled back rooms in which counterfeiters are busily working. Remember, most money is deposits, not currency. What banks create is deposits, and they do so by making loans.

Liquid Assets

Banks' liquid assets are short-term Treasury bills and overnight loans to other banks. The interest rates on liquid assets are low but these are low-risk assets. The interest rate on interbank loans, called the federal funds rate, is the central target of the Fed's monetary policy actions.

Which of the following are included in the M1 definition of money?

CURRENCY AND CHECKABLE DEPOSITS

Profit and Risk: A Balancing Act

Commercial banks try to maximize their stockholders' wealth by lending for long terms at high interest rates and borrowing from depositors and others. But lending is risky. Risky loans sometimes don't get repaid and the prices of risky securities sometimes fall. In either of these events, a bank incurs a loss that could even wipe out the stockholders' wealth. Also, when depositors see their bank incurring losses, mass withdrawals—called a run on the bank—might create a crisis. So a bank must perform a balancing act. It must be careful in the way it uses the depositors' funds and balance security for depositors and stockholders against high but risky returns. To trade off between risk and profit a bank divides its assets into four parts: reserves, liquid assets, securities, and loans.

In August 2011, M1 was $2,108 billion; M2 was $9,545 billion; checkable deposits owned by individuals and businesses were $1,127 billion; time deposits were $810 billion; and money market funds and other deposits were $716 billion. Calculate currency held by individuals and businesses and traveler's check. Calculate savings deposits.

Currency held by individuals and businesses and traveler's checks is $981 billion. Currency and traveler's checks equals M1 ($2,108 billion) minus checkable deposits owned by individuals and businesses ($1,127 billion). Savings deposits are $5,911 billion. Savings deposits equals M2 ($9,545 billion) minus M1 ($2,108 billion) minus time deposits ($810 billion) minus money market funds and other deposits ($716 billion)

Deposits .

Deposits at banks, credit unions, savings banks, and savings and loan associations are also money. Deposits are money because they can be used to make payments. You don't need to go to the bank to get currency to make a payment. You can write a check or use your debit card to tell your bank to move some money from your account to someone else's

An Embryonic New Money: E-Cash

Electronic cash (or e-cash) is an electronic equivalent of paper notes (dollar bills) and coins. It is an electronic currency, and for people who are willing to use it, e-cash works like other forms of money. But for e-cash to become a widely used form of money, it must evolve some of the characteristics of physical currency. People use physical currency because it is portable, recognizable, transferable, untraceable, and anonymous and can be used to make change. The designers of e-cash aim to reproduce all of these features of notes and coins. Today's e-cash is portable, untraceable, and anonymous, but it has not yet reached the level of recognition that makes it universally accepted as a means of payment. E-cash doesn't yet meet the definition of money. Like notes and coins, e-cash can be used in shops. It can also be used over the Internet. To use e-cash in a shop, the buyer uses a smart card that stores some e-cash and the shop uses a smart card reader. When a transaction is made, e-cash is transferred from the smart card directly to the shop's bank account. Users of smart cards receive their e-cash by withdrawing it from a bank account by using a special ATM or a special cell phone. Several versions of e-cash in U.S. dollars, euros, and other currencies are available on the Internet. The most popular and widely used e-cash system is PayPal, which is owned by eBay. The most sophisticated and secure e-cash is a currency called Bitcoin, which can be used to settle debts and be traded for dollars and other currencies on the Internet. A handy advantage of e-cash over paper notes arises when you lose your wallet. If it is stuffed with dollar bills, you're out of luck. If it contains e-cash recorded on your smart card, your bank can cancel the e-cash stored on the card and issue you replacement e-cash. Although e-cash is not yet universally accepted, it is likely that its use will grow and that it will gradually replace physical forms of currency.

A bank's deposits and assets are $320 in checkable deposits, $896 in savings deposits, $840 in small time deposits, $990 in loans to businesses, $400 in outstanding credit card balances, $634 in government securities, $2 in currency, $30 in its reserve account at the Fed. Calculate the bank's loans, securities, and reserves.

Loans are $990 + $400 = $1,390. Securities are $634. Reserves are $30 + $2 = $32.

In January 2011, currency held by individuals and businesses was $920 billion; traveler's checks were $5 billion; checkable deposits owned by individuals and businesses were $926 billion; savings deposits were $5,378 billion; small time deposits were $905 billion; and money market funds and other deposits were $705 billion. Calculate M1 and M2 in January 2011.

