University Chapter 16 Notes: Money Creation and Banking Operations

Chapter 16: Banking and the Management of the Money Supply

Overview and Learning Objectives

Objective 16.1: Differentiate between various money aggregates (M1 and M2).
Objective 16.2: Explain the similarities and differences between debit card transactions, cash transactions, and credit card transactions.
Objective 16.3: Explain why banks occupy a superior position for lending individual savings compared to individuals themselves.
Objective 16.4: Calculate money creation in a fractional reserve banking system for specific scenarios.
Objective 16.5: Differentiate between limited reserves and ample reserves in monetary policy contexts.
Objective 16.6: Summarize Fed tools for limited-reserve banking systems.
Objective 16.7: Summarize Fed tools for ample-reserve banking systems.
Key Role of Banks: In macroeconomics, banks are unique because they convert a borrower's IOU into money, which signifies a healthy economy.
Money Creation Misconception: While popular imagery suggests the Federal Reserve "prints" physical bills, contemporary money creation primarily involves electronic figures in bank ledgers. Physical currency is a small part of the total money supply.
Historical Transformation: The banking world and monetary policy tools have been revamped significantly since the Great Recession of 2007–2009.

Money Aggregates

Narrow Definition of Money: M1

Definition: M1 encompasses the most liquid and widely accepted assets used for transactions.
Checkable Deposits: Bank deposits that allow account owners to draw down funds via check, debit card, or online apps. Recently, hybrid offerings like money market deposit accounts and high-yield checking have blended liquidity with interest-earning benefits.
Historical Classification Shift (April 2020): - Prior to April 2020: M1 consisted of currency, demand deposits, and other checkable deposits (OCDs) at institutions like thrifts. Savings accounts were excluded because they were less liquid due to transfer limits. - Post-April 2020: The Fed reclassified savings deposits as liquid assets. M1 now includes currency outside the U.S. Treasury, Fed banks, and depository vaults, plus demand deposits and "other liquid deposits" (OCDs combined with savings deposits).
Impact of Reclassification: Previously, OCDs were approximately $17\%$ of M1. Following the 2020 change, liquid deposits (including savings) make up about $70\%$ of M1, causing a massive uptick in the M1 charts for 2020.
Currency Management: The Federal Reserve oversees distribution, but the Department of the Treasury handles production. The Bureau of Engraving and Printing creates paper bills; the U.S. Mint produces coins.
Costs and Values: - In 2022, the Fed spent about $1 \text{ trillion}$ on buying, storing, and distributing bills. - Fiat Money: U.S. currency is fiat money because it is redeemable for nothing other than more Federal Reserve bills. - Token Money: Face value exceeds production cost, though the penny and nickel now cost more to mint than their face value.
Global Circulation: About half of Federal Reserve bills are held abroad. Countries like Panama and Ecuador use the U.S. dollar (dollarization), while others (like Vietnam) see the dollar circulate alongside local currency (the dong) to combat inflation.

Broader Definition of Money: M2

Definition: M2 includes all of M1 plus "near-monies" that serve as a store of value and can be converted to currency/checkable deposits.
Components: - M1 content. - Small-denomination time deposits (less than $100,000). - Balances in retail money market funds (MMFs).
Liquidity Difference: M2 assets are less liquid than M1 due to restrictions on minimum balances, check counts per month, or minimum check amounts.
Update (May 2020): Since savings deposits moved into M1, M1 is now much larger and numerically closer to M2 than it was historically.

Credit Cards, Debit Cards, and Payment Preferences

Credit vs. Debit Functions

Credit Cards: These are not money; they are a means of obtaining a short-term loan from the issuer. Money is only used when the balance is repaid. They accounted for $36\%$ of consumer purchases in 2023.
Debit Cards (Check/Bank Cards): These tap directly into a checking account, paying with electronic money already part of M1. They accounted for $54\%$ of purchases in 2023.
Apple Pay Example: - Apple Cash: Functions like a debit card; funds are part of M1 and deducted immediately. - Apple Card: A credit facility where funds are borrowed and repaid later (typically monthly with interest).

Consumer Trends and Disadvantages

Electronic Dominance: In a 2023 Forbes Advisory Survey, only $9\%$ of transactions involved cash or checks.
ACH (Automated Clearing House): This network handles online bill payments and social platforms like Venmo and Zelle.
Security and Protections: Debit cards usually require a PIN and are safer against theft than credit cards, but credit cards offer a "grace period" and the ability to dispute bills or withhold payment, which debit cards do not.

Cryptocurrencies and the Functions of Money

Definition and Mechanics

Nature: Unlike digital forms of national currency (issued by central banks), cryptocurrencies like Bitcoin, Ethereum, BNB, and Dogecoin are decentralized and operate outside conventional financial systems via global computer networks ("mining").
Security: Secured by cryptographic keys and stored in digital wallets.

Evaluation as Money

Medium of Exchange: Facilitates peer-to-peer transactions without intermediaries, but not universally accepted. Transactions are irreversible, leading to fraud risks (2022: cyber thefts totaled nearly $3.7 \text{ billion}$ , with $95\%$ from hacking).
Store of Value: Highly volatile. No traditional banking safeguards or deposit insurance. - Case Study: Sam Bankman-Fried (FTX founder) convicted of fraud in November 2023 for a scheme causing at least $10 \text{ billion}$ in losses.
Unit of Account: Global but hampered by price volatility and lack of regulation.
Adoption Examples: - El Salvador: First country to adopt Bitcoin as legal tender (September 2021). - Central African Republic (CAR): Adopted Bitcoin in April 2022 but reversed the decision within a year due to infrastructure/access hurdles.

