Quiz 2 Notes - Chapter 4

February 4, 2025

Money

• Money Definition: is the stock of assets that can be readily used to make transactions.

• Money Functions

  • Medium of exchange

    • We use it to buy stuff

  • Store of value

    • Transfers purchasing power from the present to the future

  • Unit of account

    • The common unit by which everyone measures prices and value

• Money Types

  • Fiat money

    • Has no intrinsic value

      • Example: The paper money we use.

    • Why do we use fiat money?

      • M V = P * Y

        • Money times velocity = price times output

        • Velocity is just a number that makes the equation work.

        • (M * V) / Y = P

          • Explains what’s happening to prices.

  • Commodity money

    • Has intrinsic value

      • Examples: Gold/Silver coins, cigarettes in POW camps.

Money Supply

• The money supply is the quantity of money available in the economy.

• Monetary policy is control over the money supply.

The central bank and monetary control

• Monetary policy is conducted by a country’s central bank.

• The U.S. central bank is called the Federal Reserve. (“The Fed”).

• To control the open money supply, the Fed uses open-market operations, the purchase and sale of government bonds.

  • The Federal Reserve also uses these to control the money supply:

    • The discount rate: the interest rate when commercial banks borrow from the Federal Reserve.

    • The reserve requirement??? (Currently 0%)

      • The reserve requirement used to be a percentage of deposits (used to be 5%) that a bank had to keep in vault or on deposit with the Federal Reserve.

        • The reason behind the reserve requirement is because of fractional-reserve requirement.

  • Open-Market Operations: the Federal Reserve basically uses these everyday when they need more money.

    • If the Federal Reserve sees that interest rates are rising, this is an indication that there is not enough money in the system (they need to increase the supply). [Shift the money supply curve to the right].

      • The Federal Reserve would contact banks to buy any government bonds they have in exchange for money. The banks would say yes depending on the offer (hypothetically increase the banks deposits with the Federal Reserve at 4% or buy the bonds at a target interest rate premium).

Banks + their role in the monetary system

• The money supply equals the currency plus demand (checking account) deposits.

  • M = C + D

  • Currency currently is several thousands per person. (Per capita)

    • A lot of US currency is held outside of the United States, usually in countries where their currency is not as stable.

• Since the money supply includes demand deposits, the banking system plays an important role.

• Reserves (R): The portion of deposits that banks have not lent.

• A bank’s liabilities include deposits: assets include reserves and outstanding loans.

  • Deposits are liabilities because they must be paid on demand. The bank can’t say “we can pay you back at the end of the month after this dude pays his bill”.

• 100-percent-reserve banking: a system in which banks hold all deposits as reserves.

  • Every dollar you deposit is put into the vault, these banks don’t make any loans.

• Fractional reserve banking: a system in which banks hold a fraction of their deposits as reserves.

Scenario 1: No Banks

With no banks,

D = 0 and M = C = $1,000

Scenario 2: 100 percent-reserve banking

• Initially C = $1,000, D = $0, M = $1,000

• Now suppose households deposit $1,000 at “Firstbank”

  • Firstbank deposits and reserves currently = $1,000

Scenario 3: Fractional Reserve banking

• Suppose banks hold 20% of deposits in reserve, making loans with the rest.

• Firstbank will make $800 in loans.

  • Person who is loaned the money will deposit it into another bank and so on and so on.

  • This will continue to increase the money supply over and over again even though currency doesn’t increase, the deposits will increase.

• Bank capital: the resources a bank’s owners have put into a bank; difference between the value of a bank’s assets and liabilities.

• Leverage: the use of borrowed money to supplement existing funds for purposes of investment.

  • Leverage ration = Assets / Capital

• Being highly leveraged makes banks vulnerable.

• Capital requirement:

  • Minimum amount of capital mandated by regulators.

February 6, 2025

Bank capital, leverage, and capital requirements

• Bank capital: The resources a bank’s owners have put into the bank; difference between the value of a bank’s assets and liabilities.

• Leverage: the use of borrowed money to supplement existing funds for purposes of investment.

  • Leverage ratio: assets/capital

  • Being highly leveraged makes banks vulnerable.