M1 is $1,851 billion. M1 is the sum of currency held by individuals and businesses ($920 billion), traveler's checks ($5 billion), and checkable deposits owned by individuals and businesses ($926 billion). M2 is $8,839 billion. M2 is the sum of M1 ($1,851 billion), savings deposits ($5,378 billion), small time deposits ($905 billion), and money market funds and other deposits ($705 billion).

Banks create money by

MAKING LOANS

Money Today

Money in the world today is called fiat money. Fiat is a Latin word that means decree or order. Fiat money is money because the law decrees it to be so. The objects used as money have value only because of their legal status as money. Today's fiat money consists of • Currency • Deposits at banks and other financial institutions

A Commodity or Token

Money is always something that can be recognized and that can be divided up into small parts. So money might be an actual commodity, such as a bar of silver or gold. But it might also be a token, such as a quarter or a $10 bill. Money might also be a virtual token, such as an electronic record in a bank's database (more about this type of money later).

Definition of Money

Money is any commodity or token that is generally accepted as a means of payment. This definition has three parts that we'll examine in turn. A Commodity or Token Generally Accepted Means of Payment

In the United States today, which of the items in List 1 are money? LIST 1 • Your Visa card • The quarters inside vending machines • U.S. dollar bills in your wallet • The check that you have just written to pay for your rent • The loan you took out last August to pay for your school fees

Money is defined as a means of payment. Only the quarters inside vending machines and U.S. dollar bills in your wallet are money.

Generally Accepted

Money is generally accepted, which means that it can be used to buy anything and everything. Some tokens can be used to buy some things but not others. For example, a bus pass is accepted as payment for a bus ride, but you can't use your bus pass to buy toothpaste. So a bus pass is not money. In contrast, you can use a $5 bill to buy either a bus ride or toothpaste—or anything else that costs $5 or less. So a $5 bill is money.

The Functions of Money

Money performs three vital functions. It serves as a • Medium of exchange • Unit of account • Store of value

Extraordinary Crisis Measures The financial crisis of 2008, the slow recovery, and ongoing financial stress have brought three more tools into play. They are:

Quantitative easing (or QE) Credit easing Operation Twist

When we keep part of our wealth in a bank checking account, we are using money as a

STORE OF VALUE

Securities and Loans

Securities are bonds issued by the U.S. government and by other organizations. Some bonds have low interest rates and are safe. Some bonds have high interest rates and are risky. Mortgage-backed securities are examples of risky securities. Loans are the provision of funds to businesses and individuals. Loans earn the bank a high interest rate, but they are risky and, even when not very risky, cannot be called in before the agreed date. Banks earn the highest interest rate on unpaid credit card balances, which are loans to credit card holders.

The Board of Governors

The Board of Governors has seven members (including the Chairman), who are appointed by the President of the United States and confirmed by the Senate, each for a 14-year term. The terms are staggered so that one seat on the board becomes vacant every two years. The President appoints one of the board members as Chairman for a term of four years, which is renewable.

The Chairman of the Board of Governors

The Chairman of the Board of Governors is the Fed's chief executive, public face, and center of power and responsibility. When things go right, the Chairman gets the credit; when they go wrong, he gets the blame. Ben S. Bernanke, a former Princeton University economics professor, is the Fed's current Chairman.

If the Fed makes an open market sale of $1 million of securities, who can buy the securities? What initial changes occur if the Fed sells to a bank?

The Fed sells securities to banks or the public, but not the government. The initial change is a decrease in the monetary base of $1 million. Ownership of the securities passes from the Fed to the bank, and the Fed's assets decrease by $1 million. The bank pays for the securities by decreasing its reserves at the Fed by $1 million. The Fed's liabilities decrease by $1 million. The bank's total assets are unchanged, but it has $1 million less in reserves and $1 million more in securities.

How the Fed's Policy Tools Work

The Fed's normal policy tools work by changing either the demand for or the supply of the monetary base, which in turn changes the interest rate.

The Federal Open Market Committee

The Federal Open Market Committee (FOMC) is the Fed's main policy-making committee. The FOMC consists of the following twelve members: The Chairman and the other six members of the Board of Governors The president of the Federal Reserve Bank of New York Four presidents of the other regional Federal Reserve Banks (on a yearly rotating basis) The FOMC meets approximately every six weeks to review the state of the economy and to decide the actions to be carried out by the New York Fed.

