Transcript presentation

Ch. 12: Money and Banking
Del Mar College
John Daly
©2003 South-Western Publishing, A Division of Thomson Learning
Money and its Function
• Money is any good that is widely accepted for
purposes of exchange and in the repayment of
debts.
• Money reduces transaction costs because it is a
medium of exchange.
• Money is a unit of account. We don’t have to keep
prices in oranges, apples, or computers; money
provides this role for us.
• Money is a store of value, it maintains its value
over time. We accept payment for our efforts and
keep money until we spend it.
Money Vs. Barter
• Making exchanges takes longer in a barter system:
not only do you have to find something you want,
but you have to have something the seller wants as
well. This is called a double coincidence of wants.
• Some goods are more readily accepted than other
goods.
• Historically, goods that have evolved into money
are: gold, silver, copper, cattle, rocks, and shells.
Money in a Prisoner Of War Camp
During WW2, R.A.
Radford was captured and
imprisoned in a POW
camp. During his
captivity, he noticed an
economy built up based on
the ration packages sent
by the red cross. Instead
of having money, items
were initially bartered
until some started using
cigarettes as currency.
Money, Leisure, and Output
• A money based economy
frees up time spent
looking for someone
interested in your goods,
who has something you
want.
• A person’s standard of
living is, to a degree,
dependent on the number
and quality of goods he
consumes and the amount
of leisure he consumes.
What Gives Money its Value?
• Our money has value because of its general
acceptability.
• We accept paper dollars because we know
that other people will accept dollars later
when we try to spend them.
• Money has value to people because it is
widely accepted in exchange for other
goods that are valuable.
Gresham’s Law: Good Money
and Bad Money
• Bad money drives
good money out of
circulation.
• In truth, bad money
drives out good money
if both moneys have
the same face value,
have different intrinsic
values, and are fixed at
an exchange rate of
one to one.
Defining the Money Supply
• M1 is sometimes
referred to as the
narrow definition of
the money supply or as
transactions money.
• M1 consists of
currency held outside
banks, checkable
deposits, and traveler’s
checks.
Defining the Money Supply: M2
• M2 is sometimes referred to as the broad
definition of the money supply.
• M2 is made up of M1 plus smalldenomination time deposits, savings
deposits, money market accounts, overnight
repurchase agreements, and overnight
eurodollar deposits held by US residents.
Where Do Credit Cards Fit In?
• A credit card is an instrument or document
that makes it easier for the holder to obtain
a loan.
• Credit card transactions shift around the
existing quantity of money between various
individuals and firms, but do not change to
total money available.
Q&A
• Why (not how) did money evolve out of a
barter economy?
• If individuals remove funds from their
checkable deposits and transfer them to
their money market accounts, will M1 fall
and M2 rise? Explain your answer.
• How does money reduce the transaction
costs of making exchanges?
How Banking Developed
• Early bankers used
goldsmith’s warehouse
receipts.
• Early bankers began to
issue receipts for more
gold than they had on
hand.
• This was the
beginning of fractional
reserve banking.
The Federal Reserve System
• Commonly called “The Fed”, this is the
central bank of the United States.
• The Fed is essentially a bank’s bank.
• The Fed’s chief function is to control the
nation’s money supply.
The Money Creation Process
• The sum of bank deposits at the Fed and the
bank’s cash vault is total bank reserves.
• The Fed mandates member commercial banks to
hold a certain fraction of their checkable deposits
in reserve form. This fraction is called the
required reserve ratio.
• The difference between a bank’s total reserves and
its required reserves is its excess reserves.
The Banking System and The
Money Creation Process
• The process starts with the Fed.
• The Fed prints the funds, and Jack deposits the
funds in his bank.
• The Reserves of the bank increases, while the
reserves of no other bank decreased.
• The banking system made loans and in the process
created checkable deposits for the people who
received the loans.
• Remember, checkable deposits are part of the
money supply. So, in effect, by extending loans,
and in the process creating checkable deposits, the
banking industry has increased the money supply.
The Banking System Creates
Checkable Deposits (Money)
The Banking System And The
Money Expansion Process
• When the $9000 that bankers created in new
checkable accounts is added to the $1000 the Fed
initially printed, we see that $10,000 has been
added to the money supply.
Maximum change in checkable deposits = (1/r) x R
• Where r = the required reserve ratio and R is the
change in reserves resulting from the original
injection of funds.
• In the formula, (1/r) is known as the simple
deposit ratio.
Why Maximum? Answer: No Cash
Leakages And Zero Excess Reserves
• All monies were deposited in bank checking
accounts.
• Every bank lent all its excess reserves,
leaving every bank with zero excess
reserves.
• Because we assumed no cash leakages and
zero excess reserves, the change in
checkable deposits is the maximum possible
change.
Who Created What?
• The money expansion
process has two major
players: the Fed, and
the Banking System.
• The maximum change
in bankable deposits is
equal to: (1/r) x ER,
where ER is the excess
reserves.
