Download MACROECONOMICS LECTURE 5

MACROECONOMICS LECTURE 3
MONEY & BANKING
MONEY
Money: Money Basics
Topic: What It Is
Money can be just about anything.
Two points:
1. The 'thing' part: Money is an asset, something of value. In modern world we
use paper currency, coins or checks.
2. The 'any' part: Anything can function as money. What money is, is less
important than what money does.
Money is something that can be readily traded for valuable assets.
A definition:


Money is anything that is generally accepted in exchange for goods and
services.
Money can be pieces of paper, metal coins, bank accounts, animal skins,
shiny trinkets, or anything as long as it is generally accepted by society as
payment.
Money: Money Basics
Topic: THE Medium
The notion of general acceptance makes money THE medium of exchange for
economic transactions.
It must be generally accepted.


Two types of value:
1. Value in use (intrinsic value): An item provides satisfaction of wants
and needs.
2. Value in exchange: An item does not provide satisfaction directly but
can be traded for something that does.
Money may or may not have value in use, but to be a medium of exchange, it
must have value in exchange.
Money is an economic lubricant.

Too much money prompts inflationary expansion and too little entices
recessionary unemployment.

The challenge is to maintain the proper balance between too much and too
little.
Money: Money Basics
Topic: Summary

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
The basic definition of money, which is anything that is generally accepted
in exchange for goods and services.
That money is something that can be readily traded for valuable assets.
That money is THE medium through which market exchanges travel.
The two types of value:
1. Value in use which means an item provides satisfaction of wants and
needs.
2. Value in exchange which means an item does not provide satisfaction
directly but can be traded for something that does.
That money is an economic lubricant and that much money prompts
inflationary expansion and too little entices recessionary unemployment.
Money: More About Money
Topic: Functions
Money has four important functions.
Four functions:
1. Medium of exchange: Money makes it easier to buy, sell, produce, and
consume goods and services.
2. Measure of value: Prices are stated in terms of the monetary unit.
3. Store of value: Value can be stored over time with money.
4. Standard of deferred payment: Future payments are also in terms of the
monetary unit.
Page ahead for details.
Money: More About Money
Topic: Medium of Exchange
The primary function of money is to as THE medium of exchange.
An economy without money:


Barter exchange happens when you trade one good for another.
A barter economy is one that uses nothing but barter trades, no money.


Barter requires double coincidence of wants: I must want what you have and
you must want what I have.
With no money, resources are used for trading and not for production.
The bottom line:

Using money as a medium of exchange eases the exchange process, makes it
more efficient, and frees resources for production.
Money: More About Money
Topic: Measure of Value
Money functions as the measuring unit for prices, it is the unit of account or
measure of value.

Markets prices are expressed in terms of the medium of exchange.
Reason:

Sellers are willing to trade for, and buyers are willing to give up, THE medium
of exchange: Money.
Therefore:



Money is used for exchanges.
Using money as the unit for prices gives a measure for value, that is, how
much value we place on a good.
The measure of value helps macroeconomist calculate gross domestic
product.
Money: More About Money
Topic: Store of Value
Another function of money is store of value.

It means that we retain the value, the satisfaction of wants and needs,
provided by a good over a period of time.
Ways to store of value:

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
Buy a product and store it for a week.
Buy a gift certificate and redeem it after a week.
Buy another good, keep it for a week, sell it and then use this money to buy a
product.
Keep the money one week or then buy the good.
A potential problem:


