Chapter 14 Notes and Vocabulary - Banking and the Money Supply

How Banks Create Money - continued 2

-1st Bank has $0 in excess reserves, and 2nd Bank has $810 in excess reserves (i.e., $90 of new demand deposits are required reserves) -2nd Round change in the money supply -$900 loan (which becomes a demand deposit in 2nd Bank) -Money supply: +$900 -Required reserves: +$90 -Excess reserves: +$810 -3rd Round: Money Supply expands with another loan -2nd Bank will loan out $810 in excess reserves borrower spends the $810 and the loan is checked away which is deposited in 3rd Bank. -3rd Bank will receive $810 reserves ($81 in required reserves and $729 in excess reserves).

How Banks Create Money - continued 3

-3rd round change in the money supply -$810 loan (which becomes a demand deposit in 4th Bank) -Money supply: +$810 -Required reserves: +$81 -Excess reserves: +$729 -4rd Bank will lend out $729 and the money supply will expand again by $729.

How Banks Create Money -continued 4

-4th Round and beyond: -Same pattern of making loans and monetary expansion until all excess reserves are eliminated from the banking system -Multiple money stock expansion processes continues but each successive loan is less and less do to the 10% required reserves -For the initial purchase of $1000 bond and creation of $1000 in excess reserves, the multiplier process increase the money supply by $10,000 -Delta Ms = $1000 + $900 + $810 + $729 + all successive lending out rounds = $10,000 -Exhibit 7 -Excess reserves - new loans -Required reserves: +10% of new checkable deposits -Excess reserve - maximum amount for loans -Money supply expansion

How Banks Create Money - continued 5

-A summary of rounds -Fed: $1,000 injection in fresh reserves from purchasing bond -Increased reserves by $1000 -Lending out of excess reserve will cause an increase in new demand deposits (i.e., the money supply) -Money supply increase: up to $10,000 in checkable deposits -As the banking system eliminates excess reserves, it expands money supply by a multiplier of 10

Simple Multiplier - notes

-Assumptions -No bank holds excess reserves -Loans are checked away -People don't use loan checks to increase cash holdings -Required reserve ratio = r -Simple money multiplier = 1/r =1/.1 =10 -Delta money supply = delta excess reserves from open market purchase x 1/r -Simple money multiplier = 1/r --> -Maximum multiple of injected excess reserves by which the money supply can increase

Starting a Bank

-Bank - obtains a charter (state or national) -Net worth = Owner's equity -Shares of stock in the bank by owners (public or private) -Balance sheet -Assets = Liabilities + Net worth -Asset - owned by bank -Physical property -Financial claim on interest earning assets -Stock in district Fed (required by Federal Reserve Act) -Liabilities and Net Worth -Net worth is owed to shareholders of the Bank -Deposits are owed to the individuals with funds in checking and savings accounts

How Banks Work

-Banks are in business to earn profits -Attract deposits from savers -Lend to borrowers -Difference between interest paid by borrower and interest paid to depositors is the banks earnings -Banks are financial intermediaries -Reduce transaction costs and increase economic efficiency -Banks can assess risk better than individuals (i.e., asymmetric information on borrowers ability to repay loans) -Reduce risk through diversification by lending to multiple borrowers (versus lending funds to a single borrower)

How Banks Create Money - continued

-Buying securities will have the same effect as lending out excess reserves because a check is issued to bond dealer. -First round change in the money supply: +$1,000 (open market purchase) -Required reserves: +$100 -Excess reserves: +$900 -Round 2: Checking away the proceeds of the $900 loan -The loan customer makes expenditures by check and the seller deposits the check in their Bank -Check clearing process by Fed results in $900 in reserves transferred from 1st Bank to 2nd Bank -Clearing of the $900 check → 1st Bank's excess reserves (assets) & deposits (liabilities) to decrease by $900 and 2nd Bank's . reserves & deposits increase by $900

