ECN 212 Chapter 22, Spring 2007

The Supply of Money and the Central Bank An Overview of Money 1 FUNCTIONS OF MONEY • MEDIUM OF EXCHANGE • STANDARD OF VALUE • STORE OF VALUE 2 MEDIUM OF EXCHANGE MONEY ALLOWS TO ESCAPE THE COMPLICATIONS OF BARTER ECONOMY BARTER ECONOMY IS THE ECONOMY THAT WAS PRACTICED IN THE EARLY AGES PRIOR TO THE EXISTANCE OF MONEY. IT IS BASED ON EXCHANGING GOODS FOR GOODS. 3 STANDARD OF VALUE MONEY IS A YARDSTICK FOR MEASURING THE RELATIVE WORTH OF HETEROGENIOUS GOODS AND SERVICES. 4 STORE OF VALUE MONEY IS THE MOST CONVENIENT FORM IN STORING WEALTH. 5 Interest Rate Quantity of Real Money Ms Money Market 5% 10% 15% 6 Real Money Supply M P = Money -- Official Definitions • Monetary Base (M0) – Cash and coins (currency) • M1 – Base plus Demand Deposits • M2 – M1 plus Savings Deposits, plus Time Deposits 7 As definition of money becomes broader, less liquid assets are added. Liquid Asset: an asset which can be easily converted into a means of payment at a predictable price 8 M0 M0 = CURRENCY = COINS + PAPER MONEY COINS: ARE KNOWN AS ‘‘TOKEN MONEY’’ THEY ARE MADE OF METALS. THE VALUE OF THE METAL COMPONENT OF A COIN IS ITS INTRINSIC VALUE. IT IS A MUST THAT THE INTRINSIC VALUE OF A COIN IS LESS THAN ITS MONEY VALUE. 9 M1 DEPOSITS AT BANKS ARE OF THREE MAJOR TYPES: 1. DEMAND DEPOSITS 2. TIME DEPOSITS 3. SAVINGS DEPOSITS DD: DEMAND DEPOSITS ARE CHECKING ACCOUNTS. 10 DEPOSITS AT BANKS ARE OF THREE MAJOR TYPES: 1. DEMAND DEPOSITS 2. TIME DEPOSITS 3. SAVINGS DEPOSITS DD: DEMAND DEPOSITS ARE CHECKING ACCOUNTS. 10 M1 = CURRENCY + DD Money is commonly defined as: a. A generally accepted medium of exchange b. A U.S. dollar c. Paper currency and coins d. Gold The correct answer is “a” 11 • M1 IS THE NARROW DEFINITION OF MONEY SUPPLY. • ONLY CURRENCY IN CIRCULATION AND PERSONAL DEMAND DEPOSITS ARE COUNTED IN M1 . • CURRENCY AT BANKS AND INTER- BANK DEPOSITS ARE NOT COUNTED IN M1 . 12 M2 NEAR MONIES ARE TIME DEPOSITS AND SAVINGS DEPOSITS. THESE ARE NOT USED AS AN IMMEDIATE MEDIUM OF EXCHANGE. M2 = M 1 + NEAR MONEY M2 IS KNOWN AS THE BROAD DEFINITION OF MONEY. 13 The narrow definition of the money supply is a. Currency b. M2 c. M3 d. M1 e. M1 + M2 The correct answer is “d” REASONS FOR THE IMPORTANCE OF NEAR MONEY: 1. THE HIGHER THE NEAR MONEY, THE GREATER THE SPENDING TENDENCY. 2. CONVERSION INTO MONEY AFFECTS ECONOMIC STABILITY. EXAMPLE: DURING INFLATION CONVERTING IT INTO MONEY. 3. M1 MIGHT BE CONSTANT, BUT M2 IS INCREASING. IF MONETARY AUTHORITIES WANT TO EXPAND MONEY SUPPLY, AND THEY ACCEPT M1, THEY HAVE TO ISSUE NEW CURRENCY AND DD. BUT IF THEY ACCEPT M2, NO NEED TO TAKE ANY ACTION, BECAUSE NEAR MONEY KEEPS ON EXPANDING. 