If the price of the good rises money becomes a less effective means of storing
value.
Price inflation is the nemesis for the store of value function of money.
Money: More About Money
Topic: Standard of Deferred Payment
Money is used as a standard of deferred payment, buying now and paying later.
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A car loan: Borrow money to buy a car today, then pay off the loan with
deferred payments into the future.
Money as a standard of deferred payment is a direct consequence of the unit
of account and store of value functions of money.
Money is the standard for current prices and future payments based on those
prices.
For money to function as a deferred payment, it must retain value.
The key to storing value in money is price inflation.
Deferred payments need to anticipate future money values based on future
inflation.
The inflation adjustment is accomplished by through interest rates.
Money: More About Money
Topic: Characteristics
There are four characteristics that let money do what money does.
Four characteristics:
1. Durable: It helps to retain value from one exchange to the next and store
value for future exchanges.
2. Divisible: It lets us accurately match an amount of money to the precise value
of a good.
3. Transportable: It lets us to conduct exchanges far and wide, to go where we
need to go for an exchange.
4. Non-counterfeitable: It keeps the value of money from being diluted.
Page ahead for details.
Money: More About Money
Topic: Summary
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The four functions of money:
1. Medium of exchange: money makes it easier to buy, sell, produce,
and consume goods and services.
2. Measure of value: prices are stated in terms of the monetary unit.
3. Store of value: value can be stored over time with money.
4. Standard of deferred payment: future payments are also in terms of
the monetary unit.
Using money as a medium of exchange eases the exchange process, makes it
more efficient, and frees resources for production.
Using money as the unit for prices gives a measure for value, that is, how
much value we place on a good.
Price inflation is the nemesis for the store of value function of money.
Money is used as a standard for buying now and paying later.
The four characteristics of money:
1. Durable: It helps to retain value from one exchange to do the next and
store value for future exchanges.
2. Divisible: It lets us accurately match an amount of money to the
precise value of a good.
3. Transportable: It allows us to conduct exchanges far and wide, to go
where we need to go for an exchange.
4. Non-counterfeitable: It keeps the value of money from being diluted.
Money: Monetary Aggregates
Topic: M1
The United States uses currency, coins,
and checks as money, which is M1.
We have several different 'definitions' of
money called monetary aggregates.
Monetary aggregate M1:
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It is the sum of currency and coins
held by the non-bank public, and
checkable deposits.
These are the items in our
economy that are generally
accepted in payment and regularly
used for market transactions.
We have over one trillion dollars of
M1.
Total M1 averaged over 270 million people in the U. S. is about $4,000 per
person.
Page ahead for details.
Money: Monetary Aggregates
Topic: M2
M2 is a broader measure of money that
includes M1 plus what we can call near
money.
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We have over four trillion dollars of
M2 in total.
Total M2 averaged over 270 million
people is about $15,000 per
person.
Near monies:
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
These are temporary savings, a
pool of funds that can be accessed
quickly and easily.
These funds are very liquid, but
not perfectly liquid as M1.
Some people, specially economists, argue that M2 is the best indicator of our
total supply of 'money.'
Money: Monetary Aggregates
Topic: Near Monies
Near monies are savings, but there are several different types of savings.
Types of savings:
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Standard savings accounts: They pay an interest, but lack check-writing
privileges. These are relatively liquid.
Certificates of deposit (CDs): They require a minimum deposit for a specified
time period and pay higher interest rates. They are less liquid than savings
accounts.
Money market funds: These funds are invested in negotiable, short-term
assets like U.S, treasury bills or commercial paper.
Overnight Eurodollars: Accounts denominated in U.S. dollars that are held in
foreign banks.
Overnight repurchase agreements: Interest-paying business savings accounts
that are temporary repositories of non-interest paying business checking
account balances.
Money: Monetary Aggregates
Topic: M3
M3 is equal to M2 plus other near monies.
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We have five trillion dollars of M3.
M3 averaged over 270 million
people in the U. S. is about
$18,000 per person.
Other near monies added to M3
are less liquid than the M2 near
monies.
M3 other near monies are
essentially investments.
M3 other near monies:
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Larger denomination certificates of
deposit and longer-term
repurchase agreements.
M2 includes CDs less than $10,000.
M3 includes CDs over $100,000.
M3 includes repurchase agreements and Eurodollars of longer duration than
the ones M2 includes.
These longer term and bigger M3 other near monies are less liquid than the
M2 near monies.
Money: Monetary Aggregates
Topic: L
L is the economy's total financial assets that
can be converted to M1.
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L stands for liquid assets.
Total L is over six trillion dollars.
We get to L by adding liquid assets to M3:
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Commercial paper
U.S. Treasury Bills
Saving Bonds
Banker's acceptances
These big-time assets can be
converted to M1 in short order, with
little loss of value.
However, these assets aren't as easily converted to M1 as the near monies
added to M2 and M3.
Money: Monetary Aggregates
Topic: Summary
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The concept and definition of M1, which is the sum of currency and coins
held by the non-bank public, and checkable deposits.
That credit cards are not part of M1, they are not money.
That M2 is a broader measure of money that includes M1 plus what we can
call near money, that is, temporary savings, a pool of funds that can be
accessed quickly and easily.
That near monies are savings and that there are several different types of
savings: standard savings accounts, certificates of deposit (CDs), money
market funds, overnight Eurodollars and overnight repurchase agreements.
M3 is equal to M2 plus other near monies which include larger denomination
certificates of deposit and longer-term repurchase agreements.
Liquid assets L, are the economy's total financial assets that can be converted
to M1.
Money: Money's History
Topic: Barter
A long time ago, our ancestors realized that life could be better with a little trading.
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Our ancestors first satisfied their own wants and needs.
Then, self-sufficiency gave way to barter.
Two reasons for barter:
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First: Barter lets resources specialize in production.
Second: With barter trades, people can access a wider variety of goods than
they could produce on their own.
Barter is a more effective way of satisfying our wants and needs.
However barter is not perfect:
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
We need double coincidence of wants.
It takes resources for trades.
Therefore:

Our ancestors progressed to the next stage: commodity money.
Money: Money's History
Topic: Commodity Money
Because barter has limitations, the double coincidence of needs, peoples used
commodities as money.
Commodity money:
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When they began using a widely desired commodity, they created commodity
money.
Commodity money has value in use and value in trade.
The value in use dictates value in trade.
Some commodities are better than others in terms of the four money
characteristics.
Our ancestors tried many different commodities before finding one type that
fits the characteristics better than most metals.
Money: Money's History
Topic: Metal Commodity Money
Metals are a natural for use as a commodity money.
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The most important characteristic of metals is durability.
Some people erroneously think that metals and only metals are true money.
Metals:
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They are extremely durable, quite divisible, relatively easy to transport and
difficult to counterfeit.
They are not perfect.
Drawbacks:
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Transportability: Metals are heavy.
Value in use affects value in exchange: A change in the market price brought
by disruptions of the market, affect value in exchange and can play havoc
with the economy.
Money: Money's History
Topic: Fiat Money
Fiat money has little or no value in use compared to value in exchange. The value
in exchange of fiat money is under control of an authority, usually government.
The transition:
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First: Paper currency was backed by metal stored in a secure location. The
paper could be traded for equivalent amounts of silver or gold.
Second: Because no one traded paper currency for metal, metal wasn't

needed to back the paper. They just need a paper currency-to-metal
exchange rate.
Third: Authorities stopped fixing the currency-to-metal exchange price. Paper
currency was valuable based on the ability to purchase goods.
A two-edged sword:
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Authority acquires the ability to control money and also the responsibility.
Money: Money's History
Topic: Electronic Money
Computers reduce the use of paper currency and checks.
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Electronic money is another logical step in the historical progression of
money.
Modern checking accounts are little more than digital information.
The trend is toward accessing information directly with computers, including
ATM machines, point-of-purchase terminals in stores, and home computers.
Electronic money:
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It fits two of the four characteristics of money: easy to transport and
completely divisible.
The other two characteristics raise questions:
o Counterfeitable: Electronic money could be the easiest or the hardest
money to counterfeit.
o Durability: This depends on the stability of the government and the
banking system.
Money: Money's History
Topic: Summary
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Barter lets resources specialize in production and that with barter trades,
people can access a wider variety of goods than they could produce on their
own.
That commodity money has value in use and value in trade and that the value
in use dictates value in trade.
That metals are a natural for use as a commodity money and that their most
important characteristic is durability.
That fiat money has little or no value in use compared to value in exchange.
That electronic money fits two of the four characteristics of money: it is easy
to transport and completely divisible, but it raises questions about being
counterfeitable and durable.
Money: Scarcity
Topic: Efficiency
Money is critical to the production, consumption, and exchange activities that take
place in a complex economy.
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We could not have a complex economy without money.
Money is so important because it makes our system more efficient.
With money we can use our limited resources to provide more satisfaction of
our unlimited wants and needs.
Two reasons:
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
First: Money improves efficiency by reducing the amount of resources that
would be needed for barter exchanges.
Second: Money improves efficiency by letting resources specialize in
production.
Money: Scarcity
Topic: Monetary Policy
The key to money is control, that is, monetary policy.
Money is not the root of evil, but it can cause problems:
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Too much money, can cause inflation.
Too little money, can cause a recession.
Therefore:
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Government is given regulatory responsibility over money. We don't let
people print their own money.
However:
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Government leaders could also use money control for personal reasons.
Ideologies play an important role.
The bottom line:

Money must be controlled. When they control money they achieve some goals
and prevent others.
Money: Scarcity
Topic: Summary
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That money is critical to the production, consumption, and exchange
activities that take place in a complex economy.
That money improves efficiency by reducing the amount of resources that
would be needed for barter exchanges and that it improves efficiency by
letting resources specialize in production.
That money is not the root of evil, but it can cause problems.
That government is given regulatory responsibility over money, but
government leaders could also use money control for personal reasons.
BANKING
Banking: What It Is
Topic: Banking
The primary profit-motivating task of a bank is to match up borrowers and savers.
Two main functions:
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First: Banks maintain deposits for costumers.
Second: Banks offer loans to credit-worthy customers.
Banks and the money supply:
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Banks are financial intermediaries.
Banks must remain stable because their deposits are part of the economy's
money supply.
Closing down a bank would be detrimental to the money supply.
Regulation:

Banks are heavily regulated by government.
Banking: What It Is
Topic: Intermediary
There are several types of financial intermediaries.
Note that:
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Intermediaries bring together buyers and sellers.
Buyers and sellers often need an intermediary.
Banks perform a 'financial' intermediary function.
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By maintaining financial deposits and making financial loans, banks navigate
the financial side of the economy.
Other types of financial intermediaries include:
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Insurance agencies, stock brokers, finance companies, mutual funds, and
bond traders.
Their function:
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All these entities divert household income away from consumption
expenditures to investment.
Banks are important because they maintain checking accounts that are about
60% of the money supply.
Banking: What It Is
Topic: Summary
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The primary financial intermediary task of banks is to match up borrowers
and savers.
Two main functions of banks: Maintaining deposits for costumers and offering
loans to credit-worthy customers.
That banks perform a 'financial' intermediary function, that is, divert
household income away from consumption expenditures and to investment.
The importance of banks maintaining checking accounts, which are about
60% of the money supply.
Banking: Banking Details
Topic: Types
There are four types of financial institutions.
Four types:
1.
2.
3.
4.
Banks
Savings and Loans Associations
Credit Unions
Mutual Savings Banks
Important point:

Each type was established for different reasons and to play distinct roles in
the economy. But now, they all operate much the same.
Page ahead for details.
Banking: Banking Details
Topic: Commercial Banks
The first type of financial institution is a traditional bank.
Traditional banks have a long history in the economy:
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They were the original financial intermediaries.
They diverted household income into loans for business investment.
They offered checking accounts.
They were heavily regulated entities:
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The big ones, the national banks, were subject to the regulations by the
Federal Reserve System, the Federal Deposit Insurance, etc.
Other banks, more numerous, but usually smaller, were chartered and
regulated by state or local agencies.
Before the 1970's:

Banks were the only financial intermediaries that offered checking accounts.
Banking: Banking Details
Topic: S&Ls
The second type is a savings and loans association.
History:
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Created by the Federal Home Loan Act after the WWII.
Promoted homed ownership for the middle class.
Regulated by the Federal Home Loan Bank and by the Federal Savings and
Loan Deposit Insurance Corporation.
Operated during the 50's and 60's using the 3-6-3 rule.
Used savings accounts to make mortgage loans.
Didn't offer checking accounts or business loans.
Changes in the 70's:

Went for riskier loans and offered checking accounts.
In the 80's:
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Many went out of business, others merged with traditional banks, and a few
survived.
Operate now like traditional banks: Offer the same services and come under
the same regulations.
Banking: Banking Details
Topic: Credit Unions
A third type is a credit union.
History:
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The first credit union was created in 1909.
Experienced tremendous growth after WWII.
Primary regulator is the National Credit Union Association (NCUA).
Created for reasons similar to labor unions.
Credit unions:
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Relatively small, non-profit entities, associated with a particular business or
group with something in common.
Pool savings and make personal loans to members.
Evolution:
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Originally offered limited banking services.
Began offering checking accounts in the 70's, which gave them control over
part of the M1 money supply.
Banking: Banking Details
Topic: Savings Banks
The last type of is a mutual savings bank.
Savings banks:
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A cross between credit unions and savings and loans associations.
Nonprofit cooperatives that pool members' savings like credit unions, but
their primary lending activity is mortgage loans, like savings and loans
associations.
They also began issuing checking accounts in the 1970's.
Banking: Banking Details
Topic: Balance Sheet
A balance sheet is the record of a bank's
assets and liabilities.
Two parts:
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
Assets
Liabilities and Net Worth
As a balance sheet, both parts are equal,
they balance.
Concepts:
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Assets: What the bank owns.
Liabilities: What the bank owes.
Net worth: The difference between assets and liabilities.
The sum of liabilities and net worth must equals assets.
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Banks don't make adjustments with real production.
These financial entries in the balance sheet are the bank's production.
Banking: Banking Details
Topic: Summary



The four types of financial institutions: banks, savings and loans
associations, credit unions, and mutual savings banks.
That banks were once the only financial intermediaries that offered checking
accounts, but that all four types of banks now offering checking accounts.
That a balance sheet is the record of a bank's assets and liabilities, which
contains two parts: (1) Assets, and (2) Liabilities and Net Worth.
Banking: Reserve Banking
Topic: Reserves
Banks divide assets between loan and reserves using fractional-reserve banking:
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The profit-pursuing, financial intermediary function of banks dictates that
deposits be used for loans.
The safekeeping, money supply security function dictates that banks keep
reserves.
A) 100% reserve banking would imply that:

