THE MONEY SUPPLY

Anything that serves all of the following
purposes can be thought of as 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 – Serves as a measurement for
the prices of goods and services.
Chapter 13 & 14
MONEY, BANKS, AND THE FED
2
MODERN CONCEPTS
DIVERSITY OF BANK ACCOUNTS
Money is anything generally accepted as a
medium of exchange.
 The “greenbacks” we carry around today are
not the only form of “money”
money we use
use.
 Checking accounts can and do perform the
same market functions as cash.
 Credit cards are another popular medium of
exchange but are not money.

Some bank accounts are better substitutes for
cash than others.
 Money supply (M1): - Currency held by the
public plus balances in transactions accounts
public,
accounts.

are only a payment service with no store of
value in and of themselves.
 M1
includes currency in circulation, transactionaccount balances, and traveler’s checks.
 A transactions account is a bank account that
permits direct payment to a third party, for example,
with a check.
 They
 Largest
M2: M1 + SAVINGS ACCOUNTS, ETC.

M2 money supply – M1 plus balances in most
savings accounts and money market mutual
funds.
 Savings-account
component of Money Supply
3
balances are almost as good a
substitute for cash as transaction-account
balances.
 How much money is available affects consumers’
ability to purchase goods and, services – aggregate
demand.
 M1 and M2 are fairly reliable benchmarks for
gauging how much purchasing power market
participants have.
5
4
COMPOSITION OF THE MONEY SUPPLY
M2
($5383 billion)
Money market mutual funds and deposits ($1027 billion)
Savings account balances ($3167 billion)
M1
($1189 billion)
Traveler’s checks ($8 billion)
Transactions-account balances ($612 billion)
Currency in circulation ($569 billion)
6
CREATION OF MONEY

DEPOSIT CREATION
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.
 There are two basic principles of the money
supply:

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).
 When a bank lends someone money, it simply
credits that individual’s bank account.
Transactions-account balances are a large portion of
our money supply.
 Banks can create transactions-account balances by
making loans.

7
BANK REGULATION
A MONOPOLY BANK
The deposit-creation activities of banks are
regulated by the government.
 The Federal Reserve System limits the amount
of bank lending,
lending thereby controlling the basic
money supply.

Assume a student deposits $100 from their
piggy 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.

9
THE INITIAL LOAN

8
10
SECONDARY DEPOSITS
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.
11
In a one bank system, when Campus Radio
uses the loan, the money supply does not
contract, rather ownership of deposits change.
 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 (Fed requirement).

Reserve ratio =
Bank reserves
Total deposits
12
THE T-ACCOUNT OF THE BANK

MONEY CREATION
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).
University Bank
Assets
+$100.00 in
coins
i
Money Supply
Liabilities
+$100.00 in
d
deposits
it
Cash held by the public
T
Transactions
ti
deposits
d
it
at bank
–$100
+$100
Change in M
0
13
REQUIRED RESERVES
MONEY CREATION

University Bank
Assets
Liabilities
+$100.00 in
coins
i
+$100 in
loans
+$100.00 in
your accountt
+$100.00 in
borrower’s
account
14
Money Supply
Cash held by the public
T
Transactions
ti
deposits
d
it
at bank
Change in M
no change
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.
+$100
Required reserves = minimum reserve ratio
X total deposits
+$100

The minimum reserve requirement directly
limits deposit-creation possibilities.
16
15
A MULTIBANK WORLD


A MULTIBANK WORLD
In reality, there is more than one bank.
The ability of banks to make loans depends on
access to excess reserves.

Example: If a bank is required to hold $20 in
reserves but has $100 currently, it can lend out
the $80 excess.
 Excess

17
reserves =Total
Total reserves
reserves-Required
Required reserves)
So long as a bank has excess reserves, it can
make loans.
18
CHANGES IN THE MONEY SUPPLY
DEPOSIT CREATION
The creation of transaction deposits via new
loans is the same thing as creating money.
 As the excess reserves are loaned out again,
more deposits are created and thus more
money is created.

