Chapter 12 - Money and the Banking System
We will now switch from fiscal policy to monetary policy
in the next two chapters. We first look at Money and the Banking System
and then focus on monetary policy in the next chapter.
WHAT IS MONEY?
Unlike gold or silver, modern money has no intrinsic value - green paper - but everyone wants more of it. Why? Because of what it will buy.
Money is an asset that performs three functions:
1. Medium of exchange - used as a means of final payment. We use dollars to pay for goods and services. Increases efficiency of trade and exchange. Without money, we would have a barter economy, trade goods for goods, or services for goods, etc. Barter is inefficient because it relies on the "double coincidence of wants."
For example, to get food, you would have to find a farmer who has what you want and you would have to have exactly what he/she wants. To get medical service, the farmer would have to find a doctor who wants a cow or milk, etc.
Barter is extremely inefficient. Compared to barter, money is extremely efficient. The farmer can sell a cow for money, and then go out and buy whatever he/she wants with the cash - medical services, electricity, etc. Money eliminates the "double coincidence of wants."
When is barter efficient? - baseball card convention, coin/stamp trading, etc. Market for dating/sex/marriage. Russia - Pepsi/Stolys. To avoid high taxes. Or during hyperinflation.
2. Money is used as a unit of account. In the US, everything is priced in dollars, so we have a unit of measurement. Money is a measuring rod of value. By having a common unit of account, unit of measurement, we can compare prices/values easily. Everything is priced in a common unit of measurement, US dollars.
A barter economy is inefficient because there is no standard unit of measurement. Makes comparison shopping very difficult. Thousands of terms of trade or trading ratios. 5 goods - A, B, C, D and E. In a barter economy, there are ten trading ratios. With a common unit of account, there are only 5.
3. Store of value/wealth - money is used as a financial asset to transfer purchasing power from one period to another period in the future. You can put $100 bills under your mattress.
Advantages of money as an asset (vs. stocks, bonds, real estate):
a. completely liquid - the degree to which an asset can be converted to cash quickly without loss of value. No transaction costs like with stocks and bonds.
b. fixed nominal value - unlike stocks/bonds/real estate.
Disadvantages of money as an asset:
a. pays no interest
b. loses value if inflation is positive
In most cases, the same currency is used for the unit of account, the medium of exchange and a store of value. We price everything in dollars, we use dollars for final pmt. and we use dollars to store wealth. Not always the case:
a. Israel - unit of account was dollar. Med of exchange was shekl. To avoid menu costs.
b. Russia, S. America, etc - local currency is not used as a store of value, people hoard US dollars.
c. ECUs, SDRs - unit of accounts without medium of exchange. Basket of currencies.
WHY IS MONEY VALUABLE?
Commodity money has been used throughout history until this century - gold, silver, copper, tobacco, beads, salt, etc. We were on a limited form of commodity money until 1970 - all silver was removed from the half dollar. Silver was removed from quarters/dimes in 1964.
Advantage of commodity money - limited supply of precious metal can prevent inflation and stabilize the price level. Exception: tobacco.
Disadvantage: uses up scarce resources. High opp. cost. Gold/silver have other valuable uses besides as coins.
Fiat money = money which has no intrinsic value and is not backed by a commodity. Paper money, metal coins and checks are now used - fiat money. Fiat money means that the government has issued a decree of fiat, that US dollars are legal tender - for all debts, public and private. Illegal for a bank or private company to issue legal tender.
Money's source of value is related to: a) the fact that it is generally accepted as payment for real goods and services and b) how much it will buy (purchasing power).
The greater the supply of dollars the less valuable a $1 bill is. More money and higher prices reduce the purchasing power of money. If money grows faster than the rate of real output, prices will rise.
"Too much money chasing too few goods."
"Inflation is always and everywhere a monetary phenomenon."
Extreme case - hyperinflation. Money becomes worthless. Example: 1922-23, German gov printed so much money that inflation was 250% per month. It cost 80B marks for an egg and 200B marks for a loaf of bread. Workers picked up wages in suitcases. Shops closed at lunchtime to change price tags. Menu Costs.
