ECON 1010B Ch 4

In the economy of Panicia, the monetary base is $1,000. People hold one-third of their money in the form of currency (and thus two-thirds as bank deposits). Banks hold one-third of their deposits in reserve. One day, fear about the banking system strikes the population, and people now want to hold half their money in the form of currency. If the central bank does nothing, what is the new money supply?

$500 in currency and $500 in the bank

Monetary base

(B) A total number of dollars held by the public as currency C and by banks as reserves R so that B = C + R. High-Powered money The monetary base is under the direct control of the Fed

Currency-deposit ratio

(cr) Amount of currency holdings C by public as a fraction of itsholdings of demand deposits D.Reflects the preferences of households about the form of moneythey want to hold

Fiat money

(government-issued) Money that is not intrinsically useful and is valued only because it is used as money

Reserve-deposit ratio

(rr) Fraction of deposits that banks hold in reserve. The business decisions of banks and banking regulations determine it.

Money

- The stock of assets used for transactions

Recent Fed Actions and Money Supply: During and after the Global Financial Crisis and the pandemic, explain how the balance sheet was effected of the Fed and Bank

1) Acted as lender of last resort to financial institutions - Direct loans of reserves to financial institutions through a discount window at the discount rate (increased bank reserves in assets and debt in liabilities) (increased Fed loans in assets, which increased reserves in liabilities) - Also supplied reserves through special programs like the Term Auction Facility (TAF) 2. Engaged in quantitative easing (QE) - Purchasing massive amounts of securities from banks. These securities were then held on the Fed's balance sheet (assets)

Quantitative easing and affect on B

A central bank policy of increasing the money supply by buying long-term bonds, aiming to reduce long-term interest rates - open-market operations on steroids (large-scale asset purchases) - bought many treasuries and MBS from banks and paid them for creating many reserves Since raising Reserves, it raises B (B=C+R)

A higher interest rate on reserves makes banks...

A higher interest rate on reserves makes banks want to maintain a higher reserve-deposit ratio. If not earning interest, then banks would rather give them out as loans to earn positive interst

Capital requirement

A minimum amount of bank capital mandated by regulators

Fractional reserve banking

A system in which banks only keep some of their deposits on reserve

Store of Value

A way of transferring purchasing power from the present to the future; one of the functions of money While money is an asset that can store value, it's not the only type. Gold and silver, for example, act as stores of value.

Why might a banking crisis lead to a decrease in the money supply?

Afraid of humongous withdrawals, financial institutions would be more careful and raise the amount of money held in deposits, thereby raising the reserve ratio. Increases in the currency and reserve deposit ratios reduce the money multiplier and decline in the money supply.

100 percent reserve banking: How does the invention of Firstbank affect the money supply M? Before Firstbank, money supply M = $1,000 worth of currency C

After Firstbank, money supply M = $1,000 worth of deposits D. Firstbank does not change the size of the money supply M

An economy has a monetary base of 1,000 $1 bills. Calculate the money supply in scenarios (a)-(d) and then answer part (e). All money is held as currency All money is held as demand deposits. Banks hold 100 percent of deposits as reserves. ll money is held as demand deposits. Banks hold 20 percent of deposits as reserves.

All money is held as currency. $1,000 All money is held as demand deposits. Banks hold 100 percent of deposits as reserves. $1,000 All money is held as demand deposits. Banks hold 20 percent of deposits as reserves. M = 1/0.2 = 5 x 1000 =5000

M2

All of M1 + less immediate (liquid) forms of money to include savings, money market mutual funds, and small denomination time deposits. M2 is the U.S. Federal Reserve's estimate of the total money supply including all of the cash people have on hand plus all of the money deposited in checking accounts, savings accounts, and other short-term saving vehicles such as certificates of deposit (CDs).

Balance sheet

An accounting statement that shows assets and liabilities

Medium of Exchange

An item widely accepted in transactions for goods and services; one of the functions of money money is what people use to buy goods and services. "This note is legal tender for all debts, public and private" is printed on the U.S. dollar. When you walk into stores, you are confident that shopkeepers will accept your money in exchange for the items they are selling. The ease with which an asset can be converted into the medium of exchange and used to buy other things (goods, services, or capital assets) is called the asset's liquidity. Because money is the medium of exchange, it is the economy's most liquid asset.

Demand deposits

Assets that are held in banks and can be used on demand to make transactions, such as checking accounts

A commercial bank's deposits at The FED are:

Assets to the commercial bank and liabilities to the Federal Reserve Bank holding them. The deposit of commercial bank at the Federal Reserve is an important asset type used to preserve the safety of deposits. In the balance sheet, a commercial bank's deposits with the Federal Reserve are recognized as assets. Since the deposits belong to the commercial banks, the Federal Reserve will categorize them as liabilities.

