Lecture Essentials of economics (3/e): Chapter 14 - Brue, McConnell, Flynn

Chapter 14 - Money, banking, and financial institutions. In this chapter, we start by looking at the functions of money and the definitions of the money supply. Then there is a discussion of the factors that back the money supply. In this chapter, you will be introduced to the U.S. banking system, in particular, the Federal Reserve. You will learn about their functions and how the Fed has been set up.

Chapter 14 Money, Banking, and Financial Institutions McGraw­Hill/Irwin Copyright © 2014 by The McGraw­Hill Companies, Inc. All rights reserved 14­1 1­1 Functions of Money  • Medium of exchange • Used to buy/sell goods • Unit of account • Goods valued in dollars • Store of value • Hold some wealth in money form • Liquid 14­2 Money Definition M1 • M1 • Currency • Checkable deposits • Institutions offering checkable deposits • Commercial banks • Savings and loan associations • Mutual savings banks • Credit unions 14­3 Money Definition M2 • M2 • M1 plus near-monies • Savings deposits including money market deposit accounts (MMDA) • Small-denominated time deposits • Money market mutual funds (MMMF) 14­4 Money Definitions Money supply, M2 $9001 billion Currency 50% Savings deposits, including money market deposit accounts 61% M1 22% Checkable deposits 50% Money supply, M1 $1935 billion Source: Federal Reserve System Small time deposits 9% Money market mutual funds 8% 14­5 What “Backs” the Money Supply? • Guaranteed by government’s ability to • • keep value stable Money as debt Why is money valuable? • Acceptability • Legal tender • Relative scarcity 14­6 What “Backs” the Money  Supply? • Prices affect purchasing power of • • money Hyperinflation renders money unacceptable Stabilizing money’s purchasing power • Intelligent management of the money supply—monetary policy • Appropriate fiscal policy 14­7 Federal Reserve — Banking System • Historical background • Board of Governors • 12 Federal Reserve Banks • Serve as the central bank • Quasi-public banks • Banker’s bank 14­8 Federal Reserve — Banking System Board of Governors Federal Open Market Committee 12 Federal Reserve Banks Commercial banks Thrift institutions (savings and loan associations, mutual savings banks, credit unions) The public (households and businesses) 14­9 Federal Reserve — Banking System The 12 Federal Reserve Banks 14­10 A Single Commercial Bank Transaction #2 Acquiring property and equipment Acquiring Property and Equipment Balance Sheet 2: Wahoo Bank Assets Cash Property Liabilities and Net Worth $ 10,000 Stock shares 240,000 $250,000 14­25 A Single Commercial Bank Transaction #3 Commercial bank functions • • Accepting deposits Making loans Accepting Deposits Balance Sheet 3: Wahoo Bank Assets Cash Property Liabilities and Net Worth $110,000 240,000 Checkable deposits Stock shares $100,000 250,000 14­26 A Single Commercial Bank Transaction #4 Depositing reserves in a Federal Reserve Bank • • Required reserves Reserve ratio Reserve ratio = Commercial bank’s required reserves Commercial bank’s checkable-deposit liabilities 14­27 A Single Commercial Bank Transaction #4 Assume the bank deposits all cash on reserve at the Fed Depositing Reserves at the Fed Balance Sheet 4: Wahoo Bank Assets Cash Reserves Property Liabilities and Net Worth $ Checkable 110,000 Deposits 240,000 Stock Shares $100,000 250,000 14­28 A Single Commercial Bank • Excess reserves • Actual reserves - Required reserves • Required reserves • Checkable deposits × Reserve ratio • Example: • Checkable deposits: $100,000 • Reserve ratio: 20 percent 14­29 A Single Commercial Bank Transaction #5 Clearing a check • $50,000 check reduces reserves and checkable deposits Clearing a Check Balance Sheet 5: Wahoo Bank Assets Liabilities and Net Worth Reserves Checkable deposits Property $ 60,000 240,000 Stock shares $ 50,000 250,000 14­30 Money­Creating Transactions Transaction #6a Granting a loan • $50,000 loan deposited to checking When a Loan Is Negotiated Balance Sheet 6a: Wahoo Bank Assets Reserves Loans Property Liabilities and Net Worth $ 60,000 Checkable deposits 50,000 240,000 Stock shares $100,000 250,000 14­31 Money­Creating Transactions Transaction #6b Using the loan • $50,000 loan cashed After a Check Is Drawn on the Loan Balance Sheet 6b: Wahoo Bank Assets Reserves Loans Property Liabilities and Net Worth $ 10,000 Checkable deposits 50,000 240,000 Stock shares $ 50,000 250,000 A single bank can only lend an amount equal to its preloan excess reserves 14­32 The Banking System • Multiple-deposit expansion • Assumptions: • 20 percent required reserves • All banks “loaned up” • Banks lend all of their excess • • reserves A $100 bill is found and deposited Multiple deposits can be created 14­33 The Banking System The Banking System’s Lending Potential Multiple-Deposit Expansion Process Balance Sheet: Commercial Bank A Assets Reserves Liabilities and Net Worth $+100 (a1) Checkable deposits -80 (a ) Loans +80 (a2) $+100 (a1) +80 (a2) -80 (a3) 14­34 The Banking System The Banking System’s Lending Potential Multiple-Deposit Expansion Process Balance Sheet: Commercial Bank B Assets Reserves Liabilities and Net Worth $+80 (b1) Checkable Deposits -64 (b ) Loans +64 (b2) $ +80 (b1) +64 (b2) -64 (b3) 14­35 The Banking System Bank (2) (1) Required Acquired Reserves Reserves and Deposits (Reserve Ratio = 2) Bank A $100.00 Bank B 80.00 Bank C 64.00 Bank D 51.20 Bank E 40.96 Bank F 32.77 Bank G 26.21 Bank H 20.97 Bank I 16.78 Bank J 13.42 Bank K 10.74 Bank L 8.59 Bank M 6.87 Bank N 5.50 Other Banks 21.99 $20.00 16.00 12.80 10.24 8.19 6.55 5.24 4.20 3.36 2.68 2.15 1.72 1.37 1.10 4.40 (3) Excess Reserves (1)-(2) $80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.59 (4) Amount Bank Can Lend; New Money Created = (3) $80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.59 $400.00 14­36 The Monetary Multiplier Monetary multiplier = Required reserve ratio = R 14­37 The Monetary Multiplier • Maximum amount of new money • • created by a single dollar of excess reserves Higher R, lower m Reversibility • Making loans creates money • Loan repayment destroys money 14­38 Bank Panics of 1930–1933 • • • • • • • Before deposit insurance Bank failure led to mass withdrawals Forced loan reduction 25-33 percent decline in money supply 1933 national bank holiday to evaluate all banks Contributed to the Great Depression Regulation protects the system today 14­39 ...Functions of Money  • Medium of exchange • Used to buy/sell goods • Unit of account • Goods valued in dollars • Store of value • Hold some wealth in money form • Liquid 14 2 Money Definition M1... incentives provided by mortgage-backed bonds 14 15 The Financial Crisis of 2007 and  2008 • Securitization — the process of • • LO5 slicing up and bundling groups of loans into new securities As... Historical background • Board of Governors • 12 Federal Reserve Banks • Serve as the central bank • Quasi-public banks • Banker’s bank 14 8 Federal Reserve — Banking System Board of Governors Federal