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					Chapter 13
   http://www.youtube.com/watch?v=iYZM58dulPE

 Money
 Money  Supply: M1 and M2
 Banking System: Balance Sheet
 Federal Reserve System: Structure and
 The Fed and the money supply: Demand
  Deposit Multiplier
Money  Assets that people are
 generally willing to accept in
 exchange for goods and services or
 for payment of debts.

Asset Anything of value owned by a
 person or a firm.
   Medium of exchange
   Unit of account
   Store of value
   Standard of deferred payment

   Question: Should credit cards, stocks and bonds be
    considered money?

 Priorto 1970, each colony had its own
  currency, named ―pound‖
 In 1970, soon after the constitution went into
  effect, congress created a new unit of value
  called the dollar.
 The primary means of payment in the United
  States was paper currency issued by private
 During the Civil war, however, the
  government issued the first federal paper
  currency, Greenback
 Commodity  money
 Precious metals and other valuable
 Requires DCOW (Double Coincidence of
 Paper money (Fiat Money)
Money   Supply
  Total amount of money held by the

  Anasset is considered liquid if it
  can be converted to cash quickly
  and at little cost

   Most liquid asset is cash in the hands of the public
   Next in line are asset categories of about equal liquidity
       Demand deposits
           Checking accounts held by households and business firms at commercial
       Other checkable deposits
           Catchall category for several types of checking accounts that work very
            much like demand deposits
       Travelers checks
           Specially printed checks that you can buy from banks or other private
            companies, like American Express
       Savings-type accounts
           At banks and other financial institutions
           Are less liquid than checking-type accounts, since they do not allow you
            to write checks
   Next on the list are deposits in retail money market mutual
       Time deposits (sometimes called certificates of deposit, or CDs)
           Require you to keep your money in the bank for a specified period of
            time (usually six months or longer)
               Impose an interest penalty if you withdraw early

                    Demand            Savings
                    Deposits           Type
                 ($314 billion)      Accounts
                     Other        ($3,093 billion)
                   Checkable                            Money                          Large
                    Deposits                            Market          Small          Time
 Cash in the                                                            Time
Hands of the
                 ($298 billion)                         Mutual                       Deposits
                                                        Funds         Deposits     ($903 billion)
   Public          Travelers
($646 billion)       Checks                          ($880 billion) ($846 billion)
                  ($8 billion)

More Liquid                                                                         Less Liquid
   Standard measure of money stock is M1
       Sum of the first four assets in our list
           M1 = cash in the hands of the public + demand deposits +
            other checking account deposits + travelers checks
       When economists or government officials speak about
        ―money supply,‖ they usually mean M1
   Another common measure of money supply, M2,
    adds some other types of assets to M1
       M2 = M1 + savings-type accounts + retail MMMF balances
        + small denomination time deposits
   Other official measures of money supply besides
    M1 and M2 that add in assets that are less liquid
    than those in M2
       M1 and M2 have been most popular, and most commonly
        watched, definitions

 Important to understand that M1 and M2 money
  stock measures exclude many things that people
  use regularly as a means of payment
 Technological advances—now and in the future—
  will continue trend toward new and more varied
  ways to make payments
 We will assume money supply consists of just two
       Cash in the hands of the public and demand deposits
   Our definition of the money supply corresponds
    closely to liquid assets that our national
    monetary authority—the Federal Reserve—can

   What are banks?
       Financial intermediaries—business firms that specialize
           Assembling loanable funds from households and firms whose
            revenues exceed their expenditures
           Channeling those funds to households and firms (and
            sometimes the government) whose expenditures exceed
   An intermediary helps to solve problems by
    combining a large number of small savers’ funds
    into custom-designed packages
       Then lending them to larger borrowers
   Intermediaries must earn a profit for providing
    brokering services
       By charging a higher interest rate on funds they lend
        than rate they pay to depositors

   United States boasts a wide variety of financial
    intermediaries, including
       Commercial banks
       Savings and loan associations
       Mutual savings banks
       Credit unions
       Insurance companies
       Some government agencies
   There are four types of depository institutions
       Savings and Loan associations
       Mutual savings banks
       Credit unions
       Commercial banks