15 WHAT ‘‘BACKS’’ THE MONEY SUPPLY MONEY AS DEBT: MONEY IS BACKED BY PROMISES TO PAY.  CURRENCY BY GOVERNMENT.  DD BY COMMERCIAL BANKS. IT IS NOT RELATED TO GOLD. VALUE OF MONEY: 1. SOCIAL VALUE 2. LEGAL VALUE 3. MICROECONOMIC VALUE 16 • THE SOCIAL VALUE OF MONEY IS ITS ACCEPTABILITY. • THE LEGAL VALUE OF MONEY IS IT’S BEING A LEGAL TENDER. PAPER MONEY IS “FIAT” MONEY. • THE MICROECONOMIC VALUE OF MONEY IS IT’S RELATIVE SCARCITY. 17 MONEY AND PRICES • THE PURCHASING POWER OF MONEY IS INVERSELY RELATED TO PRICE LEVELS. • D = 1 P WHERE D STANDS FOR THE VALUE OF THE DOLLAR, P STANDS FOR PRICE LEVEL EXPRESSED IN INDEX NUMBER. 18 P = 1  D = 1 P = 1.2  D = 0.83 1/3 20 %  IN P  16 2/3 %  IN D INFLATION  VALUE OF MONEY   ‘‘ HOT MONEY ’’  ACCEPTABILITY OF MONEY AS A MEDIUM OF EXCHANGE . 19 MANAGING MONEY THE MAJOR “BACKING” OF PAPER MONEY IS THE GOVERNMENTS’ ABILITY TO KEEP THE VALUE OF MONEY REASONABLY STABLE. THIS ENTAILS: 1. APPROPRIATE FISCAL POLICY 2. INTELLIGENT MANAGEMENT OF THE MONEY SUPPLY 20 MONEY AND COMMERCIAL BANKING HISTORY AS PROLOGUE: THE GOLDSMITHS BARTER  GOLD  GOLDSMITHS’ RECEIPTS ( PAPER MONEY ) GOLDSMITHS UTILIZED A 100% RESERVE SYSTEM  THEY FOUND OUT THAT MONEY COULD BE ISSUED IN EXCESS OF THE AMOUNT OF GOLD HELD  FRACTIONAL RESERVE SYSTEM OF BANKING CAME INTO BEING 21 Fractional reserve banking means that a. Only a fraction of required reserves are bank reserves b. Bank loans are less than bank reserves c. A fraction of bank reserves needs to be backed by gold d. Bank assets are less than bank reserves e. Only a fraction of total deposits are bank reserves The correct answer is “e” 22 CHARACTERISTICS OF FRACTIONAL SYSTEM BANKING 1. MONEY CREATION AND RESERVES: BANKS IN SUCH A SYSTEM CAN CREATE MONEY. THE SMALLER THE AMOUNT OF RESERVES, THE LARGER THE AMOUNT OF PAPER MONEY THE GOLDSMITHS COULD CREATE. 23 2. BANK PANICS AND REGULATION: IF ALL THE HOLDERS OF PAPER MONEY APPEAR SIMULTANEOUSLY DEMANDING GOLD, THE GOLDSMITH WHO HAS ISSUED THOSE PAPER MONEY IN EXCESS OF THE VALUE OF GOLD RESERVES OBVIOUSLY CANNOT CONVERT ALL THAT PAPER MONEY INTO GOLD  BANK PANIC OR BANK RUN. THE PREVENTION OF BANK RUNS IS A BASIC REASON WHY BANKING SYSTEMS ARE HIGHLY REGULATED INDUSTRIES. 24 MONEY AND COMMERCIAL BANKING THE BALANCE SHEET OF A COMMERCIAL BANK: A BALANCE SHEET IS A STATEMENT OF ASSETS AND CLAIMS WHICH PORTRAYS THE FINANCIAL POSITION OF A FIRM ( BANK ) AT SOME SPECIFIC POINT IN TIME. 25 A SINGLE COMMERCIAL BANK IN A BANKING SYSTEM FORMATION OF A COMMERCIAL BANK: TRANSACTION 1: THE BIRTH OF A BANK GOVERNMENT CHARTER  SELL $600,000 WORTH OF CAPITAL STOCK 26 _________BALANCE_SHEET________ RESERVES $600,000 CAPITAL $600,000 TRANSACTION 2: BECOMING A GOING CONCERN: PURCHASED A BUILDING AND OFFICE EQUIPMENTS FOR $100,000. _________BALANCE_SHEET________ RESERVES $500,000 CAPITAL $600,000 PLANT & EQ. 100,000 27 COMMERCIAL BANKS HAVE TWO BASIC FUNCTIONS: COMMERCIAL BANKS HAVE TWO BASIC FUNCTIONS: 1. 