SUPPLY OF MONEY -
How to measure money? No clear definition of money. Economists and the FRS use three arbitrary measures of money - M1, M2 and M3.
M1 - measure of money used as a medium of exchange. Money used for final payment, transactions. Only three ways to make final pmt.: cash, check or traveler's check. There are actually two different forms of checks:
a) demand deposits, non-interest bearing checking accounts and
b) other checkable deposits, interest-bearing accounts. Usually limits/restrictions to get interest, like minimum balance, minimum check amount, limit on number of checks, etc.
See page 299. M1 = $1125B, little over $1T. About 1/3 currency ($373B) and 2/3 checking accounts ($743B), small fraction (less than 1%) in travelers checks.
M2 - broader definition of money than M1. M2 includes everything in M1 plus other forms of money, all interest bearing financial assets. Money as a store of value. Includes all savings accounts, small CDs, money market mutual funds, short-term overnight deposits.
Money market mutual funds - act like checking accounts, available at investment banks like Merrill-Lynch, investments in short-term money market instruments like 3 month T-bills for example. Operates like a mutual fund, pooled assets, but you have check-writing privileges like a checking account.
M2 = $3.66T, more than 3x the amount of M1. Reflects the fact that most people will try to keep as much money as possible in interest-bearing accounts.
M3 = M2 + large CDs(over $100,000) + longer term repurchase agreements and Eurodollars (dollar denominated time deposits outside the U.S.). M3 = $4.6T, about 1/2T more than M2.
CHANGES IN M1 and EMPHASIS ON M2
Due to financial and banking regulations of the 1930s, banks were not allowed to pay interest on checking accounts until deregulation of 1980. Before 1980, M1 was all non-interest bearing (cash + demand deposits + trav checks). After 1980, M1 is a combination of interest bearing and non-interest bearing.
See page 301. The most growth has been in Other Checkable Deposits. There is no longer a clear distinction between a checking and savings account. You can now have a combined checking and savings account combined in one account. The financial deregulation made a big impact on M1.
M2 has always included M1 + savings accounts, so the deregulation didn't impact M2. M2 has also been more stable than M1 over time. Because of this, economists and policymakers focus more on M2, especially when comparing money supply in different times periods, before and after 1980. In studies/research on monetary policy over the last several decades, M2 is preferred.
CREDIT CARDS VS MONEY -
Money is a financial asset that provides us with current or future purchasing power. Credit cards are not part of the money supply because they are just convenient ways to make a loan. You are actually borrowing money from the bank that issued the card, and payment is deferred until you make pmt. to the credit card issuer. Money is an asset that represents future purchasing power. Credit purchases are not money because they don't fit that definition.
BUSINESS OF BANKING -
We will now focus on the Banking Industry and look at the role of the banking industry in the process of money creation. Banking industry operates under the jurisdiction of the Federal Reserve System, the nation's central bank, although not all banks actually belong to the FRS. FRS supervises the banking system, sets banking requirements, processes checks and sets the nation's monetary policy.
Banks are in the process of Financial Intermediation, acting as financial intermediaries or middlemen, to bring savers and borrowers together. We make deposits in checking accts/svgs accts, which provides the bank with a source of funds, get paid 3-4% interest. The bank then uses those funds to make loans to borrowers for cars, home improvement, mortgages, credit cards, student loans, etc. Banks are trying to maximize profits.
Banks can be set up in several different ways -
State charter vs. National charter - Dual Banking System
Commercial Banks vs Investment banks
S&L charter vs. Commercial bank vs Credit Union
Most commercial banks now are very similar - offer checking, savings, etc. When we talk about the "banking industry" we are referring to commercial banks, S & Ls, and credit unions.
See page 303 for a consolidated balance sheet for the Commercial Banks. The majority (2/3) of a bank's source of funds comes from checking accounts and savings accounts. Most of that money gets loaned out - $2632, or invested - used to purchase treasury securities ($706). Only $57B is actually totally liquid - available immediately to meet cash withdrawals - $37B in vault cash (currency) and $20B on reserve at the Fed.