How Banks Work

Financial Intermediation

Banks act as financial intermediaries (go-betweens) for savers and borrowers.
Transaction Costs: Banks reduce the cost of channeling savings to creditworthy borrowers.
Asymmetric Information: Inequality in information. Borrowers know more about their risk than lenders. Banks use expertise/experience to evaluate creditworthiness, which individuals lack.
Diversification: Banks lend small fractions of deposits to many borrowers. A single default by one borrower does not jeopardize the bank, whereas it would ruin a single individual lender.
Systemic Risk: The 2007–2009 Great Recession showed that if many borrowers fail (e.g., the housing collapse), banks suffer heavy losses and the economy ripples with crisis.

Bank Balance Sheets

Balance Sheet Equation: $\text{Assets} = \text{Liabilities} + \text{Net Worth}$ .
Asset: Physical property or financial claim owned (e.g., Reserves, Loans).
Liability: An amount the bank owes (e.g., Deposits).
Net Worth (Equity): The difference between assets and liabilities; signifies financial health.
Liquidity vs. Profitability: - Liquidity: Ease of conversion to cash without loss. - Profitability: Goal for survival. High-liquidity assets (cash) earn no interest; high-profit assets (long-term loans) are illiquid.

Money Creation and the Multiplier

Fractional Reserve Banking Mechanics

Banks keep only a fraction of deposits as reserves and lend the rest.
Reserve Ratio ( $r$ ): Reserves as a percentage of total deposits.
Federal Funds Market: Banks with excess reserves lend to banks with shortages for day-to-day operations at the Federal Funds Rate (FFR).
Excess Reserves: The "raw material" for money creation. These are reserves above the bank's preferred level.

The Multiplier Effect

Simple Money Multiplier: $M = \frac{1}{r}$
Maximum Money Creation: $\text{Total Increase in Checkable Deposits} = \text{Initial Injection} \times \frac{1}{r}$
Scenario Example ( $r = 0.1$ ): - Initial Deposit: $200,000. - Round 1 (Bank A): Keeps $20,000, lends $180,000. - Round 2 (Bank B): Receives $180,000, keeps $18,000, lends $162,000. - Round 3 (Bank C): Receives $162,000, keeps $16,200, lends $145,800. - Total new deposits in system: $200,000 \times 10 = 2,000,000$ . - Net increase in money supply: $2,000,000 - 200,000 = 1,800,000$ .

Limitations on Expansion

Idle Reserves: Banks might hold more than required for safety or due to interest offered by the Fed.
Borrower Behavior: People must want to borrow and spend.
Cash Leakages: People might prefer holding cash (M1 currency) rather than depositing it, which drains reserves from the system and reduces the effective multiplier.
Contraction of Money Supply: If the Fed sells a bond (e.g., $1,000), it drains reserves. Banks must recall loans or sell assets, reducing deposits through a reverse multiplier effect (Max reduction: $1,000 10 = $10,000).

The Fed’s Tools of Monetary Control

Banking System Environments

Limited Reserves (Pre-2008): Reserves were scarce. The Fed managed the money supply by creating artificial shortages or surpluses.
Ample Reserves (Post-2008): The system is "flush" with liquid assets due to Quantitative Easing (QE). Traditional tools like OMO are less effective because reserve requirements no longer bind banks.

Tools for Limited Reserves

Open-Market Operations (OMO): Buying (to increase supply) or selling (to decrease supply) U.S. government bonds.
Discount Rate: Interest rate for banks borrowing directly from the Fed at the "discount window."
Required Reserve Ratio: Manipulating the fraction banks must keep. This was eliminated in March 2020.

Tools for Ample Reserves

Interest on Reserve Balances (IORB): The Fed’s primary tool today. It is an administered rate. - Reservation Rate: The minimum rate banks accept (banks won't lend in the market for less than the Fed pays them). - Arbitrage: Banks borrow at the low market rate and deposit at the higher IORB to lock in profit, which pulls the FFR toward the IORB.
Overnight Reverse Repurchase Agreement Facility (ON RRP): Testing began in 2013; permanent in 2014. Non-bank entities lend to the Fed to set a floor for interest rates.
Discount Rate: Remains as a signal and emergency safety valve.

Interest Rates Summary (September 2023)

ON RRP Rate: $5.30\%$
Federal Funds Effective Rate (FFR): $5.33\%$
IORB Rate: $5.40\%$
Primary Discount Rate: $5.50\%$
Secondary Discount Rate: $6.00\%$
30-year Fixed Mortgage: $7.49\%$
Bank Prime Loan Rate: $8.50\%$

The "Death" of the Money Multiplier

Empirical Evidence: The ratio of M2 deposits to reserves SURGED in the 1990s (from 40 to 80), showing the multiplier became unstable/irrelevant.
Policy Shift: In March 2020, the Fed officially eliminated reserve requirements. Mathematically, the simple money multiplier ( $\frac{1}{r}$ ) is no longer a binding constraint in an ample-reserve world.

Response to Financial Crises

September 11, 2001: Fed bought a record $150 \text{ billion}$ in securities in two days to prevent cash hoarding.
2007–2008 Crisis: - Discount rate slashed from $6.25\%$ to $0.25\%$ . - Invested over $1 \text{ trillion}$ in mortgage-backed securities. - Invested over $90 \text{ billion}$ to save AIG.
Covid-19 Pandemic (2020): - Slashed FFR by $1.5$ percentage points to $0–0.25\%$ . - Modified the Discount Window: Reduced premium over FFR to zero and extended terms to $90$ days. - Primary credit borrowing peaked at nearly $50 \text{ billion}$ in April 2020. - Extensive asset purchases to stabilize capital markets.