Chapter 29

Banking and
the Money Supply
2009 South-Western/ Cengage Learning
Introduction
We examine how financial institutions work,
first by studying the types of deposits held
then by considering the role of the financial
intermediaries
the role these institutions play in the creation of
money.
We will discuss on how depository institutions can
affect the money supply through the credit creation
process
And how the Federal Reserve System controls the
money supply by regulating bank reserves.
Banks are special because they can convert a
borrowers IOU into money, and an adequate supply
of money is a key ingredient in a healthy economy.

2
Narrow Definition of Money
Money aggregates: Measures of the
money supply defined by the Federal
Reserve (e.g., M1).
M1: Currency (including coins) held by
the non-banking public, checkable
deposits, and travelers checks.


3
Money Aggregates
Money aggregates
Measures 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
Travelers checks



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Money Aggregates
Currency = Fiat money
Federal Reserve Notes
US Bureau of Engraving and Printing
Issued by & Liabilities of
12 Federal Reserve Banks
60% - abroad
Coins
US Mint
5
Faking it
The Supernote = Counterfeit $100 note
High quality
Sequential numbers
Polymer security thread
Redesign every 7 to 10 years
Additional colors
Most popular counterfeit
Domestic: $20 note
International: $100 note
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Money Aggregates
Broader Definition of Money: M2:
Assets that perform the store of value
function and can be converted into
currency or checkable deposits.
M2: Includes M1 as well as savings
deposits, small-denomination time
deposits, and money market mutual fund
accounts.

7
Money Aggregates
M2 = Broader definition of money
M1
Savings deposits
Earn interest; no specific maturity date
Small-denomination time deposits
Time deposit / Certificates of deposits, CDs
Earn interest; specific maturity date
Money market mutual fund accounts
Restrictions
8
Exhibit 1
Measures of the money supply (July 2007)
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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

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Money Aggregates
Credit card issuers lend money to pay
for purchases. You dont need money
until you repay the credit card.
Therefore, credit cards merely delay the
use of money.
Debit cards reduce your bank balance
immediately, electronic transfer (M1).
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How Banks Work
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
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How Banks Work
Coping with Asymmetric Information
Asymmetric Information: An inequality in
whats known by each party to a
transaction.
Banks, by developing expertise in
evaluating creditworthiness, structuring
loans, and enforcing loan contracts,
make the economy more efficient.


13
How Banks Work
Banks attract deposits from savers to
lend to borrowers.
Earn a profit on the difference between
the interest paid depositors and the
interest charged borrowers
14
Starting a Bank
Home Bank obtains a charter
Net worth = Owners 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 - owed by bank

15
Starting a Bank:
To obtain a charter, first owners must
apply to the state banking authority.
Next, owners issue themselves shares of
stock, called owners equity or net worth,
and start accepting deposits.
The banks balance sheet consists of
assets, liabilities, and net worth.
Assets must always equal liabilities plus
net worth.
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Exhibit 2
Home Banks balance sheet
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Assets Liabilities
Building and furniture
Stock in district Fed
$450,000
50,000
Net worth $500,000
Total $500,000 Total $500,000
Exhibit 3
Home Banks balance sheet after $1,000,000 deposit
into checking account
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Assets Liabilities
Cash
Building and furniture
Stock in district Fed
$1,000,000
450,000
50,000
Checkable deposits
Net worth
$1,000,000
500,000
Total $1,500,000 Total $1,500,000
Reserve Accounts
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 banks vault
Deposits at the Fed
Excess reserves
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Reserve Accounts
Required reserves: The Fed requires banks
to hold a minimum percentage of their
deposits in reserve.
Computed by multiplying checkable
deposits by the required reserve ratio.
Required Reserve Ratio: Dictates the
minimum portion of deposits the bank must
hold in reserve.
Excess Reserves: Bank reserves in excess
of required reserves; can be used to make
loans or purchase interest-bearing assets.

