Banking and the Money Supply CHAPTER 29 2003

Banking and the Money Supply CHAPTER 29 © 2003 South-Western/Thomson Learning 1

Definitions of the Money Supply M 1 Money supply narrowly defined Currency, including coins, held by nonbanking public Checkable deposits • Deposits against which checks can be written • Demand deposits do not earn any interest • Other types of accounts, NOW, that carry check writing privileges but earn interest • Are liabilities of issuing banks which stand ready to convert them into currency • Are not legal tender Travelers checks 2

Circulating Currency Primary currency circulating in the U. S. consists of Federal Reserve notes Issued by and are liabilities of the Federal Reserve Banks Redeemable for nothing other than Federal Reserve notes fiat money U. S. coins are token money because their metal value is less than their face value 3

M 2 Money Supply Includes M 1, plus Savings deposits • earn interest but have no specific maturity date savings deposits Small-denomination time deposits • also called certificates of deposit, or CDs, earn a fixed rate of interest if held for the specified period with premature withdrawals penalized by loss of interest Money market mutual funds • carry additional restrictions 4

Other Money Supply Definitions M 3 includes M 2 plus large-denomination time deposits Less liquid than other two definitions 5

Financial Intermediaries Banks serve as financial intermediaries, or as go-betweens by bringing together the two sides of the money market Banks reduce the transaction costs of channeling savings to credit worthy borrowers Coping with Asymmetric Information Reducing risk through diversification 6

Asymmetric Information As lenders, banks try to identify borrowers who are willing to pay interest and are able to repay the loans However, borrowers have more reliable information about their own credit history and financial plans than do lenders in the market for loans there is asymmetric information an inequality in what’s known by each party to the transaction 7

Asymmetric Information This asymmetry would not create a problem if borrowers could be trusted to report relevant details to lenders Because they have experience in evaluating applicants, banks have a greater ability to cope with asymmetric information and in drawing up and enforcing contracts than would an individual savers are better off dealing with banks 8

Reducing Risk By developing a diversified portfolio of assets rather than lending funds to a single borrower, banks reduce the risk to each individual saver A bank, in effect, lends a tiny fraction of each saver’s deposits to each of its many borrowers 9

Starting a Bank To obtain a charter, or the right to operate, they must apply to the state banking authority (state bank) or to the U. S. Comptroller of the Currency (national bank) The founders invest $500, 000 for shares which become the owner’s equity or the net worth of the bank Part of this goes to the FED to buy shares in their district bank $450, 000 left 10

Reserve Accounts Recall that banks are required by the FED to set aside, or to hold in reserve a percentage of their checkable deposits The dollar amount that must be held in reserve is called required reserves Checkable deposits multiplied by the required reserve ratio The required reserve ratio dictates the minimum proportion of deposits the bank must hold in reserve 11

Reserve Accounts The current reserve requirement is 10% on checkable deposits These required reserves are held either as cash in the bank’s vault or as deposits at the FED, but neither earns the bank any interest In our example, Home Bank must therefore hold $100, 000 as reserves ($1, 000 *. 10) 12

Reserve Accounts If Home Bank deposits their required reserves with the FED, they now have $900, 000 in excess reserves held as cash in the vault Excess reserves have two additional uses They can be used to make loans, or To purchase interest-bearing assets, such as government bonds 13

Liquidity versus Profitability Required reserves are not meant to be used to meet depositor requests for funds therefore banks often hold some excess reserves or other assets that can be easily converted to cash to satisfy any unexpected demand for funds Banks management must structure the portfolio of assets with an eye towards Liquidity Profitability 14

Liquidity is the ease with which an asset can be converted into cash without a significant loss of value The most liquid asset is bank reserves, either in the bank’s vault as cash or on account with the FED, but reserves earn no interest Complete liquidity would mean holding all its assets as cash reserves no difficulty meeting depositors’ demands for funds 15

Liquidity versus Profitability However, since it holds no interestearning assets, it earns no income no profits At the other extreme, if the bank uses all its excess reserves to acquire highyielding but illiquid assets, it will run into problems whenever withdrawals exceed new deposits Tradeoff between liquidity and profitability 16

Reserves Since reserves earn no interest, banks usually try to keep excess reserves to a minimum The federal funds market provides for day-to-day lending and borrowing among banks of excess reserves on account at the FED The interest rate paid on these loans is called the federal funds rate, and it is this rate that the FED targets as a tool of monetary policy 17

Creation of Money Excess reserves are the raw material the banking system employs to support the creation of money We will concentrate on commercial banks because they are the largest and most important depository institutions, although thrifts carry out similar functions 18

Check Clearing When you spend the $900, your college promptly deposits the check into its checking account at Merchant’s Trust This increases the college account by $900 and sends your check to the Fed which transfers $900 in reserves from Home Bank’s account to Merchants Trust’s account and then sends the check to Home Bank, which reduces your checkable deposits by $900 The Fed has thereby cleared your check by setting the claim of Merchants Trust 19