THE BANKING SYSTEM

The banking system consists of the Federal Reserve and the banks and other institutions that accept deposits and that provide the services that enable people and businesses to make and receive payments. Three types of financial institutions accept the deposits that are part of the nation's money: Commercial banks Thrift institutions Money market funds

Discount Rate

The discount rate is the interest rate at which the Fed stands ready to lend reserves to commercial banks. A change in the discount rate begins with a proposal to the FOMC by at least one of the 12 Federal Reserve Banks. If the FOMC agrees that a change is required, it proposes the change to the Board of Governors for its approval.

Creating Deposits by Making Loans

The easiest way to see that banks create deposits is to think about what happens when Andy, who has a Visa card issued by Citibank, uses his card to buy a tank of gas from Chevron. When Andy signs the card sales slip, he takes a loan from Citibank and obligates himself to repay the loan at a later date. At the end of the business day, a Chevron clerk takes a pile of signed credit card sales slips, including Andy's, to Chevron's bank. For now, let's assume that Chevron also banks at Citibank. The bank immediately credits Chevron's account with the value of the slips (minus the bank's commission). You can see that these transactions have created a bank deposit and a loan. Andy has increased the size of his loan (his credit card balance), and Chevron has increased the size of its bank deposit. And because deposits are money, Citibank has created money. If, as we've just assumed, Andy and Chevron use the same bank, no further transactions take place. But the outcome is essentially the same when two banks are involved. If Chevron's bank is the Bank of America, then Citibank uses its reserves to pay the Bank of America. Citibank has an increase in loans and a decrease in reserves; the Bank of America has an increase in reserves and an increase in deposits. The banking system as a whole has an increase in loans, an increase in deposits, and no change in reserves.

The Multiplier Effect of an Open Market Operation An open market purchase that increases bank reserves also increases the monetary base by the amount of the open market purchase. Regardless of whether the Fed buys securities from the banks or from the public, the quantity of bank reserves increases and gives the banks excess reserves that they then lend.

The following sequence of events takes place: • An open market purchase creates excess reserves. • Banks lend excess reserves. • Bank deposits increase. • The quantity of money increases. • New money is used to make payments. • Some of the new money is held as currency—a currency drain. • Some of the new money remains in deposits in banks. • Banks' desired reserves increase. • Excess reserves decrease but remain positive.

What are the institutions that make up the banking system?

The institutions that make up the banking system are the Fed, commercial banks, thrift institutions, and money market funds.

Federal funds rate

The interest rate on interbank loans (loans made in the federal funds market).

The Structure of the Federal Reserve

The key elements in the structure of the Federal Reserve are • The Chairman of the Board of Governors • The Board of Governors • The regional Federal Reserve Banks • The Federal Open Market Committee

Required reserve ratio

The minimum percentage of deposits that the Fed requires banks and other financial institutions to hold in reserves.

What is the monetary base?

The monetary base is the sum of coins, Federal Reserve notes (dollar bills), and banks' reserves at the Fed.

Currency

The notes (dollar bills) and coins that we use in the United States today are known as currency. The government declares notes to be money with the words printed on every dollar bill, "This note is legal tender for all debts, public and private."

To see how the desired reserve ratio and the currency drain ratio determine the size of the money multiplier, begin with two facts:

The quantity of money, M, is the sum of deposits, D, and currency, C, or M = D + C, and The monetary base, MB, is the sum of reserves, R, and currency, C, or MB = R + C. The money multiplier is equal to the quantity of money, M, divided by the monetary base, MB, that is: Money multiplier = M/MB. Because M = D + C and MB = R + C then: Money multiplier = (D + C) / (R + C).

Are M1 and M2 Means of Payment?

The test of whether something is money is whether it is a generally accepted means of payment. Currency passes the test. Checkable deposits also pass the test because they can be transferred from one person to another by using a debit card or writing a check. So all the components of M1 serve as means of payment. Some of the savings deposits in M2 are also instantly convertible into a means of payment. You can use the ATM to get currency to pay for your groceries or gas. But other savings deposits, time deposits, and money market funds are not instantly convertible and are not a means of payment.

