BankingBankingMoney and Banking 2Elias YannopoulosOctober 26, 2012Elias Yannopoulos Money and Banking 2BankingCommercial BanksHeads Up! Commercial banks and investment banks aredifferent things. In this class we will not talk about investmentbanks, so when I say bank I mean commercial bankBanks have two major functions in the economyThey are the middlemen in the market for loans - they acceptdeposits and extend loansThis function reduces to transaction costs of matching theborrowers and lenders also reduce information asymmetrybetween the partiesBanks are a channel for monetary policy - the Fed uses banksto affect the money supply instead of dropping money fromhelicoptorsElias Yannopoulos Money and Banking 2BankingCommercial Banks Cont.The following is a basic balance sheet for a bankTable : Bank Balance SheetAssets LiabilitiesReserves DepositsVault Cash CheckableDeposits at Fed SavingsSecurities TimeTreasury securities BorrowingOther securities PrivateLoans Discount loans from FedOwner’s equity (Net worth)Elias Yannopoulos Money and Banking 2BankingCommercial Banks Cont. Cont.Most of the functionality of the bank is in the Loans anddeposits sections of the balance sheetBanks get money from customer deposits, they are borrowingmoney from people who deposit in their bankDeposits are assets to us, but they are a liability to the bankBanks pay interest on deposits and charge interest on loans,they make money by charging more than they payThey hold other securities to diversify their risk (Ex: so theydon’t get destroyed by a housing market crash)What the banks don’t lend out is kept in the reservesElias Yannopoulos Money and Banking 2BankingReservesBank Reserves (R) - bank assets kept in the form of cash ordeposits at the central bank (Fed)Why do banks hold reserves? If they are keeping cash theyaren’t making money off of loans.What happens if people want their money from their deposits?Then if the bank has no cash it has to go to the people itloaned to and get the money back Ex: It’s a Wonderful LifeThe government to avoid these issues requires banks to holdreservesRequired Reserves (RR) - the dollar amount of reserves abank is required by the Federal Reserve to holdHow do we figure out the amount that each bank shouldhold? It will depend on the size of the bank’s balance sheetRequired Reserves Ratio (rr) - The portion of total depositsthat banks are required to holdElias Yannopoulos Money and Banking 2BankingReserves Cont.If a bank holds more than the required reserves, because itthinks people might want their money or wants to be sure ithas enough cash the it hold Excess ReservesExcess Reserves (ER) - Reserves held in excess of thoserequired by the FedThe amount of Excess Reserves is very low compared to theRequired Reserves, this will be important for monetary policySome Reserves math:RR = RR × DepositsER = R − RRElias Yannopoulos Money and Banking 2BankingMoney CreationBanks create money, how?Imagine you find $1,000 (yes your rich!) and you deposit it atthe bankFor simplification in this example assume that there are noexcess reserves and rr=.1Also, assume that no one keeps money they just deposit it inbanksHow much can the bank lend of your $1,000?$900How much money is there in the economy now?You have $1,000 in the bank and whoever the bank lent tohas $900 in the bank, together there is $1,900! But there wasonly $1,000 cash!Elias Yannopoulos Money and Banking 2BankingMoney Creation Cont.But wait! that $900 doesn’t just sit in a bank, the bank lendsout what it can .9 × $900 = $810This will continue until we finally reach $10,000 worth ofdepositsWhere did $10,000 come from? Remember the multipliermodel!In the same fashion as the Multiplier Model, there is a moneymultiplierIn this situation (no excess reserves and everyone deposits allmoney) the simple money multiplier is usedSimple Money Multiplier -1rrIn our example,1rr=1.1= 10, $1, 000 × 10 = $10, 000Elias Yannopoulos Money and Banking
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