Understanding Money, Banks, and the Federal Reserve

Money

An asset that people are generally willing to accept in exchange for goods and services or for payment of debts.

Asset

Anything of value owned by a person or a firm.

Barter

Trading goods and services directly for other goods and services.

Double coincidence of wants

The requirement that each party in a trade wants what the other has to offer.

Four Primary Functions of Money

- medium of exchange

- unit of account

- store of value

- standard of deferred payment

Commodity money

- Goods used as money that also have value independent of their use as money

- like animal skins or precious metals

Medium of exchange

Money is acceptable to a wide variety of parties as a form of payment for goods and services.

Unit of account

Money allows a way of measuring value in a standard manner.

Store of value

Money allows people to defer consumption till a later date by storing value.

- money does this well because it is LIQUID, meaning it can be easily exchanged for goods

Standard of deferred payment

Money facilitates exchanges across time when we anticipate that its value (purchasing power) in the future will be predictable.

Characteristics of money

- acceptable to most people

- standardized in quality so any two units are alike

- durable so value is not lost by wearing out

- valuable relative to its weight so it can easily transported

- divisible enough to be used for purchases (low and high priced)

Historical commodity money examples

Cowrie shells, precious metals, animal pelts, and cigarettes in prisons.

Paper money

Currency issued by banks and governments that was exchangeable for some commodity, typically gold.

Central bank

- An institution that manages a state's currency, money supply, and interest rates

- paper money is generally issued by them

Federal Reserve

- The central bank of the United States

- money issued by them is known as fiat money

Fiat money

Money that is not backed by a physical commodity and is established as money by government regulation.

- only acceptable as long as households/firms have confidence that if they accept paper dollars in exchange for goods and services, the dollars will not lose much value during the time they hold them

Economists' measurement of money

Typically measures cash plus checking account balances (M1)

Specialization

The process that allows for the development of an economy by making trading easier through the existence of money.

Legal obligation to accept currency

Firms are not obliged to accept currency as payment; debts are a different story.

M1

The narrow definition of the money supply: the sum of currency in circulation and checking account and savings account deposits in banks.

M2

A broader definition of the money supply that includes M1, plus small-denomination time deposits, and noninstitutional money market fund shares.

U.S. currency holdings

U.S. currency holdings are unusually high by world standards; people in other countries sometimes hold and use U.S. dollars.

Choosing between M1 and M2

When discussing the money supply, M1 is suggested as it focuses on money's role as the medium of exchange.

Role of banks in money supply

Banks play an important role in the money supply, controlling what happens to money in checking and savings accounts.

Debit cards

directly access checking accounts, but the card is not money; the checking account balance is.

Credit cards

a convenient way to obtain a short-term loan from the bank issuing the card, but transactions are not complete until the loan is paid off.

E-money

Consumers have come to trust forms of e-money such as PayPal, Apple Pay, and Google Pay over the last decade.

Bitcoins

- A new form of e-money, made not by a government or firm, but by a decentralized system of linked computers

- we typically think of currency issued by a government, but currency is only a small part of the money supply.

Money in Checking Accounts

There is more money held in checking accounts than there is actual currency in the economy.

Balance Sheet

On a balance sheet, a firm's assets are listed on the left, and its liabilities (and stockholders' equity or net worth) are listed on the right. The left and right sides must add to the same amount.

Bank Loans and Securities

Banks use money deposited with them to make loans and buy securities (investments).

Legal Liabilities of Banks

Their legal liabilities are their deposit accounts: money they owe to their depositors.

Reserves

- Reserves are deposits that a bank keeps as cash in its vault or on deposit with the Federal Reserve.

- The bank does not keep enough deposits on hand to cover all of its deposits. This is how the bank makes a profit: lending out or investing money deposited with it.

Required Reserves

- Reserves that a bank is legally required to hold, based on its checking account deposits.

- The portion of deposits that banks are required to hold and not lend out.

Required Reserve Ratio (RR)

10% is the required reserve ratio: The minimum fraction of deposits banks are required by law to keep as reserves.

Excess Reserves

Reserves that banks hold over the legal requirement.

Fintech Companies

- Some new financial technology companies - such as LendingClub and FreedomPlus - have emerged to offer peer-to-peer lending on the Internet.

- earn flat fees for facilitating a loan an charge fees for collecting payments

- These firms take none of the risk of the loans defaulting

Credit Interest Rate Cap

U.S. Senators Sanders and Ocasio-Cortez have introduced legislation to cap credit interest rates at 15%.

