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What is Money? • Money is any commodity or token that is generally acceptable as the means of payment. • A means of payment is a method of settling a debt. Copyright © 1998 Addison Wesley Longman, Inc. TM 13-‹#› What Money Does? • functions of Money 1) Medium of exchange 2) Unit of account 3) Store of value Copyright © 1998 Addison Wesley Longman, Inc. TM 13-‹#› Measures of Money? • Official Measures of Money 1) M1 consists of currency and traveler’s checks plus checking deposits. • Includes accounts held by individuals and businesses, but does not include currency held by banks, or currency and checking deposits owned by the U.S. government Copyright © 1998 Addison Wesley Longman, Inc. TM 13-‹#› Measures of Money? • Official Measures of Money 2) M2 consists of M1 plus saving deposits and time deposits Copyright © 1998 Addison Wesley Longman, Inc. TM 13-‹#› Measures of Money? • Official Measures of Money 3) M3 consists of M2 plus large-scale time deposits and term deposits Copyright © 1998 Addison Wesley Longman, Inc. TM 13-‹#› Two Measures of Money Copyright © 1998 Addison Wesley Longman, Inc. TM 13-‹#› Financial Intermediaries • Financial intermediaries are firms that take deposits from households and firms and makes loans to other households and firms. Copyright © 1998 Addison Wesley Longman, Inc. TM 13-‹#› Financial Intermediaries • Four Types of Financial Intermediaries 1) Commercial banks 2) Savings and loan associations 3) Savings banks and credit unions 4) Money market mutual funds Copyright © 1998 Addison Wesley Longman, Inc. TM 13-‹#› Financial Intermediaries • Commercial Banks • A commercial bank is a firm, licensed by the Comptroller of the Currency or by a state agency to receive deposits and make loans. Copyright © 1998 Addison Wesley Longman, Inc. TM 13-‹#› Financial Intermediaries • Commercial Banks • Their balance sheet is described by the following formula: Liabilities + Net Worth = Assets Copyright © 1998 Addison Wesley Longman, Inc. TM 13-‹#› Financial Intermediaries • Reserves and Loans • Banks divide their funds into two parts: • Reserves are cash in a bank’s vault plus its deposits at Federal Reserve banks • Loans Copyright © 1998 Addison Wesley Longman, Inc. TM 13-‹#› Financial Intermediaries • Three Types of Assets Held by Banks 1) Liquid assets are U.S. government Treasury bills and commercial bills 2) Investment securities are longer-term U.S. government bonds and other bonds 3) Loans are commitments of fixed amounts of money for agreed- upon periods of time Copyright © 1998 Addison Wesley Longman, Inc. TM 13-‹#› Financial Intermediaries (FI) • The Economic Functions of FI 1) Creating Liquidity 2) Minimizing the cost of borrowing 3) Minimizing the cost of monitoring borrowers 4) Pooling Risk Copyright © 1998 Addison Wesley Longman, Inc. TM 13-‹#› How Banks Create Money • Reserves: Actual and Required • The reserve ratio is the fraction of a bank’s total deposits that are held in reserves. • The required reserve ratio is the ratio of reserves to deposits that banks are required, by regulation, to hold. • Excess reserves are actual reserves minus required reserves. Copyright © 1998 Addison Wesley Longman, Inc. TM 13-‹#› How Banks Create Money • Creating Deposits by Making loans in a One-Bank Economy Let’s see an example of how banks create money. Copyright © 1998 Addison Wesley Longman, Inc. TM 13-‹#› Creating Money at the One-and-Only Bank Balance sheet on January 1 Assets (millions of dollars) Liabilities (millions of dollars) Reserves $100 Loans $300 Total $400 Copyright © 1998 Addison Wesley Longman, Inc. Deposits $400 Total $400 TM 13-‹#› Creating Money at the One-and-Only Bank Balance sheet on January 2 Assets (millions of dollars) Liabilities (millions of dollars) Reserves $101 Loans $300 Total $401 Copyright © 1998 Addison Wesley Longman, Inc. Deposits $401 Total $401 TM 13-‹#› Creating Money at the One-and-Only Bank Balance sheet on January 3 Assets (millions of dollars) Liabilities (millions of dollars) Reserves $101 Loans $303 Total $404 Copyright © 1998 Addison Wesley Longman, Inc. Deposits $404 Total $404 TM 13-‹#› How Banks Create Money • The Deposit Multiplier Change in deposits Deposit multiplier Change in reserves Copyright © 1998 Addison Wesley Longman, Inc. TM 13-‹#› How Banks Create Money • Creating Deposits by Making Loans with Many Banks Let’s see how the banking system creates money Copyright © 1998 Addison Wesley Longman, Inc. TM 13-‹#› The Multiple Creation of Bank Deposits The sequence The running tally Reserves Copyright © 1998 Addison Wesley Longman, Inc. Loans Deposits TM 13-‹#› The Multiple Creation of Bank Deposits The sequence The running tally Reserves Loans Deposits Deposit $100,000 Copyright © 1998 Addison Wesley Longman, Inc. TM 13-‹#› The Multiple Creation of Bank Deposits The sequence The running tally Reserves Loans Deposits $75,000 $25,000 Deposit $100,000 Reserve $25,000 Copyright © 1998 Addison Wesley Longman, Inc. Loan $75,000 $25,000 $75,000 $100,000 TM 13-‹#› The Multiple Creation of Bank Deposits The sequence The running tally Reserves Loans Deposits $75,000 $25,000 Deposit $100,000 Reserve $25,000 Loan $75,000 $25,000 $75,000 $100,000 Deposit $75,000 Copyright © 1998 Addison Wesley Longman, Inc. TM 13-‹#› The Multiple Creation of Bank Deposits The sequence The running tally Reserves Loans Deposits $75,000 $25,000 Deposit $100,000 Reserve $25,000 Loan $75,000 $25,000 $75,000 $100,000 $43,750 $131,250 $175,000 Deposit $75,000 Reserve $18,750 Copyright © 1998 Addison Wesley Longman, Inc. Loan $56,250 TM 13-‹#› The Multiple Creation of Bank Deposits The sequence The running tally Reserves Loans Deposits Deposit $56,250 Copyright © 1998 Addison Wesley Longman, Inc. TM 13-‹#› The Multiple Creation of Bank Deposits The sequence The running tally Reserves Deposit $56,250 Reserve $14,063 Copyright © 1998 Addison Wesley Longman, Inc. Loan $42,187 $43,750 $57,813 Loans $131,250 $173,437 Deposits $175,000 $231,250 TM 13-‹#› The Multiple Creation of Bank Deposits The sequence The running tally Reserves Deposit $56,250 Reserve $14,063 Loan $42,187 $43,750 $57,813 Loans $131,250 $173,437 Deposits $175,000 $231,250 Deposit $42,187 Copyright © 1998 Addison Wesley Longman, Inc. TM 13-‹#› The Multiple Creation of Bank Deposits The sequence The running tally Reserves Reserve $10,547 Copyright © 1998 Addison Wesley Longman, Inc. Loan $31,640 $68,360 Loans $205,077 Deposits $273,437 TM 13-‹#› The Multiple Creation of Bank Deposits The sequence The running tally Reserves Reserve $10,547 Loan $31,640 Loans Deposits $68,360 $205,077 $273,437 $100,000 $300,000 $400,000 and so on... Copyright © 1998 Addison Wesley Longman, Inc. TM 13-‹#› The Fed controls the money supply by adjusting the reserves of the banking system. Copyright © 1998 Addison Wesley Longman, Inc. TM 13-‹#› The Fed controls the money supply by adjusting the reserves of the banking system. These reserves are controlled by three tools available to the Fed. Copyright © 1998 Addison Wesley Longman, Inc. TM 13-‹#› 1) Required reserve ratios Copyright © 1998 Addison Wesley Longman, Inc. TM 13-‹#› 1) Required reserve ratios 2) Discount rate Copyright © 1998 Addison Wesley Longman, Inc. TM 13-‹#› 1) Required reserve ratios 2) Discount rate 3) Open market operations Copyright © 1998 Addison Wesley Longman, Inc. TM 13-‹#› • Required Reserve Ratios • The Fed determines a required reserve ratio for each type of deposit. • In 1997, banks were required to keep 3 percent of checking deposits up to $49 million and 10 percent of deposits in excess of $49 million. • Other deposits had no reserve requirement. Copyright © 1998 Addison Wesley Longman, Inc. TM 13-‹#› • Discount Rate • The discount rate is the interest rate at which the Fed stands ready to lend reserves to commercial banks. Copyright © 1998 Addison Wesley Longman, Inc. TM 13-‹#› • Open Market Operations • Open market operations are the purchase or sale of government securities by the Federal Reserve System on the open market. Copyright © 1998 Addison Wesley Longman, Inc. TM 13-‹#›