Thrift Institutions

The three types of thrift institutions are savings and loan associations, savings banks, and credit unions. A savings and loan association (S&L) is a financial institution that accepts checkable deposits and savings deposits and that makes personal, commercial, and home-purchase loans. A savings bank is a financial institution that accepts savings deposits and makes mostly consumer and home-purchase loans. The depositors own some savings banks (called mutual savings banks). A credit union is a financial institution owned by a social or economic group, such as a firm's employees, that accepts savings deposits and makes mostly consumer loans. Like commercial banks, the thrift institutions hold reserves and must meet minimum reserve ratiIOS

The Regional Federal Reserve Banks

There are 12 regional Federal Reserve Banks, one for each of the 12 Federal Reserve districts. Each regional Federal Reserve Bank has nine directors, three of whom are appointed by the Board of Governors and six of whom are elected by the commercial banks in the Federal Reserve district. The directors of each regional Federal Reserve Bank appoint that Bank's president, and the Board of Governors approves this appointment. The Federal Reserve Bank of New York (known as the New York Fed) occupies a special place because it implements some of the Fed's most important policy decisions.

Suppose that at the end of December 2009, the monetary base in the United States was $700 billion, Federal Reserve notes were $650 billion, and banks' reserves at the Fed were $20 billion. Calculate the quantity of coins.

To calculate the quantity of coins, we use the definition of the monetary base: coins plus Federal Reserve notes plus banks' reserves at the Fed. Quantity of coins = Monetary base − Federal Reserve notes − Banks' reserves at the Fed. So at the end of December 2009, Quantity of coins = $700 billion − $650 billion − $20 billion = $30 billion.

A bank's deposits and assets are $320 in checkable deposits, $896 in savings deposits, $840 in small time deposits, $990 in loans to businesses, $400 in outstanding credit card balances, $634 in government securities, $2 in currency, and $30 in its reserve account at the Fed. Calculate the bank's total deposits, deposits that are part of M1, and deposits that are part of M2.

Total deposits are $320 + $896 + $840 = $2,056. Deposits that are part of M1 are checkable deposits, $320. Deposits that are part of M2 include all deposits, $2,056.

Desired Currency Holding

We hold our money in the form of currency and bank deposits. The proportion of money held as currency isn't constant but at any given time, people have a definite view as to how much they want to hold in each form of money. Because households and firms want to hold some proportion of their money in the form of currency, when the total quantity of bank deposits increases, so does the quantity of currency that they want to hold.

A Commercial Bank Sells

When the Fed buys $100 million of securities from the Manhattan Commercial Bank, two things happen: 1. The Manhattan Commercial Bank has $100 million less in securities, and the Fed has $100 million more in securities. 2. To pay for the securities, the Fed increases the Manhattan Commercial Bank's reserve account at the New York Fed by $100 million. The commercial bank's total assets remain constant, but their composition changes. Its holdings of government securities decrease by $100 million, and its reserves increase by $100 million. The bank can use these additional reserves to make loans. When the bank makes loans, it creates deposits and the quantity of money increases.

Operation Twist

When the Fed buys long-term government securities and sells short-term government securities, the action is called Operation Twist. The idea is to lower long-term interest rates and stimulate long-term borrowing and investment expenditure. An Operation Twist was conducted in September 2011.

Credit Easing

When the Fed buys private securities or makes loans to financial institutions to stimulate their lending, the action is called credit easing.

How Open Market Operations Change the Monetary Base

When the Fed buys securities in an open market operation, it pays for them with newly created bank reserves and money. With more reserves in the banking system, the supply of interbank loans increases, the demand for interbank loans decreases, and the federal funds rate—the interest rate in the interbank loans market—falls. Similarly, when the Fed sells securities in an open market operation, buyers pay for the securities with bank reserves and money. With smaller reserves in the banking system, the supply of interbank loans decreases, the demand for interbank loans increases, and the federal funds rate rises. The Fed sets a target for the federal funds rate and conducts open market operations on the scale needed to hit its target. A change in the federal funds rate is only the first stage in an adjustment process that follows an open market operation. If banks' reserves increase, the banks can increase their lending and create even more money. If banks' reserves decrease, the banks must decrease their lending, which decreases the quantity of money. We'll study the effects of open market operations in some detail, beginning with an open market purchase.

Quantitative Easing (QE)

When the Fed creates bank reserves by conducting a large-scale open market purchase at a low or possibly zero federal funds rate, the action is called quantitative easing. There have been two episodes of quantitative easing, QE1 and QE2—see Eye on Creating Money on pp. 286-287.