- banks are primary issuers of credit cards and argue the cap would result in many people with poor credit score and not having access to credit

T-account

is a stripped-down version of a bank balance sheet, showing only how a transaction changes a bank's balance sheet

Bank of America Deposit

- When you deposit $1,000 in currency at Bank of America, its reserves increase by $1,000 and so do its deposits

- The currency component of the money supply decreases by the $1,000 since that $1,000 is no longer in circulation

- The checking deposits component increases by $1,000

- bank needs to make a profit so it keeps 10% of the deposit as reserves and lends out the rest (creating a $900 checking account deposit, increasing the money supply by $900)

Money Supply

The total amount of money available in an economy at a specific time.

Deposit Multiplier

The ratio of the total amount of deposits created by banks to the amount of new reserves.

Simple Deposit Multiplier

- Calculated as 1 divided by the required reserve ratio (RR), indicating how much deposits can increase

- (1/RR) where it is 10% or .10; so it = 10

- the ratio of the amount of deposits created by banks to the amount of new reserves

Real-World Deposit Multiplier

- The actual multiplier observed in the economy, which is often less than the simple deposit multiplier

- end up being multiplied by less than 2

- banks may not lend out as much as we predict because they want to keep excess reserves or cannot find credit-worthy borrowers

- consumers also keep some currency out of the bank

Conclusions on Banks and the Money Supply

- when banks gain reserves, they make new loans, and the money supply expands

- when banks lose reserves, they reduce their loans, and the money supply contracts

Fractional Reserve Banking

A banking system where banks hold less than 100% of deposits as reserves.

Bank Run

many depositors simultaneously lost confidence in a bank and tried to withdraw their money

Bank Panic

if many banks experience bank runs at the same time

Currency Deposit

Money deposited in a bank that can be used to create additional deposits through lending.

Multiplier Effect

The process by which an initial deposit leads to a greater final increase in the total money supply.

Loan

An amount of money borrowed from a bank that must be paid back with interest.

Recession

A period of economic decline characterized by falling GDP and reduced consumer spending.

Lender of last resort

A role of central banks, like the Federal Reserve, to provide loans to banks to pay off depositors

- if bank panic occurs

Discount loans

Loans made by the Federal Reserve to banks, charging a rate of interest known as the discount rate.

Discount rate

The interest rate charged on discount loans made by the Federal Reserve to banks.

Federal Deposit Insurance Corporation (FDIC)

- An agency that insures deposits in many banks up to a limit (currently $250,000)

- helped to limit bank panics

-

The Federal Reserve System

- Congress divided the country into 12 Federal Reserve districts, each of which provides services to banks in the district

- real power of FED lies in Washington DC, with Board of Governors

Federal Open Market Committee (FOMC)

- A committee responsible for open market operations and managing the money supply in the United States.

- meeting 8 times per year

Monetary policy

The actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic objectives.

The Fed's Six Monetary Policy Tools

- open market operations

- discount policy

- reserve requirements

- interest on reserves

- overnight reserve repurchase agreement facility

- term deposit facility

Open market operations

The buying and selling of Treasury securities by the Federal Reserve to control the money supply

- open market purchase

- open market sale

Trading desk

The department in New York that conducts open market purchases and sales of U.S. Treasury securities

Open market purchase

An action taken by the Fed to increase the money supply by buying U.S. Treasury securities.

Open market sale

An action taken by the Fed to decrease the money supply by selling its securities.

Discount Policy

- lowers the discount rate (interest paid on money banks borrow from the Fed), and the Fed encourages the banks to borrow (and hence lend out) more money, increasing the money supply

- raising the discount rate has the opposite effect

Reserve requirements

The regulations set by the Fed that determine the minimum reserves each bank must hold

- the Fed can alter the required reserve ration

- a decrease would result in more loans beings made, increasing the money supply

- an increase would result in fewer loans being made

Interest on reserves

The interest paid by the Fed on the required and excess reserves held by banks

- a decrease in the interest rate paid will increase the incentive of banks to make loans rather than hold reserves

- as banks increase the loans they make, the money supply will increase

- Fed can raise interest rate on bank reserves and has opposite effect

Overnight reverse repurchase agreement facility

A tool used by the Fed to manage the money supply through short-term borrowing

- large banks and other financial firms often use these agreements to borrow and lend with each other and with the Fed for very short periods; typically overnight

Term deposit facility

A tool used by the Fed to manage the money supply by accepting deposits from banks for a fixed term

- Fed has offered banks the opportunity to purchase term deposits (similar to the certificates of deposit that banks offer to households/firms)

- interest rate offered is slightly higher than reserve balances

- when banks place money in term deposits it reduces the funds to loan

- used least by the Fed

Board of Governors

The main governing body of the Federal Reserve, located in Washington DC.

