Money, Banking, and the Federal Reserve System

1. Money, Banking, and the Federal Reserve System Chapter 14

2. The Meaning of Money What are some examples of money? • Money is an asset that can easily be used to purchase goods and services. • Currency in circulation is cash held by the public. • Checkable bank deposits are bank accounts on which people can write checks. • The money supply is the total value of financial assets in the economy that are considered money. • Narrowest: currency in circulation, traveler’s checks, and checkable bank deposits (M1) • Broader: currency in circulation, traveler’s checks, and checkable bank deposits PLUS “almost” checkable—savings accounts. (M2)

3. Global Comparison: Currency

4. Roles of Money • Medium of exchange • Store of value • Unit of Account

5. Money of Medium of Exchange • A medium of exchange is an asset that individuals acquire for the purpose of trading rather than for their own consumption. • Money makes the transactions easier. • The alternative is barter.

6. Money as Store of Value • A store of value is a means of holding purchasing power over time. • Money keeps its value over time. • What can threaten the “store of value” of money?

7. Money as Unit of Account • A unit of account is a measure used to set prices and make economic calculations. • Money as a unit of account allows one to compare the values of goods and services.

8. Types of Money • Commodity Money • Good that is used as a medium of exchange that has value in its own right. • Examples are gold and silver. • Representative Money • Commodity-backed money is a medium of exchange with no intrinsic value whose ultimate value is guaranteed by a promise that it can be converted into valuable goods. • An example is a bank note redeemable for a commodity like gold or silver. • Fiat Money • Something that has value because government says that it has value—US $.

9. Measuring the Money Supply • Monetary Aggregates • An overall measure of the money supply • Federal Reserve calculates the size of two monetary aggregates • M1: currency in circulation, traveler’s checks, and checkable bank deposits • M2: currency in circulation, traveler’s checks, and checkable bank deposits PLUS “almost” checkable—savings accounts—example of near-moneys.

10. Monetary Aggregates, Sept. 2011

11. Monetary Role of Banks What do banks do? • A bank is a financial intermediary that uses liquid assets in the form of banks deposits to finance the illiquid investments of borrowers. • Bank reserves are the currency banks hold in their vaults plus their deposits at the Federal Reserve. • The reserve ratio is the fraction of bank deposits that a bank holds as reserves. • T-account summarizes a bank’s financial position • Bank’s assets include its reserves as well as loans • Bank’s liabilities include the deposits it holds.

12. Bank Regulation • A bank run is a phenomenon in which many of a bank’s depositors try to withdraw their funds due to fears of a bank failure. • Deposit insurance guarantees that a bank’s depositors will be paid even if the bank does not have the funds, up to a maximum per account. • Federal Deposit Insurance Corporation (FDIC) currently guarantees the first $250,000 held in each account at a bank. • Capital requirements are requirements by the Federal Reserve that bank owners hold substantially more assets than the value of bank deposits. • Reserve requirements are rules set by the Federal Reserve that determine the minimum reserve ratio for a bank. (10%) • The Federal Reserve lends money to banks through an arrangement known as the discount window.

13. Reserves, Bank Deposits, and the Money Multiplier • Excess reserves are a bank’s reserves over and above its required reserves. • Money is created when a bank loans any excess reserves it holds. • Banks lending leads to new deposits in the banking system and a multiplier effect on the money supply. • In a checkable-deposits-only system, the money supply equals bank reserves divided by the reserve ratio.

14. Determining the Money Supply How Banks Create Money

15. ASSETS LIABILITIES Loans $225,000 Deposits $250,000 Reserves $25,000 Practice: • The A&Z Bank has $250,000 in deposits. If the reserve ratios is 10%, how much of these deposits must the bank hold in reserve? • How much in loans can the A&B Bank issue in the given situation? • What does the T-Account for A&B Bank look like?

16. Practice: • Steve deposits his $15,000 Christmas bonus into his savings account at the New Market Bank. If the required reserve ratio is 15%, how much must the bank hold in required reserves? • Sam deposits $5,000 in cash into his checking account at the First Bank of Macroland. If the required reserve ratio is 20% what are the bank’s excess reserves?

17. Money Multiplier in Reality • Federal Reserve controls the sum of bank reserves and currency in circulation, monetary base. • The money multiplier is the ratio of the money supply to the monetary base. • The size of the money multiplier is reduced when funds are held as cash rather than as checkable deposits. • In reality, the money multiplier is smaller than the bank reserves divided by the reserve ratio.

18. Money Multiplier 1 Monetary multiplier = required reserve ratio 1 .2 5 = = 1 = rr • Assume reserve requirement = 20% • $100 put in bank 1 . rr Graphic Example New Reserves $100 $80 Excess Reserves $20 Required Reserves $100 Initial Deposit $400 Bank System Lending Money Created 32-18

19. Think, Pair, Share • What is the difference between the monetary base and the money supply? • Bank reserves are in the monetary base and not in the money supply.