1. ACCEPTING DEPOSITS ACCEPTING DEPOSITS 2. 2. MAKING LOANS MAKING LOANS CITIZENS AND BUSINESSES DEPOSIT $200,000 IN CITIZENS AND BUSINESSES DEPOSIT $200,000 IN DEMAND DEPOSITS ACCOUNT IN A BANK. DEMAND DEPOSITS ACCOUNT IN A BANK. _____________ _____________BALANCE BALANCE__SHEET SHEET______________ ______________ RESERVES $700,000 DD RESERVES $700,000 DD $200,000 $200,000 PL. & EQ. 100,000 CAPITAL 600,000 PL. & EQ. 100,000 CAPITAL 600,000 TRANSACTION 3 ACCEPTING DEPOSITS 28 MONEY SUPPLY = CURRENCY + DD = NO  TRANSACTION 4: JOINING THE CENTRAL BANK IT IS FREE. IT MAKES THE BANK TO KEEP A LEGAL_RESERVE_DEPOSIT. • Reserves: The amount of funds which a member bank must legally keep on deposit with the Central Bank or in its vault as cash. • Based on the total deposits of the bank, a fixed percentage of deposits must be held as reserves. • The reserve ratio is decided by the Central Bank. 29 • Graduated scale reserve ratio. • Assume reserve ratio is 20% (constant). • Vault cash: 1½ - 2 % of total assets. • Assume no vault cash. ____________BALANCE_SHEET__________ RESERVES $700,000 DD $200,000 PL. & EQ. 100,000 CAPITAL 600,000 EXCESS RESERVES = ACTUAL - REQUIRED = RESERVES - ( RES. RATIO x DD ) = 700,000 - ( 0.2 x 200,000 ) = $660,000 30 • CONTROL: THE OBJECTIVE OF LEGAL CONTROL: THE OBJECTIVE OF LEGAL RESERVES IS NOT LIQUIDITY AS RESERVES IS NOT LIQUIDITY AS PEOPLE THINK, RATHER IT IS PEOPLE THINK, RATHER IT IS CONTROLLING AND PREVENTING CONTROLLING AND PREVENTING BANKS FROM OVEREXTENDING BANK BANKS FROM OVEREXTENDING BANK CREDITS. CREDITS. • ANOTHER FUNCTION OF RESERVES IS ANOTHER FUNCTION OF RESERVES IS CLEARING OF CHECKS AMONG BANKS. CLEARING OF CHECKS AMONG BANKS. • RESERVES ARE ASSETS TO THE RESERVES ARE ASSETS TO THE COMMERCIAL BANK BUT ARE COMMERCIAL BANK BUT ARE LIABILITIES TO THE CENTRAL BANK. LIABILITIES TO THE CENTRAL BANK. 31 31 Which of the following is a service provided by the Central Bank? a. Providing permission to open a national bank b. Clearing checks between private banks c. Regulating credit unions d. Insuring individuals’ deposits The correct answer is “b” 32 TRANSACTION 5: ASSUME A CHECK IN THE AMOUNT OF $20,000 IS DRAWN BY ONE OF THE CUSTOMERS, MR. X, OF OUR BANK ‘‘A’’, IN PAYMENT FOR A PURCHASE FROM MRS. Y, WHO IS A CUSTOMER OF BANK ‘‘B’’. 