6/12/20141 Money and Banking Chapter 09. 2 Outline The Functions of Money The Functions of Money The Components of Money Supply The Components of Money

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Money and BankingMoney and Banking

Chapter 09Chapter 09

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OutlineOutline

The Functions of MoneyThe Functions of Money The Components of Money SupplyThe Components of Money Supply What “Backs” the Money Supply?What “Backs” the Money Supply? The Federal Reserve and the The Federal Reserve and the

Banking SystemBanking System The Fractional Reserve SystemThe Fractional Reserve System

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OutlineOutline

A Commercial BankA Commercial Bank The Banking System: Multiple-The Banking System: Multiple-

Deposit ExpansionDeposit Expansion

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The Functions of MoneyThe Functions of Money

Medium of exchangeMedium of exchange Unit of accountUnit of account Store of valueStore of value

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The Functions of MoneyThe Functions of Money

Store of valueMedium of exchange Unit of account

= Allows people totransfer purchasingpower from thepresent to the future.

- Is usable for buying & selling G&S.- Allows society toescape the complications of barter.

- Is used as a yardstick for measuring therelative worth of G&Sand resources.- Enables buyers andsellers to easily compare prices ofG&S and resources.

Liquidity = the ease with which an asset can be converted into cash.(Cash is perfectly liquid.)

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The Components of Money The Components of Money SupplySupply

Money definition: M1Money definition: M1– Currency: coins + paper moneyCurrency: coins + paper money– Checkable depositsCheckable deposits– Institutions that offer checkable depositsInstitutions that offer checkable deposits– Two qualificationsTwo qualifications

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M1M1

Currency Checkable deposits

Issued by theU.S. Treasury

Money outside banks Money inside banks

Issued by theFederal ReserveSystem

Token money(face value unrelated to

intrinsic value)

Paper moneyCoins + Issued by

Commercialbanks

Thrift institutions

Checkbook money(deposits in banks or thrifts against

which checks may be written)

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Money definition: M2Money definition: M2– Savings deposit, including money Savings deposit, including money

market deposit accountmarket deposit account– Small (less than $100,000) time Small (less than $100,000) time

depositsdeposits– Money market mutual fundsMoney market mutual funds

M2M2

Savings deposits,including MMDAs

M1 +

Near-monies(can be readily converted into currency or checkable deposits)

Small time deposits(< $100,000)

MMMFsSavings deposits,including MMDAs


MMMFsSavings deposits,including MMDAs


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What “Backs” the Money What “Backs” the Money Supply?Supply?

Value of moneyValue of money– AcceptabilityAcceptability– Legal tenderLegal tender– Relative scarcityRelative scarcity

Money and pricesMoney and prices– The purchasing power of the dollarThe purchasing power of the dollar– Inflation and acceptabilityInflation and acceptability

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What “Backs” the Money What “Backs” the Money Supply?Supply?

The money supply is “backed” The money supply is “backed” (guaranteed) by the government’s (guaranteed) by the government’s ability to keep the value of money ability to keep the value of money relatively stable.relatively stable.

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Value of moneyValue of money

Relative scarcityAcceptability Legal tender

The demand for andsupply of money

determine the valueor “purchasing

power” of monetaryunit

People acceptcurrency and

checkable depositsas a medium of

exchange

Paper money is a validand legal means of

payment of any debtthat was contracted

in dollars.

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Money and pricesMoney and prices

The purchasing power (PP)of the dollar

PP = $1 / CPI

Inflation and acceptability

High inflation => Low PP=> Lower acceptability

CPI rises => PP falls

CPI falls => PP risesLow inflation => stable PP

=> High acceptability

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The Federal Reserve andThe Federal Reserve andthe Banking Systemthe Banking System

Board of GovernorsBoard of Governors The 12 Federal Reserve banksThe 12 Federal Reserve banks FOMCFOMC Commercial banks and thriftsCommercial banks and thrifts Fed functions and responsibilitiesFed functions and responsibilities Federal Reserve independenceFederal Reserve independence

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12 Federal Reserve Districts12 Federal Reserve Districts

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Fed functions and responsibilitiesFed functions and responsibilities– Issuing currencyIssuing currency– Setting reserve requirements and holding Setting reserve requirements and holding

reservesreserves– Lending money to financial institutionsLending money to financial institutions– Providing for check collectionProviding for check collection– Acting as fiscal agentActing as fiscal agent– Supervising banksSupervising banks– Controlling the money supplyControlling the money supply

