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© 2013, published by Flat World Knowledge
Chapter 9
The Nature and
Creation of Money
© 2013, published by Flat World Knowledge
Published by:
Flat World Knowledge, Inc.
One Bridge Street
Irvington, NY 10533
© 2013 by Flat World Knowledge, Inc. All rights reserved. Your use of this work is subject to the License Agreement available here http://www.flatworldknowledge.com/legal. No part of this work may be used, modified, or reproduced in any form or by any means except as expressly permitted under the License Agreement.
© 2013, published by Flat World Knowledge
1. WHAT IS MONEY?
Learning Objectives1. Define money and discuss its three basic
functions.2. Distinguish between commodity money
and fiat money, giving examples of each.3. Define what is meant by the money
supply and tell what is included in the Federal Reserve System’s two definitions of it (M1 and M2).
© 2013, published by Flat World Knowledge
1.1 The Functions of Money
− A medium of exchange is anything that is widely accepted as a means of payment.
• To Barter an individual exchanges goods directly for other goods.
− A unit of account is a consistent means of measuring the value of things.
− A store of value is an item that holds value over time.
• Money is anything that serves as a medium of exchange.
© 2013, published by Flat World Knowledge
1.2 Types of Money
• Commodity money is money that has value apart from its use as money.
– E.g. Mackerel in federal prisons, gold, and silver • Fiat money is money that some authority, generally
a government, has ordered to be accepted as a medium of exchange.
– E.g. paper money and coins in the U.S. “this note is legal tender for all debts public and private”
• Currency is paper money and coins.• Checkable deposits are balances in checking
accounts.• A check is a written order to a bank to transfer
ownership of a checkable deposit.
© 2013, published by Flat World Knowledge
1.3 Measuring Money
• Money supply refers to the total quantity of money in the economy at any one time.
• Liquidity is the ease with which an asset can be converted into currency.
• M1 is the narrowest of the Fed’s money supply definitions that includes currency in circulation, checkable deposits, and traveler’s checks.
• M2 is a broader measure of the money supply than M1 that includes M1 and other deposits.
© 2013, published by Flat World Knowledge
The two M’s: January 2012
© 2013, published by Flat World Knowledge
2. THE BANKING SYSTEMS AND MONEY CREATION
Learning Objectives1. Explain what banks are, what their
balance sheets look like, and what is meant by a fractional reserve banking system.
2. Describe the process of money creation (destruction), using the concept of the deposit multiplier.
3. Describe how and why banks are regulated and insured.
© 2013, published by Flat World Knowledge
2.1 Banks and Other Financial Intermediaries
• A financial intermediary is an institution that amasses funds from one group and makes them available to another.
• A bank is a financial intermediary that accepts deposits, makes loans, and offers checking accounts.
© 2013, published by Flat World Knowledge
2.2 Bank Finance and a Fractional reserve System
• A balance sheet is a financial statement showing assets, liabilities, and net worth.
• Assets are anything of value.• Liabilities are obligations to other
parties.• Net worth refers to assets less
liabilities.
© 2013, published by Flat World Knowledge
2.2 Bank Finance and a Fractional reserve System
• Reserves are bank assets held as cash in vaults and in deposits with the Federal Reserve.
• A fractional reserve banking system is a system in which banks hold reserves whose value is less than the sum of claims outstanding on those reserves.
© 2013, published by Flat World Knowledge
The Consolidated Balance Sheet for U.S. Commercial Banks, January
2012
Assets Liabilities and Net Worth
Reserves $1,592.9 Checkable deposits $8,517.9
Other assets 1,316.2 Borrowings 1,588.1
Loans 7,042.0 Other liabilities 1,049.4
Securities 2,546.1
Total assets $12,497.2 Total Liabilities $11,155.4
Net worth $1,341.8
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2.3 Money Creation
• Required reserves are the quantity of reserves banks are required to hold.
• The required reserve ratio is the ratio of reserves to checkable deposits a bank must maintain.
• Excess reserves are reserves in excess of the required level.
• A bank is said to be loaned up when its excess reserves equal zero.
14
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Fractional Reserve Banking
A system in which banks keep less than 100 percent of the deposits available for withdrawal.– Regulated by Federal Reserve Board
15
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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 reserves ratio is the ratio of
reserves to deposits that banks are required, by regulation, to hold. Required reserves are those reserves which must be kept on hand or on deposit with the Federal Reserve in order to comply with the reserve requirements.
– Excess reserves are the cash reserves beyond those required, which can be loaned.
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How Banks Create Money
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How Banks Create Money
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How Banks Create Money
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How Banks Create Money
NOTE: Cash leakage or excess reserves held in banks will reduce the multiplier effect
Deposit Expansion Multiplier =1
Reserve Requirement (ratio)
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The Multiple Creation of Bank Deposits
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Required Reserve RatioFrom the Federal Reserve web site (5/1/07)
Liability Type RRR in %
Transaction accounts
$8.5 million 0%
$8.5 to $45.8 million 3%
$45.8 million + 10%
Non-personal time deposits 0%
Eurocurrency liabilities 0%
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A Balance Sheet for ACME Bank
ACME Bank
Assets Liabilities
Reserves $1,000 Deposits $10,000
Loans $9,000
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A Balance Sheet for ACME Bank
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A Balance Sheet for ACME Bank
© 2013, published by Flat World Knowledge
2.4 The Deposit Multiplier
• A deposit multiplier is the ratio of the maximum possible change in checkable deposits (ΔD) to the change in reserves (ΔR).