University Bank
Assets
19
DEPOSIT CREATION
University Bank
Assets
Liabilities
Required
Reserves $36
Excess
Reserves $64
Loans
$80
Your
account $100
Campus
Radio
account $ 80
Total Assets
$180
Total Liabilities
$180
Irwin/McGraw-Hill
Liabilities
Assets
Total Assets
$100
Total Liabilities
$100
Liabilities
$100
Total Assets
Irwin/McGraw-Hill
Total Liabilities
© The McGraw-Hill Companies, Inc., 200220
Total Assets
University Bank
Assets
Liabilities
Total Liabilities
Liabilities
Eternal Savings
Assets
Liabilities
Required
Reserves $20
Excess
Reserves $ 0
Loans
$80
Your
account $100
Campus
Radio
account $ 0
Required
Reserves $16
Excess
Reserves $64
Atlas
Antenna
account $80
Total Assets
$100
Total Liabilities
$100
Total Assets
$80
Total Liabilities
$80
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 200222
THE MONEY MULTIPLIER
Eternal Savings
Assets
Liabilities
Required
Reserves $20
Excess
Reserves $ 0
Loans
$80
Your
account $100
Campus
Radio
account $ 0
Required
Reserves $29
Excess
Reserves $51
Loans
$64
Atlas
Antenna
account $80
Herman’s
Hardware
account $64
Total Assets
$100
Total Liabilities
$100
Total Assets
$144
Total Liabilities
$144
Irwin/McGraw-Hill
Your
account
Eternal Savings
DEPOSIT CREATION
Assets
Required
Reserves $20
Excess
Reserves $80
Eternal Savings
Assets
DEPOSIT CREATION
© The McGraw-Hill Companies, Inc., 200221
University Bank
Liabilities
© The McGraw-Hill Companies, Inc., 200223
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.

24
THE MONEY MULTIPLIER

THE MONEY MULTIPLIER
The money multiplier is the number of deposit
(loan) dollars that the banking system can
create from $1 of excess reserves.
Money multiplier =

When a new deposit enters the banking
system, it creates both excess and required
reserves.
 The
required reserves represent leakage from the
flow of money, since they cannot be used to create
new loans.
 Excess reserve can be used for new loans (often
turned into transactions deposits elsewhere).
 Some additional leakage into required reserves
occurs, and further loans are made.
1
Required reserve requirement
25
THE MONEY MULTIPLIER
26
THE MONEY MULTIPLIER PROCESS
The entire banking system can increase the
volume of loans by the amount of excess
reserves multiplied by the money multiplier.
 The money supply can be increased through
the process of deposit creation to this limit:

The public
Excess reserves
Leakage into
Potential deposit creation =
Excess reserves of banking system
X Money multiplier
Required
reserves
27
EXCESS RESERVES AS LENDING POWER
28
THE MONEY MULTIPLIER AT WORK
Each bank may lend an amount equal to its
excess reserves and no more.
 The entire banking system can increase the
volume of loans by the amount of excess
reserves multiplied by the money multiplier.

Original deposit
Bank A loans:
Bank B loans
B k C loans
Bank
l



Total money supply
29
=$
=$
=$
=$
100.00
80.00 [=0.8 x $100.00]
64.00 [=0.8 x $80.00]
51
51.20
20 [[=0.8
0 8 x $64.00]
$64 00]



= $ 500.00
30
BANKS AND THE CIRCULAR FLOW

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.
Market participants respond to changes in the
money supply by altering their spending
behavior (shifting the aggregate demand
curve).
31
32
FINANCING INJECTIONS
BANKS IN THE CIRCULAR FLOW
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.
 A substantial portion of consumer saving is
deposited in banks which can be used to make
loans, thereby returning purchasing power to the
circular flow.
 The banking system can create any desired level
of money supply if allowed to expand or reduce
loan activity at will.


