Transcript Chapter No. 9

34
Money, Banking, and Financial
Institutions
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Money, Banking, and Financial Institutions
• Learning objectives – After reading this chapter students
should be able to:
• Identify and explain the functions of money and the
components of the money supply.
• Describe what “backs” the money supply, making us willing to
accept it as payment.
• Identify and explain the main factors that contributed to the
financial crisis of 2007-2008.
• Explain the basics of a bank’s balance sheet and discuss why
the U.S. banking system is called a “fractional reserve”
system.
• Explain the distinction between a bank’s actual reserves and
its required reserves.
• .
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Money, Banking, and Financial Institutions
• Describe how a bank can create money
• Describe the multiple expansion of loans and money by the
entire banking system.
• Define the monetary multiplier, explain how to calculate it,
and demonstrate its relevance
• Discuss how the equilibrium interest rate is determined in the
market for money.
• List and explain the goals and tools of monetary policy.
• Identify the mechanisms by which monetary policy affects
GDP and the price level.
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Money, Banking, and Financial Institutions
• Functions of Money
• Medium of exchange: Money can be used for buying and
selling goods and services.
• Unit of account: Prices are the U.S. are quoted in dollars and
cents.
• Store of value: Money allows us to transfer purchasing power
from present to future. It is the most liquid (spendable) of all
assets, a convenient way to store wealth.
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Money, Banking, and Financial Institutions
• Components of the Money Supply
• 1. Narrow definition of money: M1 includes currency and
checkable deposits (see Figure 34.1a).
• Currency (coins + paper money) held by public. (51% of M1)
• a. It is “token” money, which means its intrinsic value is less than
actual value. The metal in a dime is worth less than 10¢.
• B. All paper currency consists of Federal Reserve Notes issued by the
Federal Reserve.
• 2. Checkable deposits are included in M1, since they can be
spent almost as readily as currency and can easily be
changed into currency. (49% of M1)
• a. Commercial banks are a main source of checkable deposits for
households and businesses.
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Money, Banking, and Financial Institutions
• b. Thrift institutions (savings & loans, credit unions, mutual savings
banks) also have checkable deposits.
• Money Definition: M2 = M1 + some near-monies which
include: (See Figure 34.1b)
• Savings deposits and money market deposit accounts.
• Small-denominated time deposits (certificates of deposit) less than
$100,000.
• Money market mutual fund balances, which can be redeemed by
phone calls, checks, or through the Internet.
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Money, Banking, and Financial Institutions
• C. CONSIDER THIS … Are Credit Cards Money?
• Credit cards are not money, but their use involves short-term
loans; their convenience allows you to keep M1 balances low
because you need less for daily purchases.
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Money, Banking, and Financial Institutions
• What “backs” the money supply?
• A. The government’s ability to keep its value stable
provides the backing.
• B. Money is debt; paper money is a debt of Federal Reserve
Banks and checkable deposits are liabilities of banks and
thrifts because depositors own them.
• C. Value of money arises not from its intrinsic value, but its
value in exchange for goods and services.
• 1. It is acceptable as a medium of exchange.
• 2. Currency is legal tender or fiat money.
• 3. The relative scarcity of money compared to goods and services will
allow money to retain its purchasing power.
•
LO2
Money’s purchasing power determines its value. Higher
prices mean less purchasing power.
Money, Banking, and Financial Institutions
• Excessive inflation may make money worthless and
unacceptable. An extreme example of this was German
hyperinflation after World War I, which made the mark worth
less than 1 billionth of its former value within a four-year
period.
1. Worthless money leads to use of other currencies that are more
stable.
2. Worthless money may lead to barter exchange system.
• Maintaining the value of money
1. The government tries to keep supply stable with appropriate fiscal
policy.
2. Monetary policy tries to keep money relatively scarce to maintain its
purchasing power, while expanding enough to allow the economy to
grow.
