Money and Banks

Chapter 13

Students Learning Objectives

In this chapter, you should understand the following questions:

What is money? How is money created? What role do banks play in the circular flow of income and spending?

What Is Money?

Without money, you would have to use barter to get items you want. Barter is the direct exchange of one good for another, without the use of money. The use of money in market transactions depends on sellers willingness to accept money as a medium of exchange. Without money, the process of acquiring goods and services would be more difficult and time-consuming.

The Money Supply

Anything that serves all of the following purposes can be thought of as money:

Medium of exchange Store of value Standard of value

Purposes of Money

Medium of exchange Is accepted as payment for goods and services (and debts) Store of value Can be held for future purchases. Standard of value Standard of value Serves as a measurement for the prices of goods and services.

Many Types of Money

After the colonies became an independent nation, the U.S. Constitution prohibited the federal government from issuing paper money. Money was instead issued by state chartered banks. Between 1789 and 1863, paper bills were issued by state banks.

Many Types of Money

People preferred to be paid in gold, silver, or other commodities rather than the uncertain paper currency. The first paper money issued by the federal government was called greenbacks and was printed in 1861 to finance the Civil War. The National Banking Act of 1863 gave the federal government permanent authority to issue money.

Modern Concepts

Money is anything generally accepted as a medium of exchange. The greenbacks we carry around today are not the only form of money we use. Checking accounts can and do perform the same market functions as cash. They must be included into our concept of money. Credit cards are another popular medium of exchange but are not money. They are only a payment service with no store of value in and of themselves

Diversity of Bank Accounts

There are many forms of bank accounts. Some bank accounts are better substitutes for cash than others.

M1: Cash and Transactions Accounts

Money supply (M1): - Currency held by the public, plus balances in transactions accounts. M1 includes currency in circulation, transaction-account balances, and travelers checks.

M1: Cash and Transactions Accounts

A transactions account is a bank account that permits direct payment to a third party, for example, with a check. The distinguishing feature of transaction accounts is that they permit direct payment to a third party (by check or debit card).

Transaction-account balances are the largest component of the money supply.

M2: M1 + Savings Accounts, etc.

M2 money supply M1 plus balances in most savings accounts and money market mutual funds. Savings-account balances are almost as good a substitute for cash as transactionaccount balances.

M2: M1 + Savings Accounts, etc.

How much money is available affects consumers ability to purchase goods and, services aggregate demand.
l

Aggregate demand is the total quantity of output demanded at alternative price levels in a given time period, ceteris paribus.

M2: M1 + Savings Accounts, etc.

The official measures of the money supply (particularly M1 and M2) are fairly reliable benchmarks for gauging how much purchasing power market participants have.

Composition of the Money Supply

M2
($5383 billion)

Money market mutual funds and deposits ($1027 billion)

Savings account balances ($3167 billion)

M1
($1189 billion)
Travelers checks ($8 billion) Currency in circulation ($569 billion) Transactions-account balances ($612 billion)

Creation of Money

The deposit of funds into a bank does not change the size of the money supply. It changes the composition of the money supply (transfers from cash to transaction deposits).

Deposit Creation

When a bank lends someone money, it simply credits that individuals bank account. Deposit creation is the creation of transactions deposits by bank lending. When a bank makes a loan, it effectively creates money because transactions-account balances are counted as part of the money supply.

Deposit Creation

There are two basic principles of the money supply:

l l

Transactions-account balances are a large portion of our money supply. Banks can create transactions-account balances by making loans.

Bank Regulation

The deposit-creation activities of banks are regulated by the government. The Federal Reserve System limits the amount of bank lending, thereby controlling the basic money supply.

A Monopoly Bank

Assume a student deposits $100 from their home bank into the monopoly bank and receives a new checking account.

When someone deposits cash or coins in a bank, they are changing the composition of the money supply, not its size.

The Initial Loan

The monopoly bank loans $100 to the Campus Radio station and issues a checking account. This loan is accomplished by a simple bookkeeping entry. Total bank reserves have remained unchanged. Bank reserves are assets held by a bank to fulfill its deposit obligations. Money has been created because the checking account is considered to be money.