EQUATION 2.1
EQUATION 2.2
EQUATION 2.3
EQUATION 2.4
EQUATION 2.5
10000,1$
000,10$
R
Dmd
rrrDR
DrrrR
DRrrr
1
dmR
D
rrr
1
© 2013, published by Flat World Knowledge
2.5 The Regulation of Banks
• Deposit insurance– In the U.S., if a commercial bank fails, the FDIC
guarantees to reimburse depositors up to at least $250,000 per account.
• Regulation to Prevent Bank Failure– The FDIC audits banks to ensure they are
operating safely (i.e. not making investments deemed too risky and maintaining a minimum level of net worth as a fraction of total assets)
• Regulation in Response to Financial Crises– The Glass-Steagall Act post Great Depression
created the FDIC and the separation between commercial banks and investment banks.
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2.5 The Regulation of Banks
• Regulation in Response to Financial Crises– In the U.S. in 1999 the Glass-Steagall Act
was largely repealed.– The financial crisis of 2008 led to the
passage of the Dodd-Frank Act. – Elimination of the separation between the
two types of banks by a law passed in 1999.
© 2013, published by Flat World Knowledge
2.5 The Regulation of Banks
• Regulation in Response to Financial Crises– Creation of the Dodd-Frank Wall Street
Reform and Consumer Protection Act post financial crisis of 2008.
• Supervision and regulation of consumer credit markets, such as credit card and bank fees and mortgage contracts.
© 2013, published by Flat World Knowledge
3. THE FEDERAL RESERVE SYSTEM
Learning Objectives1. Explain the primary functions of central banks.2. Describe how the Federal Reserve System is
structured and governed.3. Identify and explain the tools of monetary policy.4. Describe how the Fed creates and destroys money
when it buys and sells federal government bonds.
• A central bank is a bank that acts as a banker to the central government, acts as a banker to banks, acts as a regulator of banks, conducts monetary policy, and supports the stability of the financial system.
30
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The Federal Reserve System
The Federal Reserve System (“the Fed”) serves as the central bank for the United States.
A central bank typically has the following functions:– It is the banks’ bank: it accepts deposits from
and makes loans to commercial banks.– It acts as banker for the federal government.– It controls the money supply.– Performs certain regulatory functions for the
financial industry.
31
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Structure of the Federal Reserve System
The primary elements in the Federal Reserve System are:
1. The Board of Governors
2. The Regional Federal Reserve District Banks (FRBs)
3. The Federal Open Market Committee (FOMC)
32
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The Federal Reserve Banks
12 District banks Nine directorsThe directors appoint the district
president who is approved by the Board of Governors
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The Federal Reserve System
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The Board of Governors
Seven members Appointed by the President Confirmed by the Senate Serve 14-year term Terms are staggered so that one comes
vacant every two years President appoints a member as Chairman
to serve a four-year term – Confirmed by the US Senate
35
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Federal Open Market Committee (FOMC)
Meets approximately every six weeks to review the economy
Made up of the following voting members:– 7 members of the Board of Governors– 5 of the FRB presidents (they rotate
yearly)= 12 FOMC members
36
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Functions of the Fed (1)
Banking Services and Supervision– It supplies currency to banks through its 12 district
banks.– It holds the reserves of banks in the district bank of
each bank.– It processes and routes checks to banks through its
district banks and processing centers.– It makes loans to banks—it is the “lender of last resort”,
the “banker’s bank”.– It supervises and regulate banks, ensuring that they
operate in a sound and prudent manner.– It is the banker for the U.S. government. It sells
government securities for the U.S. Treasury.
37
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Functions of the Fed (2)
Controlling the Money Supply– The money supply is varied through the course
of the year to meet seasonal fluctuations in the demand for money. This helps keep interest rates less volatile.
• Example: 4th quarter holiday season creates an increased demand for money to buy gifts.
– The Fed also changes the money supply to achieve policy goals set by the FOMC.
38
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Policy Goals of the Fed
Ultimate Goal:Economic growth with stable prices. This means greater output (GDP) and a low, steady rate of inflation.
Intermediate Targets:– The Fed does not control output or the prices
directly. It does control the money supply.– The Fed establishes target growth rates for the
money supply, which it believes are consistent with its ultimate goals.
– The money supply growth rate becomes an intermediate target, an objective used to achieve some ultimate policy goal.
© 2013, published by Flat World Knowledge
3.2 Powers of the Fed
• Reserve requirements• The discount window and other credit
facilities– The discount rate is the interest rate
changed by the Fed when it lends reserves to banks.
– The federal funds market is a market in which banks lend reserves to one another.
– A federal funds rate is the interest rate charged when one bank lends reserves to another.
© 2013, published by Flat World Knowledge
3.2 Powers of the Fed
• Open market operations– A bond is a promise by the issuer of the bond
to pay the owner of the bond a payment or a series of payments on a specific date or dates.
– Open market operations are the buying and selling of federal government bonds by the Fed.
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3.2 Powers of the Fed
The Fed
Banks
The Public
Reserves
DepositsLoans