Ch30 Notetaking Guide

The 3 Functions of Money
Medium of exchange:
Unit of account:
Store of value:
The 2 Kinds of Money

Commodity money:
Fiat money:
The Money Supply

The money supply (or money stock):
What assets should be considered part of the

money supply? Two candidates:
Currency: the paper bills and coins in the
hands of the (non-bank) public
Demand deposits:
Measures of the U.S. Money Supply
M1:
M1 = $2.6 trillion (September 2013)

M2:
M2 = $10.8 trillion (September 2013)
The distinction between M1 and M2

will often not matter when we talk about
“the money supply” in this course.
Central Banks & Monetary Policy

Central bank:
Monetary policy:
Federal Reserve (Fed):
The Structure of the Fed

The Federal Reserve System
consists of:
Board of Governors
(7 members),
located in Washington, DC
12 regional Fed banks,
located around the U.S. Janet L. Yellen
Federal Open Market Chair of FOMC,
Committee (FOMC), Feb 2014 – present
includes the Bd of Govs and
presidents of some of the regional Fed banks.
The FOMC decides monetary policy.
Bank Reserves
In a fractional reserve banking system,
The Fed establishes reserve requirements,
Banks may hold more than this minimum amount

if they choose.
The reserve ratio, R
Bank T-Account
T-account:
Example:
FIRST NATIONAL BANK
Assets Liabilities
Banks’ liabilities include

assets include
In this example, notice
Banks and the Money Supply: An Example

Suppose $100 of currency is in circulation.
To determine banks’ impact on money supply,
we calculate the money supply in 3 different cases:
1. No banking system
2. 100% reserve banking system:
banks hold 100% of deposits as reserves,
make no loans
3. Fractional reserve banking system
CASE 1: No banking system
Public holds the $100 as currency.
Money supply =

CASE 2: 100% reserve banking system
Public deposits the $100 at First National Bank (FNB).
FNB holds FIRST NATIONAL BANK

100% of Assets Liabilities
deposit
Reserves Deposits
as reserves:
Loans
Money supply
= currency + deposits =
In a 100% reserve banking system,

CASE 3: Fractional reserve banking system
Suppose R = 10%. FNB loans all but 10%
of the deposit:
FIRST NATIONAL BANK
Assets Liabilities
Reserves Deposits
Loans
Depositors have
borrowers have
Money supply =
How did the money supply suddenly grow?
When banks make loans,
The borrower gets
$90 in currency—an asset counted in the
money supply
$90 in new debt—a liability that does not have
an offsetting effect on the money supply
A fractional reserve banking system

Borrower deposits the $90 at Second National Bank.
SECOND NATIONAL BANK

Initially, SNB’s
T-account Assets Liabilities
looks like this: Reserves $ 90 Deposits $ 90
Loans $ 0
If R = 10% for SNB, it will loan all but 10% of the

deposit.

SNB’s borrower deposits the $81 at Third National
Bank.
THIRD NATIONAL BANK
Initially, TNB’s
T-account Assets Liabilities
looks like this: Reserves $ 81 Deposits $ 81
Loans $ 0
If R = 10% for TNB, it will loan all but 10% of the

deposit.
The process continues, and money is created with
each new loan.
Original deposit = $ 100.00
FNB lending = $ 90.00
SNB lending = $ 81.00
TNB lending = $ 72.90
.. ..
. .
Total money supply =
The Money Multiplier

Money multiplier:
The money multiplier equals

In our example,
R = 10%
money multiplier =
ACTIVE LEARNING 1
Banks and the money supply
While cleaning your apartment, you look under the
sofa cushion and find a $50 bill (and a half-eaten
taco). You deposit the bill in your checking account.
The Fed’s reserve requirement is 20% of deposits.
A. What is the maximum amount that the
money supply could increase?
B. What is the minimum amount that the
money supply could increase?
A More Realistic Balance Sheet
Assets: Besides reserves and loans, banks also
hold securities.
Liabilities: Besides deposits, banks also obtain
funds from issuing debt and equity.
Bank capital:
Leverage:
A More Realistic Balance Sheet
MORE REALISTIC NATIONAL BANK

Assets Liabilities
Reserves $ 200 Deposits $ 800
Loans $ 700 Debt $ 150
Securities $ 100 Capital $ 50
Leverage ratio:
In this example, the leverage ratio =
Interpretation: for every $20 in assets,
Leverage Amplifies Profits and Losses