The Discount Rate

-Changes in the Discount Rate on Borrowed Reserves -Fed is the lender of last resort -Reserves provided through OMO are non-borrowed reserves -Reserves loaned by Banks by the Fed are borrowed reserves -Borrowed reserves are provided by Discount Window -Interest Rate paid by Banks on Borrowed Reserves are called the Discount Rate -Primary discount rate: 1% above the federal funds rate -Secondary discount rate: ½% above the primary (paid by less solvent banks -Banks are only allowed to borrow reserves for short-term periods of reserve deficiency -Changes in the discount rate functions as a signal to financial markets of a change in direction of monetary policy

How Banks Create Money

-Creating money through excess reserves -Round one: Fed buys $1,000 US government bond -Fed clears the check for bond by crediting the reserve account of the bond sellers bank -The Fed Creates reserves by an electronic transaction (i.e., out of thin air) which is much more efficient than printing money -Effect on Bank's balance sheet -$1000 increase in deposits causes excess reserves to increase by $900 because reserve requirement is 10% -Bank now has incentive (to increase profits) to lend out $900 of excess reserves (in reality bank may want to hold some excess reserves)

Federal funds market - notes

-Day-to-day lending and borrowing of reserves between banks to meet temporary required reserve deficiencies -Interbank market for reserves on account at the Fed

Liquidity - notes

-Ease of converting assets into cash -Liquidity provides safety for the ability to meet deposit withdrawals by customers -Penalty for liquidity is lower interest rates on assets

Currency (Fiat money)

-Federal Reserve Notes (US Bureau of Engraving and Printing) -Issued by & Liabilities of 12 Federal Reserve Banks -Two-thirds circulate abroad -Coins -Manufactured by the U.S. Mint Sells them to the Fed at face value

Reserve Requirements - notes continued

-How much money the banking system can create with each dollar of fresh reserves -If the Fed increases the reserve requirement, -then banks have less excess reserves to lend out. -Changes in reserve requirements disrupt the banking system

Open-Market Operations - continued

-If it wants to increase (decrease) economic activity, Fed announces an decrease (increase) in the targeted federal funds rate and directs the New York Fed to engage in open market purchase (sale) of securities until the federal funds rate decrease (increase) to the target. -O.M. purchases of govt bonds increase total reserves money supply expansion by: delta Ms = (money mult) x delta Total Reserves -O.M. sales of govt bonds decrease total reserves → money supply contraction by: Delta Ms = (money mult) x delta Total Reserves

The objectives of liquidity and profitability are conflicting goals

-Increase (decrease) in liquidity --> Decrease (increase) in profitability

Federal funds rate - notes

-Interest rate charged in the federal funds market on reserves lent to banks for overnight borrowing -The Fed's target interest rate for the Fed's monetary policy

Bank Demand for Excess Reserves

-Inverse relationship between interest rate (opportunity cost) and quantity demanded of excess reserves -Decrease (increase) federal funds rate --> Increase (decrease) demand for excess reserves

Coping with Financial Crisis - continued

-Invested more than a $1 trillion in mortgage-backed securities -Invested more than a $1 trillion in mortgage-backed securities to stabilize banking system -Invested more than $90 billion in AIG (a major provider of insurance and pensions) -Provides sufficient liquidity to reduce the harm of mortgage defaults on the overall economy -Stockpiled extra cash in bank vaults around the country and around the world to avoid bank runs

Credit cards

-Loan from the card issuer which is repaid later -Disputed a charges (card company can reverse charges) -Not part of money supply since it is a loan

Reserve Requirements - notes continued 1

-Long-term borrowing by banks in financial trouble isn't allowed unless there is a serious financial crisis -Emergency tool to inject liquidity (bank were allowed to borrow heavily from discount window to stabilize the markets) -Primarily a signal to financial markets on the direction of monetary policy -Required reserve ratio -Required Reserve Ratios (this instrument isn't used for day-to-day control -Effects on money supply are dramatic and disruptive to the banking system -Changing required reserve ratio alters the money multiplier -Increasing required reserve ration from 10% to 20% → simple money mult. to contract from 10 to 5, causing a 50% fall in demand deposits

