1. Chapter 14
Banking and the Money Supply

2. Narrow Definition of Money: M1
• M1: the most narrowly defined MS
– Measures purchasing power
– M1= currency held by the nonbanking public +
checkable deposits + traveler’s checks
– What are checkable deposits?
• Bank deposits that allow the account owner to write
checks to third parties.
– Is currency in bank vaults included?
• NO!!! It is not being used as a medium of exchange

3. Broader Definition of Money: M2
• M2: adding near monies to M1
– M2= M1 +near monies
• Near monies are easy to convert into currency or
checkable deposits
– Savings deposits
– Time deposits (CDs- certificates of deposit)
– Money market mutual fund accounts

4. LO1 Measures of the Money Supply
(February 2009)
Exhibit 1

5. Credit Cards and Debit Cards: What’s
the Difference
• What do credit cards offer?
– They offer an easy way to get a loan from the card
issuer.
• What do debit cards offer?
– They reduce the balance of your checking
account; thus, they are part of M1.
– It combines the functions of an ATM card and a
check.

6. Banks Are Financial Intermediaries
• By bringing together both sides of the money
market, banks serve as financial
intermediaries (go-betweens).

7. Coping with Asymmetric Information
• What borrowers do banks want?
– Willing to pay interest and are able to repay the
loan.
• Asymmetric information: an inequality in
what’s known by each party to the
transaction.
– The borrower knows more about their credit
history.

8. Reducing Risk Through Diversification
• They develop a diversified portfolio to reduce
the risk to each individual saver.

9. Starting a Bank
• First, they must apply to the state banking
authority in the case of a state bank or the U.S.
Comptroller of the Currency for a national bank.
– A charter
• The authority will decide to or not to approve the
charter.
• If approved they are established.
• Net Worth= Owners’ Equity
– Shares of Stock in the bank

10. Balance Sheet
• The balance sheet shows a balance between
the two sides of the bank’s account.
• Left-hand side= Assets
– Any physical property or financial claim owned by
the bank
– Building and equipment
– Stocks in the district Fed
• Right-hand side= Liabilities and Net Worth
– An amount the bank owes

11. What if all excess reserves are gone?

12. LO2
Exhibit 2
Home Bank’s Balance Sheet

13. Reserve Accounts
• Now what??
– They are required to hold a certain percentage of
the checkable deposits.
– This amount is the required reserve, the dollar
amount that must be held as reserves.
– The required reserve ratio dictates the minimum
proportion of deposits the bank must hold in
reserve.

14. Required Reserves for Banks
• $0 to 10.7 million – 0%
• $10.7 million to $55.2 million- 3%
• Greater than $55.2 million- 10%
– They are held as cash in the bank’s vault with NO
interest or as deposits at the Fed with some
interest

15. Excess Reserves
• Excess Reserves: The amount of checkable
deposits the bank holds over the required rate
the Fed mandates
– Starting in 2008, the Fed now gives interest on
excess reserves.
– What can they do with them?
• Make loans
• Buy government securities ( by law limited to this)

16. Liquidity vs. Profitability
• Liquidity is the ease with which an asset can
be converted into cash without a significant
loss of value.
– Selling government bonds
• The objectives of liquidity and profitability are
at odds.

17. Federal funds market
• The federal funds market provides for day-to-day
lending and borrowing among banks of
excess reserves on account at the Fed.
• They don’t leave the Fed, they shift among
accounts.
• Federal funds rate: the interest rate banks
charge one another for overnight borrowing-banks
loaning to banks

18. LO2 Exhibit 3
Home Bank’s Balance Sheet After
$1,000,000 Deposit Into Checking Account

19. LO3 Exhibit 4
Changes in Home Bank’s Balance Sheet
After Fed Buys a $1,000 Bond from
Securities Dealer

20. How Banks Create Money
 Creating money through excess reserves
LO3
– Round two
• $900 loan
• Money supply: +$900
• Required reserves: +$90
• Excess reserves: +$810

21. LO3 Exhibit 5
Changes in Home Bank’s Balance Sheet
After Lending $900 to You

22. How Banks Create Money
 Creating money through excess reserves
LO3
– Round three
• $810 loan
• Money supply: +$810
• Required reserves: +$81
• Excess reserves: +$729

23. LO3 Exhibit 6
Changes in Merchants Trust’s Balance
Sheet After Lending $810 to English Major

24. How Banks Create Money
 Creating money through excess reserves
LO3
– Round four and beyond
• Excess reserves – new loans
• Required reserves: +10% of new
checkable deposits
– Excess reserve – maximum amount for
loans
– Money supply expansion

25. How Banks Create Money
 Creating money through excess reserves
 A summary of rounds
LO3
– Fed: $1,000 injection in fresh reserves
– Increased excess reserves
– Money supply increase: Up to $10,000
• Checkable deposits
– Banking system
• Eliminates excess reserves
– Expand money supply

26. LO3 Exhibit 7
Summary of the Money Creation
Resulting from the Fed’s Purchase of
$1,000 U.S. Government Bond

27. Reserve Requirements and Money
Expansion
• The multiple by which the money supply
increases as a result of an increase in the
banking system’s reserves is called the money
multiplier.

28. The Money Multiplier
• Def: The money multiplier is equal to 1
divided by the required reserve ratio.
• In our case, it is 10
1 1
Re quired Re serve Ratio

29. The Real-World Money Multiplier
• It is much smaller than MM
• It must be observed over time
• What happens to it?
– Leakage
• Banks could let excess reserves sit idle
• Borrowers do something with the money
• People may not choose to increase their cash holdings

30. The Fed’s Tools of Monetary Control
• Open-Market Operations and the Federal
Funds Rate
• The Discount Rate
• Reserve Requirements
• Coping with Financial Crises
• The Fed is a money machine

31. Open Market Operations and the
Federal Funds Rate
• Buying and selling of U.S. Government bonds
• FOMC meet every six weeks and during
emergencies to make these decisions.
• To increase MS- the Fed directs the NY Fed to
buy U.S. bonds (open-market purchase).
• To decrease MS- the Fed directs the NY Fed to
sell U.S. bonds (open-market sale).

32. Open Market Operations and the
Federal Funds Rate
• The Federal Funds Rate is the interest rate
banks charge one another for borrowing
excess reserves at the Fed, typically just for a
day or two.
• If the Fed is buying bonds the federal funds
rate is lower because less demand for federal
funds market.
• The lower federal funds rate prompt banks to
lower short-term interest rates in general.

33. The Discount Rate
• The Discount Rate: the interest rate the Fed
charges for loans it makes to banks.
• Two discount rates:
– The primary discount rate is usually one
percentage point about the federal funds rate.
– The secondary discount rate is usually about one-half
a percentage point higher than the primary
discount rate.
• Banks that are less sound

34. Reserve Requirement
• The minimum amount of reserves that banks
must hold to back up deposits.
• If the Fed increase the reserve requirement,
then banks have less excess reserves to lend
out
– This reduces the banking system’s ability to create
money.

35. Coping with Financial Crises
• In 2001- the Fed bought all the government
securities offered for sale, purchasing a record
$150 billion worth in two days.
• In 2008- The Fed lowered the discount rate to
nearly zero and encourage banks improve
their balance sheets and a few other policies

36. The Fed is a money machine
• The Fed injected more that a trillion dollars of
liquidity into the banking system in response
to the 2008 meltdown.
• April 2009- 24% of Fed assets were U.S.
government bonds, but in more normal times
about 90% of assets.

37. LO4 Exhibit 8
Federal Reserve Bank Balance Sheet as of
April 1, 2009 (Billions)