They could not be financial intermediaries, but only storage buildings. The
financial intermediary function performed by banks would have to be
performed by something else.
B) 0% reserve banking would imply:
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
Problems with customers who want their wealth, but can't get it because the
bank loaned it out.
The bank can easily be put out of business when customers spread the word
that the bank is out of funds.
Banking: Reserve Banking
Topic: Legal, Required, and Excess Reserves
1. Legal reserves:

Vault cash and deposits with the Federal Reserve that can be used to satisfy
the legal reserve requirements and are needed for daily operations.
2. Required reserves:

The vault cash and deposits with the Federal Reserve that they have to keep
to back deposits.
3. Excess reserves:
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Any reserves over and above required reserves.
Excess reserves don't add to revenue and profit.
Two uses of excess reserves:
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First: banks use them for loans.
Second: banks use them for investment securities.
Important point:

Controlling excess reserves is key to controlling the nation's money supply.
Banking: Reserve Banking
Topic: Goldsmith
Banking sort of evolved from the goldsmithing profession.
Setting the stage of the story:
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It takes place at a time and a place when gold is the economy's commodity
money: Medieval Europe.
Fred is a goldsmith, a craftsman who fashions products from gold.
Fred:
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Fred's raw material is also the economy's money.
Gold input is valuable in use for what Fred creates and also valuable as the
medium of exchange.
Fred must keep his raw material safe and secure.
Fred has a safe.
Banking: Reserve Banking
Topic: Goldsmith Deposits
The story continues when Bill the Knight needs to store some gold for a short time.
The story:
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Bill has some gold he would like to store in Fred's safe.
Fred agrees and charges Bill for this storage service.
When Bill returns from his journey he retrieves his gold, less a modest service
charge.
Bill informs other knights about this service and they also begin taking
advantage of Fred's storage service.
Fred realizes that storing gold is an easy way to earn a living.
Fred has stumbled upon the depository function of modern banks.
Banking: Reserve Banking
Topic: Goldsmith Loans
The story continues when Elizabeth the Innkeeper needs to expand her business
and ask Fred for a loan.
The story:
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Elizabeth's business is booming, but she is temporarily short of money, short
of gold.
She asks Fred for a loan of gold that belongs to Bill the Knight that Fred
keeps on his safe.
Elizabeth is willing to pay Fred a sizable fee for taking the risk of making this
loan.
Fred makes the loan.
Elizabeth expands her inn, she repays the loan on schedule with interest with
profit from business.
Bill collects his gold upon returning.
Other local merchants soon seek interest lending services from Fred.
Fred has discovered the lending function of modern banks.
Banking: Reserve Banking
Topic: Goldsmith Reserves
Knights make gold deposits, others withdraw gold, merchants seek investment
loans, and others repay loans.
Fred must keep sufficient gold to satisfy any withdrawal.
Required reserves:
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Fred concludes that he needs no more than 10 pounds of gold to back each
100 pounds of gold deposits.
He doesn't need to keep 100% of the deposits in reserves.
Fred has discovered modern fractional-reserve banking.
Excess Reserves:
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Fred uses the other 90% for the loans which earn interest and make his
business a profitable one.
Banking: Reserve Banking
Topic: Summary
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The concept of fractional-reserve banking, which implies that deposits are
used for loans and that banks must keep reserves to back deposits.
The three types of reserves:
o Legal reserves, which are vault cash and deposits with the Federal
Reserve.
o Required reserves, which are the vault cash and deposits with the
Federal Reserve that regulators say a bank must keep for daily
transactions.
o Excess reserves, which are any legal reserves over and above required
reserves.
That banking sort of evolved from the goldsmithing profession.
How Fred stumbled upon the depository function of modern banks.
How Fred discovered the lending function of modern banks.
How Fred discovered modern fractional-reserve banking.
Banking: Regulating Banks
Topic: Why?
Banking is a heavily regulated industry.
Reasons:

First: Banks have the temptation to go for large profits at the expense of

protecting deposits.
Second: The economy's health rests with having the 'correct' money supply.
The problems:

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

Banks get carried away seeking profits without having enough depositprotecting reserves.
Customers can't withdraw deposits and lose trust.
Banks shut down, remaining bank deposits become worthless, and the money
supply shrinks.
The economy heads into a recession.
Important points:


A failed bank is bad for the economy.
Government can control the checking account part of money only by
controlling and regulating banks.
Banking: Regulating Banks
Topic: Who?
Several institutions which regulate banks.
The main players:
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
Federal Reserve System (Fed): They have primary responsibility of the
nation's money supply by controlling banking reserves.
Federal Deposit Insurance Corporation (FDIC): Their mission is to insure bank
deposits. If a bank can't satisfy customer withdrawals the FDIC pays off the
customers.
Comptroller of the Currency: They charter national banks, they decide which
ones qualify for a national charter.
Other regulatory agencies:

State banking regulatory agencies.
Banking: Regulating Banks
Topic: How?
How are banks regulated?


First: Government regulators say do something, and if you don't do it, then
you suffer the consequences--dollar fines, losing operating control to
regulators, or spending a little time in jail.
Second: Many bank regulations involve accounting procedures and practices.

The FDIC and Comptroller of the Currency are the institutions that take care
of these matters.
Third: The regulations we are most concerned with are those involving
reserves and deposits, which play a key role in controlling the money supply.
Banking: Regulating Banks
Topic: Summary





That banking is one of the most heavily regulated industries in the economy.
The main reasons of bank regulations:
o When balance between profit and safety fails, customers lose trust and
banks may have to shut down.
o Banks control 60% of the M1 money supply.
The problems for the economy when banks get carried away seeking profits
without having enough deposit-protecting reserves.
The main institutions which regulate banking activities and their main
functions: Federal Reserve System (Fed), Federal Deposit Insurance
Corporation (FDIC), and Comptroller of the Currency.
The ways in which banks are regulated.
Banking: The Economy
Topic: Benefits
Banks have two beneficial roles in the economy.
First: As financial intermediaries, banks match up savers and borrowers.


They are an effective means of diverting household income into investment
expenditures for capital goods.
They are a vital link between the real and financial sides of the economy.
Second: As depository institutions, banks supervise a share of the nation's M1
money supply.

