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kwe3_macro_student_ch14.pptxMoney, Banking, and the Federal Reserve System
Chapter 14(29)
THIRD EDITION
ECONOMICS
and
MACROECONOMICS Paul Krugman | Robin Wells
1
The various roles money plays and the many forms it takes in the economy.
How the actions of private banks and the Federal Reserve determine the money supply.
How the Federal Reserve uses open-market operations to change the monetary base.
WHAT YOU
WILL LEARN
IN THIS CHAPTER
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The Meaning of Money
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The Meaning of Money
Money is any asset that can easily be used to purchase goods and services.
Currency in circulation is cash held by the public.
Checkable bank deposits are bank accounts on which people can write checks.
The money supply is the total value of financial assets in the economy that are considered money.
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Roles of Money
A medium of exchange is an asset that individuals acquire for the purpose of trading rather than for their own consumption.
A store of value is a means of holding purchasing power over time.
A unit of account is a measure used to set prices and make economic calculations.
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Types of Money
Commodity money is a good used as a medium of exchange that has other uses.
A commodity-backed money is a medium of exchange with no intrinsic value whose ultimate value is guaranteed by a promise that it can be converted into valuable goods.
Fiat money is a medium of exchange whose value derives entirely from its official status as a means of payment.
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Measuring the Money Supply
A monetary aggregate is an overall measure of the money supply.
Near-moneys are financial assets that can’t be directly used as a medium of exchange but can readily be converted into cash or checkable bank deposits.
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Monetary Aggregates, August 2008
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Figure Caption: Figure 14(29)-1: Monetary Aggregates, September 2011
The Federal Reserve uses two definitions of the money supply, M1 and M2. As panel (a) shows, more than half of M1 consists of currency in circulation, with checkable bank deposits making up almost all of the rest. M2, as panel (b) shows, has a much broader definition: it includes M1, plus a range of other deposits and deposit-like assets, making it more than five times as large.
Source: Federal Reserve Bank of St. Louis.
The Monetary Role of Banks
A bank is a financial intermediary that uses liquid assets in the form of bank deposits to finance the illiquid investments of borrowers.
A T-account is a tool for analyzing a business’s financial position by showing, in a single table, the business’s assets (on the left) and liabilities (on the right).
Bank reserves are the currency banks hold in their vaults plus their deposits at the Federal Reserve.
The reserve ratio is the fraction of bank deposits that a bank holds as reserves.
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Assets and Liabilities of First Street Bank
A T-account summarizes a bank’s financial position. The bank’s assets, $900,000 in outstanding loans to borrowers and reserves of $100,000, are entered on the left side. Its liabilities, $1,000,000 in bank deposits held for depositors, are entered on the right side.
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The Problem of Bank Runs
A bank run is a phenomenon in which many of a bank’s depositors try to withdraw their funds because of fears of a bank failure.
Historically, they have often proved contagious, with a run on one bank leading to a loss of faith in other banks, causing additional bank runs.
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Bank Regulations
Deposit insurance — guarantees that a bank’s depositors will be paid even if the bank can’t come up with the funds, up to a maximum amount per account. The FDIC currently guarantees the first $250,000 of each account.
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Bank Regulations
Capital requirements — regulators require that the owners of banks hold substantially more assets than the value of bank deposits. In practice, banks’ capital is equal to 7% or more of their assets.
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Bank Regulations
Reserve requirements — rules set by the Federal Reserve that determine the minimum reserve ratio for a bank. For example, in the United States, the minimum reserve ratio for checkable bank deposits is 10%.
The discount window is an arrangement in which the Federal Reserve stands ready to lend money to banks in trouble.
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Determining the Money Supply
Effect on the money supply of a deposit at First Street Bank
Initial effect before bank makes new loans:
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Figure Caption: Figure 14(29)-4: Effect on the Money Supply of a Deposit at First Street Bank
When Silas deposits $1,000 (which had been stashed under his mattress) in a bank account, there is initially no effect on the money supply: currency in circulation falls by $1,000, but bank deposits rise by $1,000. The corresponding entries on the bank’s T-account show deposits initially rising by $1,000 and the bank’s reserves initially rising by $1,000.
Determining the Money Supply
Effect on the money supply of a deposit at First Street Bank
Effect after bank makes new loans:
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Figure Caption: Figure 14(29)-4: Effect on the Money Supply of a Deposit at First Street Bank
In the second stage, the bank holds 10% of Silas’s deposit ($100) as reserves and lends out the rest ($900) to Mary. As a result, its reserves fall by $900 and its loans increase by $900. Its liabilities, including Silas’s $1,000 deposit, are unchanged. The money supply, the sum of bank deposits and currency in circulation, has now increased by $900—the $900 now held by Mary.
Reserves, Bank Deposits, and the Money Multiplier
Excess reserves are bank reserves over and above the bank’s required reserves.
Increase in bank deposits from $1,000 in excess reserves =
$1,000 + ($1,000 × (1 − rr)) + ($1,000 × (1 − rr)2) + ($1,000 × (1 − rr)3) + . . .