A Model of Money Supply (exogenous variables)

B: Monetary base rr: Reserve-Deposit Ratio cr: Currency-Deposit Ratio

Banks as financial intermediaries

Banks act as financial intermediaries because they stand between savers and borrowers. Savers place deposits with banks, and then receive interest payments and withdraw money. Borrowers receive loans from banks and repay the loans with interest. In turn, banks return money to savers in the form of withdrawals, which also include interest payments from banks to savers. Banks are special types of financial institutions that can create money by creating deposits. Consequently, banks are the only institutions that influence the money supply

Explain how banks create money.

Banks create money when they lend the rest of the money depositors give them. This money can be used to purchase goods and services and can find its way back into the banking system as a deposit in another bank, which then can lend a fraction of it.

Recent Fed actions: did acting as a lender of last resort and quantitative easing (QE) effect M?

Both Fed actions raised reserves R and thus B (B=C+R). However, the money supply M (= m x B) did not rise to the same degree, because of an increase in the reserve-deposit ratio rr. Banks chose to hold excess reserves—they did not lend out as many reserves as possible. Why not? - Fears that loans would not be paid back during and after the financial crisis and pandemic. After October 2008, the Fed started paying interest on reserves-- banks never started successive lending) The decline in m prevented the explosion in the monetary base from causing an explosion in the money supply M.

Fractional reserve banking with reserve-deposit ratio of .2 (20%) Someone deposits $1,000 into bank

Firstbank loans out $800 to a borrower, who now holds $800 in currency. Reserve-deposit ratio = .2 = 20%. In fractional-reserve banking, banks create money. Before Firstbank, M = C = $1,000 After Firstbank, M = C + D = $1,000 + $800 = $1,800

Fed's Instruments of Monetary Policy Changes in rr via ...

Formal regulations - One such regulation was reserve requirements, which required banks to hold a minimum reserve-deposit ratio. - In March 2020, the Fed eliminated reserve requirements. Payments of interest on reserves to banks - The Fed began paying banks interest on the banks' reserves in October 2008, during the Global Financial Crisis (GFC) that prompted the Great Recession of the late 2000s. - A higher interest rate on reserves makes banks want to maintain a higher reserve-deposit ratio.

Jimmy Paul Miller starts his own bank, called JPM. As owner, Jimmy puts in $2,000 of his own money. JPM then borrows $4,000 in a long-term loan from Jimmy's uncle, accepts $14,000 in demand deposits from his neighbors, buys $7,000 of U.S. Treasury bonds, lends $10,000 to local businesses to finance new investments, and keeps the remainder of the bank's assets as reserves at the Fed. Show JPM's balance sheet. What is JPM's leverage ratio? An economic downturn causes 5 percent of the local businesses to declare bankruptcy and default on their loans. Show JPM's new balance sheet.

If 5% of businesses default on their loans, the banks assets fall by 5% due to loan defaults. Deposits and debt do not change, so the value of owner's equity must fall by the same amount to balance it out

Explain how each of the following events affects the monetary base, the money multiplier, and the money supply. Rumors about a computer virus attack on ATMs increase the amount of money people hold as currency rather than demand deposits.

If people want to hold more money as currency, rather than deposits, this increases the currency-deposit ratio which decreases the money multiplier People are holding more currency, so monetary base increases (B=C+R), YET banks hold less reserves, so monetary base decreases ---Net effect on monetary base is zero → no change in monetary base If money multiplier decreases (m=MxB), money supply increases

If bank has $1000 assets and $50 Capital, what is the leverage ratio and what is the meaning

In this example, the bank's leverage ratio is 1,000/50 = 20. For every one dollar in capital, the bank has $19 in deposits and debts.

Explain how each of the following events affects the monetary base, the money multiplier, and the money supply. The Fed flies a helicopter over 5th Avenue in New York City and drops newly printed $100 bills.

Increase money supply, and thus also the monetary base If people take this money and hold it → m falls If people take the money and make more deposits → m rises and then further increase in money supply

M1

M1 is a narrow measure of the money supply that includes currency, demand deposits, and other liquid deposits, including savings deposits. M1 includes demand deposits and checking accounts, which are the most commonly used exchange mediums through the use of debit cards and ATMs. M1 does not include financial assets, such as bonds.

Money supply and size

M=C+D the size of M will depend on: - Monetary policy of the Fed - Holdings of currency C by the public - Holding of public demand deposits D at the bank

Commodity money

Money that is intrinsically useful and would be valued even if it did not serve as money - Gold Standard, cigarettes in a POW camp

Fed's Instruments of Monetary Policy Changes in monetary base B = C + R via ..