They have a big responsibility because money is critical to a complex, marketoriented economy.
Banking: The Economy
Topic: Problems
When banks are properly controlled they provide benefits, but when they get out of
hand they can do a world of bad.
Problems:

When a bank fails to maintain adequate reserves, it runs the risk of starting a
chain reaction that could cause economy-wide financial instability.
Instability:


Banking regulations have lessened, but not eliminated, banking instability
problems.
Controlling instability is one challenge of monetary policy.
Banking: The Economy
Topic: Summary



Some of the main benefits provided by banks as:
o Financial intermediaries: banks match savers and borrowers.
o Depository institutions: banks oversee a share of the nation's M1
money supply.
That when a bank fails to maintain adequate reserves, it runs the risk of
starting a chain reaction that could cause economy-wide financial instability.
That banking regulations have lessened but not eliminated banking instability
problems.
Money Creation: A Little Magic
Topic: Money
First:



Money is currency and checkable deposits.
Currency is issued by the federal government.
Checkable deposits are issued by commercial banks.
Second:



Money is the medium of exchange.
Money makes production and exchange more efficient.
Too much money causes inflation and too little causes recession.
Third:


Banks balance profit-seeking loans and deposit-protecting reserves.
Because a failed bank can trigger economic instability, banks are heavily
regulated by the government.
Note:

Controlling checkable deposits is controlling a little magic.
Money Creation: A Little Magic
Topic: Banks
The mystical source of magic is fractional-reserve banking.
Remember:

Banks control 60% of the M1 money supply.
Fractional-reserve banking activities:


First: As financial intermediaries banks pool unspent household income, which
is used for business loans for investment in capital.
Second: As safekeepers of deposits, they provide 60% of the money that our
economy uses for exchanges.
Important:

The division between reserves and loans is the source of banking magic.
Money Creation: A Little Magic
Topic: Money Creation
The magic is that banks create something of value: they create money.
Note that:


To create other valuable items we need valuable resources.
Banks create money by adding to a checking account.
Precedents:

Governments have done this for centuries: When they print paper currency,
they transform items with little or no value into money with more value, value
that is created from nothing.
The reality of money creation:


Banks do part of the money 'printing' or creation function historically
performed by governments.
This is the reason why banks are heavily regulated.
Money Creation: A Little Magic
Topic: Summary




That money is currency and checkable deposits, that currency is issued by
the federal government, and that checkable deposits, 60% of M1, is issued
by commercial banks
That money is essential to our economy as a medium of exchange, that banks
are perpetually balancing assets between profit-seeking loans and depositprotecting reserves, and that banks are heavily regulated by the government.
That the mystical source of magic is fractional-reserve banking. And that
banks can create money by merely adding it to our checking accounts.
Banks do part of the money 'printing' or creation function historically
performed by governments.
Money Creation: Fred Returns
Topic: Review
Let's do a review of our story of Fred the Goldsmith.





Fred the Goldsmith, has developed several modern banking functions.
Gold, his raw material, is also the economy's medium of exchange, so he has
found the SAFEKEEPING function.
Requests to store extra gold owned by Bill the Knight and others is the
DEPOSITORY function of modern banks.
Requests to borrow gold by Elizabeth the Innkeeper, has led to the LENDING
function of modern banks.
The need to keep some of the gold deposited, but not all of it, has led to the
modern banking function of backing deposits with reserves, FRACTIONALRESERVE banking.
Money Creation: Fred Returns
Topic: Currency
Our honest and trustworthy Fred discovers paper currency.
Fred's system:







Fred tracks gold deposits and withdrawals by issuing receipts for each
deposit.
Fred returns the gold in exchange for a receipt.Three features:
First: The knight need not, and probably does not, withdraw the same gold
deposited.
Second: Fred need not personally know each knight requesting services.
Third: Gold receipts are as good as gold, because people know the receipts
can be redeemed for gold.Therefore:
Gold receipts become money for the local economy.
Fred has discovered paper currency, fiat money, and what is comparable to
the checkable deposit function of modern banks.
Money Creation: Fred Returns
Topic: Paper Loans
Elizabeth needs a loan, but she doesn't want gold, she wants receipts, she wants
money.Remember that:








Fred issues receipts only for deposits.
Can he just issue receipts?Two options:
One: Fred can loan gold from his safe, which Elizabeth can deposit for
receipts.
Two: Fred can loan Elizabeth the receipts directly. Note that:
With both, Elizabeth ends up with receipts and Fred ends up with the same
amount of gold in his safe.
With both, receipts are not all backed by gold: The loan increases the number
of receipts in circulation.Fractional-reserve banking:
If every receipt is redeemed, then Fred is in trouble.
But Fred knows that only a fraction of the gold is redeemed at any given time.
Money Creation: Fred Returns
Topic: Money Creation
The money creation mechanism is a profitable opportunity.


With 10% of his receipts redeemed at any given time Fred can issue up to
1,000 pounds of receipts.
100 pounds for the original deposits plus another 900 pounds for loans.
Important points:


Fred has created money: Because his receipts are money, he can create
money by making loans.
The new extra 900 pounds of money is used for investment that promotes
economic growth.
A precarious balancing act:


If people redeem more than the 10% of the receipts, Fred is in trouble.
If so, the receipts become worthless, the money supply shrinks, and the local
economy enters a recession.
Money Creation: Fred Returns
Topic: Summary

Reviewing Fred the Goldsmith, that Fred has developed several modern
banking functions: safekeeping, depository, lending and fractional-reserve




banking functions.
Fred's system of tracking gold flows by issuing receipts for each deposit.
The three main features of Fred's system:
o Knights need not withdraw the same gold deposited.
o Fred need not personally know each knight requesting services.
o These gold receipts are as good as gold and become money.
Two options Fred has to make a loan:
o Loan some gold from the safe which could be deposited back in return
for receipts.
o To loan the receipts directly.
The importance of fractional-reserve banking and Fred's ability to create
money that is used for investment and economic growth.
Money Creation: Modern Banking
Topic: Fractional-Reserve Magic
Modern banks practice fractional-reserve banking, which is the key to money
creation.
Note that:




Modern reserves take the form of vault cash and Federal Reserve deposits.
Both ensure the safety of deposits.
Banks seek profits by making loans and adding to checkable deposits.
Checkable deposits add to the money supply.
Money creation:
1. Banks practice fractional-reserve banking, seek revenue through loans, and
keep reserves.
2. Banks keep 10% of outstanding deposits in reserves.
3. Reserves over those required to are excess reserves.
4. If a bank has excess reserves, then it can make loans, increase checkable
deposits, and create money.
Money Creation : Modern Banking
Topic: Injection
Suppose you find a $100 bill that you
deposit in Amos National Bank.



