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Economics: Principles and Policy

William J. Baumol, Alan S. Blinder, John L. Solow

14th edition

Powerpoint Slides prepared by: Philip Heap, James Madison University

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in part.

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Part 3

Fiscal and Monetary Policy

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Chapter 12

Money and the Banking System

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An Opening Quote

[Money] is a machine for doing quickly and commodiously what would be done, though less

quickly and commodiously, without it.

John Stuart Mill

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The Circular Flow Diagram

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Why are Banks So Heavily Regulated?

• Regulation and deregulation of banks since the 1970s

• Banks regulated for two main reasons

• Allows better control of the money supply

• Concern for safety of depositors

• Run on a bank

• Many depositors withdraw cash from their accounts all at once

• Runs could lead to bank failure, which could spread

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Figure 1 Bank Failures in the United States, 1921–2017

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The Nature of Money 1 of 4

• Barter versus Monetary Exchange

• Barter

• System of exchange in which people trade one good for another

• Money is not used as an intermediate step

• Requires the double coincidence of wants

• Money

• Greases the wheels of exchange and makes the economy more productive

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The Nature of Money 2 of 4

• Money and its functions:

• Medium of exchange

• The object or objects used to buy and sell other items such as goods and services

• Unit of account

• Standard unit for quoting prices

• Store of value

• Store wealth from one point in time to another

• Why may money not be a good store of value?

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The Nature of Money 3 of 4

• What serves as money?

• Cattle, stones, candy bars, cigarettes, woodpecker scalps, porpoise teeth, giraffe tails, cigarettes, large disk shaped boulders

• Commodity money

• An object in use as a medium of exchange that also has a substantial value in alternative nonmonetary uses

• To be useful as a medium of exchange, a commodity must be:

• Easily divisible

• Uniform or readily identifiable quality

• Storable and durable

• High value per unit of volume and weight

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The Nature of Money 4 of 4

• Commodity money

• Gold and silver

• Fiat money

• Money that is decreed as such by the government

• Little value as a commodity

• Maintains its value as a medium of exchange because

• People have faith that the issuer will stand behind the pieces of printed paper and limit their production

• Evolution of money

• Commodity money → Full-bodied paper money → Partially backed money → Fiat Money

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How the Quantity of Money is Measured 1 of 2

• Two measures of the money supply:

• M 1: Narrowly defined money supply

• Coins and paper money in circulation

• Traveler’s checks

• Conventional checking accounts and other checkable deposit balances

• M 2: Broadly defined money supply

• M 1

• Money market deposit accounts

• Money market mutual funds

• Savings accounts

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Figure 2 Two Definitions of the Money Supply, Aug 2018

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How the Quantity of Money is Measured 2 of 2

• Other measures of the money supply:

• M 3 and beyond

• Near moneys

• Liquid assets that are close substitutes for money

• Liquidity - the ease with which it can be converted into cash

• Should we include credit cards in the money supply?

• We will assume that money consists of coins, paper money, and checkable deposits (most of M 1)

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The Banking System 1 of 6

• How banking began

• Gold used as commodity money

• Gold stored at goldsmiths who issued paper receipts backed by gold

• Clever goldsmiths started lending out “gold”

• Fractional reserve banking system

• A system under which bankers keep only a fraction of deposits as reserves

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The Banking System 2 of 6

• Three features of a fractional reserve banking system:

1. Bank profitability

• Interest on loans minus interest on deposits

2. Discretion over the money supply

• By lending, banks essentially create money

• Amount of money created depends on how much banks hold in reserve

3. Exposure to runs

• Keep prudent reserves and lend out money carefully

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The Banking System 3 of 6

• Principles of bank management: Profit vs. Safety

• How do banks maintain a reputation for prudence?

• Maintain a sufficient level of reserves to minimize vulnerability to runs

• Be cautious in making loans and investments since large losses undermine confidence

• Failure during the housing boom of 2003-2006

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The Banking System 4 of 6

• What government regulations are in place to ensure the safety of the banking system?

• Bank regulations

• Rules designed to ensure depositors’ safety and to control the money supply

• Deposit insurance

• Guarantees that depositors will not lose money even if their bank goes bankrupt

• Federal Deposit Insurance Corporation (F D I C 1933)

• Why might deposit insurance lead to a system that is less safe?