This illustrates that we operate under a Fractional Reserve Banking system. Banks are only required to maintain a small amount of reserves against their deposits (less than 2% in this case). Vs. 100% reserve banking where a bank would be required to hold 100% of deposits in liquid reserves.
Required Reserves = minimum amount of reserves required by the FRS, to be held as vault cash and on deposit at the FRS. All banks are required to have an account with the FRS. In 1995, there was less than 2% in reserves, against deposits ($57/2690).
Required reserves are based on required reserve ratios - percentage requirement based on the type of deposit. See page 311 for current required reserve ratios.
Total Reserves = Required Reserves + Excess Reserves.
Excess reserves are reserves over and above the min requirement. Banks try to minimize reserves, ideally have 0 excess reserves, because Reserves pay 0% interest. Non-interest bearing asset for the banks.
Banks operate under what might seem like a very risky system - what is there is a run on the bank. Bank could not meet the demand for withdrawals if all depositors showed up at once. FDIC provides deposit insurance to stabilize the banking system. It was est in 1933 after 9000 banks failed. FDIC insures deposits up to $100,000. Banks pay a small premium based on their deposits and FDIC pays off depositors when a bank fails and can't pay its depositors.
HOW BANKS CREATE MONEY BY EXTENDING LOANS
Fractional reserve system allows money to be created through the banking system, there is an expansionary effect that takes place.
See page 307, Exhibit 12-4.
Example: Suppose that you found $1000 hidden in the basement. Or we could assume that the Fed had expanded the money supply by $1000. What effect would that have on M1? Assume that the required reserve ratio is 20%.
Step 1 - You take the $1000 and deposit it in your checking account at Bank A. Bank A's reserves inc by $1000 and DD increase by $1000. The bank is only required to keep 20% or $200 on reserve, so it has excess reserves of $800.
Step 2 - They then loan out the $800 to somebody that wants to buy a car. The bank has now created $800 in new money (demand deposit). The process starts all over again. When the $800 gets spent it becomes $800 in new reserves at a new bank - Bank B. The bank is only required to hold 20%, or $160, so it lends out a new loan for $640, and increases the demand deposits by $640.
Step 3 - The person with the loan spends the $640 on another car, or something else, and the process starts all over again when the $640 gets into a new bank - Bank C.
The deposit expansion process continues until there is $5000 of new demand deposits and M1. So, starting with $1000 of new money, the MS/M1 grew by 5x that amount.
The potential deposit multiplier (DM) is eqaul to: 1/required reserve ratio. In this case it was:
DM = 1/.2 = 5x, meaning that for every $1 of new money created, the money supply will increase by 5x that amount, or $5.
If the reserve requirement were .1, the DM would be 1/.1 = 10x. As we will see later, one of the tools of monetary policy is the reserve requirement. If the FRS LOWERS the required reserve ratio, MS will go up, because the DM will go up. If FRS RAISES the RRR, the DM will fall, and the MS will fall.
ACTUAL DEPOSIT MULTIPLIER -
In reality, the actual DM will be less that the full potential amount, for example, of 5, for two reasons:
1. Cash leakages - if people hold cash, outside the banking system, the MS will inc by less than the full DM. For example, if the person who got the loan for $800 spent only $700 and kept $100 in cash for emergency, only $700 would go the next stage instead of $800, that would reduce the DM, DM < 5.
2. Excess reserves - if banks hold some excess reserves, the DM will also be less than 5. See page 308, Exhibit 12-5. Banks only hold about 1% excess reserves.
Currency leakages and excess reserves will result in a DM that is less than its full potential. But since banks hold very few excess reserves, and since people hold very little cash, the actual DM would usually be very close to the full DM. Example: with credit cards, checks, ATMs, there is little need to hold very much cash.
FEDERAL RESERVE SYSTEM -
Most countries have a central banking authority that controls the MS and conducts monetary policy. In US it is the FRS, in UK it is the Bank of England, in Germany, the Bundesbank. Central banks are supposed to promote monetary stability. To achieve that goal, most effective central banks are supposed to be independent of the political authorities - pres/prime minister, Congress/Parliament, etc.