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Money, Banking, and Financial Institutions
• The Financial Crisis of 2007 and 2008
• In 2007 and 2008 the malfunctioning U.S. financial system
experienced the worst financial crisis since the Great
Depression which led to problems in the credits markets and
spread to the rest of the economy resulting in a recession.
• The Mortgage Default Crisis: In 2007 there were a huge
number of defaults on home mortgages in the United States,
mostly subprime loans which previously the Federal
government had encouraged banks to make. When banks
wrote-off these loans it reduced their reserves and their ability
to loan out other funds.
• Banks and mortgage lenders packaged hundreds or
thousands of mortgages together and sold them as bonds,
believing that this would protect them from defaults on the
mortgages.
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Money, Banking, and Financial Institutions
• Buyers of the mortgage-backed securities collected the
mortgage payments as returns on their investment.
• The banks received a single up-front payment for the
mortgage-backed securities.
• Banks lent a substantial amount of money to
investment firms so that they could buy the
mortgage-backed securities. The banks also bought
mortgage-backed securities as investment.
• With the defaults the banks lost money on the loans
that they still held, on the money they had loaned to
investment funds for the purchase of mortgagebacked securities and on the mortgage-backed
securities that they had purchased themselves
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Money, Banking, and Financial Institutions
• Causes of the substantial number of defaults:
• Government programs that encouraged and subsidized
home ownership for previous renters.
• Declining home prices.
• Lax standards by banks because they felt protected from
defaults with the mortgage-backed securities.
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Money, Banking, and Financial Institutions
• The Fractional Reserve System:
• Significance of fractional reserve banking:
• Banks can create money by lending more than the original
reserves on hand.
• Lending policies must be prudent to prevent bank “panics” or
“runs” by depositors worried about their funds. Also, the U.S.
deposit insurance system prevents panics
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Money, Banking, and Financial Institutions
• A Single Commercial Bank
• A balance sheet states the assets and claims of a bank at
some point in time.
• All balance sheets must balance, that is, the value of assets
must equal value of claims.
• 1. The bank owners’ claim is called net worth.
• 2. Non-owners’ claims are called liabilities.
• 3. Basic equation: Assets = liabilities + net worth.
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Money, Banking, and Financial Institutions
• The Banking System: Multiple-Deposit Expansion (all
banks combined)
• The entire banking system can create an amount of money
which is a multiple of the system’s excess reserves, even
though each bank in the system can only lend dollar for dollar
with its excess reserves.
• Three simplifying assumptions:
1. Required reserve ratio assumed to be 20 percent.
2. Initially banks have no excess reserves; they are “loaned up.”
3. When banks have excess reserves, they loan it all to one
borrower, who writes check for entire amount to give to
someone else, who deposits it at another bank. The check
clears against original lender.
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The Banking System
(3)
Excess
Reserves
(1)-(2)
(1)
Acquired
Reserves
and Deposits
(2)
Required
Reserves
Bank A
$100
$20
$80
$80
Bank B
$80
$16
$64
$64
Bank C
$64
$12.80
$51.20
$51.20
Bank D
$51.20
$10.24
$40.96
$40.96
Bank
(4)
Amount Bank Can
Lend; New Money
Created = (3)
The process will continue…
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The Banking System
Bank
(1)
Acquired
Reserves
and Deposits
Bank A
$100.00
Bank B
80.00
Bank C
64.00
Bank D
51.20
Bank E
40.96
Bank F
32.77
Bank G
26.21
Bank H
20.97
Bank I
16.78
Bank J
13.42
Bank K
10.74
Bank L
8.59
Bank M
6.87
Bank N
5.50
Other Banks
21.99
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(2)
Required
Reserves
(Reserve
Ratio = .2)
(3)
Excess
Reserves
(1)-(2)
$20.00
16.00
12.80
10.24
8.19
6.55
5.24
4.20
3.36
2.68
2.15
1.72
1.37
1.10
4.40
$80.00
64.00
51.20
40.96
32.77
26.21
20.97
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.59
(4)
Amount Bank Can
Lend; New Money
Created = (3)
$80.00
64.00
51.20
40.96
32.77
26.21
20.97
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.59
$400.00
The Monetary Multiplier
Monetary
multiplier
LO5
=
1
required reserve ratio
=
1
R
Money, Banking, and Financial Institutions
• System’s lending potential: Suppose a junkyard owner finds
a $100 bill and deposits it in Bank A. The system’s lending
begins with Bank A having $80 in excess reserves, lending
this amount, and having the borrower write an $80 check
which is deposited in Bank B. See further lending effects on
Bank C. The possible further transactions are summarized in
Table 13.2.