▶ Moral hazard problem

⁃ If insured against consequences of risk people engage in riskier behavior

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The Banking System 5 of 6

• Another government regulation in place to ensure the safety of the banking system:

• Bank supervision

• Periodic bank examinations

• Tighter regulation since 2006

• Bureau of consumer financial protection

• Mechanism for dealing with potential failure of giant banks

• Limit the kinds and quantities of assets in which banks may invest

▶ Banks can own only limited amounts of common stock

▶ Limits on proprietary trading

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The Banking System

• One more regulation:

• Reserve requirements

• Minimum amount of reserves required by law

• Proportional to the volume of deposits

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Systemic Risk and the “Too Big to Fail” Doctrine 1 of 2

• Systemic risk

• Risks to the entire system of banks or financial institutions

• Arises because these institutions (large) are linked in many ways

• banks runs spread

• exchanging funds with other banks and non-bank financial institutions

• Systemically important (or “too big to fail”)

• A financial institution that by virtue of its size or interconnectedness, can threaten the entire system if it runs into trouble

• Lehman Brothers and American International Group (A I G)

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Systemic Risk and the “Too Big to Fail” Doctrine 2 of 2

• The Dodd-Frank Act, 2010

• The Fed given powers to supervise systemically important financial institutions

• Tougher regulatory regime than ordinary banks

• New procedure in case of failure

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The Origins of the Money Supply

• A Banker’s Books

• Asset

• An item of value that an individual or firm owns

• Liability

• An item of value that an individual or firm owes

• Many liabilities are known as debts

• Balance sheet - accounting statement

• Left side: values of all assets

• Right side: values of all liabilities and net worth

• Net worth = Asset – Liabilities

• Assets = Liabilities + Net Worth

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Table 1a Balance Sheet of Bank-a-Mythica, Dec 31, 2018

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Banks and Deposit Creation 1 of 12

• Suppose someone deposits $100,000 into their checking account. How does that lead to a multiple expansion of the money supply?

• Deposit creation:

• The process by which a fractional reserve banking system turns $1 of bank reserves into several dollars of bank deposits

• Assume the required reserve ratio is 20%. How much excess reserves does the bank have?

• Excess reserves are reserves held in excess of the legal minimum

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Table 1b Balance Sheet of Bank-a-Mythica, Dec 31, 2018

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Banks and Deposit Creation 2 of 12

• We will use a T Account to trace the $100,000 checking deposit

• Shows changes in balance sheets rather than the balance sheets themselves

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Table 2 Changes in Bank-a-Mythica’s Balance Sheet, January 2, 2019

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Table 3 Changes in Bank-a-Mythica’s Balance Sheet, January 3–6, 2019

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Table 4 Changes in Bank-a-Mythica’s Balance Sheet, January 2–6, 2019

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Banks and Deposit Creation 3 of 12

• What we have so far:

• $100,000 less in cash

• $100,000 more in checkable deposits

• $80,000 loan so new cash in circulation

• So money supply up by $80,000

• What happens when that $80,000 is deposited into a different bank: First National Bank?

• First National bank has excess reserves

• It lends out those reserves, which get deposited at Second National Bank

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Table 5 Changes in First National Bank’s Balance Sheet

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Table 6 Changes in Second National Bank’s Balance Sheet

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Banks and Deposit Creation 4 of 12

• We could go on to the Third National Bank, Fourth, Fifth . . .

• When does it end?

• Assumptions

• Each bank holds exactly 20% required reserves

• Each loan recipient redeposits entire proceeds into the next bank

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Figure 3 The Chain of Multiple Deposit Creation

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Banks and Deposit Creation 5 of 12

• Suppose someone deposits $100,000 into their checking account. How does that lead to a multiple expansion of the money supply?

• Putting it all together:

• Initial deposit of $100,000 in cash

• Led to $500,000 in new deposits

• Money supply rises by $400,000

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Banks and Deposit Creation 6 of 12

• The math behind expansion of the money supply:

• Each column forms a geometric progression

• In the last figure, each entry is 80% of the previous entry or 20% less

• From before we learned:

▶ 1 + R + R2 + . . . = 1 / (1 – R)

• Applying this to the $100,000 initial deposit:

▶ $100,000 + $80,000 + $64,000 + $51,200 +. . .