In most cases, the lower the inflation, the more independent the central bank. The higher the inflation the less independent the central bank. Example - Turkey, Brazil, most S. American countries.
Structure of the Fed -
FRS is a quasi-governmental agency, part private, part public, supposed to be independent from Congress/Pres.
12 FRS districts - 25 regional branches. We are in the Chicago district, and there is a regional FRS branch in Detroit.
Board of Governors - Decision-making center of the FRS. 7 Members appointed to 14 year staggered terms by Pres and approved by Congress. Every other year a term expires, so the most number of appointees by any one president is 2 per term, or 4 total. President designates one of the members as Chair for a four year term. Greenspan is in third term as chairman of FRS. Appointed by Reagan in 1987, been through three presidents. Current term expires June 2000.
Board of Governors has two major functions:
1. Regulate the banking industry, e.g. set reserve requirements. Lend money to banks. Provide check-clearing services.
2. Conduct monetary policy. Regulate the money supply and thereby influence inflation, interest rates and ex-rates. Promote monetary stability.
How policy is determined:
FOMC - Federal Open Market Committee - 7 Governors + president of the NY District Bank + 4 of the remaining 11 district bank presidents, who rotate on the committee. FOMC determines the Fed's policy with respect to setting money supply and int rates. All presidents can attend meetings, but only those on the FOMC can usually vote. FOMC is the true policymaking group for establishing monetary policy.
12 District Banks operate under the control of the Board of Governors and differ from commercial banks in several important respects:
1. FRS banks are not profit-making banks. All earnings go the Dept of Treasury.
2. FRS banks can issue money, private/commercial banks cannot.
3. FRS banks are the bankers' banks. Only commercial banks can have accounts with the FRS. The FRS does 85% of check-clearing, which is facilitated by having all banks having accounts with the FRS. As the check clears, the FRS credits one bank's reserve account and debits the other banks account.
FRS goal is to promote monetary stability, full employment and econ growth. Although it is technically independent, a quasi-governmental agency, it works closely with Congress, the Treasury, and the President's Council of Econ Advisors, to co-ordinate fiscal/monetary policy. Fed reports to Congress twice a year at public hearings.
HOW THE FED CONTROLS THE MS
The Fed has three tools of monetary policy:
1. Establish reserve requirements
2. Open market operations - buying/selling Treasury securities
3. Setting the discount rate - the rate it will lend money to member banks.
1. RESERVE REQUIREMENTS -
Reserves are vault cash and bank deposits at the Fed. Both can be used to meet depositors' withdrawals. Fed establishes minimum reserve requirements to make sure that all banks can meet a sudden increase in cash withdrawals. Stabilizes the banking system.
Currently banks are not required to have reserves against time deposits/savings accounts, only transaction accounts - checking accounts (int) and demand deposits (no int). Reserve ratios are listed on page 311. 3% up to $52m and then 10%.
Fed can affect the MS by changing the reserve requirements. If the Fed lowers reserve requirement, the MS will increase. If the reserve requirements were lowered from 10% to 5%, the banks would then have excess reserves. Banks don't like excess reserves, because they are non-interest bearing assets. The excess reserves would be loaned out, and the MS would increase.
Lower reserve requirements results in Expansionary monetary policy, or an easing of monetary policy.
Higher reserve requirements result in contractionary policy, or restrictive policy or tightening. Changes in reserve requirements are rarely used as a tool of monetary policy. Reserve requirements are usually put in place and left alone.
2. OPEN MARKET OPERATIONS
Used MOST often.
Unlike us, or businesses or even other gov agencies, state gov, the FRS can write a check without funds in its account. When the Fed buy things, it creates money. The Fed is restricted to buying/selling treasury securities, but the process would work no matter what it bought.
Fed buys Tbills - MS increases. Fed buys a Tbill from a bank, business or individual and writes a check with "new money." When the check is deposited, the reserves of the banking system are increased. The increased reserves support the creation of new loans, which increases the MS.
