Money and Banking

Study Questions

1. What is money? 2. What are the three functions of money? 3. What is the money supply? 4. How do banks create money? 5. What is fractional reserve banking?

Study Questions

6. What are the three tools the Federal Reserve can use to manipulate the money supply?

7. How does the Fed conduct Open Market Operations?

8. When would the Fed favor an “easy money” policy?

9. When would the Fed favor a “tight money” policy?

Money

It is a tool.Makes transactions easier.

The size of the money supply is controlled by the central bank:The Federal Reserve System.

Barter

Exchanges one good for another. Problem:

double coincidence of wants.high transaction costs.

extra effort time lost in search

Money eliminates the double coincidence of wants.

Money

Anything that is generally accepted as payment of goods and services and for employment.

Typically:cash in circulation (paper money and coins)deposits (electronic data entries)

Money

What gives money value? Its purchasing power.Our trust that the Federal Reserve System will

not expand the money supply faster than what is needed for transactions.

What backs our money? Our money is no longer “backed” by gold or

silver.

Gold Standard

U.S. went off Gold Standard in 1933 Gold was exchanged for Federal Reserve

notes 1971- Nixon closed the gold window

completely and U.S. went on exchange rate system ($$ against Yen., etc.)

Have you ever seen a Federal Reserve Note?

Have you ever seen a Federal Reserve Note?Do any of you have any Federal Reserve Notes?A=BostonB= New YorkC= PhiladelphiaD= ClevelandE= Richmond, VAF= AtlantaG= ChicagoH= St. LouisI= MinneapolisJ= Kansas CityK= DallasL= San Francisco

Money’s Characteristics

Portable Durable Divisible Recognizable Rare

Functions of Money

Medium of Exchange Store of Value Standard of Value

Money Supply

This is money that people can access. Its size is limited by the Federal Reserve

System. It is categorized by its liquidity (how easy it

is to spend):M1 (most liquid)M2M3 (least liquid)

Money Supply

Are credit cards money?No…you are borrowing from the issuer when

you use a credit card. (they are called “near money”)

Are debit cards money?Yes…using a debit card is just like writing a

check; it draws down your checking account.

Commercial Banks

Privately owned Profit seeking Receive deposits (pay out interest) Make loans (charge interest) Perform other services for fees Economic function: redirects savings into

investments and spending

Money “is created”

When a bank makes a loan, the money supply is increased.Loan is approvedBorrower’s checking account is increasedMore money can be accessed by peopleMoney supply increases

Money “is destroyed”

When a borrower pays back a loan, the money supply is decreased.Borrower pays back a loanBorrower’s checking account is decreasedLess money can be accessed by peopleMoney supply decreases

The Federal Reserve System

Our nation’s central bank. Twelve regional Federal Reserve Banks Acts as banker to the banking system Has a policy making role:

manages the size and growth of the money supply.

manages interest rates and the availability of credit.

Federal Reserve

FEDERAL RESERVE STRUCTURE

Board of Governors7 Members

12 District Banks

Member Banks

One of 7 is Chairman

1. A.Boston

2. B. NY

3.C. Philadelphia

4.D. Cleveland

5.E. Richmond,VA

6.F. Atlanta

7. G. Chicago

8.H. St. Louis

9. I. Minneapolis

10. J. Kansas City11. K. Dallas*12.L. San Francisco

12 Regional Banks

12 District Banks.Dallas is the 11th District… Khttp://www.dallasfed.org/

25 Regional Banks.Dallas has region banks in El Paso, San Antonio, Houston.

3 Monetary Tools for the FED

1. Reserve Requirement

2. Discount Rate

3. FOMC

Fractional Reserve Banking

Banks receive deposits (also called reserves) from its clients.

The Fed requires a fraction of those deposits to be set aside (required reserves) and not used to make loans.

The rest of the deposits (excess reserves) may be loaned out to borrowers.

Fractional Reserve Banking

The fraction of deposits (reserves) that must be set aside is the reserve ratio.

The Fed controls the amount of loans that can be made by setting the reserve ratio.

Since loans create money, this controls the size and growth of the money supply.