▶ = $100,000 x (1 + 0.80 + 0.802 + 0.803 + . . .)

▶ = $100,000 x 1/(1 – 0.80)

▶ = $500,000 in new deposits

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Banks and Deposit Creation 7 of 12

• In general

• If the required reserve ratio = m

• Deposit multiplier = 1/m

• Banking system can convert each $1 of reserves into $1/m in new deposits

• Oversimplified Deposit Multiplier

• Ratio of newly created bank deposits to new reserves

• Change in deposits = (1/m) ˣ change in reserves

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Banks and Deposit Creation 8 of 12

• Oversimplified Deposit Multiplier

• Ratio of newly created bank deposits to new reserves

• Change in deposits = (1/m) ˣ change in reserves

• Our example:

• m = 20%

• Change in reserves: $100,000

• Change in deposits = (1/0.20) x $100,000

• = $500,000

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Banks and Deposit Creation 9 of 12

• What has happened to to the money supply?

• Cash: - $100,000

• Deposits created: + $500,000

• Money supply: + $400,000

• What happens if someone withdraws $100,000 from Bank A Mythica?

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Table 7 Changes in the Balance Sheet of Bank-a- Mythica

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Banks and Deposit Creation 10 of 12

• At Bank Mythica:

• Loses $100,000 in checkable deposits

• Required reserves fall by $20,000

• Actual reserves fall by $100,000

• Excess reserves short by -$80,000

• Outstanding loans paid off and no new loans until bank has accumulated enough reserves

• Where did the borrowers get the money to pay off the loans?

• They made withdrawals from other banks: First National

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Table 8 Changes in the Balance Sheet of First National Bank

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Banks and Deposit Creation 11 of 12

• At First National Bank:

• Loses $80,000 in checkable deposits

• Required reserves fall by $16,000

• Actual reserves fall by $80,000

• Excess reserves short by -$64,000

• Outstanding loans paid off until bank has accumulated enough reserves

• And the process continues:

• Change in deposits = -$100,000 - $80,000 - $64,000 - . . .

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Banks and Deposit Creation 12 of 12

• What is the overall effect?

• Deposits: -$500,000

• = (1/ 0.20) x - $100,000

• Loans: -$400,000

• Reserves: -$100,000

• Money supply: -$400,000

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Why the Deposit-Creation Formula Is Oversimplified

• Our money multiplier only accurate under two circumstances

• Every recipient of cash must redeposit cash to another bank rather than hold it

• Every bank must hold reserves no larger than the legal minimum

• What happens if individuals and business firms hold more cash?

• Fewer dollars of cash available for use as reserves

• Limits the multiple expansion of bank deposits

• Smaller money supply

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Figure 3 Chain of Multiple Deposit Creation

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Why the Deposit-Creation Formula Is Oversimplified 1 of 3

• What happens if individuals and business firms hold more cash?

• Fewer dollars of cash available for use as reserves

• Limits the multiple expansion of bank deposits

• Smaller increase in the money supply

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Why the Deposit-Creation Formula Is Oversimplified 2 of 3

• What happens if banks decide to hold on to some excess reserves?

• Limited multiple expansion of bank deposits

• Smaller supply of money

• Excess reserves after September 2008

• Failure of Lehman Brother led to financial panic

• Banks held excess reserves at a massive scale

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Figure 4 Excess Reserves in the U.S. Banking System, 2008–2018

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Why the Deposit-Creation Formula Is Oversimplified 3 of 3

• Excess reserves after September 2008

• From $2 billion to $267 billion by October 2008, $800 billion by January 2009.

• Currently at $1.9 trillion

• 10 fold increase in excess reserves, but M1 less than tripled

• Banks holding on to excess reserves reduces the multiplier effect

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The Need for Monetary Policy 1 of 2

• Government regulates money supply to maintain stability

• During a recession

• Banks prone to reduce money supply

• Increase excess reserves

• Decrease lending to less creditworthy applicants

• Without government intervention contraction in money supply would aggravate recession

• Federal Reserves during the Great Depression

• and the recent financial crisis and Great Recession

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The Need for Monetary Policy 2 of 2

• During an economic boom

• Banks expand money supply

• Undesirable momentum to economy

• Without government intervention rapid money growth could lead to inflation