Unit 3: Ch 15 & 16

Reserve ratio rr

*The ratio of reserves to deposits in a bank* Bank doesn't want to reserve (hold onto) too much $ in vault b/c $ sitting doesn't do anything for bank, plus they have to guard/store it, BUT bank can't be empty of reserves b/c they need to meet ordinary depositor demands for currency services

4 Assets that serve as payment in US

1. Currency (paper bills, coins) 2. Total reserves held by banks at Fed 3. Checkable desposits- your checking/debit account 4. Savings deposits, money market mutual funds, small-time deposits

How Fed controls money supply (MB)

1. Open market transactions 2. Changes in discount rate 3. Paying interest on reserves held by banks at Fed

3 uses for money

1. a medium of exchange 2. serves as unit of account ($ gives value to object so value can be compared between objects) 3. stores wealth (when invested, lenders store wealth)

Liquid asset

Asset that can be used for payments or, quickly and without loss of value, be converted into an asset that can be used for payments The more liquid an asset --> more it can serve as money *Currency* is most liquid

Fractional reserve banking

Banks hold only a fraction of your deposits in reserve, and lends the rest

High reserve ratio RR

Banks want this when depositors want to withdraw their cash or when loans don't seem profitable. A high amount of reserves, low amount of deposits

Low reserve ratio RR

Banks want this when they're not worried about depositors demanding cash and when loans are profitable

Small-time deposits (CDs or certificates of deposit)

Cannot be withdrawn without penalty before a certain time period has elapsed, usually 6 months or a year

Equation!

Change in money supply= (1/rr) x MM

Federal Deposit Insurance Corporation: FDIC

Created to guarantee bank deposits up to $250,000 for each depositor name in an account. *Depositors know their deposits are insured--> less reason to withdraw deposits at a bank.* Mere existence of FDIC can reduce bank panics

M1

Currency + checkable deposits Banks don't just store $; they lend your $ to others, so your $ isn't necessarily at that bank

Monetary base

Currency + total bank reserves Fed Res controls this

Checkable deposits

Deposits you can write checks on or can access w/ debit card Used most often in making daily transactions a.k.a *demand deposits* b/c can be accessed on demand

Term Auction Facility

Fed announces that it wants to *inject a certain quantity of reserves into banks*; those funds then auctioned until the rate was low enough that banks would borrow the $ In contrast to *discount rate* Gives Fed more control over M

When Fed buys T-bills (open market transaction)...

Fed electronically increases reserves of seller (bank) --> bank then increases loans --> people deposit more --> *more money in circulation*

Insolvent bank

Has *long term* liabilities that are greater than its assets The value of a bank's loans falls so far that the bank can no longer pay back its depositors

Illiquid bank

Has *short-term* liabilities that are greater than its short-term assets but overall has assets that are greater than its liabilities

Total reserves

Held by banks at the Fed Major banks have accounts at Federal Reserve System (used for trading w/ other banks and Fed itself) *Not currency but electronic claims that can be converted to currency*

Buying bonds stimulates economy by...

High money supplies and lower interest rates (bonds and interest rates inversely related)

Ideally, Fed uses *discount window* to lend to *illiquid but solvent* institutions and waits for them to regain liquidity, return to health

If Fed knows a bank is *insolvent*, usually the best thing is to *pay off depositors and close down* the bank before it can incur any more losses

Money multiplier MM

Inverse of reserve ratio RR Ratio of deposits to reserve The amount the money supply (deposits) expands with each dollar increase in reserves MM = 1/RR *If MM is 10, then increase in reserves of $1,000 will lead to increase in deposits of $10,000

When Fed sells bonds...

It reduces the money supply as ppl give up their reserves to buy the bonds. Also lowers bond price --> increases interest rate

M2

M1 + savings deposit + money market mutual funds + CDs Less liquid than M1 Most all-encompassing measurement

When banks are fearful and reluctant to lend (they wish to hold high level of reserves)...

MM is low (so rr is high) and change in MB need not change broader monetary aggregates much at all *MM is not fixed*

3 types of money supply

Monetary base (MB) M1 M2

Moral hazard

Occurs when banks and other financial institutions take on too much risk (i.e. investing in, say, Bear Stearns, which is failing), hoping the Fed will later help them out

Liquidity crisis

Occurs when banks are illiquid

Solvency crisis

Occurs when banks become insolvent

Currency

Paper bills, coins, held by people and nonbank firms So much US cash exists b/c quite a bit used in other countries

Required reserve ratio

Ratio of checkable deposits required to be on reserve at the Fed Res

Federal Funds rate

The *overnight* rate for a loan from one major bank to another

Lender of last resort

The Fed, b/c it loans money to bank and other financial institutions when no one else will

Discount rate

The interest rate banks pay when they borrow directly from Fed

Systemic risk

The risk that the failure of one financial institution can bring down other institutions as well. Ex: Bear Stearns was failing & owed a lot of $ to banks, the Fed aided Bear Stearns so it wouldn't fail then cause the banks to fail, too.

US Treasury

The world's largest bank customer: more income and borrows more than any other bank customer

Quantitative easing

When Fed buys *longer-term* (instead of short term) gov't bonds to boost economy Opposite is quantitative tightening (sells longer term bonds)

Open market transaction

When the Fed buys/sells government bonds to increase/decrease money supply