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

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Liquidity Versus Profitability
The bank manager must structure the portfolio of
assets with an eye toward liquidity but must not forget
that the banks survival depends on profitability.
Liquidity: The ease with which an asset can be
converted into cash without a significant loss of
value.
The most liquid asset is bank reserves, but reserves
earn no interest.
Since reserves earn no interest, banks try to keep
excess reserves to a minimum.
Banks continuously sweep their accounts for
excess reserves that can be put to some interest-
bearing use.
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Liquidity Versus Profitability
Federal funds market: Provides day-to-
day lending and borrowing among banks
of excess reserves on account at the
Fed.
Federal funds rate: Interest rate paid in
the federal funds market for excess
reserves at the Fed.
The Fed targets this rate as a tool of
monetary policy.
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How Banks Create Money
Creating money through excess reserves:
Round one
Fed buys $1,000 US government bond
Creates reserves (bond from Home Bank,
injecting fresh reserves into the banking system.)
Money supply: +$1,000
Required reserves: +$100
Excess reserves: +$900
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How Banks Create Money
Creating Money Through Excess;
A banks lending is limited to the amount of its excess
reserves.
The bank, by loaning its excess reserves, creates money.
In Round One
The Fed buys a $1,000 U.S. Home Banks assets:
reserves at Fed increase by $1,000.
Home Banks liabilities: checkable deposits increase by
$1,000.
Of the $1,000, $100 must be set aside in required
reserves (based on a 10% reserve requirement); the
remaining $900 is excess reserves.
The money supply increases by $1,000 in this first round.
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Exhibit 4
Changes in Home Banks balance sheet after Fed
buys a $1,000 bond from Securities dealer
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Assets Liabilities
Reserves at Fed +$1,000 Checkable deposits +$1,000
How Banks Create Money
Creating money through excess reserves
Round two
$900 loan
Money supply: +$900
Required reserves: +$90
Excess reserves: +$810
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How Banks Create Money
In Round Two
Home Bank is your bank.
You apply for a $900 student loan.
The loan is approved and your checking account is
increased by $900.
Checkable deposits are money so the money supply increases
by $900.
The total impact on the money supply is now an increase of
$1,900.
You write a $900 check for college fees.
Your college deposits the funds in its bank, Merchants
Trust,
Increases the colleges account by $900 and sends your
check to the Fed.
The Fed transfers the $900 from Home Banks account to
Merchant Trusts account.

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Exhibit 5
Changes in Home Banks balance sheet after lending
$900 to you
29
Assets Liabilities
Loans +$900 Checkable deposits +$900
How Banks Create Money
Creating money through excess reserves
Round three
$810 loan
Money supply: +$810
Required reserves: +$81
Excess reserves: +$729
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How Banks Create Money
Round Three
Merchants Trust now has $900 more in
reserves on deposit at the Fed.
After setting aside required reserves of
$90, it can lend the remaining $810,
Increasing the money supply in the
economy to $2,710.
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Exhibit 6
Changes in Merchants Trusts balance sheet after
lending $810 to English Major
32
Assets Liabilities
Loans +$810 Checkable deposits +$810
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
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How Banks Create Money
Round Four and Beyond:
The process continues.
Each bank can lend its excess reserves.
If a bank allows its excess reserves to
stand idle, the money creation process
stops.
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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
35
Exhibit 7
Summary of money creation resulting from Feds
purchase of $1,000 US Government Bond
36



Bank
(1)
Increase in
Checkable
Deposits
(2)
Increase in
Required
Reserves
(3)
Increase in
Loans
=(1)-(2)
1. Home Bank
2. Merchants Trust
3. Fidelity Bank
All remaining rounds
$1,000
900
810
7,290
$100
90
81
729
$900
810
729
6,561
Totals $10,000 $1,000 $9,000
Reserve Requirements & Money Expansion
Assumptions
No bank holds excess reserves
Borrowed funds dont sit idle
People dont want to hold more cash
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Reserve Requirements & Money Expansion
Required reserve ratio = r
Money multiplier:
Multiple by which the money supply
increases as a result of an increase in
the banking systems excess reserves
Simple money multiplier = 1/r (where r is
the reserve ratio.
Change in the money supply = Change in
fresh reserves 1/r
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Reserve Requirements & Money Expansion
The higher the reserve requirement (r),
the smaller the money multiplier (1 / r )
As long as the banks excess reserves
do not remain idle, these excess
reserves can fuel an expansion of the
money supply.
The fractional reserve requirement is the
key to the multiple expansion of
checkable deposits.

39
Limitations of Money Expansion
Leakages from expansion
Smaller money multiplier
Cash preferred to checking accounts
People hold money
Fewer excess reserves

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Limitations on Money Expansion:
Leakages from the multiple expansion process
reduce the size of the money multiplier:
Banks do not let reserves sit idle.
Banks have a profit incentive to make loans or
buy other interest-bearing assets with excess
reserves.
Borrowers do something with the money.
Why would people borrow money if they didnt
need it for something?
People normally do not choose to increase their
cash holdings.
Since cash is more versatile, people may hold
some of the newly-created money as cash.

41
Multiple Contraction of the Money Supply:
By selling government bonds, the Fed
can reduce bank reserves,
Forcing banks to recall loans or sell
some other asset to replenish reserves
The maximum possible effect is to
reduce the money supply by the amount
of the original reduction in bank reserves
times the simple money multiplier (1/ r).