One Tool to Control Money SupplyReserve Requirement

The Fed requires banking institutions, including S&Ls, Credit Unions, Loan Assns, to maintain reserves against the demand deposits of their customers. Required and excess are important concepts

Required Reserves are: vault cash and deposits held for them at the Fed.

This RR can alter the loans that members can make by:

a) Lowering RR = creating more money to loan

b) Raising the RR= decreasing money creation.

RR’s do not change very often.

Changes in RR can be disruptive of banking operations. RR change could force banks to sell securities quickly or call in loans to meet the Fed requirement.

Current: 3% 0-$46.5 Mil 10% $46.5 +

How Fractional Banking WorksFed RR is 20%(bank required to hold a percentage of its deposits on RR

Deposit made = $100,000

-20,000 (bank holds in reserve

$ 80,000 (bank can loan this amount)

This $80,000 is considered new money

Whoever receives the $80,000 as a loan then deposits it into an account and can write checks immediately, but the bank views it as “never seen before.”

CONTINUED RR/FRACTIONAL BANKING EXAMPLE

$80,000$80,000

-16,000-16,000 (20% reserve required) (20% reserve required)

$64,000 (potential new loan which can be $64,000 (potential new loan which can be created and loaned out to another customercreated and loaned out to another customer

$64,000 new deposit in mind of bank$64,000 new deposit in mind of bank

- 12,800- 12,800 (20 % must be kept in reserve) (20 % must be kept in reserve)

$51,200 considered new money available for $51,200 considered new money available for loanloan

CONTINUED RR/FRACTIONAL EXAMPLE

This cycle keeps going on and on- This cycle keeps going on and on-

The money multiplier factor for 20% RR is 5 to 1The money multiplier factor for 20% RR is 5 to 1

Using the above example- banks could create 5 Using the above example- banks could create 5 times the $100,000 at 20% reserve required or in times the $100,000 at 20% reserve required or in other words, it can create $500,00 “NEW MONEY”other words, it can create $500,00 “NEW MONEY”

At 25% required as opposed to say 10%- higher At 25% required as opposed to say 10%- higher requirement would lower the multiplier effect from requirement would lower the multiplier effect from 10 to 4 which in turn would not allow banks to have 10 to 4 which in turn would not allow banks to have as much money to loan- or would be taking money as much money to loan- or would be taking money out of circulation.out of circulation.

Summary/RR/Fractional Banking/Multiplier

The higher the required reserve- the lower the multiplier.

The potential deposit expansion multiplier is merely the reciprocal of the required reserve ratio (r ) In case of 20% example or l/5 of total deposits to be held- deposit expansion multiplier is 5

If 10% was to be held- deposit expansion multiplier is 10.

DOES MULTIPLIER ALWAYS WORK? no

Creating New Money with the deposit expansion Creating New Money with the deposit expansion multiplier effect will not work if:multiplier effect will not work if:

All excess reserves are tied up.All excess reserves are tied up. (purchase securities, (purchase securities, loans, etc.)loans, etc.)

IfIf person receiving the loan decides to hold currencyperson receiving the loan decides to hold currency rather than deposit it into the bankrather than deposit it into the bank

If banks decide not to extend loansIf banks decide not to extend loans even though they even though they have excess reserves available (referred in the early have excess reserves available (referred in the early 90’s as “credit crunch.” 90’s as “credit crunch.” And… is happening today!And… is happening today!

Tools of the Fed

Changing the reserve ratio. Changing the discount rate. Conducting open market operations.

Changing the reserve ratio

If reserve ratio is 5%, or 1/20, a $10,000 deposit will trigger an increase in the money supply of $200,000.

Raise the reserve ratio to 10%, or 1/10, and the increase can only go to $100,000. fewer loans will be made

Lower the reserve ratio to 2%, of 1/50, and the increase can go to $500,000. more loans will be made.

SECOND TOOL TO CONTROL MONEY SUPPLY- DISCOUNT RATE

There are two types of interest: Simple and discount.Simple- paid each time a payment is made on

the loan.Discount- entire amount of interest owed is

deducted from loan before it is issued

Changing the discount rate

Banks can borrow reserves from the Fed if they wish to make more loans than their deposits allow. They must pay interest on these loans – the discount rate.