• Monetary multiplier is illustrated in Table 35.2.
• Formula for monetary or checkable deposit multiplier is:
• Monetary multiplier = 1/required reserve ratio or m = 1/R or
1/.20 in our example.
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Money, Banking, and Financial Institutions
• Maximum deposit expansion possible is equal to: excess
reserves x monetary multiplier. Figure 35.1 illustrates this
process.
• Higher reserve ratios generate lower money multipliers.
• a. Changing the money multiplier changes the money
creation potential.
• b. Changing the reserve ratio changes the money multiplier
but be careful! It also changes the amount of excess
reserves that are acted on by the multiplier. Cutting the
reserve ratio in half will more than double the deposit creation
potential of the system.
• The process is reversible. Loan repayment destroys money,
and the money multiplier increases that destruction.
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Money, Banking, and Financial Institutions
• The fundamental objective of monetary policy is to aid the
economy in achieving full-employment output with stable
prices.
• 1. To do this, the Fed changes the nation’s money supply.
• 2. To change money supply, the Fed manipulates size of excess
reserves held by banks.
• Monetary policy has a very powerful impact on the economy;
Ben Bernanke, the head of the U.S. Federal Reserve System,
and Jean-Claude Trichet, the president of the European
Central Bank, are often listed as among the most powerful
people in the world.
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Money, Banking, and Financial Institutions
• The Demand for Money: Two Components
• A. Transactions demand, Dt, is money kept for purchases
and will vary directly with GDP (Key Graph 36.1a).
• B. Asset demand, Da, is money kept as a store of value for
later use. Asset demand varies inversely with the interest
rate, since that is the price of holding idle money (Key Graph
36.1b).
• C. Total demand will equal quantities of money demanded for
assets plus that for transactions (Key Graph 36.1c).
LO2
Rate of interest, i percent
Demand for Money
(a)
Transactions
demand for
money, Dt
(b)
Asset
demand for
money, Da
10
Sm
7.5
=5
+
5
2.5
Dt
0
50
100
Da
150
200
Amount of money
demanded
(billions of dollars)
LO1
(c)
Total
demand for
money, Dm
and supply
50
100
150
200
Amount of money
demanded
(billions of dollars)
Dm
50
100
150
200
250
300
Amount of money
demanded and supplied
(billions of dollars)
Money, Banking, and Financial Institutions
• The Equilibrium Interest Rate and Bond Prices
• A. Key Graph 36.1c illustrates the money market. It
combines demand with supply of money.
• B. If the quantity demanded exceeds the quantity supplied,
people sell assets like bonds to get money. This causes
bond supply to rise, bond prices to fall, and a higher market
rate of interest.
• C. If the quantity supplied exceeds the quantity demanded,
people reduce money holdings by buying other assets like
bonds. Bond prices rise, and lower market rates of interest
result (see example in text).
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Money, Banking, and Financial Institutions
• Tools of Monetary Policy
• A. Open-market operations refer to the Fed’s buying and
selling of government bonds.
• 1. Buying securities will increase bank reserves and the
money supply (see Figure 36.2)
• a. If the Fed buys directly from banks, then bank reserves go
up by the value of the securities sold to the Fed. See impact
on balance sheets using text example.
