Money and Banking

Study Questions

n 1. What is money?

n 2. What are the three functions of money?

n 3. What is the money supply?

n 4. How do banks create money?

n 5. What is fractional reserve banking?

n 6. What are the three tools the Federal Reserve can use to manipulate the money supply?

n 7. How does the Fed conduct Open Market Operations?

n 8. When would the Fed favor an “easy money” policy?

n 9. When would the Fed favor a “tight money” policy?

Money

n It is a tool.

¨ Makes transactions easier.

n The size of the money supply is controlled by the central bank:

¨ The Federal Reserve System.

Barter

n Exchanges one good for another.

n Problem:

¨ double coincidence of wants.

¨ high transaction costs.

n extra effort

n time lost in search

n Money eliminates the double coincidence of wants.

Money

n Anything that is generally accepted as payment of goods and services and for employment.

n Typically:

¨ cash in circulation (paper money and coins)

¨ deposits (electronic data entries)

Money

n What gives money value?

¨ Its purchasing power.

¨ Our trust that the Federal Reserve System will not expand the money supply faster than what is needed for transactions.

n Our money is no longer “backed” by gold or silver.

Money’s Characteristics

n Portable

n Durable

n Divisible

n Recognizable

n Rare

Functions of Money

n Medium of Exchange

n Store of Value

n Standard of Value

Money Supply

n This is money that people can access.

n Its size is limited by the Federal Reserve System.

n It is categorized by its liquidity (how easy it is to spend):

¨ M1 (most liquid)

¨ M2

¨ M3 (least liquid)

Money Supply

n Are credit cards money?

¨ No…you are borrowing from the issuer when you use a credit card.

n Are debit cards money?

¨ Yes…using a debit card is just like writing a check; it draws down your checking account.

Commercial Banks

n Privately owned

n Profit seeking

n Receive deposits (pay out interest)

n Make loans (charge interest)

n Perform other services for fees

n Economic function: redirects savings into investments and spending

Money “is created”

n When a bank makes a loan, the money supply is increased.

¨ Loan is approved

¨ Borrower’s checking account is increased

¨ More money can be accessed by people

¨ Money supply increases

Money “is destroyed”

n When a borrower pays back a loan, the money supply is decreased.

¨ Borrower pays back a loan

¨ Borrower’s checking account is decreased

¨ Less money can be accessed by people

¨ Money supply decreases

The Federal Reserve System

n Our nation’s central bank.

n Twelve regional Federal Reserve Banks

n Acts as banker to the banking system

n Has a policy making role:

¨ manages the size and growth of the money supply.

¨ manages interest rates and the availability of credit.

Fractional Reserve Banking

n Banks receive deposits (also called reserves) from its clients.

n The Fed requires a fraction of those deposits to be set aside (required reserves) and not used to make loans.

n The rest of the deposits (excess reserves) may be loaned out to borrowers.

Fractional Reserve Banking

n The fraction of deposits (reserves) that must be set aside is the reserve ratio.

n The Fed controls the amount of loans that can be made by setting the reserve ratio.

n Since loans create money, this controls the size and growth of the money supply.

Fractional Reserve Banking

n A new deposit not only triggers the ability to make one loan, it sets off a multiplier effect of several new loans.

n The money multiplier is the reciprocal of the reserve ratio:

¨ Bank must set 1/20, or 5%, of its deposits aside? Money multiplier is 20.

How does the multiplier work?

n A bank has a new deposit.

n They set 5% aside and loan the rest to a borrower.

n Borrower spends the funds; the vendor deposits the money in his bank.

n His bank has a new deposit; sets 5% aside and loans out the rest.

n The cycle repeats, but each deposit gets smaller and smaller.

How does the multiplier work?

n Initial new deposit = $10,000

n Reserve ratio = 5%, or 1/20

n Money multiplier = 20.

n Total new money created by the cycle of loans= 20 x $10,000, or = $200,000.

Tools of the Fed

n Changing the reserve ratio.

n Changing the discount rate.

n Conducting open market operations.

Changing the reserve ratio

n If reserve ratio is 5%, or 1/20, a $10,000 deposit will trigger an increase in the money supply of $200,000.

n Raise the reserve ratio to 10%, or 1/10, and the increase can only go to $100,000.

¨ fewer loans will be made

n Lower the reserve ratio to 2%, of 1/50, and the increase can go to $500,000.

¨ more loans will be made.

Changing the discount rate

n Banks can borrow reserves from the Fed if they wish to make more loans than their deposits allow.

¨ They must pay interest on these loans – the discount rate.

n If the Fed raises the discount rate, the cost to borrow by banks goes up, and they will borrow fewer reserves (make fewer loans)

n If the Fed lowers the discount rate, the cost to borrow by banks goes down, and they may borrow more reserves (make more loans).

Benchmark Interest Rates

n Discount rate

n Federal Funds rate

n When the Fed raises these rates, banks and other lenders raise all interest rates.

¨ more expensive to borrow

n When the Fed lowers these rates, banks and other lenders lower all interest rates.

¨ less expensive to borrow

Conduct Open Market Operations

n The Open Market in question is the daily buying and selling of US Treasury Securities, or bonds.

n In the past, the US Treasury issued these bonds to raise funds to cover the budget deficit.

n Bondholders might wish to redeem their funds earlier than the maturity date. They can do so by selling their bonds in the Open Market.

n Others may wish to invest funds in these bonds. They can do so by buying bonds in the Open Market.

Conduct Open Market Operations

n The Fed owns US Treasury Securities.

n The Fed Open Market Committee can change the size and growth of the money supply using Open Market Operations.

Conduct Open Market Operations

n If the Fed buys securities, they must pay for them.

¨ The seller’s checking account increases.

¨ Bank deposits (reserves) increase.

¨ More loans can be made.

¨ Money Supply increases.

Conduct Open Market Operations

n If the Fed sells securities, the buyer must pay the Fed for them.

¨ The seller’s checking account decreases.

¨ Bank deposits (reserves) decrease.

¨ Fewer loans can be made.

¨ Money Supply decreases.

“Easy Money” Policy

n In an underperforming economy:

¨ encourage lending to encourage spending

¨ expand credit

¨ options:

n lower the reserve ratio

n lower the discount rate

n buy securities in the open market

“Tight Money” Policy

n In an overheated economy:

¨ discourage lending to discourage spending

¨ shrink credit

¨ options:

n raise the reserve ratio

n raise the discount rate

n sell securities in the open market