Wages,
dividends, etc.
Saving
S
Product
markets
BANKS
Loans
Factor
markets
Domestic
consumption
Consumers
Loans
Income
Business
firms
Sales
receipts
Investment
expenditures
34
33
CONSTRAINTS ON DEPOSIT CREATION

WHEN BANKS FAIL
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.
35
Because of the fractional reserve system, no
bank can pay off its customers if they all sought
to withdraw their deposits at one time.
36
BANK PANICS

DEPOSIT INSURANCE
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 bank’s insolvency.
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 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.

INTRODUCTION: FEDERAL RESERVE

•

The fed’s control over the supply of money is
the key mechanism of monetary policy.
Monetary policy is the use of money and
credit controls to influence macroeconomic
activity.
38
FEDERAL RESERVE BANKS
Congress passed the Federal Reserve Act in
1913 to avert recurrent financial crises.
 Each of the twelve (12) Federal Reserve banks
act as a central banker for the private banks in
their region.

The Federal Reserve maintains an excellent synopsis of the
roles of the respective parts of the system here.
FEDERAL RESERVE BANKS

37
The Federal Reserve performs the following
services:
l
l
l
l
Clears checks between private banks
Holds bank reserves.
Provides currency to the public.
Provides loans to private banks.
THE BOARD OF GOVERNORS
The Fed is controlled by a seven person Board
of Governors.
 Each governor is appointed to a 14-year term by
the President (with confirmation byy the U.S.
Senate).

 The
President selects one of the governors to serve
as chairman for a 4-year term.

The long term is intended to give the Fed a
strong measure of political independence.
THE FEDERAL OPEN MARKET COMMITTEE(FOMC)
STRUCTURE OF THE FEDERAL RESERVE SYSTEM
The FOMC is a twelve member group (the seven
governors along with five of the 12 regional
Reserve bank presidents).
 The FOMC oversees the daily activity of the Fed
and meets every 4-5 weeks to review monetary
policy and outcomes.

Federal Open
Market
Committee
(12 members)
Federal Advisory
Council and
other
committees
Board
of
Governors
(7 members)
Federal Reserve banks
(12 banks, 24 branches)
Private banks
(depository institutions)
MONETARY TOOLS
RESERVE REQUIREMENTS
The Fed directly alters the lending capacity of
the banking system by changing the reserve
requirement (to change the level of excess
reserves).
Excess reserves = Total reserves –
Required reserves
 The money multiplier determines how much in
additional loans the banking system can make
based on their excess reserves.
Available lending capacity of the
banking system = excess reserves X
money multiplier


The Federal Reserve controls the money supply
using the following three policy instruments:
 Reserve
requirements
rates
 Open-market operations
 Discount
RESERVE REQUIREMENTS
By raising the required reserve ratio, the Fed
can immediately reduce the lending capacity of
the banking system.
 A change in the reserve requirement causes a
change in:
IMPACT OF AN INCREASED RESERVE
REQUIREMENT

l
l
l
Excess reserves.
The money multiplier.
The lending capacity of the banking system.
Required Reserve Ratio
Total deposits
p
Total reserves
20 percent
25 percent
$100 billion
$100 billion
30 billion
30 billion
Required reserves
20 billion
25 billion
Excess reserves
10 billion
5 billion
Money multiplier
Unused lending capacity
5
4
$ 50 billion
$ 20 billion
THE DISCOUNT RATE
EXCESS RESERVES AND BORROWINGS
Excess reserves earn no interest.
 Banks have a tremendous profit incentive to
keep their reserves as close to their required
reserve level as possible.
possible

7
Excess reserves
4
3
2
Borrowings at
Federal Reserve banks
1
1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
THE FEDERAL FUNDS MARKET
SALE OF SECURITIES
The federal funds market is where a bank that
finds itself short of reserves can turn to other
banks for help.
 The federal funds rate is the interest rate for
inter-bank reserve loans.


