Macro Lecture 6: The Banking System and the Money Market

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1 Macro Lecture 6: The Banking System and the Money Market Banking System The banking system plays a crucial role in financial markets. We shall study the banking system using one the accountant s favorite tools: the balance sheet. A balance sheet reports on the financial position of a firm or individual at one point in time. A balance sheet includes two columns; we list assets in the left column and liabilities in the right column. Your assets are everything you own plus everything others owe you. Your liabilities are everything you owe others. Your assets Your liabilities Everything you Everything you own plus everything owe others others owe you Next, consider a bank s assets and liabilities: Bank s assets Everything the bank owns plus everything others owe the bank Bank s liabilities Everything the bank owes others Consolidated Balance Sheet of the Commercial Banking System, July 24, 2013 Table 6.1 reports the relevant balance sheet data for the commercial banks in the U.S. on July 24, 2013: Billions of Dollars Cash 2,230 Deposits 9,530 Securities 2,700 Loans 7,325 Borrowing 1,520 Other 1,365 Other 1,100 Table 6.1: Balance sheet items of the U.S. commercial banking system: July 24, 2013 Bank The bank s assets are everything the bank owns plus everything others owe the bank. Cash assets include vault cash and deposits at the Federal Reserve Board. Banks clearly own the cash in their vaults. Also, each bank owns the deposits it has at the Federal Reserve Board, the Fed. The Fed is the bank s bank. Just as we deposit funds at our bank, banks deposit funds at their bank, the Fed. Securities are the stocks and bonds that banks own. Loans are something that others owe the banks. Other assets include land, buildings, etc. that banks own. Bank The bank s liabilities are everything the bank owes to others. Deposits of the banks customers represent a liability. Customer deposits are something that the banks owe others. Borrowing, everything banks have borrowed from others, are liabilities. Other liabilities include any rent the banks might owe to their landlords, wages they might owe their employees, etc.

2 2 Bank Net Worth Using the data we construct the consolidated balance sheet of the commercial banking system on this date: Cash assets 2,230 Deposits 9,530 Securities 2,700 Borrowing 1,520 Loans 7,325 Other liabilities 1,100 Other assets 1,365 Bank assets = 2, , , ,365 = 13,620 Bank liabilities = 9, , ,100 = 12,150 Net worth equals assets minus liabilities Bank Net Worth = Bank Bank = 13,620 12,150 = 1,470 Federal Reserve Board and the U.S. Treasury The U.S. Treasury and the Federal Reserve Board are two different government agencies. The U.S. Treasury is part of the President s cabinet. The Treasury Secretary serves at the pleasure of the President. The President could fire the Treasury Secretary at any time. On the other hand, the Federal Reserve Board is a semi-autonomous government agency. The President nominates members to the Federal Reserve Board and the Senate must confirm them. Once confirmed, however, members of the Federal Reserve Board have a specified term of fourteen years. Unlike the Treasury Secretary, members of the Federal Reserve do not serve at the President s pleasure; the President cannot fire them. This gives the Federal Reserve Board considerable independence. Federal Reserve Board and the Fractional Reserve Banking System The Federal Reserve Board (Fed) plays several important roles in the banking system. One role the Fed plays is that of the bank s bank. Just as you and I can deposit funds at our bank and borrow funds from our bank, a bank can deposit funds at the Fed and borrow from the Fed. The funds a bank deposits at the Fed shows up on the bank s balance sheet in the cash assets entry. borrows from the Fed shows up in the borrowing entry. Note that banks do not have enough cash assets to cover their customers deposits. If all the banks customers would try to withdraw their deposits as cash, banks would not be able to immediately meet their customers demands. This is what we mean by a fractional reserve banking system. By definition, a bank equal the cash in their vaults plus their deposits at the Federal Reserve Board (Fed). (Actual) Reserves = Vault cash + Deposits at Fed A bank has immediate access to the cash in its vault; furthermore, the banks can quickly gain access to their deposits at the Fed. Consequently, the banks have ready access to all their. The Fed requires banks to keep a fraction of its deposits as. The fraction is called the required reserve. The Fed sets the required reserve. equal the required reserve times the bank s deposits: = Deposits The Fed monitors banks to be certain that their actual never fall short of their required.

3 3 Simplified Bank Balance Sheet To understand how the banking system works, we shall consider the banking system as a whole. That is, we will lump all the banks together as though there was a single bank in the U.S. Note that this is much in the spirit of macroeconomics: in macro we consider the economy as a whole. Also, we shall simplify the balance sheet to include only the crucial items. We will not use the actual numbers to keep the arithmetic straightforward: Reserves 50 Deposits 400 Vault Cash 30 Loans 380 Borrowing 10 What is net worth? Total assets = = 490 Total liabilities = = 410 Net Worth = 80 Recall that we have a fractional reserve banking system. In a fractional reserve banking system, the required reserve is crucial. The Federal Reserve Board is not only the banks bank, but it also regulates banks. The Fed sets the required reserve. This determines how many banks are required to keep. Currently, the required reserve for large commercial banks is 10 percent: Reserve Ratio = 10% In general, a bank s required equal the required reserve times deposits: = reserve Deposits What are required in our simplified example? = reserve Deposits = 10% 400 = 40 The bank s actual are 50 and its required are 40; the actual exceed what is required. The bank has excess of 10: Excess (Actual) = = = 10 How would the bank respond? A bank earn profits from making loans. Like any firm, banks are interested in profits; consequently, we would expect the bank to issue more loans to increase its profits. Since actual are 50 and required are 40, what would happen if the bank president issued a memo instructing the loan officer to issue 10 more loans?