In our example, suppose bank assets appreciate
by 5%, from $1000 to $1050.
Instead, if bank assets decrease by 5%,
If bank assets decrease more than 5%, bank

capital is negative and bank is insolvent.
Capital requirement:
Leverage and the Financial Crisis
In the financial crisis of 2008–2009, banks suffered
losses on mortgage loans and mortgage-backed
securities due to widespread defaults.
Many banks became insolvent:
In the U.S., 27 banks failed during 2000–2007,
166 during 2008–2009.
Many other banks found themselves with too little
capital, responded by reducing lending, causing a
credit crunch.
The Government’s Response

To ease the credit crunch, the Federal Reserve
and U.S. Treasury injected hundreds of billions of
dollars’ worth of capital into the banking system.
This unusual policy temporarily made U.S.
taxpayers part-owners of many banks.
The policy succeeded in recapitalizing the banking
system and helped restore lending to normal
levels in 2009.
The Fed’s Tools of Monetary Control

Earlier, we learned
The Fed can change the money supply by

How the Fed Influences Reserves
Open-Market Operations (OMOs):
If the Fed buys a government bond from a

bank, it pays by depositing new reserves in that
bank’s reserve account.
With more reserves,
To decrease bank reserves and the money

supply, the Fed
How the Fed Influences Reserves

The Fed makes loans to banks, increasing their
reserves.
Traditional method: adjusting the discount rate
New method: Term Auction Facility
The more banks borrow, the more reserves they

have for funding new loans and increasing the
money supply.
How the Fed Influences the Reserve Ratio

Recall: reserve ratio = reserves/deposits,
which inversely affects the money multiplier.
The Fed sets reserve requirements:
Reducing reserve requirements
Since 10/2008, the Fed has paid interest on

reserves banks keep in accounts at the Fed.
Raising this interest rate
Problems Controlling the Money Supply
If households
If banks
Yet, Fed can compensate for household

and bank behavior to retain fairly precise control
over the money supply.
Bank Runs and the Money Supply

A run on banks:
Under fractional-reserve banking, banks don’t

have enough reserves to pay off ALL depositors,
hence banks may have to close.
Also, banks may make fewer loans and hold more
reserves to satisfy depositors.
Bank Runs and the Money Supply

During 1929–1933, a wave of bank runs and
bank closings caused money supply to fall 28%.
Many economists believe this contributed to the
severity of the Great Depression.
Since then,
In the U.K., though, Northern Rock bank

experienced a classic bank run in 2007 and was
eventually taken over by the British government.
The Federal Funds Rate
On any given day, banks with insufficient reserves
can borrow from banks with excess reserves.

Changes in the fed funds rate cause changes in

other rates and have a big impact on the economy.
The Fed Funds rate and other rates, 1970–2013
20 Fed Funds
Mortgage
Prime
15
3 Month T-Bill
(%)
10
0
1970 1975 1980 1985 1990 1995 2000 2005 2010
Monetary Policy and the Fed Funds Rate

The Federal
Funds market

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The 3 Functions of Money

The 2 Kinds of Money

The Money Supply

What assets should be considered part of the

M1 = $2.6 trillion (September 2013)

M2 = $10.8 trillion (September 2013)

The distinction between M1 and M2

Central Banks & Monetary Policy

Federal Reserve (Fed):

The Structure of the Fed

The Fed establishes reserve requirements,

Banks may hold more than this minimum amount

Banks’ liabilities include

Banks and the Money Supply: An Example

Banks and the Money Supply: An Example

FNB holds FIRST NATIONAL BANK

Banks and the Money Supply: An Example

Banks and the Money Supply: An Example

SECOND NATIONAL BANK

If R = 10% for SNB, it will loan all but 10% of the

Banks and the Money Supply: An Example

If R = 10% for TNB, it will loan all but 10% of the

The Money Multiplier

The money multiplier equals

A More Realistic Balance Sheet

MORE REALISTIC NATIONAL BANK

Leverage Amplifies Profits and Losses

Instead, if bank assets decrease by 5%,

If bank assets decrease more than 5%, bank

The Government’s Response

The Fed’s Tools of Monetary Control

The Fed can change the money supply by

If the Fed buys a government bond from a

To decrease bank reserves and the money

How the Fed Influences Reserves

New method: Term Auction Facility

The more banks borrow, the more reserves they

How the Fed Influences the Reserve Ratio

Reducing reserve requirements

Since 10/2008, the Fed has paid interest on

Yet, Fed can compensate for household

Bank Runs and the Money Supply

Under fractional-reserve banking, banks don’t

Bank Runs and the Money Supply

In the U.K., though, Northern Rock bank

Changes in the fed funds rate cause changes in

The Fed Funds rate and other rates, 1970–2013

Monetary Policy and the Fed Funds Rate

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