Chapter 4Slide 2Money: DefinitionMoney: FunctionsMoney: TypesThe money supply and monetary policy definitionsThe central bank and monetary controlMoney supply measures, April 2012Banks’ role in the monetary systemA few preliminariesBanks’ role in the monetary systemSCENARIO 1: No banksSCENARIO 2: 100-percent-reserve bankingSCENARIO 3: Fractional-reserve bankingSCENARIO 3: Fractional-reserve bankingSCENARIO 3: Fractional-reserve bankingFinding the total amount of money:Money creation in the banking systemBank capital, leverage, and capital requirementsBank capital, leverage, and capital requirementsBank capital, leverage, and capital requirementsBank capital, leverage, and capital requirementsA model of the money supplySolving for the money supply:The money multiplierNOW YOU TRY The money multiplierSOLUTION The money multiplierThe instruments of monetary policyThe instruments of monetary policyWhy the Fed can’t precisely control MCASE STUDY: Quantitative EasingCASE STUDY: Quantitative EasingCASE STUDY: Bank failures in the 1930sCASE STUDY: Bank failures in the 1930sCASE STUDY: Bank failures in the 1930sCould this happen again?CHAPTER SUMMARYCHAPTER SUMMARYCHAPTER SUMMARY1Chapter 4The Monetary System:What It Is and How It Works2the definition, functions, and types of moneyhow banks “create” moneywhat a central bank is and how it controls the money supply23Money: DefinitionMoney is the stock of assets that can be readily used to make transactions.Money is the stock of assets that can be readily used to make transactions.4Money: Functionsmedium of exchangewe use it to buy stuffstore of valuetransfers purchasing power from the present to the futureunit of accountthe common unit by which everyone measures prices and values5Money: Types1. Fiat moneyhas no intrinsic valueexample: the paper currency we use2. Commodity moneyhas intrinsic valueexamples: gold coins, cigarettes in P.O.W. camps6The 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.7The 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.8Money supply measures, April 20129,842M1 + small time deposits, savings deposits, money market mutual funds, money market deposit accountsM22,248C + demand deposits, travelers’ checks, other checkable depositsM11,035CurrencyCamount ($ billions)assets includedsymbol9Banks’ 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.10A 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.11Banks’ role in the monetary systemTo understand the role of banks, we will consider three scenarios:1. No banks2. 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 = $1,000.12SCENARIO 1: No banksWith no banks, D = 0 and M = C = $1,000.13SCENARIO 2: 100-percent-reserve bankingAfter the deposit: C = $0, D = $1,000, M = $1,000 LESSON:100%-reserve banking has no impact on size of money supply. FIRSTBANK’S balance sheetAssets Liabilitiesreserves $1,000 deposits $1,000Initially C = $1000, D = $0, M = $1,000. Now suppose households deposit the $1,000 at “Firstbank.”14FIRSTBANK’S balance sheetAssets Liabilitiesreserves $1,000reserves $200loans $800SCENARIO 3: Fractional-reserve bankingThe money supply now equals $1,800:Depositor has $1,000 in demand deposits.Borrower holds $800 in currency.deposits $1,000Suppose banks hold 20% of deposits in reserve, making loans with the rest.Firstbank will make $800 in loans. LESSON: in a fractional-reserve banking system, banks create money.LESSON: in a fractional-reserve banking system, banks create money.15SECONDBANK’S balance sheetAssets Liabilitiesreserves $800loans $0reserves $160loans $640SCENARIO 3: Fractional-reserve bankingSecondbank will loan 80% of this deposit.deposits $800Suppose the borrower deposits the $800 in Secondbank. Initially, Secondbank’s balance sheet is:16SCENARIO 3: Fractional-reserve bankingTHIRDBANK’S balance sheetAssets Liabilitiesdeposits $640If this $640 is eventually deposited in Thirdbank,then Thirdbank will keep 20% of it in reserve and loan the rest out: reserves $640loans $0reserves $128loans $51217Finding 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 depositsIn our example, rr = 0.2, so M = $5,00018Money creation in the banking systemA 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.19Bank capital, leverage, and capital requirementsBank capital: the resources a bank’s owners have put into the bankA more realistic balance sheet:AssetsLiabilities and Owners’ EquityReserves $200 Deposits $750Loans 500 Debt 200Securities 300Capital (owners’ equity)5020Bank 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 = 20AssetsLiabilities and Owners’ EquityReserves $200 Deposits $750Loans 500 Debt 200Securities 300Capital (owners’ equity)5021Bank 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