Money, Banks & Central Banks
Money, Banks & Central Banks
Outline
Introduction
What is Money and Why Do We Use It?
The Federal Reserve System
Measuring the Money Supply
The Money Supply Process
Bank Runs and the Money Supply
Introduction
This lecture covers the following topics:
Money
Central banks
The money supply process
In the long run, central bank monetary policy largely determines the rate of inflation.
In the short run, monetary policy can influence the level of economic activity.
What is Money?
Income:
The flow of payments to factors of production.
Wealth:
The value of a set of assets.
Money:
An asset widely accepted as a means of payment.
Money is one form of wealth.
Why Do People Use Money?
Question: Is money a good way to hold wealth?
Answer: No! Money is a dominated asset.
Definition of Dominated Asset:
A dominated asset pays a lower rate of return than another asset under all circumstances.
Reason for Holding Money:
People hold money because it makes conducting transactions easier.
Put another way, money is the most liquid asset in the economy.
Liquidity
Definition:
Liquidity is the ease with which an asset can be converted into money.
Ranking by Liquidity:
Money:
It is already money.
Stocks and Bonds:
Can be sold quickly and at low cost.
Houses, Art, Collectibles:
Selling may take time and involve significant costs.
One Alternative to Using Money: Barter
Definition:
Barter is the exchange of one good or service for another.
Problem with Barter:
Transactions require a double coincidence of wants—an unlikely occurrence that two people each have a good the other wants.
Advantage of Money:
Money allows trades to be conducted at lower cost.
Functions of Money
Means of Payment:
Anything acceptable as payment for goods and services.
Unit of Account:
A common unit for measuring how much something is worth.
Store of Value:
A form in which wealth can be stored.
If money were not a store of value, people would be reluctant to hold it.
Types of Money
Commodity Money:
A type of money that has intrinsic value (e.g., gold or silver coins).
Redeemable Paper Currency:
Such a bill could be redeemed for gold or silver coins; the amount is determined by the note’s value.
Fiat Money:
Money without intrinsic value that serves as a means of payment by government decree.
If a government declares its notes or coins legal tender, they must be accepted in payment.
Central Banks
Focus:
The Federal Reserve System.
Definition of a Central Bank:
A nation’s principal monetary authority.
Money Supply:
The quantity of money available in the economy.
Monetary Policy:
The setting of the money supply or interest rates by policymakers in the central bank.
The Federal Reserve System
Board of Governors:
7 Governors appointed by the president, confirmed by the Senate, appointed for 14-year terms.
The Chair is selected from the 7 Governors for a 4-year term.
Currently, Jerome Powell serves as Chair.
Structure:
The Federal Reserve System is made up of 12 Districts & Reserve Banks.
Example of Districts:
San Francisco, New York, Chicago, Boston, etc.
Federal Open Market Committee (FOMC):
Comprised of the 7 Governors and the New York Federal Reserve Bank president, along with 4 other Federal Reserve Bank presidents on a rotating basis.
The FOMC meets about 8 times a year to set monetary policy.
Functions of the Federal Reserve System
Supervising and Regulating Banks:
Acting as a “Banker’s Bank.”
Issuing Paper Currency:
Check Clearing:
Conducting Monetary Policy:
The Fed vs. the Treasury
Federal Reserve System (Fed):
Manages the money supply.
Treasury Department:
Makes sure the federal government can pay its bills.
If there is a deficit, it will raise money by borrowing (selling bonds).
Its activities do not affect the money supply.
The Money Supply Process
Monetary Aggregates (as of August 2024):
M1 Total: $18,117.5 Billion
Currency in the hands of the public (C): $2,262.5 Billion
Demand deposits of the banking system (D): $5,301.3 Billion
Other liquid deposits (D): $10,553.7 Billion
Note: Other liquid deposits include savings deposits (including money market deposit accounts).
Money Supply (M1) vs. Monetary Base (B)
Focus on M1 (M).
The Fed does not completely control M1.
The monetary base (B) is defined as:
B = C + R where:
C = Currency in the hands of the public
R = Reserves of the banking system
Money supply (M) is defined as:
M = C + D
A Sample Bank Balance Sheet
Liabilities and Shareholders' Equity:
Total Assets: $1,000 million
Assets Breakdown:
Property and Buildings: $40 million
Checking Account: $600 million
Government and Corporate Bonds: $100 million
Other Deposits: $200 million
Loans: $800 million
Bank Borrowing: $75 million
Cash in Vault and ATMs: $10 million
In Accounts with Federal Reserve: $50 million
Total Liabilities and Shareholders' Equity:
$1,000 million
Bank T-Account
Bank T-Account Example:
Assets:
Reserves: $10
Loans: $90
Liabilities:
Deposits: $100
Definition of a T-account:
A simplified accounting statement that shows a bank’s assets and liabilities.
Assets: Represents the value of things the bank owns.
Liabilities: The bank’s debts, i.e., what it owes.