    • Example: suppose a recession causes our bank’s loans and securities to fall 5%. Then, capital = assets - Liabilities.

• Capital requirement:

  • Minimum amount of capital mandated by regulators.

  • Intended to ensure that banks will be able to pay off depositors.

  • Higher for banks that hold more risky assets.

  • 2008 - 2009 financial crisis

    • Losses on mortgages shrank bank capital, slowed lending, and exacerbated the recession.

    • Regulatory changes imposed higher capital requirements with the goal of reducing the likelihood of future crisis.

    • Most of this financial crisis was brought on to bad lending. Banks were lending to people with no income, job, or assets.

      • Banks were giving mortgages for 100% of the homes value instead of requiring a down payment and things like that because “the home would increase in value”.

A model of the money supply

• Monetary base, B = C + R

  • Controlled by the central bank (The federal reserve).

• Reserve-Deposit ratio, rr = R/D

  • Depends on regulations and bank policies.

• Currency-Deposit ratio, cr = C/D

  • Depends on. households’ preferences

  • If someone prefers to keep more cash on them, they like to have more currency over deposits.

• Money multiplier, m

Solving for the money supply

• M = C + D = (C + D)/B B = m * B

  • M = (C+D)/B = (C+D)/(C+R) = ((C/D)+(D/D))/((C/D)+(R/D)) = (cr+1)/(cr+rr)

  • M = m * b where m = (cr+1)/(cr+rr)

• If rr < 1, then m > 1

  • The higher the reserve rate, the lower the money multiplier.

  • If the reserve rate was somehow 100%, the money supply would be lower because the banks can’t make anymore money.

  • The lower the reserve rate, the higher the money multiplier will go because the banks can produce more money.

• If monetary base changes by ∆B, then ∆M = m * ∆B

• m is the money multiplier, the increase in the money supply, resulting from a one-dollar increase in the monetary base.

The instruments in monetary policy

• The Fed can change the monetary base by using:

  • Open market operations (the Fed’s preferred method of monetary control)

    • To increase the base, the Fed could buy government bonds, paying with new dollars.

  • The discount rate: the interest rate the Fed charges on loans to banks.

    • To increase the base, the Fed could lower the discount rate, encouraging banks to borrow more reserves.

• The Fed can change the reserve-deposit ratio by using:

  • Reserve requirement: Fed regulations impose a minimum reserve-deposit ratio.

    • To reduce the reserve-deposit ratio, the Fed could reduce reserve requirement.

      • Current reserve requirements is 0%.

  • Interest on reserves: The Fed pays interest on bank reserves deposited with the Fed.

    • To reduce the reserve-deposit ratio, the Fed could pay a lower interest rate on reserves.

Why the Fed can’t precisely control M

• Households can change cr, causing m and M to change.

• Banks often hold excess reserves (reserves above the reserve requirement).

  • If banks change their excess reserves, then rr, m, and M change.

  • Excess reserves may not be voluntary, the Fed may make them hold above the requirement because of their loan portfolio.

Case Study: Quantitative easing

• Quantitative easing: The Fed bought long-term federal government bonds instead of T-bills (short-term debt) to reduce long-term rates.

• The Fed also bought mortgage-backed securities to help the housing market.

• In 2020, the Fed started buying state and local government debit and corporate debt.

  • The treasury saved Ford Motor Company from going under by getting the banks to lend more money to Ford but the treasury backed it.

    • If Ford still ends up going under, its up to the US government (basically the tax payers) to pay off their debt to the banks.

• But after losses on bad loans, banks tightened lending standards and increased excess reserves, causing the money multiplier to fall.

Case study: Bank failures in the 1930s

• From 1929 to 1933:

  • More than 9,000 banks closed.

  • The money supply fell 28%

    • This drop in the money supply may not have cause the Great Depression, but it certainly contributed to its severity.

• Loss of confidence in banks: increases cr, reduces m

• Banks became more cautious: increases rr, reduces m

Could this happen again?

• Many policies have been implemented since the 1930s to prevent such widespread of bank failures. An example is Federal Deposit Insurance (FDIC) to prevent bank runs and large swings in the currency-deposit ratio.