This can be simplified to:
Increase in bank deposits from $1,000 in excess reserves = $1,000/rr
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The Money Multiplier in Reality
The monetary base is the sum of currency in circulation and bank reserves.
The money multiplier is the ratio of the money supply to the monetary base.
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Figure Caption: Figure 14(29)-5: The Monetary Base and the Money Supply
It is different from the money supply, bank deposits plus currency in circulation. Each dollar of bank reserves backs several dollars of bank deposits, making the money supply larger than the monetary base.
The Federal Reserve System
A central bank is an institution that oversees and regulates the banking system and controls the monetary base.
The Federal Reserve is a central bank—an institution that oversees and regulates the banking system, and controls the monetary base.
The Federal Reserve system consists of the Board of Governors in Washington, D.C., plus 12 regional Federal Reserve Banks.
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The Federal Reserve System
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Reserve Requirements and the Discount Rate
The federal funds market allows banks that fall short of the reserve requirement to borrow funds from banks with excess reserves.
The federal funds rate is the interest rate determined in the federal funds market.
The discount rate is the rate of interest the Fed charges on loans to banks.
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Open-Market Operations
Open-market operations by the Fed are the principal tool of monetary policy: the Fed can increase or reduce the monetary base by buying government debt from banks or selling government debt to banks.
The Federal Reserve’s Assets and Liabilities:
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Open-Market Operations by the Federal Reserve
An Open-Market Purchase of $100 Million
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Figure Caption: Figure 14(29)-8: Open-Market Operations by the Federal Reserve
In panel (a), the Federal Reserve increases the monetary base by purchasing U.S. Treasury bills from private commercial banks in an open-market operation. Here, a $100 million purchase of U.S. Treasury bills by the Federal Reserve is paid for by a $100 million addition to private bank reserves, generating a $100 million increase in the monetary base. This will ultimately lead to an increase in the money supply via the money multiplier as banks lend out some of these new reserves.
Open-Market Operations by the Federal Reserve
An Open-Market Sale of $100 Million
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Figure Caption: Figure 14(29)-8: Open-Market Operations by the Federal Reserve
In panel (b), the Federal Reserve reduces the monetary base by selling U.S. Treasury bills to private commercial banks in an open-market operation. Here, a $100 million sale of U.S. Treasury bills leads to a $100 million reduction in private bank reserves, resulting in a $100 million decrease in the monetary base. This will ultimately lead to a fall in the money supply via the money multiplier as banks reduce their loans in response to a fall in their reserves.
Crisis in American Banking
In response to the Panic of 1907, the Fed was created to centralize holding of reserves, inspect banks’ books, and make the money supply sufficiently responsive to varying economic conditions.
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Responding to Banking Crises
The Great Depression sparked widespread bank runs in the early 1930s, which greatly worsened and lengthened the depth of the Depression.
Federal deposit insurance was created, and the government recapitalized banks by lending to them and by buying shares of banks.
By 1933, banks had been separated into two categories: commercial (covered by deposit insurance) and investment (not covered).
Public acceptance of deposit insurance finally stopped the bank runs of the Great Depression.
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The Savings and Loan Crisis of the 1980s
The savings and loan (thrift) crisis of the 1980s arose because insufficiently regulated S&Ls engaged in overly risky speculation and incurred huge losses.
Depositors in failed S&Ls were compensated with taxpayer funds because they were covered by deposit insurance.
The crisis caused steep losses in the financial and real estate sectors, resulting in a recession in the early 1990s.
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Mid-1990s
During the mid-1990s, the hedge fund LTCM (Long-Term Capital Management) used huge amounts of leverage to speculate in global financial markets, incurred massive losses, and collapsed.
LTCM was so large that, in selling assets to cover its losses, it caused balance sheet effects for firms around the world, leading to the prospect of a vicious cycle of deleveraging.
As a result, credit markets around the world froze.
The New York Fed coordinated a private bailout of LTCM and revived world credit markets.
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The Financial Crisis of 2008
Subprime lending during the U.S. housing bubble of the mid-2000s spread through the financial system via securitization.
When the bubble burst, massive losses by banks and nonbank financial institutions led to widespread collapse in the financial system.
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The Financial Crisis of 2008
To prevent another Great Depression, the Fed and the U.S. Treasury expanded lending to bank and nonbank institutions, provided capital through the purchase of bank shares, and purchased private debt.
Because much of the crisis originated in nontraditional bank institutions, the crisis of 2008 indicated that a wider safety net and broader regulation are needed in the financial sector.
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The TED Spread
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Figure Caption: Figure 14(29)-10: The TED spread
The TED spread is the difference between the interest rate at which banks lend to each other and the interest rate on U.S. government debt. It’s widely used as a measure of financial stress. The TED spread soared as a result of the financial crisis of 2007–2008.
Source: British Bankers’ Association; Federal Reserve Bank of St. Louis.