Double-entry bookkeeping: Assets and liabilities must always be equal.
The Fed and the Money Supply
The money supply process involves:
The Fed changes the monetary base.
The banking system decides what fraction of deposits to hold as reserves.
Individuals decide how much of their money to hold as currency vs. deposits.
Scenarios Exploring the Money Supply
1. No Banking System
The public holds the $100 as currency:
C = 100, D = 0, R = 0.
Monetary base (B) = C + R = 100 + 0 = 100.
Money supply (M) = C + D = 100 + 0 = 100.
Conclusion: If there is no banking system, M = B.
2. 100% Reserve Banking
The public deposits the $100 at First Bank.
First Bank holds 100% reserves against deposits:
C = 0, R = 100.
Monetary base (B) = C + R = 0 + 100 = 100.
Money supply (M) = C + D = 0 + 100 = 100.
Conclusion: If banks don’t make any loans, M = B.
3. Fractional Reserve Banking
In fractional reserve banking, banks hold a fraction of deposits as reserves and lend out the rest.
Total reserves (R):
Required reserves + Excess reserves.
The Reserve Ratio (RR):
RR = rac{R}{D}
Includes required reserves ratio (RRR, set by the Fed) and excess reserve ratio (ERR, set by banks).
Assume RD = 10% for All Banks
The public deposits the $100 at First Bank:
Outcomes:
M = 190
Depositors have $100 in deposits (D).
Borrowers have $90 in currency (C).
First Bank Assets Breakdown:
Reserves: $10
Loans: $90
Money Creation through Fractional Reserve Banking
The borrowers spend the $90, and the payees deposit it in Second Bank.
This increases the money supply (M) by further $81
Second Bank Assets Breakdown:
Reserves: $9
Deposits: $90
Loans: $81
Continued process:
The same applies to the Third Bank, further increasing M by $72.90.
Simple M1 Money Multiplier (m)
Definition:
The amount of money (M) the banking system generates with each dollar of reserves (R).
Formula:
M = ext{(1 - RR)^n} imes B
This process continues recursively as illustrated across banks, generating a multiplier effect on the money supply.
Using the Money Multiplier
The money multiplier (m) can be used to find the money supply (M) or the change in the money supply (ΔM).
Example Calculation for $100 Base:
M = m imes B = 100 imes 10 = 1,000
Change in Monetary Base:
If ΔB = 5, ΔM = m imes ΔB = 5 imes 10 = 50
Fed Tools of Monetary Control
The Fed has 4 tools to influence the money supply:
Open market operations
The discount rate
Reserve requirements
Interest rate paid on bank reserves deposited with the Fed
Tools 1 & 2 work by altering the monetary base (B), while tools 3 & 4 change the money multiplier (m).
Open Market Operations
Definition:
Purchases or sales of government bonds by the Fed.
Effects:
Open market purchase increases B, while open market sale decreases it.
Discount Loans
Definition:
A discount loan is money loaned from the Fed to a bank.
The Discount Rate
Definition:
The discount rate is the interest rate the Fed charges on its loans to banks.
Effects on Money Supply:
To increase the money supply, the Fed lowers the discount rate, encouraging banks to borrow more.
To decrease the money supply, the Fed raises the discount rate, discouraging bank borrowing.
Reserve Requirements
Definition:
Required reserve ratio (RRR), which affects how much money banks can create through lending.
Effects on Money Supply:
To increase the money supply, the Fed lowers RRR, allowing banks to make more loans.
To decrease the money supply, the Fed raises RRR, resulting in fewer loans.
Interest Rate on Reserves
Definition:
The Fed pays interest on the reserves banks hold on deposit with the Fed.
Effects on Money Supply:
To increase the money supply (M), the Fed lowers the interest rate on reserves (iR), so banks hold fewer excess reserves.
To decrease the money supply (M), the Fed raises iR, leading banks to hold more excess reserves.
Limitations of Fed Control Over the Money Supply
If households decide to hold more money as currency and less as bank deposits, banks can make fewer loans, leading to a decrease in the money supply.
If banks hold more excess reserves than previously, they make fewer loans and the money supply declines.
If banks decide to borrow less from the Fed, they make fewer loans, which also results in a fall in the money supply.
Bank Runs
Definition:
A run on the bank occurs when people suspect their bank is in trouble and rush to withdraw their funds.
Banking Panic:
A situation where fearful depositors attempt to withdraw funds from many banks simultaneously.
Under fractional-reserve banking, banks do not have enough reserves to pay off all their depositors, which may lead to bank closures if they run out of reserves.
Bank Runs & the Money Supply
Banking panics can produce sudden declines in the money supply.
Bank closures result in deposit losses, impacting the money multiplier.
People move to hold more currency rather than deposits fearing runs, which leads banks to maintain higher excess reserves.
Historical Example: During 1929-1933, a wave of bank runs and bank closings caused the money supply to fall by 28%.
Since then, federal deposit insurance has helped to prevent bank runs in the United States.