Example: Fed buys a $10,000 Tbond from me. I give the Fed a $10,000 Tbond, it writes me a check for $10,000. I deposit the check in my bank account and the bank's reserve account with the Fed is increased by $10,000. Assuming a 10% reserve requirement, the bank can create $9000 in new loans. That $9000 gets spent and when deposited, increases the reserves of another bank by $9000. Only $900 has to be kept as a deposit, so $8100 gets loaned out, etc.... The deposit expansion takes place over many banks and many transactions.
The Fed directly controls the Monetary Base, which is bank reserves (vault cash + deposits at Fed) plus the currency in circulation. The monetary base in 1995 was approx $439B and M1 was approx $1125B. There was about $382B in cash and $57B in bank reserves. Actual money multiplier was about 2.6x.
Remember that the deposit expansion multiplier is 1/req res ratio. If the res req is .10, the DM would be 10. It is actually less than that because of leakages:
1. People hold cash, outside of the banking system, reduces the effect of the full DM. The more cash people hold, the lower the actual DM.
2. Some banks hold excess reserves.
Fed can directly control the monetary base, but it cannot really directly control M1 because it can't directly control people's demand for cash, and it can't control bank's desire to hold excess reserves. The actual Money Expansion multiplier is around 3. See page 314.
A Money Deposit Expansion Multiplier of 3 means that for every $1 increase in the Monetary Base (M0), M1 will increase by $3. If the Fed wants to increase the MS by $30B, it would engage in a $10B open market operation, it would buy $10B of treasury securities.
If the Fed wants to contract the MS, it would sell treasury securities from its portfolio. They give you a Tbill, you give them a check. When the check clears, the reserves in the banking system are reduced/contracted, which then contracts the MS. The multiplier works the same way in reverse.
3. DISCOUNT RATE - BORROWING FROM THE FED
If banks have a shortage of reserves, and it needs to meet the reserve requirements, it has two sources for funds: FRS and the Federal Funds market. Banks can borrow from the Fed at the Discount Rate, currently at 5%. Banks can also deal directly with each other in the Fed Funds Market. Banks with excess reserves can lend money to banks that need reserves, sometimes on just an overnight basis.
The current FFR is X%. Most banks would rather borrow at the FFR, even if it is higher.
If the Fed lowers the discount rate, it would be easier/cheaper to borrow reserves, would be considered expansionary. If the discount rate is very low, and it is cheap to borrow, banks will not need to hold excess reserves, they will make loans.
If the Fed raises the discount rate, it is expensive to borrow and banks will hold excess reserves to avoid having to borrow at the high discount rate.
See page 317. To increase MS, or have expansionary policy, or "easing of money" the FRS can:
1. Lower reserve requirements
2. Lower the discount rate
3. Open market operation - buy Tbills
To decrease MS, have contractionary policy or "tightening of money" the FRS:
1. Raise res requirements
2. Raise discount rate
3. OMO - sell Tbills.
On net, the MS is increasing. Reserve requirements don't change very often, and the discount rate doesn't change very often. The primary tool used most often by FRS is OMO.
See Exhibit 12-10, page 316. Illustrates the MS process. FRS directly affects the Monetary Base by increasing the amount of bank reserves. If the increased reserves stay in the banking system and get loaned out there is an expansionary effect, 1/res req. If some of the new reserves are held as cash, it is a "leakage" and the multiplier effect is only 1. Reserves are "high powered" money if they stay in the banking system and expanded.
Point: FRS can directly control the MB, but it cannot directly control M1. M1 is influenced by peoples demand for currency/cash, and by bank's willingness to hold excess reserves.
Also, since OMOs are the primary tool used to influence M1, we would expect a direct relation between growth in the MB and M1, since the FRS is expanding the MB with OMOs to inc M1.
FED and TREASURY
There is a tendency to confuse the Fed and the Treasury. They are totally different and distinct. The Treasury is concerned with the federal budget and financing G exp, and is the agency that issues Treasury bills, bonds and notes to finance deficits. Treasury securities are sold at auctions to the public, not to the Fed. Does NOT change the MS. Just transfers money from the private sector to the public sector.
The Fed buys tbond in the secondary market, from individuals, banks, ins cos., etc. The Fed does NOT issue gov securities, it just buys and sells them. Fed's action does change the MS.
See Thumbnail Sketch, page 318.
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