M2 continued

-M2 (broad money): M2 = M1 plus highly liquid assets that are easily converted into transaction accounts) -Savings deposits: traditional savings accounts -Money market mutual funds: checkable account offered by security brokers and mutual funds that pools small savers funds to invest in short-term securities that pay market interest rates -Money market deposit accounts: money market account offered by depository institutions -"Small" time deposits (CDs): time deposits, < $100k (pay a fixed interest rate for a specific period of time early withdrawal subject to interest penalties) -Overnight repurchase agreements -M2 is about 3 times large than M1

The Fed's Monetary Control Tools

-Open-market operations: buy / sell US government bonds -The discount rate: interest rate the Fed charges for borrowed reserves lent to banks -The required reserve ratio -Minimum fraction of reserves

Profitability

-Profitability increases with assets earning a higher return -Higher return required greater risk of default or losses -Higher risk assets increases the risk of insolvency (bank is unable to meet withdrawals which typically causes the bank to fail)

Reserve Accounts continued

-Required reserves deficiency: Total Reserves < Required Reserves -Banks must sell assets or borrow reserves from Fed (govt) or federal funds market (private reserves) to make up the deficiency -Total Reserve = Borrowed + nonborrowed reserves -There is no regulation on the amount of excess reserves (which are lent on the federal funds market overnight to other banks) -When economic conditions are good, loan demand is high, risks are lower, and excess reserves are minimal -When economic conditions are poor, loan demand is slack, default risks are higher, then excess reserves may be higher -non-FDIC insured banks may carry higher reserves to avoid potential runs

Reserve Accounts

-Reserve Requirement: minimum percentage of deposits that must be held as vault cash or deposits with the Fed -Such reserves are required reserves -ratio of required reserves to deposits is the required reserve ratio (Required reserve ratio = Required/Deposits) -if the bank holds more than the required reserves, these are excess reserves -The average required reserve ratio is approx. 10% -Required Reserves = Deposits Required reserve ratio -Excess Reserves = Total Reserves Required Reserves -Bank reserves exceeding required reserves -Can be used to make loans or to purchase interest-bearing or profit generating assets

The Fed is a Money Machine

-The Fed is a money machine -Assets (most earn interest) -U.S. government bonds (55%) -From open-market operations -Source of funding for Fed's operating budget -Mortgage-baked securities (40%) -AIG investments -Foreign currencies -Liabilities (Supplies Federal Reserve notes) -Federal Reserve notes outstanding (30%) -U.S. currency -Main liability: Banks reserve deposits receive no interest payment (Fed has paid interest since the financial crisis)

Multiple Contraction

-The Fed sells a $1,000 bond -Fed clears the check for bond by debiting the reserve account of the bond sellers bank by $1000 -1st Round: Required reserves: -$900 -Bank must recall loans or sell securities to raise required reserves by $900 -Money supply: -$900 -2nd Round: $900 check clears and required reserves: -$810 -Bank must recall loans or sell securities to raise required reserves by $810 -Successive rounds of money supply contraction -Final round: Delta Excess Reserves = -$1000 & mult = 1/r =1/.1 = 10 --> decrease total demand deposits = -$1000 x 10 = -$10,000 -The money multiplier process works the same whether there is an expansion or contraction.

Coping with Financial Crisis

-The Fed's object is to stabilize financial markets: -Regulation of the banking system and oversight of financial markets -Prevents major disruptions and financial panics -Ensures sufficient liquidity in the financial system -In 2007 and 2008 -Lowered discount rate from 6.25 percent to 0.25 percent -Encouraged banks to borrow from the Fed -Pays interest on bank reserves held at the Fed

Reserve Requirements

-The money multiplier (1/r) is very sensitive to the required reserve ratio (r) -Excess reserves fuel the deposit expansion process -A higher reserve requirement Drains potential loan expansion from the banking system and reducing the amount of new money that can be created -If r increase from .1 (10%) to .2 (20%) the simple money mult. decrease 10 to 5 -In real world, banking system, some check proceeds are held as cash & some excess reserves are retained by banks -Loans will be less due to this leakage of cash & excess reserves out of lending out process -Real world money mult. is smaller than simple money mult. = 1/r