The Fed Responds to the Crisis
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Figure Caption: Figure 14(29)-11: The Fed Responds to the Crisis
Normally, the Federal Reserve holds almost no assets other than U.S. Treasury bills. In response to the 2008 financial crisis, however, the Fed created an alphabet soup of special “facilities” to lend money to troubled financial institutions, leading to a dramatic shift in its balance sheet.
Source: Board of Governors of the Federal Reserve System.
Money is any asset that can easily be used to purchase goods and services. Currency in circulation and checkable bank deposits are both considered part of the money supply. Money plays three roles: it is a medium of exchange used for transactions, a store of value that holds purchasing power over time, and a unit of account in which prices are stated.
Summary
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Over time, commodity money, which consists of goods possessing value aside from their role as money, such as gold and silver coins, was replaced by commodity-backed money, such as paper currency backed by gold. Today, the dollar is pure fiat money, whose value derives solely from its official role.
Summary
34
The Federal Reserve calculates two measures of the money supply. M1 is the narrowest monetary aggregate, containing only currency in circulation, traveler’s checks, and checkable bank deposits. M2 includes a wider range of assets called near-moneys, mainly other forms of bank deposits, that can easily be converted into checkable bank deposits.
Summary
Banks allow depositors immediate access to their funds, but they also lend out most of the funds deposited in their care. To meet demands for cash, they maintain bank reserves composed of both currency held in vaults and deposits at the Federal Reserve. The reserve ratio is the ratio of bank reserves to bank deposits. A T-account summarizes a bank’s financial position.
Summary
Banks have sometimes been subject to bank runs, most notably in the early 1930s. To avert this danger, depositors are now protected by deposit insurance, bank owners face capital requirements that reduce the incentive to make overly risky loans with depositors’ funds, and banks must satisfy reserve requirements.
Summary
When currency is deposited in a bank, it starts a multiplier process in which banks lend out excess reserves, leading to an increase in the money supply—so banks create money. If the entire money supply consisted of checkable bank deposits, the money supply would be equal to the value of reserves divided by the reserve ratio. In reality, much of the monetary base consists of currency in circulation, and the money multiplier is the ratio of the money supply to the monetary base.
Summary
The monetary base is controlled by the Federal Reserve, the central bank of the United States. The Fed regulates banks and sets reserve requirements. To meet those requirements, banks borrow and lend reserves in the federal funds market at the federal funds rate. Through the discount window facility, banks can borrow from the Fed at the discount rate.
Summary
Open-market operations by the Fed are the principal tool of monetary policy: the Fed can increase or reduce the monetary base by buying U.S. Treasury bills from banks or selling U.S. Treasury bills to banks.
In response to the Panic of 1907, the Fed was created to centralize holding of reserves, inspect banks’ books, and make the money supply sufficiently responsive to varying economic conditions.
Summary
The Great Depression sparked widespread bank runs in the early 1930s, which greatly worsened and lengthened the depth of the Depression. Federal deposit insurance was created, and the government recapitalized banks by lending to them and by buying shares of banks. By 1933, banks had been separated into two categories: commercial (covered by deposit insurance) and investment (not covered). Public acceptance of deposit insurance finally stopped the bank runs of the Great Depression.
Summary
The savings and loan (thrift) crisis of the 1980s arose because insufficiently regulated S&Ls engaged in overly risky speculation and incurred huge losses. The crisis caused steep losses in the financial and real estate sectors, resulting in a recession in the early 1990s.
Summary
During the mid-1990s, the hedge fund LTCM used huge amounts of leverage to speculate in global financial markets, incurred massive losses, and collapsed. LTCM was so large that, in selling assets to cover its losses, it caused balance sheet effects for firms around the world, leading to the prospect of a vicious cycle of deleveraging. As a result, credit markets around the world froze. The New York Fed coordinated a private bailout of LTCM and revived world credit markets.
Summary
Subprime lending during the U.S. housing bubble of the mid-2000s spread through the financial system via securitization. When the bubble burst, massive losses by banks and nonbank financial institutions led to widespread collapse in the financial system. To prevent another Great Depression, the Fed and the U.S. Treasury expanded lending to bank and nonbank institutions, provided capital through the purchase of bank shares, and purchased private debt. Because much of the crisis originated in nontraditional bank institutions, the crisis of 2008 indicated that a wider safety net and broader regulation are needed in the financial sector.
Summary
Money
Currency in circulation
Checkable bank deposits
Money supply
Medium of exchange
Store of value
Unit of account
Commodity money
Commodity-backed money
Fiat money
Monetary aggregate
Near-moneys
Bank reserves
T-account
Reserve ratio
Bank run
Deposit insurance
Reserve requirements
Discount window
Excess reserves
Monetary base
Money multiplier
Central bank
Federal funds market
Federal funds rate
Discount rate
Open-market operation
Commercial bank
Investment bank
Savings and loan (thrift)
Leverage
Balance sheet effect
Vicious cycle of deleveraging
Subprime lending
Securitization
Key Terms