Amos National adds $100 of vault
cash, or reserves, to its assets, and
$100 to its liabilities, your account.
Some of these reserves are
required ($10) and some are
excess ($90), which can be used
for a loan.
Amos National Bank adds $90 to
the customer's checking account,
so the customer can buy new tires.
Two changes:


Amos National has a $90 loan
balanced by a $90 checkable deposit.
Amos National Bank just created $90 of money.
Money Creation: Modern Banking
Topic: Another Bank









A purchase is made with a check
written on the Amos National Bank.
The store deposits the check in
Bob's State Bank.
Bob's Bank adds $90 worth of
liabilities to the store's account.
This liability is balanced with
reserves transferred from Amos
National Bank.
Amos National losses $90 of
reserves and Bob's Bank gains $90
of reserves.
Amos National ends up with $10 of
reserves and a $90 loan.
Bob's Bank has $90 in reserves. It
must keep 10% ($9), giving Bob's
Bank $81 of excess reserves.
Bob's Bank makes an $81 loan to a customer who wants to buy a CD player.
Once again, this process creates $81 worth of money.
Money Creation: Modern Banking
Topic: Yet Another Bank








A purchase is made with a check
written on Bob's State Bank, which
is deposited in Charley's Credit
Union.
Charley's Credit Union adds $81
worth of liabilities to the store's
account.
This liability is balanced with
reserves transferred from Bob's
Bank.
Bob's Bank losses $81 and
Charley's Credit Union gains $81 of
reserves.
Bob's Bank ends up with $9 of
reserves and an $81 loan.
Charley's Credit Union has $81 in
reserves. It keeps 10% ($8.10), giving it $71.90 of excess reserves.
Charley's Credit Union makes a $71.90 loan to a customer.
This creates $71.90 of money. The three banks have created $242.90 worth
of money.
Money Creation: Modern Banking
Topic: Total Creation
The amount of checkable deposits created
is a multiple of the amount of excess
reserves of the banking system.

When banks makes loans, they
create deposits, and create money.
When does the process stop?

Banks will create $900 of deposits,
which added to the original $100
deposit, gives $1,000 of deposits
that did not previously exist.
Why?



The $100 in reserves added to the first bank are used to back, in total,
$1,000 of deposits.
If banks keep 10% of deposits in reserve, then every $1 of new reserves can
be used to back $10 of new deposits.
This is the result of banks practicing fractional-reserve banking.
Money Creation: Modern Banking
Topic: Summary






That modern banks practice fractional-reserve banking, which is the key to
money creation.
That any reserves over those required to meet a given percentage are called
excess reserves, which are used by banks to make loans, increase checkable
deposits, and create money.
That when a bank receives a deposit, two things happen: the bank adds to
vault cash, or reserves, and it adds to its liabilities, the customer's account.
That when a check is cleared reserves are transferred from one bank to
another.
That when banks makes loans, they create deposits, and create money.
That the amount of checkable deposits created is a multiple of the amount of
excess reserves obtained by the banking system.
Money Creation: The Multiplier
Topic: The Concept
A multiplier captures the magnified relationship between an activity and the
triggering event.The money creation process:


The activity is the deposit creation.
The trigger event is extra bank reserves.
The multiplier:


In our example, the banking system creates $1,000 of deposits from $100
worth of reserves.
The deposit multiplier equals 10: Each $1 of extra reserves triggers 10 times
the amount in deposits.
D = mR
D = Number of deposits created.
R = Number of reserves added to the banking system.
m = The value of the multiplier (10 in the example).
Money Creation: The Multiplier
Topic: Reserve Ratio
The key to the deposit multiplier is required reserves.
It is no coincidence that when the reserve ratio is 10%:


$10 of deposits require $1 of reserves and that $1 of reserves can back up
$10 of deposits.
It's all part of the same process.
The deposit multiplier is the inverse of the reserve ratio.
The key to the deposit creation process:


Each bank keeps a fraction of the reserves received when checks are
deposited and cleared.
The bank sends along the rest to another bank by making a loan.
Therefore:

The less banks keep, the more they send to other banks and the more is used
to perpetuate the process.
Money Creation: The Multiplier
Topic: The Money Multiplier
Checkable deposits are only part of the money supply.

Looking only at checkable deposits, a $100 deposit gives us $1,000 with a
deposit multiplier of 10.
However:




Money, in total, doesn�t expand by $1,000.
First: Banks might keep a few excess reserves, which limits deposit and
money creation.
Second: Loans might leak out of checkable deposits and into savings
deposits, which limits money creation.
Third: Loans might leak out of checkable deposits and into cash, which limits
reserves and money creation.
Note:

The Federal Reserve uses a complex money multiplier to control the amount
of money circulating in the economy.
Money Creation: The Multiplier
Topic: Summary




That a multiplier captures the magnified relationship between deposit
creation and extra bank reserves.
That the multiplier can be expressed with an equation: D = mR.
That the key to the deposit multiplier is required reserves and that the
deposit multiplier is the inverse of the reserve ratio.
Other factors that influence the total amount of money created:
o Banks keep excess reserves.

o Money leaks out checkable deposits into savings deposits.
o Customers keep some deposit-creating loans in cash.
That the Federal Reserve uses a complex money multiplier in trying to control
the amount of money circulating in the economy.
Money Creation: Policy
Topic: Control
Controlling the money creation process is the key to understanding the role that
money plays in the economy.
In the old days:

Money was issued by government. With print and mint they had complete
control over the quantity of money.
In the modern economy:

Checkable deposits are directly under the control of commercial banks.
Government must control banks to control money.
Some history:



In the late 1800s, banks ran amuck, creating money as they saw fit. The
economy experienced perpetual turmoil.
In the 1970s and 1980s, S&Ls had instability problems.
Since the mid 1980's, money creation has been under control. The economy
has been strong and growing.
Money Creation: Policy
Topic: Reserve Ratio
Government controls money creation through two methods, one is reserve
requirements.
The Federal Reserve has been given the authority over reserve requirements.
The Federal Reserve:


It sets the fraction of deposits a bank must keep in reserve.
The primary reason for this authority is to ensure the stability of banks and to
facilitate check clearing.
Money supply control:

The Federal Reserve can ease money creation by reducing reserve

requirements.
It can also make money creation more difficult by increasing reserve
requirements.
Money Creation: Policy
Topic: Reserves
A second method of controlling the money creation process is to control reserves
directly.
Remember that:


The Federal Reserve maintains a system of deposits for commercial banks.
Banks keep deposits with the Federal Reserve to process checks.
A side effect:

The Federal Reserve can add to or subtract from these deposits, and change
reserves.
Therefore:


If the Federal Reserve adds reserves, banks can create more money.
If the Federal Reserve reduces reserves, banks can create less money.
Money Creation: Policy
Topic: Summary





That the money creation process and its control is the key to understanding
the role that money plays in the economy.
Checkable deposits are directly under the control of commercial banks, which
makes government's money control a difficult task.
That since the mid 1980's, money creation has been under control. The
economy has been generally strong and growing.
Government controls money creation through two methods: reserve
requirements and to control reserves directly.
The Federal Reserve can make money creation easier (more difficult) by
reducing (increasing) reserve requirements, which would expand (restrict) the
money supply; or by adding to or subtracting from bank reserves.
Federal Reserve System: The Fed
Topic: King Clarence
A key player in the medieval money game: Clarence the King. Clarence is the
government regulator.
Because Fred practices fractional-reserve banking like modern banks, he has a
problem:




Several knights redeem their gold receipts at the same time, but Fred does
not have sufficient reserves.
King Clarence provides Fred with enough gold to satisfy the knights.
If Fred's banking operation ceases to exist, economic prosperity is also in
jeopardy.
King Clarence decides to watch Fred to make sure that he keeps enough gold
in reserve to avoid similar problems.
This is how King Clarence sort of 'discovers' the regulatory function of the modern
banking system.
Federal Reserve System: The Fed
Topic: What It Is
The Federal Reserve System helps banks through a combination of regulation and
emergency reserves.
First: It is central bank, a government established and/or sanctioned bank with
assorted financial tasks, that regulates the banking system and controls the money
supply. It is a decentralized central system with several banks spread around the
country.
Second: It was established in 1913, in response to the Bank Panic of 1907, to
prevent failed banks from shrinking the money supply and causing business cycle
contractions.
Third: While it's original purpose was to provide banks with reserves, it more
recently uses the money supply to conduct monetary policy and stabilize the
business cycle.
Federal Reserve System: The Fed
Topic: Summary





The basics of how Clarence the King discovered the regulatory function of
the modern banking system.
That the Federal Reserve System keeps banks operating through a
combination of regulatory oversight and emergency reserves.
That the Federal Reserve is a central bank, which is a government established
and sanctioned bank with assorted financial tasks.
That the Federal Reserve regulates the banking system and control the
money supply.
That the Federal Reserve was established in 1913 to prevent failed banks
from shrinking the money supply and causing business cycles contractions.
Federal Reserve System: What It Does
Topic: Money Control
The Fed is responsible for ensuring that the economy has the proper amount of
money in circulation.


In the old days, governments controlled the money supply by printing and
minting money.
In modern times, with bank checkable deposits in the money supply, the Fed
controls money by controlling banks.
Two reasons:


First: Too much money causes inflation and too little money leads to
recession and unemployment. The challenge is to keep enough money in
circulation.
Second: Money is absolutely essential in a modern complex economy. Faith in
the value of fiat money is best provided by a centralized, national government
that has the authority to ensure the value of money.
Federal Reserve System: What It Does
Topic: Instability
The United States had two attempts at central banking in the late 1700s and early
1800s. From 1836 to 1913, a period marked by perpetual economic turmoil, the
United States had no central bank.
With no central bank:






Banks played fast and loose with deposits and loans.
They came up short of reserves and were forced to shut down, taking
deposits with them.
When deposits evaporated, so too did the financial wealth of customers and
part of the money supply.
Bank closings were seldom isolated events, bank panics usually spread rapidly
throughout the economy.
Without money, production went unsold and resources were unemployed.
The Federal Reserve System was established in 1913. although imperfect, it
has helped stabilize the economy.
Federal Reserve System: What It Does
Topic: Summary


That the Fed is the entity responsible for ensuring that the economy has the
proper amount of money.
The two reasons for controlling the money supply: (a) to avoid inflation and
recession and (b) to ensure the value of money.


That when the United States did not have a central bank, the economy
experienced periods of turmoil.
That the Federal Reserve System, established 1913, although not perfect, has
helped stabilize the economy.
Federal Reserve System: The Fed Pyramid
Topic: Overview
The structure of the Federal Reserve:







Chairman of the Board of Governors:
the boss of the Fed.
Board of Governors: 7 people, usually
economists who make big decisions.
Federal Reserve Banks: 37 banks
dispersed throughout the country.
Commercial Banks: traditional banks,
credit unions, savings and loan
associations and mutual savings
banks.
The Non-Bank Public: people,
businesses, and government agencies
using commercial banking services.
The Federal Open Market Committee (FOMC) is critical for money supply
control.
The Federal Advisory Council (FAC), isn't quite as important.
Federal Reserve System: The Fed Pyramid
Topic: Top
The 7-member Board of Governors is the
policy making body of the Fed.
The Board of Governors:



The Board sets the regulations, rules
and policies affecting the money
supply and the commercial banking
system.
Each member of the Board is
appointed by the President and
approved by the Senate to a 14-year
term, with terms staggered every two
years.
The system is designed to keep the
Board non-political: the Board is NOT

supposed to be working for the President.
The Fed is relatively independent of Congress, too.
Federal Reserve System: The Fed
Pyramid
Topic: Middle
The 37 Federal Reserve Banks are
responsible for implementing the Fed policies
and regulations.
Federal Reserve Banks:






Provide banking services for
commercial banks.
Provide regulatory oversight of
commercial banks.
Process checks for commercial banks.
Get newly printed currency into
circulation.
Do economic analyses and monitor
their district economies.
Offer limited services to the public.
Federal Reserve System: The Fed Pyramid
Topic: Base
Commercial banks form the base of the
Federal Reserve pyramid.
Prior to the 1980's:



The Fed automatically included only
national banks.
State and local banks could chose to
become members of the Fed.
S&Ls, credit unions, and mutual
savings banks didn't offer checking
accounts and were not part of the
system.
Legislation passed in the 1980's brought all
checkable-deposit-issuing institutions into
the Federal Reserve System.