Open-Market Operations

-The most widely used instrument of monetary control are Open-market operations (OMO) -The most flexible and most commonly used method of controlling the monetary base in the US is Federal Reserve open market operations. -These operations consist of daily sales and purchases of government securities by the Federal Reserve System. -All open market operations are conducted through the Federal Reserve Bank of New York. -Typically, the Fed will announce a target for the federal funds rate in a statement issued at the end of each FOMC meeting -Uses OMO to maintain the target range

Debit cards

-Withdraws funds from checking account -Part of M1 -Harder to dispute charges since funds are withdrawn immediately

Federal Reserves and Open Market Purchase: Reserve Requirements and Money Expansion

1. Federal Reserve injects reserves into banking system by purchasing Treasury Bonds 2. The fractional reserve requirement is the key to the multiple expansion of checkable deposits 3. Money multiplier: Multiple by which the money supply increases as a result of an increase in the banking system's excess reserves. 4. Simple money multiplier: Reciprocal of the required reserve ratio (1/ r), where r is the reserve ratio. 5. Assumes that: a. Change in the money supply = Change in excess reserves x (1 / r ) b. Banks hold no excess reserves. c. Borrowers do not let the funds sit idle. d. People do not want to hold more cash. e. The higher the reserve requirement (r), the smaller the money multiplier (1 / r ) f. As long as the bank's excess reserves do not remain idle, these excess reserves can fuel an expansion of the money supply. 6. Limitations on Money Expansion: Leakages from the multiple expansion process reduce the size of the money multiplier. 7. Deposit Contraction: The Process in Reverse 8. Federal Reserve Open Market Sale: Multiple Contraction of the Money Supply a. By selling government bonds, the Fed can reduce bank reserves, forcing banks to recall loans or sell some other asset to replenish reserves. b. The maximum possible effect is to reduce the money supply by the amount of the original reduction in bank reserves times the simple money multiplier (1/ r).

Banking System

1. How Banks Work a. Banks attract deposits from savers to lend to borrowers. b. Earn a profit on the difference between the interest paid depositors and the interest charged borrowers 2. Banks Are Financial Intermediaries: They bring together both sides of the money market: a. Banks reduce the transaction costs of channeling savings to creditworthy borrowers. b. Coping with Asymmetric Information c. Asymmetric Information: An inequality in what's known by each party to a transaction. d. Banks, by developing expertise in evaluating creditworthiness, structuring loans, and enforcing loan contracts, make the economy more efficient. e. Reducing Risk Through Diversification 3. Fractional Reserve Banking System: a. Required reserves: The Fed requires banks to hold a minimum percentage of their deposits in reserve. Computed by multiplying checkable deposits by the required reserve ratio. b. Required Reserve Ratio: Dictates the minimum portion of deposits the bank must hold in reserve. c. Excess Reserves: Bank reserves in excess of required reserves; can be used to make loans or purchase interest-bearing assets 4. Liquidity Versus Profitability: The bank manager must structure the portfolio of assets with an eye toward liquidity but must not forget that the banks' survival depends on profitability. a. Liquidity: The ease with which an asset can be converted into cash without a significant loss of value. b. The most liquid asset is bank reserves, but reserves earn no interest. c. Since reserves earn no interest, banks try to keep excess reserves to a minimum. d. Banks continuously "sweep" their accounts for excess reserves that can be put to some interest-bearing use. e. Federal funds market: Provides day-to-day lending and borrowing among banks of excess reserves on account at the Fed. f. Federal funds rate: Interest rate paid in the federal funds market for excess reserves at the Fed. The Fed targets this rate as a tool of monetary policy

How Banks Create Money - Test Review

1. How a Bank Accepts Deposits and Makes Loans 2. Making Loans: Checkable Deposit Creation by a Single Bank 3. How Checks Drawn on Newly Created Deposits Affect an Individual Bank's Balance Sheet