Secondary Deposits

In a one bank system, when Campus Radio uses the loan, the money supply does not contract, rather ownership of deposits change.

Fractional Reserves

Bank reserves are only a fraction of total transaction deposits. The reserve ratio is the ratio of a bank's reserves to its total deposits.

Bank reserves Reserve ratio = Total deposits

Fractional Reserves

The Federal Reserve System requires banks to maintain some minimum reserve ratio.

The T-account of the Bank

The books of a bank must always balance, because all of the assets of the bank must belong to someone (its depositors or its owners).

Money Creation
University Bank
Assets
+$100.00 in coins

Money Supply
Cash held by the public Transactions deposits at bank Change in M $100 +$100 0

Liabilities
+$100.00 in deposits

Money Creation
University Bank
Assets
+$100.00 in coins +$100 in loans

Money Supply
Cash held by the public Transactions deposits at bank Change in M no change +$100 +$100

Liabilities
+$100.00 in your account +$100.00 in borrowers account

Required Reserves

Required reserves are the minimum amount of reserves a bank is required to hold by government regulation; Equal to required reserve ratio times transactions deposits.

Required reserves = minimum reserve ratio X total deposits

Required Reserves

The minimum reserve requirement directly limits deposit-creation possibilities.

A Multibank World

In reality, there is more than one bank. The ability of banks to make loans depends on access to excess reserves.

A Multibank World

Example: If a bank is required to hold $20 in reserves but has $100 currently, it can lend out the $80 excess.

Excess Reserves

Excess reserves are bank reserves in excess of required reserves.

Excess reserves = Total reserves Required reserves

Excess Reserves

So long as a bank has excess reserves, it can make loans.

Excess reserves are reserves a bank is not required to hold.

Changes in the Money Supply

The creation of transaction deposits via new loans is the same thing as creating money.

More Deposit Creation

As the excess reserves are loaned out again, more deposits are created and thus more money is created.

Deposit Creation
University Bank
Assets
Required Reserves $20 Excess Reserves $80

Eternal Savings
Assets Liabilities

Liabilities
Your account

$100

Total Assets $100

Total Liabilities $100

Total Assets

Total Liabilities

Irwin/McGraw-Hill

The McGraw-Hill Companies, Inc., 2002

Deposit Creation
University Bank
Assets
Required Reserves $36 Excess Reserves $64 Loans $80 Total Assets $180

Eternal Savings
Assets Liabilities

Liabilities
Your account $100 Campus Radio account $ 80 Total Liabilities $180

Total Assets

Total Liabilities

Irwin/McGraw-Hill

The McGraw-Hill Companies, Inc., 2002

Deposit Creation
University Bank
Assets
Required Reserves $20 Excess Reserves $ 0 Loans $80 Total Assets $100

Eternal Savings
Assets
Required Reserves $16 Required Reserves $64

Liabilities
Your account $100 Campus Radio account $ 0 Total Liabilities $100

Liabilities
Atlas Antenna account $80

Total Assets $80

Total Liabilities $90

Irwin/McGraw-Hill

The McGraw-Hill Companies, Inc., 2002

Deposit Creation
University Bank
Assets
Required Reserves $20 Excess Reserves $ 0 Loans $80 Total Assets $100

Eternal Savings
Assets
Required Reserves $29 Required Reserves $51 Loans $64 Total Assets $144

Liabilities
Your account $100 Campus Radio account $ 0 Total Liabilities $100

Liabilities
Atlas Antenna account $80 Hermans Hardware account $64 Total Liabilities $144

Irwin/McGraw-Hill

The McGraw-Hill Companies, Inc., 2002

The Money Multiplier

In a multi-bank system, deposits created by one bank invariably end up as reserves in another bank. This process can theoretically continue until all banks have zero excess reserves (no more loans can be made). This is known as the money-multiplier process.

