1. Macro ECON McEachern 2010-2011 15 CHAPTER Banking and the Money Supply Designed by Amy McGuire, B-books, Ltd.

2. Money Aggregates • Money aggregates • Measure of money supply • Defined by the Fed • M1 = Narrow definition of money • Currency (including coins) • Nonbanking public • Checkable deposits • Bank deposits • Write checks to third parties • Traveler’s checks LO1

3. Money Aggregates • Currency = Fiat money • Federal Reserve Notes • U.S. Bureau of Engraving and Printing • Issued by & Liabilities of • 12 Federal Reserve Banks • 60% - abroad • Coins • U.S. Mint LO1

4. Money Aggregates • M2 = Broader definition of money • M1 • Savings deposits • Earn interest; no specific maturity date • Small-denomination time deposits • Certificates of deposits, CDs • Earn interest; specific maturity date • Money market mutual fund accounts • Restrictions LO1

5. Measures of the Money Supply (February 2009) LO1 Exhibit 1

6. Money Aggregates • Credit cards • Loan from the card issuer • Repay later • Dispute a charge • Not part of money supply • Debit cards • From checking account • Part of M1 LO1

7. How Banks Work LO2 • Banks earn profit • Attract deposits from savers • Lend to borrowers • Banks are financial intermediaries • Reduce transaction costs • Cope with asymmetric information • Reduce risk through diversification

8. Starting a Bank LO2 • Home Bank – obtains a charter • Net worth = Owner’s equity • Shares of stock in the bank • Balance sheet • Assets = Liabilities + Net worth • Asset – owned by bank • Physical property • Financial claim • Stock in district Fed • Liabilities – owned by bank

9. Exhibit 2 LO2 Home Bank’s Balance Sheet

10. Exhibit 3 LO2 Home Bank’s Balance Sheet After $1,000,000 Deposit Into Checking Account

11. Reserve Accounts LO2 • Required reserve • Dollar amount • Must be held in reserve • Required by Fed • Required reserve ratio • Percentage of checkable deposits (10%) • Must be held in reserve • Reserves (Earn no interest) • Cash in bank’s vault • Deposits at the Fed • Excess reserves

12. Liquidity vs. Profitability LO2 • Liquidity • Ease to convert assets into cash • Safety • Profitability • Federal funds markets • Day-to-day lending and borrowing • Among banks • Excess reserves on account at the Fed • Interest: federal funds rate

13. How Banks Create Money • Creating money through excess reserves • Round one • Fed buys $1,000 U.S. government bond • Creates reserves • Money supply: +$1,000 • Required reserves: +$100 • Excess reserves: +$900 LO3

14. Exhibit 4 LO3 Changes in Home Bank’s Balance Sheet After Fed Buys a $1,000 Bond from Securities Dealer

15. How Banks Create Money • Creating money through excess reserves • Round two • $900 loan • Money supply: +$900 • Required reserves: +$90 • Excess reserves: +$810 LO3

16. Exhibit 5 LO3 Changes in Home Bank’s Balance Sheet After Lending $900 to You

17. How Banks Create Money • Creating money through excess reserves • Round three • $810 loan • Money supply: +$810 • Required reserves: +$81 • Excess reserves: +$729 LO3

18. Exhibit 6 LO3 Changes in Merchants Trust’s Balance Sheet After Lending $810 to English Major

19. How Banks Create Money • Creating money through excess reserves • Round four and beyond • Excess reserves – new loans • Required reserves: +10% of new checkable deposits • Excess reserve – maximum amount for loans • Money supply expansion LO3

20. How Banks Create Money • Creating money through excess reserves • A summary of rounds • Fed: $1,000 injection in fresh reserves • Increased excess reserves • Money supply increase: Up to $10,000 • Checkable deposits • Banking system • Eliminates excess reserves • Expand money supply LO3

21. Exhibit 7 LO3 Summary of the Money Creation Resulting from the Fed’s Purchase of $1,000 U.S. Government Bond

22. Reserve Requirements & Money Expansion • Assumptions • No bank holds excess reserves • Borrowed funds don’t sit idle • People don’t want to hold more cash LO3

23. Reserve Requirements & Money Expansion • Required reserve ratio = r • Money multiplier • Simple money multiplier = 1/r • Change in the money supply = Change in fresh reserves × 1/r LO3

24. Limitations of Money Expansion • Leakages from expansion • Smaller money multiplier • Cash – preferred to checking accounts • People hold money • Fewer excess reserves LO3

25. Multiple Contraction of Money Supply • The Fed sells a $1,000 bond • Money supply: -$1,000 • Required reserves: -$900 • Recall loans • Money supply: -$900 • Required reserves: -$810 • Maximum effect • Decrease money supply = Original decrease in reserve requirements × 1/r LO3

26. The Fed’s Tools of Monetary Control • Open-market operations • Buy/sell U.S. government bonds • The discount rate • Interest rate, the Fed • For loans made to banks • The required reserve ratio • Minimum fraction of reserves LO4

27. Open-Market Operations • Increase money supply • The Fed buys U.S. bonds • Open-market purchase • Reduce money supply • The Fed sells U.S. bonds • Open-market sale LO4

28. Open-Market Operations • Tool of choice for the Fed • Influences bank reserves • Influences federal funds rate • Interest rate • Borrowing among banks • Of excess reserves at the Fed LO4

29. The Discount Rate • Discount rate • Interest rate charged by the Fed • Loans to banks • Bank borrow ‘Discount window’ • Satisfy reserve requirements • The Fed • Lender of last resort LO4

30. The Discount Rate • Primary discount rate • Secondary discount rate • Signal to financial markets • Monetary policy • Emergency tool • Injecting liquidity LO4

31. Reserve Requirements • Required reserve ratio • Money creation for each dollar of fresh reserves • Disruptive • Banking system LO4

32. Coping with Financial Crisis • Regulation of financial markets • Prevents major disruptions and financial panics • Sufficient liquidity • Financial system LO4

33. The Fed Is a Money Machine • Assets • U.S. government bonds, 24% • Earns interest • Liabilities • Federal Reserve notes, 43% • Fed pays no interest • The Fed is a money machine • Supplies Federal Reserve notes • Main asset: earns interest • Main liability: no interest payment LO4

34. Exhibit 8 LO4 Federal Reserve Bank Balance Sheet as of April 1, 2009 (Billions)