Open-market operations: - Fed purchases a security from bank with reserves: B rises - Fed sells a security from bank with reserves: B falls Direct lending of reserves to banks via discount window as well as any other special lending program

An economy has a monetary base of 1,000 $1 bills. Calculate the money supply in scenarios (a)-(d) and then answer part (e). People hold equal amounts of currency and demand deposits. Banks hold 20 percent of deposits as reserves. The central bank wants to increase the money supply by 10 percent. In each of the above four scenarios, by how much must it increase the monetary base?

People hold equal amounts of currency and demand deposits. Banks hold 20 percent of deposits as reserves. When people hold $500 in currency and $500 as deposits, and the reserve ratio is 0.20, then the currency deposit ratio is 1 M=( 1 + 1)/(1 + .2)x B = (2/1.2) x 1000 = 1.67 x 1000 = $1,666.67 The central bank wants to increase the money supply by 10 percent. In each of the above four scenarios, by how much must it increase the monetary base? The money supply is proportional to the monetary base and can be given by M=mxB Therefore, a 10% increase in the monetary base will lead to an equal increase in the money supply

Reserve requirements

Regulations imposed on banks by the central bank that specify a minimum reserve-deposit ratio.

Reserves

Reserves are deposits that a bank has received but has not lent out. Reserves can either be held as vault cash or on account at the local regional Fed as reserve balances.

Excess reserves

Reserves held by banks above the amount mandated by reserve requirements.

Fractional reserve banking with reserve-deposit ratio of .2 (20%) Secondbank and Thirdbank after bank loans out $800 to someone depositing in Secondbank

Secondbank: person collects $800 and deposits it which (.2 x 800 = $160), so $640 is created

What are open-market operations, and how do they influence the money supply?

The Fed uses open market operations to buy or sell securities to banks. When the Fed buys securities, they give banks more money to hold as reserves on their balance sheet. When the Fed sells securities, they take money from banks and reduce the money supply.

What are the various ways in which the Federal Reserve can influence the money supply?

The Fed uses three primary tools in managing the money supply and pursuing stable economic growth. The tools are (1) reserve requirements, is used to refer to the amount of money that must be held by banks in an overnight period. A low reserve gives banks more money to lend, unlike a high reserve which gives the banks less money to lend. (2) the discount rate: the rate charged by the central bank on members who borrow from their window of discount. This is only achievable when members cannot borrow from other banks since it is only a bank that is desperate or in trouble that uses the discount window. (3) open market operations: refers to the operations of buying and selling securities from banks. Once the securities are bought, cash money is added to the reserves by the central bank thus enabling the bank to have more lending money.

Explain how each of the following events affects the monetary base, the money multiplier, and the money supply. The Fed reduces its lending to banks through its Term Auction Facility.

The TAF provides term funding on a collateralized basis, at interest rates and amounts set by auction. The facility is designed to improve liquidity by making it easier for sound institutions to borrow when the markets are not operating efficiently. The monetary base will decrease, and thus, money supply will also decrease If there is no change in the cr and rr ratio then the money multiplier is not affected

Federal reserve

The central bank of the United States

Monetary policy

The central bank's choice regarding the supply of money Specifically, monetary policy is conducted by the Federal Open Market Committee (FOMC) - 12 vote at each meeting (7 governors and 12 regional bank members that rotate 5 at a time)

Interest on reserves

The central bank's policy of paying banks an interest rate for the deposits that they hold as reserves.

If, in the face of this panic, the central bank wants to conduct an open-market operation to keep the money supply at its original level, does it buy or sell government bonds? Calculate, in dollars, how much the central bank needs to transact.

The goal, then, is to increase the money supply by $300, so the central bank must take action and BUY government bonds. The change in the money supply is related to the change in the monetary base through the money multiplier formula

Money multiplier

The increase in the money supply resulting from a one dollar increase in the monetary base m= (cr + 1)/(cr + rr)

Central bank

The institution responsible for the conduct of monetary policy in a country or region, such as the federal reserve in the United States

Discount rate

The interest rate that the Fed charges when it makes loans to banks.

Unit of account

The measure in which prices and other accounting records are recorded; one of the functions of money A car dealer says that a car costs $40,000, not 800 shirts (though the two may be equivalent).