33 MR. X BANK A MRS. Y BANK B CENTRAL BANK CASH IN A $$$ DD OF X $$$ CASH IN B $$$ DD OF Y $$$ RES. OF B $$$ RES. OF A $$$ RES. $$$ RES. $$$ 34 WHEN MR. X PAYS THE CHECK TO MRS. Y, HE DEBITS PURCHASES, AND CREDITS CASH. MR. X CASH IN A $$$ -20,000 35 MRS. Y DEBITS CASH, AND CREDITS SALES. MRS. Y CASH IN B $$$ +20,000 36 MRS. Y SENDS THIS CHECK TO HER BANK AS A DEPOSIT. BANK B DD OF Y $$$ RES. $$$ +20,000 BANK B SENDS THIS CHECK TO THE CENTRAL BANK AS A DEPOSIT, FOR CLEARING. BANK B DD OF Y $$$ RES. $$$ +20,000 +20,000 IN THE CLEARING HOUSE OF THE CENTRAL BANK THIS CHECK IS CLEARED. CENTRAL BANK RES. OF B $$$ RES. OF A $$$ 37 -20,000 +20,000 THE CENTRAL BANK SENDS THE CLEARED CHECK TO BANK A. -20,000 BANK A DD OF X $$$ RES. $$$ -20,000 _________BALANCE_SHEET_________ RESERVES $700,000 DD $200,000 -20,000 -20,000 -20,000 -20,000 $680,000 $180,000 RES. = 36,000 + 644,000 38 MONEY CREATING TRANSACTIONS OF A COMMERCIAL BANK TRANSACTION 6: GRANTING A LOAN ( 2ND FUNCTION OF A COMMERCIAL BANK ) ASSUME BANK A GRANTS A LOAN OF $644,000. AS AN IMMEDIATE IMPACT, LOANS  BY $644,000, AND DD  BY $644,000. 39 _____BALANCE_SHEET_____ RESERVES $680,000 DD $824,000 LOANS 644,000 MONEY SUPPLY  = CUR. + DD  WHEN A BANK MAKES LOANS, IT CREATES MONEY. AS A FINAL IMPACT, THE BORROWER DRAWS A CHECK AGAINST THE DD  THE RECEIVER OF THE CHECK DEPOSITS IT IN ANOTHER BANK B. 40 ___________BANK_A_________ RESERVES $ 36,000 DD $180,000 LOANS 644,000 ___________BANK_B__________ RESERVES $644,000 DD $644,000 A SINGLE COMMERCIAL BANK IN A MULTI-BANK BANKING SYSTEM CAN LEND ONLY AN AMOUNT EQUAL TO ITS INITIAL PRE-LOAN EXCESS RESERVES. 41 A bank has $200,000 in deposits and $10,000 in cash. The reserve requirement is 4 percent. The bank’s required reserves are ………….. , and its excess reserves are …………… . a. $400; $199,600 b. $199,600; $400 c. $8,000; $192,000 d. $2,000; $8,000 e. $8,000; $2,000  42 __________Balance_Sheet_________ Assets Liabilities Cash $ 5,000 DD $20,000 Loans _15,000 ______ Total Ass. $20,000 Tot. L. $20,000 Refer to the above balance sheet. If the reserve requirement is 12 percent and the bank receives a new deposit of $10,000, then required reserves will increase by a. $3,600 b. $2,400 c. $2,600 d. $2,800 e. $1,200  43 __________Balance_Sheet_________ Assets Liabilities Cash $ 5,000 DD $20,000 Loans _15,000 ______ Total Ass. $20,000 Tot. L. $20,000 Refer to the above balance sheet. Assume a reserve requirement of 10 percent. The maximum amount of new loans the bank could extend is a. $500 b. $1,000 c. $2,000 d. $3,000 e. $4,000  44 __________Balance_Sheet_________ Assets Liabilities Cash $ 