A bank that is low on reserves can also sell
securities.
 Banks use some of their excess reserves to
purchase government bonds.
bonds
 Reserves
borrowed in this manner are called
“federal funds” and are lent for short periods usually overnight.
DISCOUNTING

Discounting refers to the Federal Reserve lending
of reserves to private banks.
A
bank can deal with a reserve shortage by going to
the Fed’s “discount window” to borrow reserves
directly.
directly
The discount rate is the rate of interest the
Federal Reserve charges for lending reserves to
private banks.
 By raising or lowering the discount rate, the Fed
changes the cost of money for banks and the
incentive to borrow reserves.

OPEN-MARKET OPERATIONS
Open-market operations are the principal
mechanism for directly altering the reserves of
the banking system.
 The portfolio decision is the choice of how
(where) to hold idle funds.
 People do not hold all their idle funds in
transactions accounts or cash.

HOLD MONEY OR BONDS
OPEN MARKET OPERATIONS
The Fed’s open-market operation focus on the
portfolio choices people make.
 The Fed attempts to influence the choice by
makingg bonds more or less attractive, as
circumstances warrant.
 When the Fed buys bonds from the public, it
increases the flow of deposits (reserves) to the
banking system.

 Bond
Buyers spend
Fed SELLS bonds
account balances
The Fed
O
Open
market
operations
The
Public
Banks
Sellers deposit
Fed BUYS bonds
Reserves
decrease
bond proceeds
Reserves
increase
sales by the Fed reduce the flow.
THE BOND MARKET
BOND YIELDS
Not all of us buy and sell bonds, but a lot of
consumers and corporations do.
 A bond is a certificate acknowledging a debt
and the amount of interest to be paid each year
until repayment.
 Like other markets, the bond market exists
whenever and however bond buyers and sellers
get together.

The current yield paid on a bond is the rate of
return on a bond.
n
It is the annual interest payment divided by
the bond’s price.
BOND YIELDS
OPEN MARKET ACTIVITY
A principal objective of Federal Reserve open
market activity is to alter the price of bonds,
and therewith their yields.
 The less you pay for a bond
bond, the higher its yield.
yield
 Federal Reserve open-market activity alters the
price of bonds, and their yields.
 By doing so, the Fed makes bonds a more or
less attractive alternative to holding money.



Yield =
Annual interest payment
Price paid for bond
Open market operations are Federal Reserve
purchases and sales of government bonds for
the purpose of altering bank reserves.
 If the Fed offers to pay a higher price for bonds,
bonds
it will effectively lower bond yields and market
interest rates.
 By buying bonds, the Fed increases bank
reserves.
THE FED FUNDS RATE
OPEN-MARKET PURCHASES

Regional Federal
Reserve bank
Federal Open
Market Committee
Step 3: Bank deposits
check at Fed bank,
as a reserve credit
Step 1:
St
1 FOMC purchases
h
government bonds; pays
for bonds with Federal
Reserve check
Private
bank
Step 2: Bond seller
deposits Fed check
To increase the money supply, the Fed can:

Lower reserve requirements.
 Increases
excess reserves with which they will increase the
money supply through deposit creation (loans).

Reduce the discount rate.
 Makes
M k
th
the costt off borrowing
b
i g reserves ffrom th
the Fed
F d cheaper,
h
which are used to make more loans.
 The effectiveness of lowering the discount rate depends
primarily on the difference in the new discount rate and the
rate that banks charge their loan customers.

 If
the Fed is pumping more reserves into the
banking system, the federal funds rate will decline.
 If the Fed is reducing bank reserve by selling bonds,
the federal funds rate will increase.
Public
INCREASING THE MONEY SUPPLY

Fed funds rate act as a market signal of the
changing reserve flows.
Buy bonds.
 By
purchasing bonds, the Fed places money in bank reserves
who will then increase the money supply even more through
additional loans.
End of Chapter 13 & 14
MONEY, BANKS, AND THE FED
FEDERAL FUNDS RATE
When market interest rates fall due to Fed
bond purchases, individual banks have an
incentive to borrow any excess reserves
available to increase loan creation.
 The Fed has shifted from money-supply targets
to interest targets.