A commercial bank (or just ―bank‖ for
 short) is a private corporation that
 provides services to the public
    Owned by its stockholders
 For our purposes, most important service
 is to provide checking accounts
    Enables bank’s customers to pay bills and make
     purchases without holding large amounts of
     cash that could be lost or stolen
 Banksprovide checking account services
 in order to earn a profit

   A balance sheet is a two-column list that provides
    information about financial condition of a bank at a
    particular point in time
       In one column, bank’s assets are listed
           Everything of value that it owns
       On the other side, the bank’s liabilities are listed
           Amounts bank owes
   Bond
       A promise to pay back borrowed funds, issued by a corporation
        or government agency
   Loan
       An agreement to pay back borrowed funds, signed by a
        household or noncorporate business
   Next come two categories that might seem curious
     ―Vault cash‖
     ―Account with the Federal Reserve‖
   Why does the bank hold them?

Balance Sheet for Wachovia
Bank, December 31, 2006
   Explanations for vault cash and accounts with
    Federal Reserve
       On any given day, some of the bank’s customers might
        want to withdraw more cash than other customers are
       Banks are required by law to hold reserves
           Sum of cash in vault and accounts with Federal Reserve
   Required reserve ratio tells banks the fraction of
    their checking accounts that they must hold as
    required reserves
       Set by Federal Reserve
   Net worth = Total assets – Total liabilities
       Include net worth on liabilities side of balance sheet
        because it is, in a sense, what bank would owe to its
        owners if it went out of business
           A balance sheet always balances

   Every large nation controls its money supply with
    a central bank
       A nation’s principal monetary authority
       Most developed countries established central banks long
           England’s central bank—Bank of England—was created in
           France established Banque de France in 1800
           United States established Federal Reserve System in 1913
   U.S. waited such a long time to establish a
    central authority because of
       Suspicion of central authority that has always been part
        of U.S. politics and culture
       Large size and extreme diversity of our country
       Fear that a powerful central bank might be dominated
        by the interests of one region to the detriment of others

   One major difference is indicated in the very
    name of the institution
       Does not have the word ―central‖ or ―bank‖ anywhere in
        its title
   Another interesting feature of Federal Reserve
    System is its peculiar status within government
       Strictly speaking, it is not even a part of any branch of
       Both President and Congress exert some influence on Fed
        through their appointments of key officials

                   Minneapolis                              2
                                                       New York
                                  Chicago           Philadelphia
     12              10                 Cleveland
 San Francisco    Kansas City              4 Richmond
                              St. Louis           5
                   11                     6

Note: Both Alaska and Hawaii are in the Twelfth District
    District boundaries
    State boundaries
    Reserve Bank cities
    Board of Governors of the Federal Reserve System

                                               Appoints 3 directors of
President   Chair of Board of Governors      each Federal Reserve Bank
                 Board of Governors                 12 Federal Reserve
            (7 members, including chair)               District Banks
            • Supervises and regulates                • Lend reserves
              member banks                             • Clear checks
            • Supervises 12 Federal                  • Provide currency
 Senate       Reserve District Banks
confirms    • Sets reserve requirements    Elect 6 directors
              and approves discount rate       of each
                                           Federal Reserve
                Federal Open Market
              (7 Governors + 5 Reserve              3,500 Member Banks
                  Bank Presidents)
            • Conducts open market
              operations to control the
              money supply
   Board of Governors
       Consists of seven members who are appointed by President and
        confirmed by Senate for a 14-year term
       In order to keep any President or Congress from having too
        much influence over Fed
           Four-year term of the chair is not coterminous with four-year term
            of the President
   Each of 12 Federal Reserve Banks is supervised by nine
     Three of whom are appointed by Board of Governors
     Other six are elected by private commercial banks—the official
      stockholders of the system
     Directors of each Federal Reserve Bank choose a president of
      that bank, who manages its day-to-day operations
   Only about 3,500 of the 8,000 or so commercial banks in
    United States are members of Federal Reserve System
       But they include all national banks and state banks
       All of the largest banks in United States are nationally
        chartered banks and therefore member banks as well