The Federal Reserve pyramid rests on the non-bank public: households,
businesses, and government agencies.
Federal Reserve System: The Fed Pyramid
Topic: Summary







The structure of the Fed, which is composed of: (a) Chairman of the Board
of governors, (b) Board of Governors, (c) Federal Reserve Banks, (d)
commercial banks, and (e) the non-bank public.
That the Board of Governors is the policy making body of the Fed, which sets
the regulations, rules and policies affecting the money supply and the
commercial banking system.
That the Fed is largely independent of the President and Congress.
The Federal Open Market Committee, which is responsible for monetary
policy.
The Federal Advisory Council, which is totally advisory, does not set policy nor
impose regulations.
That there are 37 Federal Reserve Banks responsible for implementing the
policies and regulations of the Board of Governors.
Commercial banks that form the base of the Federal Reserve pyramid.
Federal Reserve System: Monetary Policy
Topic: Overview
The Federal Reserve controls banks as a means of controlling the money supply.
A more specific definition:
Monetary policy is controlling the money creation activity of the fractional-reserve
banking system to control deposits and the money supply to affect business-cycle
fluctuations.
Early tasks of the Fed:

To keep banks in business and to avoid serious reductions in bank reserves
that would shrink financial wealth and money supply.
What the Fed does now:

Manipulate the money supply by manipulating reserves.
Federal Reserve System: Monetary Policy
Topic: Overview: Graphs
Expansionary monetary policy increases
aggregate demand up to full employment
and contractionary monetary policy
decreases aggregate demand back to full
employment.



Expansionary policy increases the
money supply and shifts the AD curve
rightward. This is used to correct a
recessionary gap and achieve longrun equilibrium.
Contractionary policy decreases the
money supply and shifts the AD curve
leftward. This is used to correct an
inflationary gap and achieve long-run
equilibrium.
Note that monetary policy and interest rates are closely connected.
Federal Reserve System: Monetary Policy
Topic: Open Market Operations
Open market operations are the most important tool of monetary policy.



The Federal government budget deficit is financed by issuing or selling U.S.
Treasury Securities, which are traded through the open market.
Banks, corporations, government agencies, pension funds and regular people
are the buyers and sellers in this 'open market' for Treasury Securities.
Treasury Securities are low risk investments.
Two major players in the open market:


Commercial Banks: They use secure investments to ensure bank stability.
Federal Reserve: They buy and sell treasury securities with the expressed
goal of manipulating bank reserves and the money supply.
Federal Reserve System: Monetary Policy
Topic: Discount Rate
The discount rate is the interest rate the Fed charges for reserve loans to
commercial banks.



The Federal Funds rate is for loans between commercial banks.
The discount rate is for loans from the Fed to commercial banks.
Banks borrow from the Fed when the need reserves to stay in business. The
price they pay is the discount rate.
Why don't troubled banks use the Federal Funds Market?

Other banks are probably reluctant to extend a loan.


The entire banking system might be short of reserves.
The discount rate is typically lower than the federal funds rate.
Federal Reserve System: Monetary Policy
Topic: Reserve Requirements
Reserve requirements are the regulations the Fed uses to ensure banks keep
enough reserves to back deposits.




In principle, reserve requirements can be used to control the money supply.
In practice, reserve requirement changes would cause serious bank
instability.
The Federal Reserve System is charged with ensuring that banks keep enough
reserves, through legal reserve requirements.
Reserve requirements change over the years, keeping pace with the changing
structure of the banking system.
They are currently in the 1% to 3% for checkable deposits. These are the
reserves that banks use to cash checks, process checks, and conduct daily
business.
Federal Reserve System: Monetary Policy
Topic: Moral Suasion
In addition to open market operations, discount rate, and reserve requirements,
the Fed has an additional tool called moral suasion.
Moral suasion:



It is a policy in which the Fed, usually the Chairman of the Board of
Governors, requests that the banking system take some sort of action.
These requests are usually contrary to what banks are currently doing and
likely to do under current economic conditions.
Moral suasion can and does work in the short run, especially during crisis
periods.
Federal Reserve System: Monetary Policy
Topic: Summary
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That monetary policy is controlling the money creation activity of the
fractional-reserve banking system to control deposits and the money supply.
That expansionary monetary policy increases aggregate demand up to full
employment and contractionary monetary policy decreases aggregate
demand back to full employment.
The four tools of monetary policy: open market operations, discount rate,
reserve requirements, and moral suasion.
How open market operations are used by the Fed to control the money
supply.
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That the discount rate is used by the Fed to signal the intentions of the open
market operations.
That reserve requirements are the regulations the Fed uses to ensure banks
keep enough reserves to back deposits.
That moral suasion is a policy in which the Fed requests that the banking
system take some sort of action.
Federal Reserve System: Issues
Topic: Policies
Politics are never far from economics, especially when doing economic policies.
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Some people prefer lower unemployment and higher inflation, while others
would rather have higher unemployment and lower inflation.
If the Chairman of the Fed is inclined for lower unemployment and higher
inflation, then the Fed is more likely to do expansionary monetary policy.
If the Chairman of the Fed is inclined for higher unemployment and lower
inflation, then the Fed is more likely to do contractionary monetary policy.
Federal Reserve founders took special steps to avoid an overtly political affiliation, to
avoid making the Fed part of the current administration.
Federal Reserve System: Issues
Topic: Summary
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Politics are never far from economics, especially when doing economic
policies.
That monetary policy can satisfy alternative preferences about higher or lower
inflation and unemployment.