The Fed's Tools of Monetary Control

1. Open-Market Operations and the Federal Funds Rate: Policy decisions are made by the Federal Open Market Committee (FOMC). a. Open-Market Purchase: Purchase of U.S. government bonds by the Fed to increase the money supply. b. Open-Market Sale: Sale of U.S. government bonds by the Fed to decrease the money supply. 2. The Discount Rate: The interest rates the Fed charges on loans it makes to banks. a. Changes in the discount rate are a signal to financial markets about the direction of monetary policy. b. Lowering the discount rate reduces the costs of borrowing reserves, encourages banks to borrow from the Fed, increases reserves, and increases the money supply. c. Raising the discount rate increases the cost of borrowing reserves, discourages banks from borrowing, reduces reserves, and reduces the money supply 3. Reserve Requirements a. Increasing the reserve requirement reduces excess reserves and reduces the money supply. b. Decreasing the reserve requirement increases excess reserves and increases the money supply.

The Fed Is a Money Machine: Fed's budget is independent of Congress and Executive Branch

1. The Fed's main asset, U.S. government bonds, earns interest; 2. Its main liability, Federal Reserve notes in circulation, requires no interest payments.

Coping with Financial Crises

1. The Fed, through regulation of financial markets, tries to prevent major disruptions and financial panics, such as during the uncertainty following the terrorist attacks of September 11, 2001. 2. In 2007-2008, the Fed lowered the discount rate to 0.5 percent, started paying interest on reserves, and made multibillion dollar investments in financial markets.

Balance sheet

A financial statement: at a given point in time that shows assets on one side and liabilities and net worth on the other side; because assets must equal liabilities plus net worth, the two sides of the statement must be in balance, hence the name

Federal funds market

A market for overnight lending and borrowing of reserves among banks; the interbank market for reserves on account at the Fed

Liquidity

A measure of the ease with which an asset can be converted into money without a significant loss of value

M2

A money aggregate consisting of M1 plus savings deposits, small-denomination time deposits, money market mutual funds, and other miscellaneous near-monies

Asymmetric information

A situation in which one side of the market has more reliable information than the other side

Asset

Anything of value that is owned

Liability

Anything that is owed to other people or institutions

Net worth

Assets minus liabilities; also called owners' equity

Checkable deposits

Bank deposits that allow the account owner to write checks to third parties; ATM or debit cards can also access these deposits and transmit them electronically

Time deposits

Bank deposits that earn a fixed interest rate if held for the specified period, which can range from several months to several years; also called certificates of deposit

Savings

Bank deposits that earn interest but have no specific maturity date

Excess reserves

Bank reserves exceeding required reserves

Debit card

Cards that tap directly into the depositor's bank account to fund purchases; also called a check cards, and often doubles as an ATM card

M2 continued 2

Includes -Money market deposit accounts -Savings deposits -Small-denomination time deposits -Miscellaneous near-monies -Checkable deposits -Traveler's checks -Currency

M1 continued 2

Includes: -Checkable deposits -Traveler's checks -Currency

Money aggregates

Measures of the economy's money supply defined by the Fed

M1 continued

Narrow definition of money (contains the most liquid assets or money accepted as payment) -Currency: coins and paper money -Checkable Deposits -Demand deposits: checkable deposits at commercial banks which do not earn interest -Other checkable deposits at commercial banks and thrift institutions that do pay interest (ATS, NOW, Share Drafts) -Traveler's checks

Required reserves

The dollar amount of reserves a bank is obligated by regulation to hold as cash in the bank's vault or on account at the Fed

Federal funds rate

The interest rate charged in the federal funds market; the interest rate banks charge one another for overnight borrowing; the Fed's target interest rate

Discount rate

The interest rate the Fed charges banks that borrow reserves

Money multiplier

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

M1

The narrow measure of the money supply, consisting of currency and coins held by the nonbanking public, checkable deposits, and traveler's checks

Open-market purchase

The purchase of U.S. government bonds by the Fed to increase the money supply

Required reserve ratio

The ratio of reserves to deposits that banks are obligated by regulation to hold

Simple money multiplier

The reciprocal of the required reserve ratio, or 1/r; the maximum multiple of fresh reserves by which the money supply can increase

Open-market sale

The sale of U.S. government bonds by the Fed to reduce the money supply