• b. If the Fed buys from the general public, people receive
checks from the Fed and then deposit the checks at their
bank. Bank customer deposits rise and therefore bank
reserves rise by the same amount. Follow text example to
see the impact.
LO2
• i. Banks’ lending ability rises with new excess reserves.
• ii. Money supply rises directly with increased deposits by the public.
Tools of Monetary Policy
• Fed buys bonds from commercial
banks
Federal Reserve Banks
Assets
Liabilities and Net Worth
+ Securities
+ Reserves of Commercial
Banks
(a) Securities
Assets
-Securities (a)
+Reserves (b)
LO2
(b) Reserves
Commercial Banks
Liabilities and Net Worth
Tools of Monetary Policy
• Fed sells bonds to commercial banks
Federal Reserve Banks
Assets
Liabilities and Net Worth
- Securities
- Reserves of Commercial
Banks
(a) Securities
Assets
+ Securities (a)
- Reserves (b)
LO2
(b) Reserves
Commercial Banks
Liabilities and Net Worth
Open Market Operations
• Fed buys $1,000 bond from a
commercial bank
New Reserves
$1000
Excess
Reserves
$5000
Bank System Lending
Total Increase in the Money Supply, ($5,000)
LO2
Open Market Operations
• Fed buys $1,000 bond from the
public
Check is Deposited
New Reserves
$1000
$800
Excess
Reserves
$4000
Bank System Lending
$200
Required
Reserves
$1000
Initial
Checkable
Deposit
Total Increase in the Money Supply, ($5000)
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Money, Banking, and Financial Institutions
• When Fed buys bonds from bankers, reserves rise and
excess reserves rise by same amount since no checkable
deposit was created.
• When Fed buys from public, some of the new reserves are
required reserves for the new checkable deposits.
• Conclusion: When the Fed buys securities, bank reserves
will increase and the money supply potentially can rise by a
multiple of these reserves.
• Note: When the Fed sells securities, points a-e above will be
reversed. Bank reserves will go down, and eventually the
money supply will go down by a multiple of the banks’
decrease in reserves.
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Money, Banking, and Financial Institutions
• How the Fed attracts buyers or sellers:
• i. When Fed buys, it raises demand and price of bonds, which
in turn lowers effective interest rate on bonds. The higher
price and lower interest rates make selling bonds to Fed
attractive.
• ii.When Fed sells, the bond supply increases and bond prices
fall, which raises the effective interest rate yield on bonds.
The lower price and higher interest rates make buying bonds
from Fed attractive.
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Money, Banking, and Financial Institutions
• B. The reserve ratio is another “tool” of monetary policy. It is
the fraction of reserves required relative to their customer
deposits.
• 1. Raising the reserve ratio increases required reserves and
shrinks excess reserves. Any loss of excess reserves shrinks
banks’ lending ability and, therefore, the potential money
supply by a multiple amount of the change in excess
reserves.
• Lowering the reserve ratio decreases the required reserves
and expands excess reserves. Gain in excess reserves
increases banks’ lending ability and, therefore, the potential
money supply by a multiple amount of the increase in excess
reserves.
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Money, Banking, and Financial Institutions
• Changing the reserve ratio has two effects.
• a. It affects the size of excess reserves.
• b. It changes the size of the monetary multiplier. For
example, if ratio is raised from 10 percent to 20 percent, the
multiplier falls from 10 to 5.
• Changing the reserve ratio is very powerful since it affects
banks’ lending ability immediately. It could create instability,
so Fed rarely changes it.
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Money, Banking, and Financial Institutions
• C: The third “tool” is the discount rate, which is the
interest rate that the Fed charges to commercial banks that
borrow from the Fed.
• An increase in the discount rate signals that borrowing
reserves is more difficult and will tend to shrink excess
reserves.