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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
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Banking on the net
Virtual banks
Never close
Smaller operation costs
Higher interest rates
E-banking
Banks
Speeds processing
Lowers costs
Depositors
Convenience
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The Feds Tools of Monetary Control
Open-market operations
Buy / sell US government bonds
The discount rate
Interest rate, the Fed
For loans made to banks
The required reserve ratio
Minimum fraction of reserves
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The Feds Tools of Monetary Control
Open-Market Operations and the Federal
Funds Rate: Policy decisions are made by
the Federal Open Market Committee
(FOMC).
Open-Market Purchase: Purchase of U.S.
government bonds by the Fed to increase
the money supply.
Open-Market Sale: Sale of U.S. government
bonds by the Fed to decrease the money
supply.


46
Open-Market Operations
Increase money supply
The Fed buys US bonds
Open-market purchase
Reduce money supply
The Fed sells US bonds
Open-market sale
47
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


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The Discount Rate:
The interest rates the Fed charges on loans it
makes to banks.
Changes in the discount rate are a signal to
financial markets about the direction of monetary
policy.
Lowering the discount rate reduces the costs
of borrowing reserves,
Encourages banks to borrow from the Fed,
increases reserves, and increases the money
supply.
Raising the discount rate increases the cost
of borrowing reserves,
discourages banks from borrowing, reduces
reserves, and reduces the money supply.
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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
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The Discount Rate
Primary discount rate
Secondary discount rate
Signal to financial markets
Monetary policy
Emergency tool
Injecting liquidity
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Reserve Requirements
Increasing the reserve requirement
reduces excess reserves and reduces
the money supply.
Decreasing the reserve requirement
increases excess reserves and increases
the money supply.
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Reserve Requirements
Required reserve ratio
Money creation for each dollar of fresh
reserves
Disruptive
Banking system
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Coping with Financial Crises
The Fed, through regulation of financial
markets, tries to prevent major
disruptions and financial panics
such as during the uncertainty following
the terrorist attacks of September 11,
2001, etc.
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Coping with Financial Crisis
Regulation of financial markets
Prevents major disruptions and financial
panics
Sufficient liquidity
Financial system


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The Fed Is a Money Machine
The Feds main asset, U.S. government
bonds, earns interest;
Its main liability, Federal Reserve notes
in circulation, requires no interest
payments.
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The Fed is a Money Machine
Assets
US government bonds, 90%
Earns interest
Liabilities
Federal Reserve notes, 90%
Fed pays no interest
The Fed is a money machine
Supplies Federal Reserve notes
Main asset: earns interest
Main liability: no interest payment
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Exhibit 8
Federal Reserve Bank balance sheet as of
August 22, 2007 (billions)
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Assets Liabilities

US Treasury securities
Foreign currencies
Bank buildings
Discount loans to
depository institutions
Other assets

$789.9
36.9
2.1

2.3
35.9
Federal Reserve notes
outstanding
Depository institutions reserves
US Treasury balance
Other liabilities
Net Worth

$774.5
13.1
5.3
39.5
34.4
Total $866.8 Total $866.8
Conclusion
The money supply is narrowly defined as
M1,
Which consists of currency held by the
non-banking public,
Plus checkable deposits and travelers
checks.
A broader money aggregate, M2,
includes M1 plus savings deposits, small-
denomination time deposits, and money
market mutual funds.
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Conclusion
Banks are unlike other financial
intermediaries
Because they can turn a borrowers IOU
into money they can create money.
Banks match the different desires of
savers and borrowers.
Banks also evaluate loan applications
and diversify portfolios of assets to
reduce the risk to any one saver.
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Conclusion
In acquiring portfolios of assets, banks
try to maximize profit while maintaining
enough liquidity to satisfy depositors
requests for money.
Assets that earn the bank more interest
are usually less liquid.

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Conclusion
Any single bank can expand the money supply
by the amount of its excess reserves.
For the banking system as a whole, however,
the maximum expansion of the money supply
equals a multiple of fresh bank reserves.
The simply money multiplier is the reciprocal of
the reserve ratio, or 1/r.
This multiplier is reduced to the extent that
(a) banks allow excess reserves to remain idle,
(b) borrowers sit on their proceeds,
(c) the public withdraws cash from the banking
system and holds it.
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Conclusion
The key to changes in the money supply is the Feds
impact on excess reserves in the banking system.
To increase excess reserves and thus increase the
money supply, the Fed can
Buy U.S. government bonds,
Reduce the discount rate,
or lower the reserve requirement.
To reduce excess reserves and thus reduce the money
supply, the Fed can
sell U.S. government bonds,
increase the discount rate,
or increase the reserve requirement.
By far the most important monetary tool for the Fed is
open-market operations buying and selling U.S. bonds.
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