The Money Contraction Process
• This process is the Money Creation process
in reverse
Q&A
• If a bank’s deposits equal $579 million and the
required-reserve ratio is 9.5%, what dollar amount
must the bank hold in reserve form?
• If the Fed creates $600 million in new reserves,
what is the maximum change in checkable
deposits that can occur if the required-reserve ratio
is 10%?
• Bank A has $1.2 million in reserves and $10
million in deposits. The required-reserve ratio is
10%. If Bank A loses $200,000 in reserves, by
what dollar amount is it reserve deficient?
Ch. 13: The Federal Reserve
System
Del Mar College
John Daly
©2003 South-Western Publishing, A Division of Thomson Learning
The Federal Reserve System
• There are 12 Federal Reserve Districts; each
District has a Federal Reserve Bank with its
own president.
The Fed’s Structure
• There is a seven-member board of governors that
coordinates and controls the activities of the
Federal Reserve System.
• Each governor serves a fourteen year term.
• A governor is appointed every other year, so no
one president can “stack” the Fed.
• The major policy making group within the Fed is
the Federal Open Market Committee.
• Open Market Operations is the buying and selling
of government securities by the Fed.
Functions of the Federal Reserve
System
• Control the Money
Supply.
• Supply the economy
with paper money.
• Provide checkclearing services.
• Hold depository
institutions’ reserves.
Functions of The Federal Reserve
System
• Supervise Member
Banks
• Serve as the
government’s banker
• Serve as the lender of
last resort
• Serve as a fiscal agent
for the Treasury.
The Check-Clearing Process
Q&A
• The president of which Federal Reserve
District Bank holds a permanent seat on the
Federal Open Market Committee (FOMC)?
• What is the most important responsibility of
the Fed?
• What does it mean to say the Fed acts as
“lender of last resort”?
Fed Tools For Controlling the
Money Supply: Open Market
Operations
• The main “thing” the Fed
buys and sells is U.S.
government securities, which
are bonds the government
originally sold to investors
when it needed to borrow
funds.
• The Fed buys and sells such
securities in the financial
market, it is said to be
engaged in open market
operations.
Open Market Purchases
• Consider an open market purchase of government
securities by the Fed.
• The Fed receives the securities from a bank, and
the bank’s reserves increase by the amount the
purchase (remember Reserves = Bank deposits at
the Fed + Vault Cash).
• When the banks have a reserve increase and no
other bank has a similar decline, the money supply
expands through a process of increased loans and
checkable deposits.
Open Market Sales
• Open market sales refer to Fed sales of
government securities to banks and others.
• In one of these sales, a bank buys securities from
the Fed and the money is taken from the reserves
of the bank.
• This decreases the money supply by having the
bank reduce total loans outstanding, which
reduces the total volume of checkable deposits and
money in the economy.
Open Market Operations
The Required-Reserve Ratio
• The Fed can also influence the money
supply by changing the required-reserve
ratio.
• An increase in the required-reserve ratio
leads to a decrease in the money supply, and
a decrease in the required-reserve ratio
leads to an increase in the money supply.
The Discount Rate
• There are two major places a bank can go to
acquire a loan: the federal funds market or the
Fed.
• The bank will pay an interest rate for this loan,
and the rate it pays for the loan in the federal
funds market is the federal funds rate.
• The rate it pays for the loan from the Fed is called
the discount rate.
• When a bank borrows money from the Fed’s
discount window, its reserves increase while the
reserves of no other bank decrease; meaning, the
money supply increases.
The Spread Between the
Discount Rate and the Federal
Funds Rate
The bank may borrow from the higher Federal Funds
Rate. Here are some reasons why:
1. The bank may know that the Fed is hesitant to extend
loans to banks that want to take advantage of profitmaking opportunities.
2. The bank doesn’t want to deal with the Fed bureaucracy
that regulates it, particularly if Fed officials interpret a
request for a loan as mismanagement.
3. The bank realizes that acquiring a loan from the Fed is a
privilege and not a right, and doesn’t want to abuse the
privilege.
Discount Rate Vs. Federal Funds
Rate
• If the discount rate is
significantly lower than
the federal funds rate,
most banks will borrow
from the Fed.
• An increase in the
discount rate relative to
the federal funds rate
reduces bank borrowings
from the Fed.
Which Tool Does the Fed Prefer
to Use?
• The Fed can use open market operations, the
required-reserve ratio, or the discount rate to
influence the money supply.
• The Fed prefers to us Open Market Operations.
• Open market operations are flexible
• Open market operations can be reversed
• Open market operations can be implemented
quickly
Fed Monetary Tools & their
Effects on the Money Supply
Q&A
• What is the difference between the federal
funds rate and the discount rate?
• If bank A borrows $10 million from bank B,
what happens to the reserves in bank A? In
the banking system?
• If bank A borrows $10 million from the Fed,
what happens to the reserves in bank A? In
the banking system?