The Money Multiplier

The money multiplier is the number of deposit (loan) dollars that the banking system can create from $1 of excess reserves.

1 Money multiplier = Required reserve requirement

The Money Multiplier

When a new deposit enters the banking system, it creates both excess and required reserves. The required reserves represent leakage from the flow of money, since they cannot be used to create new loans. Excess reserve can be used for new loans. Once those loans are made, they typically become transactions deposits elsewhere in the banking system.

The Money Multiplier

Some additional leakage into required reserves occurs, and further loans are made. The entire banking system can increase the volume of loans by the amount of excess reserves multiplied by the money multiplier.

The Money Multiplier

The money supply can be increased through the process of deposit creation to this limit:

Potential deposit creation = Excess reserves of banking system X Money multiplier

The Money Multiplier Process

The public

Excess reserves Leakage into

Required reserves

Excess Reserves as Lending Power

Each bank may lend an amount equal to its excess reserves and no more. The entire banking system can increase the volume of loans by the amount of excess reserves multiplied by the money multiplier.

The Money Multiplier at Work

Original deposit Bank A loans: Bank B loans Bank C loans Total money supply =$ =$ =$ =$ 100.00 80.00 [=0.8 x $100.00] 64.00 [=0.8 x $80.00] 51.20 [=0.8 x $64.00] = $ 500.00

Banks and the Circular Flow

Banks perform two essential functions for the macro economy:

Banks transfer money from savers to spenders by lending funds (reserves) held on deposit. The banking system creates additional money by making loans in excess of total reserves.

Banks and the Circular Flow

Market participants respond to changes in the money supply by altering their spending behavior (shifting the aggregate demand curve).

Banks in the Circular Flow

Income
Consumers Loans Saving Domestic consumption

Factor markets

BANKS Loans Sales receipts

Product markets

Wages, dividends, etc.

Business firms

Investment expenditures

Financing Injections

The consumer saving is a leakage. A recessionary gap will emerge, creating unemployment if additional spending by business firms, foreigners, or governments does not compensate for consumer saving at full employment.

Financing Injections

A substantial portion of consumer saving is deposited in banks.

These and other bank deposits can be used to make loans, thereby returning purchasing power to the circular flow.

Financing Injections

The banking system can create any desired level of money supply if allowed to expand or reduce loan activity at will.

Constraints on Deposit Creation

There are three major constraints on deposit creation:

Deposits Consumers must be willing to use and accept checks rather than cash. Borrowers Consumers must be willing to borrow the money that banks provide. Regulation The Federal Reserve sets the ceiling on deposit creation.

When Banks Fail

Because of the fractional reserve system, no bank can pay off its customers if they all sought to withdraw their deposits at one time.

Bank Panics

Occasional runs of depositors rushing to withdraw their funds have created panics in the past. As word spread, it became a self-fulfilling confirmation of a banks insolvency. The resulting bank closing wiped out customer deposits, curtailed bank lending, and often pushed the economy into recession. As their reserves dwindled, the ability of banks to create money evaporated and a chunk of money (bank deposits and loans) just disappeared. In the early part of the Great Depression (19301933), 9000 banks failed.

Deposit Insurance

In 1933-34, the FDIC and FSLIC were created by Congress to ensure depositors that their money would be safe -- thus eliminating the motivation for deposit runs.

The S & L Crisis

The economic conditions in the 1970s saw many S&Ls stuck earning money on lowinterest, long-term loans (mortgages etc.) while having to pay out short-term highinterest fees to their customers.

The S & L Crisis

Competition from new financial institutions (e.g. money-market mutual funds) enticed deposits away from S&Ls.

Consequently, many S&Ls failed.

Bank Bailouts

S&L failures cost the federal government billions over $60 billion in 1992 alone as the FSLIC and FDIC paid off depositors.

Bank Bailouts

The Resolution Trust Corporation was created in 1989 to manage the outstanding loans of banks the federal government had to bail out. Parts of the bailout funds were recouped from this effort.

Money and Banks

End of Chapter 13