• A decrease in the discount rate signals that borrowing
reserves will be easier and will tend to expand excess
reserves.
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Money, Banking, and Financial Institutions
• For several reasons, open-market operations give the Fed
most control of the four “tools.”
• Open-market operations are most important. This decision is
flexible because securities can be bought or sold quickly and
in great quantities. Reserves change quickly in response.
• The reserve ratio is rarely changed since this could
destabilize bank’s lending and profit positions.
• Changing the discount rate has become a passive tool of
monetary policy. During the financial crisis of 07- 08, banks
borrowed billions as the discount rate was decreased by the
Fed.
LO2
(a)
The market
for money
Sm1
Sm2
Sm3
AS
10
P3
8
AD3
I=$25
AD2
I=$20
AD1
I=$15
P2
Dm
6
ID
0
$125
$150
$175
Amount of money
demanded and
supplied
(billions of dollars)
LO4
(c)
Equilibrium real
GDP and the
Price level
(b)
Investment
demand
Price Level
Rate of Interest, i (Percent)
Monetary Policy and Equilibrium GDP
$15
$20
$25
Amount of investment
(billions of dollars)
Q1
Qf Q3
Real GDP
(billions of dollars)
Monetary Policy and Equilibrium GDP
(d)
Equilibrium real
GDP and the
Price level
(c)
Equilibrium real
GDP and the
Price level
AS
AS
P3
AD3
I=$25
AD2
I=$20
AD1
I=$15
P2
Q1
Qf Q3
Real GDP
(billions of dollars)
b
a
AD3
I=$25
AD4
I=$22.5
AD2
I=$20
AD1
I=$15
Price Level
Price Level
P3
LO4
c
P2
Q1
Qf Q3
Real GDP
(billions of dollars)
Expansionary Monetary Policy
CAUSE-EFFECT CHAIN
Problem: Unemployment and Recession
Fed buys bonds, lowers reserve ratio, lowers the
discount rate, or increases reserve auctions
Excess reserves increase
Federal funds rate falls
Money supply rises
Interest rate falls
Investment spending increases
Aggregate demand increases
Real GDP rises
LO4
Restrictive Monetary Policy
CAUSE-EFFECT CHAIN
Problem: Inflation
Fed sells bonds, increases reserve ratio, increases
the discount rate, or decreases reserve auctions
Excess reserves decrease
Federal funds rate rises
Money supply falls
Interest rate rises
Investment spending decreases
Aggregate demand decreases
Inflation declines
LO4
Money, Banking, and Financial Institutions
• Targeting the Federal Funds Rate
• The Federal funds rate is the interest rate that banks charge
each other for overnight loans.
• Banks lend to each other from their excess reserves, but
because the Fed is the only supplier of Federal funds (the
currency used as reserves), it can set the Federal funds rate
and then use open-market operations to make sure that rate
is achieved.
• 1. The Fed will increase the availability of reserves if it wants
the Federal funds rate to fall (or keep it from rising).
• 2. Reserves will be withdrawn if the Fed wants to raise the
Federal funds rate (or keep it from falling).
LO2
Money, Banking, and Financial Institutions
• Targeting the Federal Funds Rate
• The Fed may use an expansionary monetary policy if the
economy is experiencing a recession and rising rates of
unemployment.
• Restrictive monetary policy is used to combat rising inflation.
• 1. The initial step is for the Fed to announce a higher target
for the Federal funds rate, followed by the selling of bonds to
soak up reserves. Raising the reserve ratio and/or discount
rate is also an option.
• 2. Reducing reserves will produce results opposite of what we
saw for an expansionary monetary policy.
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Money, Banking, and Financial Institutions
• a. The reduced supply of Federal funds will raise the Federal
funds rate to the new target.
• b. Multiple contraction of the money supply, through the
money multiplier process (Chapter 35).
• 3. Restrictive monetary policy results in higher interest rates,
including the prime rate.
LO2