Round Three and Beyond Notice the pattern of deposits and loans Each time a bank gets a fresh deposit, 10% goes to required reserves The rest becomes excess reserves, which fuel new loans or other asset acquisitions An individual bank can lend no more than its excess reserves When the borrower spends the amount loaned, reserves at one bank usually fall, but total reserves in the banking system do not 20

Round Three and Beyond The recipient bank uses most of the new deposit to extend more loans more checkable deposits The potential expansion of checkable deposits in the banking system equals some multiple of the initial increase in reserves The example just discussed makes certain assumptions to be noted later 21

Reserve Requirements and Money Expansion The multiple by which the money supply increases as a result of an increase in the banking system’s reserves is called the money multiplier The simple money multiplier equals the reciprocal of the required reserve ratio, or 1 / r, where r is the reserve ratio In our example the reserve ratio was 10% or 0. 1 the simple money multiplier equals 10 22

Checkable Deposits / Money Supply The formula for the multiple expansion of checkable deposits can be written as Change in checkable deposits (or the money supply) = Change in reserves x 1/r Thus, for our example, the initial deposit of $1, 000 increase in fresh reserves by the Fed could support up to $10, 000 in new checkable deposits or the money supply 23

Money Multiplier The higher the reserve requirement, the greater the fraction of deposits that must be held as reserves the smaller the money multiplier Reserve requirement of 20% money multiplier of 5 Reserve requirement of 5% money multiplier of 20 24

Limitations on Money Expansion Various leakages from the multiple expansion process reduce the size of the money multiplier. That is, we assumed that Banks do not let excess reserves sit idle reasonable since the profit incentive will generally lead banks to minimize the amount of excess reserves idle Borrowers do something with the money seems likely, since people would not borrow unless they had a use for funds People do not choose to increase their cash holdings - in fact, some amount of this may be held as cash, which reduces the money multiplier 25

Contraction of the Money Supply In our example, we focused on the process whereby money was created The process would work in reverse if the Fed reduced bank reserves, thereby reducing the money supply The Fed’s sale of government bonds reduces bank reserves, forcing banks to recall loans or to somehow replenish reserves and the same multiple contraction would work 26

Contraction of the Money Supply For example, with a reserve requirement of 10%, a $1, 000 sale of bonds would reduce the checkable deposits and the money supply by a maximum of $10, 000 The process of reducing checkable deposits or the money supply would be the same as illustrated in the expansion illustration 27

Tools for Controlling Reserves The Fed has three tools for controlling reserves hence checkable deposits money supply Conducting open market operations buying and selling of U. S. government bonds Setting the discount rate, the interest rate the Fed charges for loans it makes to banks Setting the required reserve ratio, which is the minimum fraction of reserves that banks must hold against deposits 28

Open Market Operations Open market operations refers to the buying and selling of U. S. government bonds in the open market To increase the money supply, the Fed buys U. S. bonds open-market purchase To reduce the money supply, the Fed sells U. S. bonds open-market sale Advantage of open-market operations Relatively easy to carry out Require no change in laws or regulations Can be executed in any amount For these reasons, this is the tool of choice by the Fed 29

Federal Funds Market Through open-market operations, the Fed influences bank reserves and the federal funds rate Recall that the federal funds rate is the interest rate banks charge one another for borrowing excess reserves at the Fed, typically overnight Banks that are unable to meet their legal reserve requirements can borrow in the federal funds market 30

Federal Funds Market The federal funds rate serves as a good indicator of the tightness of monetary policy For example, suppose the Fed buys bonds in the open market and thereby increases reserves in the banking system banks have more excess reserves demand for excess reserves falls while the supply increases the federal funds rate declines 31

Discount Rate Discount rate is the interest rate the Fed charges on loans it makes to banks Banks can borrow from the Fed when they need reserves to satisfy their reserve requirements By lowering or raising the discount rate, the Fed encourages or discourages banks from borrowing, which alters reserves and affects the money supply 32

Discount Rate A lower discount rate reduces the cost of borrowing, encouraging banks to borrow reserves from the Fed more bank lending increase in the money supply Higher discount rate increases the cost of borrowing reserves from the Fed less bank lending reduced money supply 33

Discount Rate Since there is no guarantee that banks will necessarily borrow more even if the discount rate is reduced That is, if business prospects look poor and if banks view lending as risky, then even a lower discount rate may not entice banks to borrow from the Fed As a result, the Fed uses the discount rate more as a signal to financial markets about its monetary policy than as a tool for changing the money supply 34

Reserve Requirements Reserve requirements are the regulations regarding the minimum amount of reserves that banks must hold to back up deposits they influence how much money the banking system can create with each dollar of fresh reserves If the Fed increases the reserve requirement, banks must hold more reserves a reduction in the fraction of each dollar that can be lent out reduces the banking system’s ability to create money 35

Reserve Requirements Conversely, a decrease in the reserve requirement increases the fraction of each dollar on deposit that can be lent out which increases the banking system’s ability to create money Reserve requirements can be changed by a simple majority vote by the Board of Governors However, since even a small change in the reserve requirement can be disruptive, the Fed seldom employs this tool 36