If the Fed makes an open market sale of $1 million of securities, what is the process by which the quantity of money changes? What factors determine the change in the quantity of money?

When the Fed sells securities to a bank, the bank's reserves decrease by $1 million. The bank's deposits do not change, so the bank is short of reserves. The bank calls in loans and deposits decrease by the same amount. The desired reserve ratio and the currency drain ratio determine the decrease in the quantity of money. The larger the desired reserve ratio or the currency drain ratio, the smaller is the decrease in the quantity of money.

Required Reserve Ratios

You've seen that banks hold reserves of currency and deposits at a Federal Reserve Bank. The Fed requires the banks and thrifts to hold a minimum percentage of deposits as reserves. This minimum is known as a required reserve ratio. The Fed determines a required reserve ratio for each type of deposit. Currently, required reserve ratios range from zero to 3 percent on checkable deposits below a specified level to 10 percent on deposits in excess of the specified level.

As the central bank, the Federal Reserve System provides banking services to

banks and regulates financial institutions and markets.

The Monetary Base

You've seen that the monetary base is the sum of coins, Federal Reserve notes, and banks' deposits at the Fed. The size of the monetary base limits the total quantity of money that the banking system can create because banks have a desired level of reserves and households and firms have a desired level of currency holding and both of these desired holdings of the monetary base depend on the quantity of money.

M2

consists of M1 plus savings deposits and time deposits (less than $100,000), money market funds, and other deposits. Time deposits are deposits that can be withdrawn only after a fixed term. Money market funds are deposits that are invested in short-term securities.

M1

consists of currency held by individuals and businesses, traveler's checks, and checkable deposits owned by individuals and businesses.

A commercial bank's reserves are equal to the amount of

currency in the bank's vault plus the balance on its reserve account at a Federal Reserve Bank.

Currency Inside the Banks Is Not Money

currency inside the banks is not money. The reason is while currency is inside a bank, it isn't available as a means of payment. When you get some cash from the ATM, you convert your bank deposit into currency. You change the form of your money, but there is no change in the quantity of money that you own. Your bank deposit decreases, and your currency holding increases.

Who is the Fed's chief executive, and what are the Fed's main policy tools?

he Fed's chief executive is the Chairman of the Board of Governors, currently Ben Bernanke. The Fed's main policy tools are required reserve ratios, the discount rate, and open market operations. In unusual times, extraordinary crisis measures are an additional tool.

What is the Fed and what is the FOMC?

he Federal Reserve (Fed) is the U.S. central bank—a public authority that provides banking services to banks and the U.S. government and that regulates the quantity of money and the banking system. The FOMC is the Federal Open Market Committee—the Fed's main policy-making committee.

Suppose the Fed buys $1 million of government securities from Bank One, a large commercial bank. Bank One's reserves ________ and its deposits ________.

increase by $1 million; do not change See page 281-284 for explanation.

The monetary base

is the sum of coins, Federal Reserve notes, and banks' reserves at the Fed.

By increasing the required reserve ratio,

the Fed can force the banks to hold a larger quantity of monetary base. By raising the discount rate, the Fed can make it more costly for the banks to borrow reserves—borrow monetary base. And by selling securities in the open market, the Fed can decrease the monetary base. All of these actions lead to a rise in the interest rate.

Similarly, by decreasing the required reserve ratio,

the Fed can permit the banks to hold a smaller quantity of monetary base. By lowering the discount rate, the Fed can make it less costly for the banks to borrow monetary base. And by buying securities in the open market, the Fed can increase the monetary base. All of these actions lead to a decrease in the interest rate. Open market operations are the Fed's main tool and in the next section you will learn in more detail how they work.

The amount of loans that a bank can create is limited by

the bank's excess reserves.

If you shop for a car online and compare car prices across dealerships, money is functioning as a

unit of account

The Fed's Policy Tools The Fed's most important tasks are to influence the interest rate and regulate the amount of money circulating in the United States. How does the Fed perform these tasks? It does so by adjusting the reserves of the banking system. Also, by adjusting the reserves of the banking system and standing ready to make loans to banks, the Fed is able to prevent bank failures. The Fed's policy tools are:

• Required reserve ratios • Discount rate • Open market operations • Extraordinary crisis measures

Three factors limit the quantity of deposits that the banking system can create:

• The monetary base • Desired reserves • Desired currency holding