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The Federal Reserve --The Federal Reserve --Functions and Functions and

ResponsibilitiesResponsibilities

Issuingcurrency

Settingreserve

requirementsand

holdingreserves

Lendingmoney

tofinancial

institutions

Providingfor

checkcollection

Actingas

fiscalagent

Supervisingbanks

Controllingthe

moneysupply

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The Fractional Reserve The Fractional Reserve SystemSystem

A banking system in which banks and A banking system in which banks and thrifts are required to hold less than thrifts are required to hold less than 100 percent of their checkable 100 percent of their checkable deposits liabilities are reserves.deposits liabilities are reserves.

Two characteristics:Two characteristics:– Banks can create money through lendingBanks can create money through lending– Banks are vulnerable to “panics” or Banks are vulnerable to “panics” or

“runs.”“runs.”

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A Single Commercial BankA Single Commercial Bank

Transaction 1: Creating a bankTransaction 1: Creating a bank Transaction 2: Acquiring property Transaction 2: Acquiring property

and equipmentand equipment Transaction 3: Accepting depositsTransaction 3: Accepting deposits

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Creating a bank

Balance sheet 1

Assets Liabilities & net worth

Cash $250,000 Stock shares $250,000

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Acquiring property & equipment

Balance sheet 2


Cash $10,000 Stock shares $250,000

Property $240,000

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Accepting deposits

Balance sheet 3


Checkabledeposits

$100,000

Stock shares $250,000Property $240,000

Cash $110,000

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Transaction 4: Depositing reserves Transaction 4: Depositing reserves in a Federal Reserve bankin a Federal Reserve bank– Required reserveRequired reserve– Excess reserveExcess reserve

Transaction 5: Clearing a check Transaction 5: Clearing a check drawn against the bankdrawn against the bank

Transaction 6: Granting a loan Transaction 6: Granting a loan (creating money)(creating money)

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Depositing reserves in a Federal Reserve bank

Balance sheet 4


Checkabledeposits

$100,000


Reserves $110,000

Cash $0

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Clearing a checkdrawn against the bank

Balance sheet 5


Checkabledeposits

$50,000


Reserves $60,000

Cash $0

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Granting a loan (Creating money) –When a loan is negotiated

Balance sheet 6a


Checkabledeposits

$100,000


Loans $50,000

Reserves $60,000

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Granting a loan (Creating money) –After a check is drawn on the loan

Balance sheet 6b


Checkabledeposits

$50,000


Loans $50,000

Reserves $10,000

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The Banking System: The Banking System: Multiple Deposit ExpansionMultiple Deposit Expansion

Assumptions:Assumptions:– Reserve ratio = 20%Reserve ratio = 20%– Banks are “loaned up,” i.e. they keep Banks are “loaned up,” i.e. they keep

no excess reservesno excess reserves– The single borrower will write a check The single borrower will write a check

for the entire amount and give it to for the entire amount and give it to someone else who will deposit the check someone else who will deposit the check to another bankto another bank

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Bank

AcquiredReserves

&Deposits

(CD)

RequiredReserves

(RR)

ExcessReserves

(ER)

Amount BankCan Lend = Loans

= NewMoney Createdrr = 20%

(1) (2) = (1)x.2(3) = (1)-(2) (4) = (3)

A $100.00 $20.00 $80.00 $80.00

B $80.00 $16.00 $64.00 $64.00

C $64.00 $12.80 $51.20 $51.20

… … … … …

All banks $500.00 $100.00 $400.00 $400.00

Monetary multiplier (mm) = 1 / rr = 5

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The banking system’s lending potentialThe banking system’s lending potential– Loans = ER x mm = CD x (1 – rr) x mmLoans = ER x mm = CD x (1 – rr) x mm

The monetary multiplierThe monetary multiplier– mm = 1 / rrmm = 1 / rr

Reversibility: the multiple destruction of Reversibility: the multiple destruction of moneymoney– Money is created when banks make loansMoney is created when banks make loans– Money is “destroyed” when loans are paid Money is “destroyed” when loans are paid

off off

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Documents

6/12/20141 Money and Banking Chapter 09. 2 Outline The Functions of Money The Functions of Money The Components of Money Supply The Components of Money