If the Fed raises the discount rate, the cost to borrow by banks goes up, and they will borrow fewer reserves (make fewer loans)

If the Fed lowers the discount rate, the cost to borrow by banks goes down, and they may borrow more reserves (make more loans).

Discount Rate Continued

-Member banks “lent out” (have no money to loan and a good corporate customer wants a loan)

- Or, perhaps they can’t cover their required reserve requirement.

- Need to pay out customer request for deposited funds and poor management of prior loans left bank short of cash

DISCOUNT RATE CONTINUED

District Bank is not a charity bank… charges interest on money loaned to member banks. If Member Bank borrows $100,000 at 10%

The interest is discounted up-front- Member has $90,000 to take back to loan.

Member bank is not going to loan at 10%

Adds 2 to 3 points to constitute prime rate. In this example is 13%

Discount Rate continued

If ordinary citizen wants to borrow, points added to prime depending on type of loan, collateral, history, etc.

Prime rate is always higher than discount- each bank sets own prime, but large banks tend to all have the same.

Prime is rate given to best corporate customers.

DISCOUNT RATE CONTINUED If Fed wants to cut down on bank loans, they

can raise the discount rate. Recently the Fed lowered the discount rate to

encourage loans **Banks will borrow from Federal Funds Rate

before going to the Fed to borrow. Too many trips to the Fed to borrow signals poor fiscal management of the bank

What is the Federal Funds Rate? The rate banks can charge (as set by the BOG) for short-term loans between each other – often overnight.

Federal Funds rate will be lower than discount rate. Why?

1.25 vs 1.00 (11/24/08) Today: .75 (Discount) % vs .25% (FFR)

Benchmark Interest Rates

Discount rate Federal Funds rate When the Fed raises these rates, banks and

other lenders raise all interest rates. more expensive to borrow

When the Fed lowers these rates, banks and other lenders lower all interest rates. less expensive to borrow

THIRD TOOL TO CONTROL OPEN MARKET COMMITTEE (FOMC) This is the most common tool used by Fed to alter

the money supply. Buying and Selling of U.S. securities on the open

market FOMC meets about every six weeks. FOMC = all 7 BOG, 12 District Presidents N.Y. President permanent member, other 11

Presidents rotate on the voting 12 on yearly basis. FOMC constitutes 12 persons. Can directly influence the money supply in a non-

disruptive way.

FOMC Continued

FED can write a check without funds in an account so to speak.

FED holds large portfolio of U.S. government securities FED engages in open market trading with approximately

3 dozen major securities dealers. These transactions take place at NY Fed Trading Desk

A SELL OPERATION When Fed wishes to restrain money supply growth, the

Fed sells U.S. government securities on the open market.

Conduct Open Market Operations

The Open Market in question is the daily buying and selling of US Treasury Securities, or bonds.

In the past, the US Treasury issued these bonds to raise funds to cover the budget deficit.

Bondholders might wish to redeem their funds earlier than the maturity date. They can do so by selling their bonds in the Open Market.

Others may wish to invest funds in these bonds. They can do so by buying bonds in the Open Market.

Conduct Open Market Operations

The Fed owns US Treasury Securities. The Fed Open Market Committee can

change the size and growth of the money supply using Open Market Operations.

Conduct Open Market Operations

If the Fed buys securities, they must pay for them.The seller’s checking account increases.Bank deposits (reserves) increase.More loans can be made.Money Supply increases.

Conduct Open Market Operations

If the Fed sells securities, the buyer must pay the Fed for them.The seller’s checking account decreases.Bank deposits (reserves) decrease.Fewer loans can be made.Money Supply decreases.

“Easy Money” Policy

In an underperforming economy:encourage lending to encourage spendingexpand creditoptions:

lower the reserve ratio lower the discount rate buy securities in the open market

“Tight Money” Policy

In an overheated economy:discourage lending to discourage spendingshrink creditoptions:

raise the reserve ratio raise the discount rate sell securities in the open market

FOMC assesses growth operations directed to 4 objectives:

full employment, economic growth, stable prices and balance of payments.

FOMC Video

http://education-portal.com/academy/lesson/open-market-operations-the-federal-reserve-definition-examples.html