Recession of 2007-2009

A significant economic downturn during which some banks experienced runs from large depositors.

Janet Yellen

The chair of the Board of Governors of the Federal Reserve in 2017.

Money Supply Increase

As banks increase the loans they make, the money supply will increase.

Repo

A repo is a short-term loan backed by collateral.

Commercial Banks

The banks we have been discussing so far are commercial banks, whose primary role is to accept funds from depositors and make loans to borrowers.

Two Important Developments have occurred in the Financial System:

- Banks have begun to resell many of their loans rather than keep them until they are paid off

- Financial firms other than commercial banks have become sources of credit to businesses.

Security

is a financial asset - such as a stock or a bond - that can be bought and sold in a financial market.

Traditional Loan Management

Traditionally, when a bank made a loan like a residential mortgage loan, it would 'keep' the loan and collect payments until the loan was paid off.

Secondary Markets and Securitized Loans

- in the 1970s, secondary markets developed securitized loans, allowing them to be traded, much like stocks and bonds

Securitization

is the process of transforming loans or other financial assets into securities.

Non-Bank Financial Firms

- Investment banks

- Money market mutual funds

- Hedge funds

Shadow Banking System

By raising funds from investors and providing them directly or indirectly to firms and households, these firms have become a 'shadow banking system.'

Investment Banks

are banks that do not typically accept deposits from or make loans to households; they provide investment advice and also engage in creating and trading securities such as mortgage-backed securities.

Money Market Mutual Funds

are funds that sell shares to investors and use the money to buy short-term Treasury bills and commercial paper (loans to corporations).

Hedge Funds

are funds that raise money from wealthy investors and make 'sophisticated' (often non-standard, high-risk) investments.

What made this "shadow banking system" different from commercial banks?

- These firms were less regulated by the government, including not being FDIC-insured

- These firms were highly leveraged, relying more heavily on borrowed money; hence their investments had more risk, both of gaining and losing value

Vulnerability of Shadow Banking

- Beginning in 2007, firms in the shadow banking system were quite vulnerable to runs

- As housing prices fell, some borrowers defaulted on their mortgages, so the value of mortgage-backed securities fell.

Fed's Response to Financial Crisis

The Fed and the U.S. Treasury took vigorous action to deal with the financial crisis by:

- modifying its discount policy, granting loans to previously ineligible financial firms

- The Fed bought commercial paper for the first time since the 1930s

- The Fed took similar actions in the Covid-19 recession.

Quantity Theory of Money

- The quantity theory of money explains how high rates of inflation occur

- a theory about the connection between money and prices that assumes that the velocity of money is constant

Irving Fisher's Quantity Equation

Irving Fisher formalized the relationship between money and prices as the quantity equation: M x V = P x Y.

where:

- M: money supply

- V: velocity of money

- P: price level

- Y: real output

- rewrite as V = (P x Y)/M

Velocity of Money

is the average number of times each dollar in the money supply is used to purchase goods and services included in GDP

Calculating Velocity of Money

- measuring the money supply with M1 and price level with the GDP, so P x Y is nominal GDP

- using the equation V = (P x Y)/M

Growth rate of the money supply

The rate at which the amount of money in circulation increases.

Growth rate of velocity

The rate at which money is exchanged in the economy.

Growth rate of the price level

The rate at which the overall price level of goods and services rises, indicating inflation.

Growth rate of real output

The rate at which the economy's production of goods and services increases, adjusted for inflation.

Inflation rate

Growth rate of the money supply - the growth rate of real output.

Quantity Theory of Inflation (Growth Rates)

M x V = P x Y generates:

growth rate of the money supply + growth rate of velocity = growth rate of the price level (inflation rate) + growth rate of real output

Deflation

- A decline in the price level

- if the money supply grows slower than real GDP

Hyperinflation

- Very high rates of inflation, in excess of 50% per month

- results when central banks increase the money supply at a rate far in excess of the growth rate of real GDP

- when governments want to spend much more than they raise through taxes, so they force their central bank to "buy" government bonds