Financial intermediation

The process by which financial institutions accept savings from businesses, households, and governments and lend the savings to other businesses, households, and governments Financial institutions engage in financial intermediation—matching savers to investors (S = I) - Stock markets - Bond markets - Banks

Open market operations

The purchase or sale of government bonds by the central bank for the purpose of increasing or decreasing the money supply

Bank capital

The resources bank owners have put into the institution. The equity of the owners of the bank is called bank capital. Bank capital is required to open a bank (that is, to receive a charter)

currency (C)

The sum of outstanding paper money and coins

Leverage

The use of borrowed money to supplement existing funds for purposes of investment Makes financial intermediation risky

What would happen if the bank's assets fell by 5% (Assets: $1000; capital: $50)

The value of assets would fall to $950. Liabilities must also fall. The value of bank capital would fall to zero (because payments to depositors and creditors have priority over bank owners). Implication: With this leverage ratio, a 5% fall in the value of assets results in a 100% fall in capital value. Without deposit insurance, there could be a bank run by depositors. Requirements on the size of bank capital is thus an importantcomponent of bank regulations.

Bank's Liabilities

Things that a bank owes someone else: deposits, debt (issuing bonds for borrowing money), capital (owners equity)

Bank Assets

Things that the bank owns 1. Reserves (vault cash) 2. Securities (t-bonds) 3. Loans (to local pizza parlor)

In the nation of Wiknam, people hold $1,000 of currency and $4,000 of demand deposits in the only bank, Wikbank. The reserve-deposit ratio is 0.25. Wiknam's central bank wants to increase the money supply by 10 percent. Should it buy or sell government bonds in open-market operations? Assuming no change in the money multiplier, calculate, in dollars, how much the central bank needs to transact.

To increase the money supply, they should buy government bonds because this will increase reserves in the banking system, allowing more loans and deposits We know that M=mxB AND ΔM = m x ΔB - The bank wants to increase money supply by 10%. Therefore, $400. The m is 2.5, therefore, M+$400=2.5(B+x) 1. 5,400 = 5000+2.5x 2. 2.5x=400 3. x =160 Therefore, the monetary base must increase by $160, the bank must buy $160 of government bonds

Explain how each of the following events affects the monetary base, the money multiplier, and the money supply. The Fed increases the interest rate it pays banks for holding reserves.

When increasing the interest rate, the Fed pays banks to hold reserves which gives banks an incentive to hold more reserves relative to deposits. Thus there is an increase in the reserve-deposit ratio→decreasing the money multiplier The decline in the money multiplier→ decrease in money supply Since banks are holding more reserves (making fewer loans), the monetary base will increase

Explain how each event affects the monetary base, the money multiplier, and the money supply. The Federal Reserve buys bonds in an open-market operation.

When the Fed purchases a security from a commercial bank with reserves, then the reserves of the Fed increase and B rises: B=C+R M=mxB so when monetary base increases→money supply increase m=(cr + 1)/(cr + rr) but both cr and rr are unchanged so m is unchanged

100 percent reserve banking

a situation in which banks' reserves equal 100 percent of their deposits - In other words, banks do not earn profits by making loans. - All deposits at banks would be held as reserves, denoted R

If a central bank wants to increase the money supply, it can _____ bonds in open-market operations or _____ reserve requirements

buy, decrease

Because of leverage, a 5 percent decline in the value of a bank's assets causes the value of the bank's _____ to fall by _____ than 5%.

capital, more

types of money

commodity money and fiat money

When the Federal Reserve reduces the interest rate it pays on reserves, this tends to _____ the money multiplier and _____ the money supply.

increase, increase

Suppose that a change in transaction technology reduces the amount of currency people want to hold relative to demand deposits. If the Fed does nothing, the money supply tends to _____. But the Fed can hold the money supply constant by _____ bonds in open-market operations.

increase, selling

In a system of fractional-reserve banking, bank lending increases the

money supply

functions of Money

store of value, unit of account, and medium of exchange

Which of the following is not part of the money supply?

the balances in your retirement account

leverage ratio

the ratio of assets to bank capital

Different Measures of Money: December 2023

C, M1, M2

What are the three functions of money? Which of the functions do the following items satisfy? Which do they not satisfy? A credit card A painting by Rembrandt A Starbucks gift card Subway token

Credit card: mediums of exchange because it is simply a card, with no intrinsic value, but we can pay with it, in exchange for goods and services. It might be a negative store of value, because you can accumulate debt with it, you spend the money sooner than you receive it. It is not a unit of account because there is no value of one credit card. Painting: The Rembrandt painting is only a store of value because it is worth a certain amount of money, and will be worth as long as humanity values is highly. Gift card: stored value Subway token: A subway token in the subway system has all three functions. But outside of the system it is not used as a medium of exchange nor a unit of account and it is not a form of money.