20. Structure of the Federal Reserve • A central bank is an institution that oversees and regulates the banking system and controls the monetary base. • Federal Reserve, established in 1913, is the central bank of the US. • Federal Reserve system consists of: • Board of Governors • 12 regional Federal Reserve banks that provide various banking and supervisory services to commercial banks. What does your bill say?

21. Federal Reserve Regions

22. Federal Reserve System • Seven members of the Board of Governors are appointed by the president with Senate approval. • Serve 14-year terms • Terms staggered so one member is replaced every two years. (above political pressure) • The chairman of the Fed is appointed by the president with Senate approval and serves a four-year term with possible reappointment. Ben Bernake (2006 to Present) Alan Greenspan (1987 to 2006)

23. Role of Federal Reserve • A bank to banks and to the Federal government • Regulate the banks in their district • Provide a safe and stable financial system • Implement Monetary Policy

24. Policy Tools of Fed • Reserve requirements • Increase or decrease the amount that banks must hold in reserve. • Discount rate • The federal funds market allows banks that fall short of the reserve requirement to borrow funds from banks with excess reserves. • Interest rate the Fed charges banks to borrow for reserves • Rate is normally 1% above the federal funds rates although reduced in 2007 with financial crisis. • Open-market operations • An open-market operation is a purchase or sale of government debt by the Fed. • The Federal Reserve’s assets include government debt, mainly in the form of US Treasury bills. • The Fed’s liabilities include the currency in circulation plus bank reserves which comprise the monetary base.

25. Open-Market Operations • Federal Open Market Committee comprised of • Board of Governors • President of the New York Federal Reserve Bank + five other regional Federal Reserve Bank presidents • Federal Open Market Committee makes decisions regarding monetary policy.| • An open-market purchase of Treasury bills increases the monetary base and the money supply. • An open-market sale of Treasury bills decreases the monetary base and money supply.

26. European Central Bank • Created in January 1999 when 11 European nations decided to adopt the euro as their common currency. • Equivalent to the Fed’s Board of Governors

27. Overview of 21st Century American Banking System • Crisis at turn of century • 1907 panic originated in less regulated institutions known as trusts • The Fed was created in response to panic to centralize holding of reserves, inspect banks’ books and make the money supply sufficiently responsive to varying economic situations. • Responding to bank crises • Widespread banks runs in the early 1930s • Emergency measures were adopted that gave RFC powers to stabilize and restructure banking industry • Glass-Steagall Act (1933) separated banks into 2 categories: • Commercial bank accepts deposits and is covered by deposit insurance • Investment bank trades in financial assets (stocks and corporate bonds) and is not covered by deposit insurance. • Adoption of federal deposit insurance was most important to stop bank runs. • Regulation Q prevented commercial banks from paying interest on checking accounts. • With a long period of financial and banking stability, regulation Q was eliminated in 1980 and Glass-Steagall Act significantly weakened by 1999.

28. Overview of 21st Century American Banking System • Savings and Loan Crisis of 1980s • A savings and loan (thrift) is a type of deposit-taking bank, usually specialized in home loans. • Crisis of 1980s caused sharp losses in the financial and real estate sectors, resulting in an early 1990s recession.

29. Overview of 21st Century American Banking System • Financial Crisis of 2008 • Long-term Capital Management (LTCM) was a hedge fund created in 1994. • A financial institution engages in leverage when it finances its investments with borrowed funds. • Balance sheet effect is when sales of assets depress asset prices all over the world and other firms see the value of their balance sheets fall. • When asset prices falling from the balance sheet effect go below a critical threshold, creditors call in loans--leading to more asset sales as borrowers try to get cash to repay loans-leading to more defaults-leading to more declines in asset prices-leading to more loans called in and thus a vicious cycle of deleveraging. • Federal Reserve Bank of New York arranged a $3.625 billion bailout of LCTM in 1998 and revived world credit markets.

30. Overview of 21st Century American Banking System • Financial Crisis of 2008 • Subprime lending and the housing bubble • Subprime lending involves loans to people who don’t meet the usual criteria for borrowing and for being unable to afford their payments. • Securitization is the process of assembling pools of loans and selling shares in the income from these pools. • Housing boom turned out to be a bubble. When it burst, banks and nonbank financial instructions led to widespread collapse in the financial system. • Crisis and Response • Collapse of trust in the financial system, combined with large losses suffered by financial firms, led to a severe cycle of deleveraging and a credit crunch for the economy. • As the crisis originated in nontraditional banks institutions, the crisis of 2008 indicated a wider safety net and broader regulation are needed in the financial sector.