Chapter 4 The Monetary System What It Is and How It Works 1 the definition functions and types of money how banks create money what a central bank is and how it controls the money supply 2 Money Definition Money is the stock of assets that can be readily used to make transactions 3 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 values 4 Money Types 1 Fiat money has no intrinsic value example the paper currency we use 2 Commodity money has intrinsic value examples gold coins cigarettes in P O W camps 5 The money supply and monetary policy definitions The money supply is the quantity of money available in the economy Monetary policy is the control over the money supply 6 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 money supply the Fed uses open market operations the purchase and sale of government bonds 7 Money supply measures April 2012 symbol assets included C amount billions Currency 1 035 M1 C demand deposits travelers checks other checkable deposits 2 248 M2 M1 small time deposits savings deposits money market mutual funds money market deposit accounts 9 842 8 Banks role in the monetary system The money supply equals currency plus demand checking account deposits M C D Since the money supply includes demand deposits the banking system plays an important role 9 A few preliminaries Reserves R the portion of deposits that banks have not lent A bank s liabilities include deposits assets include reserves and outstanding loans 100 percent reserve banking a system in which banks hold all deposits as reserves Fractional reserve banking a system in which banks hold a fraction of their deposits as reserves 10 Banks role in the monetary system To understand the role of banks we will consider three scenarios 1 No banks 2 100 percent reserve banking banks hold all deposits as reserves 3 Fractional reserve banking banks hold a fraction of deposits as reserves use the rest to make loans In each scenario we assume C 1 000 11 SCENARIO 1 No banks With no banks D 0 and M C 1 000 12 SCENARIO 2 100 percent reserve banking Initially C 1000 D 0 M 1 000 Now suppose households deposit the 1 000 at Firstbank FIRSTBANK S balance sheet Assets Liabilities reserves 1 000 deposits 1 000 After the deposit C 0 D 1 000 M 1 000 LESSON 100 reserve banking has no impact on size of money supply 13 SCENARIO 3 Fractional reserve banking Suppose banks hold 20 of deposits in reserve LESSON in a fractional reserve making loans with the rest banking system banks create money Firstbank will make 800 in loans FIRSTBANK S balance sheet Assets Liabilities reserves 1 000 200 deposits 1 000 loans 800 The money supply now equals 1 800 Depositor has 1 000 in demand deposits Borrower holds 800 in currency 14 SCENARIO 3 Fractional reserve banking Suppose the borrower deposits the 800 in Secondbank Initially Secondbank s balance sheet is SECONDBANK S balance sheet Assets Liabilities reserves 160 800 deposits 800 loans 0 640 Secondbank will loan 80 of this deposit 15 SCENARIO 3 Fractional reserve banking If this 640 is eventually deposited in Thirdbank then Thirdbank will keep 20 of it in reserve and loan the rest out THIRDBANK S balance sheet Assets Liabilities reserves 128 640 deposits 640 loans 0 512 16 Finding the total amount of money Original deposit 1000 Firstbank lending 800 Secondbank lending 640 Thirdbank lending 512 other lending Total money supply 1 rr 1 000 where rr ratio of reserves to deposits In our example rr 0 2 so M 5 000 17 Money creation in the banking system A fractional reserve banking system creates money but it doesn t create wealth Bank loans give borrowers some new money and an equal amount of new debt 18 Bank capital leverage and capital requirements Bank capital the resources a bank s owners have put into the bank A more realistic balance sheet Liabilities and Owners Equity Assets Reserves 200 Deposits Loans 500 Debt Securities 300 Capital owners equity 750 200 50 19 Bank capital leverage and capital requirements Leverage the use of borrowed money to supplement existing funds for purposes of investment Leverage ratio assets capital 200 500 300 50 20 Liabilities and Owners Equity Assets Reserves 200 Deposits Loans 500 Debt Securities 300 Capital owners equity 750 200 50 20 Bank capital leverage and capital requirements Being highly leveraged makes banks vulnerable Example Suppose a recession causes our bank s assets to fall by 5 to 950 Then capital assets liabilities 950 950 0 Liabilities and Owners Equity Assets Reserves 200 Deposits Loans 500 Debt Securities 300 Capital owners equity 750 200 50 21 Bank capital leverage and capital requirements Capital requirement minimum amount of capital mandated by regulators intended to ensure 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 exacerbated the recession Govt injected billions of capital into banks to ease the crisis and encourage more lending 22 A model of the money supply exogenous variables Monetary base B C R controlled by the central bank Reserve deposit ratio rr R D depends on regulations bank policies Currency deposit ratio cr C D depends on households preferences 23 Solving for the money supply C D M C D B B m B where C D m B C D D D cr 1 C D C R C D R D cr rr 24 The money multiplier M m B c r 1 where m c r r r If rr 1 then m 1 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 25 NOW YOU TRY The money multiplier M m B c r 1 where m c r r r Suppose households decide to hold more of their money as currency and less in the form of demand deposits 1 Determine impact on money supply 2 Explain the intuition for your result CHAPTER 1 The Science of Macroeconomics 26 SOLUTION The money multiplier Impact of an increase in the currency deposit ratio cr 0 1 An increase in cr increases the denominator of m proportionally more than the numerator So m falls causing M to fall 2 If households deposit less of their money then banks can t make as many loans so the banking system won t be able to create as much money CHAPTER 1 The Science of Macroeconomics 27 The