 Federal   Open Market Committee (FOMC)
    A committee of Federal Reserve officials that
     establishes U.S. monetary policy
 Most  economists regard FOMC as most
  important part of Fed
 Consists of all 7 governors of Fed, along
  with 5 of the 12 district bank presidents
 Not even President of United States knows
  details behind the decisions, or what
  FOMC actually discussed at its meeting,
  until summary of meeting is finally
    Committee exerts control over nation’s money
     supply by buying and selling bonds in public
     (―open‖) bond market
 FederalReserve, as overseer of the nation’s
 monetary system, has a variety of important
 responsibilities including
    Supervising and regulating banks
    Acting as a ―bank for banks‖
    Issuing paper currency
    Check clearing
    Controlling money supply

 SupposeFed wants to change nation’s
 money supply
    It buys or sells government bonds to bond
     dealers, banks, or other financial institutions
        Actions are called open market operations
      make two special assumptions to
 We’ll
 keep our analysis of open market
 operations simple for now
    Households and business are satisfied holding
     the amount of cash they are currently holding
    Banks never hold reserves in excess of those
     legally required by law

   To increase money supply, Fed will buy
    government bonds
       Called an open market purchase
   Suppose Fed buys $1,000 bond, which deposits
    the total into its checking account
       Two important things have happened
           Fed has injected reserve into banking system
           Money supply has increased
             Demand deposits have increased by $1,000 and demand deposits
              are part of money supply
             Lehman Brothers’ bank now has excess reserves
               Reserves in excess of required reserves
               If required reserve ratio is 10% bank has excess reserves of
                 $900 to lend
               Demand deposits increase each time a bank lends out excess

                                       Learning Objective 13.3

Using T-Accounts to Show How a Bank Can Create Money
                                       Learning Objective 13.3

Using T-Accounts to Show How a Bank Can Create Money
Using T-Accounts to Show How a Bank Can Create Money
                                                      Learning Objective 13.3

 Using T-Accounts to Show How a Bank Can Create Money

Wachovia                             $1,000
PNC                                   + 900              (= 0.9 x $1,000)
Third Bank                            + 810              (= 0.9 x $900)
Fourth Bank                           + 729              (= 0.9 x $810)
    .                                 +•
    .                                 +•
    .                                 +
Total Change in Checking Account
Deposits                           =$10,000
                                                     Learning Objective 13.3

        The Simple Deposit Multiplier

         Simple deposit multiplier The ratio of
         the amount of deposits created by
         banks to the amount of new reserves.

                  Simple deposit multiplier 

Change in checking account deposits  Change in bank reserves x
 For any value of required reserve ratio (RRR),
  formula for demand deposit multiplier is
 Using general formula for demand deposit
  multiplier, can restate what happens when
  Fed injects reserves into banking system as
    ΔDD = (1 / RRR) x ΔReserves
 Sincewe’ve been assuming that the amount
 of cash in the hands of the public (the other
 component of the money supply) does not
 change, we can also write
    ΔMoney Supply = (1 / RRR) x ΔReserves

   Just as Fed can increase money supply by
    purchasing government bonds
       Can also decrease money supply by selling government
           An open market sale
   Process of calling in loans will involve many
       Each time a bank calls in a loan, demand deposits are
       Total decline in demand deposits will be a multiple of
        initial withdrawal of reserves
       Keeping in mind that a withdrawal of reserves is a
        negative change in reserves
           Can still use our demand deposit multiplier—1/(RRR)—and
            our general formula
           ΔDD = (1/RRR) x ΔReserves

 Whileother tools can affect the money
 supply, open market operations have two
 advantages over them
    Precision and secrecy
    This is why open market operations remain
     Fed’s primary means of changing money supply
 Fed’sability to conduct its policies in
 secret—and its independent status in
 general—is controversial
    In recent years, because Fed has been so
     successful in guiding economy, controversy has
     largely subsided

 Thereare two other tools Fed can use to
 increase or decrease money supply
  Changes in required reserve ratio
  Changes in discount rate
 Changes in either required reserve ratio or
 discount rate could set off the process of
 deposit creation or deposit destruction in
 much the same way outlined in this chapter
    In reality, neither of these policy tools is used very
 Why    are these other tools used so seldom?
    Partly because they can have unpredictable effects


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