5,000 DD $20,000 Loans _15,000 ______ Total Ass. $20,000 Tot. L. $20,000 Refer to the above balance sheet. If the excess reserves equal $2,800, what must the reserve requirement be equal to? a. 3 percent b. 11 percent c. 15 percent d. 20 percent e. 25 percent 44  Assume a reserve requirement of 20 percent. If a bank has zero excess reserves and $100 in total reserves, then its checkable deposits must equal a. $500 b. $400 c. $300 d. $200 e. $100 DD = 100 ÷ 0.2 = $500 45 TRANSACTION 6’: BUYING GOVERNMENT SECURITIES ASSUME THE BALANCE SHEET AFTER TRANSACTION # 5. ______BALANCE_SHEET_____ RES. $680,000 DD $180,000 ASSUME INSTEAD OF GRANTING A LOAN, BANK ‘A’ BUYS $644,000 OF SECURITIES FROM THE PUBLIC. AS AN IMMEDIATE IMPACT, SECURITIES  BY $644,000, AND DD  BY $644,000. 47 ________BALANCE_SHEET________ RESERVES $680,000 DD $824,000 SEC. 644,000 MONEY SUPPLY  = CUR. + DD  COMMERCIAL BANK BOND PURCHASES FROM THE PUBLIC INCREASE THE M1 IN THE SAME WAY AS DOES LENDING TO THE PUBLIC. 48 ________BALANCE_SHEET________ RESERVES $680,000 DD $824,000 SEC. 644,000 MONEY SUPPLY  = CUR. + DD  COMMERCIAL BANK BOND PURCHASES FROM THE PUBLIC INCREASE THE M1 IN THE SAME WAY AS DOES LENDING TO THE PUBLIC. 48 PROFITABILITY AND LIQUIDITY CONFLICTING GOALS. HOLDING LOANS AND SECURITIES ( PROFITABILITY ). THESE TWO ARE THE MAJOR EARNING ASSETS OF COMMERCIAL BANKS. SAFETY  LIQUIDITY  EXCESS RESERVES 49 THE COMMERCIAL BANKING SYSTEM CAN LEND, THAT IS, CAN CREATE MONEY, BY A MULTIPLE OF ITS EXCESS RESERVES. THIS MULTIPLE LENDING IS ACCOMPLISHED DESPITE THE FACT THAT EACH BANK IN THE SYSTEM CAN ONLY LEND DOLLAR FOR DOLLAR WITH ITS EXCESS RESERVES. 50 SIMPLIFYING ASSUMPTIONS: 1. RR = 20% 2. ALL BANKS ARE EXACTLY MEETING THE RR 3. IF EXCESS RESERVES  LOANS  FULLY DRAWN AND DEPOSITED IN ANOTHER BANK. 51 • Suppose You deposit $20,000 into your checking account at bank “A”. Money Supply = $20,000 Money Supply = $20,000 52 $20,000 Bank A 53 Bank A Reserves $20,000 DD $20,000 What happens to the deposit? • $4,000 stays at the bank as reserves • $16,000 of excess reserves is available for loans – Your friend borrows $16,000 for a new car Loans = $16,000 Reserves = $4,000 $20,000 Bank A 55 What happened to the amount of money in the economy? 56 The money supply is now equal to $36,000 -- $20,000 plus $16,000 -- what you deposited plus what your friend has borrowed. The loan created money. Money Supply = $36,000 Money Supply = $36,000 57 Suppose your friend deposits the $16,000 in a bank B... $16,000 Bank B 58 The bank must hold 20% as reserves ($3,200), and lends out the rest... 59 $16,000 Loans = $12,800 Reserves = $3,200 Bank 60