4 4 Assume that the figures in the simplified balance sheet are in units of thousands of dollars. Suppose that a friend, Sam, walks into a bank and applies for a $10 thousand loan to buy a used car. Since the loan officer has just received the bank president s memo, the officer approves the loan. What would the loan officer do? He/she could walk into the bank s vault take out $10 thousand of cash and give it to Sam. If this occurred, the cash in the bank s vault would fall by 10 and its loans would rise by 10: Reserves Deposits 400 Vault Cash Loans Sam +10 Borrowing 10 What are required now? = reserve Deposits = 10% 400 = 40 If this were all that happened, the story would end here; now, both actual and required are 40. This is not the end of the story, however. What would Sam now do? Would Sam feel comfortable walking down the street with $10 thousand of cash in his pocket? I think not. Before Sam left the bank, he would no doubt go to a teller s window and deposit the $10 thousand in his checking account at the bank. After all, isn t this the reason we have checking accounts? A checking account allows us to avoid carrying around large sums of cash. What happens to the balance sheet when Sam deposits the $10 thousand? Sam s deposits rise by 10; hence, deposits rise by 10. Also, the $10 thousand of cash are back in the bank s vault; accordingly, cash in the vault returns to 30 and return to 50. Reserves Deposits Vault Cash 30 Sam +10 Loans Sam +10 Borrowing 10 Let us see what has happened. When the bank issues a new loan: Loans and Deposits increase by the amount of the new loan; Reserves are unaffected. In reality, loan officers know that their customers do not like to walk around with large sums of cash. Accordingly, loan officers never go into the bank vault for cash. Instead, when a loan is approved the loan officer simply credits the customer s account with the amount of the loan. For example, the loan officer would simply credit Sam s checking account with the $10 thousand. Sam s account balance rises by $10 thousand.

5 5 What are required now? = reserve Deposits = 10% 410 = 41 The bank s actual are 50, its required are 41; the bank has excess of 9. After Sam s loan of 10, the bank still has excess. Since the bank s loans provide the bank with profits, we would expect the bank to issue more loans. How many additional loans can the bank issue? To answer this question, keep in mind that when a bank issues a new loan: The bank s loans and deposits increase by the amount of the new loan; The bank s are unaffected. Then, consider the following question: Question: With a required reserve of 10% and actual of 50, how many deposits can the bank be liable for? Answer: 500. Since actual are 50 and the required reserve equals 10%, the bank s deposits can rise to 500, 10% of 500 equals 50. Since loans and deposits change by the amount of new loans, loans can increase by an additional 90: Reserves 50 Deposits Vault Cash 30 Sam +10 Others +90 Loans Sam +10 Others +90 Borrowing 10 When the bank issues the 90 additional loans: The bank s loans and deposits increase by the amount of the new loans, by 90; loans rise from 390 to 480 and deposits rise from 410 to 500; The bank s are unaffected, remain at 50. What are required now? = reserve Deposits = 10% 500 = 50 (Actual) equal required. Since there are no excess, the bank cannot issue any additional new loans. The bank is loaned up.

6 6 What happens when Sam visits the auto dealer and purchases the car. Since the car costs $10 thousand, Sam will write out a check for $10 thousand. Sam hands the check to the dealer and after checking to be certain that Sam has $10,000 in his checking account, the dealer gives Sam the keys. What does the dealer do with Sam s check? The dealer deposits the check at the bank. What happens to the balance of Sam s account and the dealer s account? Sam s account will decline by 10 and the dealer s will rise by 10: Reserves 50 Deposits Vault Cash 30 Sam Others +90 Dealer +10 Loans Sam +10 Others +90 Borrowing 10 While the transaction, the sale of the car, changes the composition of deposits at the bank (Sam s account balance falls by 10 and the dealer s rises by 10), it has not changed the overall level of deposits that remain at 500. Next, what happens when the dealer pays the salesman a $1 thousand commission for selling the car? The dealer will write out a $1 thousand check and hand it to the salesman. What will the salesman do with the check? The salesman will deposit it. When the check is deposited, the salesman s account balance will rise by 1 and the dealer s will fall by 1: Reserves 50 Deposits Vault Cash 30 Sam Others +90 Dealer Loans Salesman +1 Sam +10 Others +90 Borrowing 10 Again, we observe that the transactions that occur after the loan has been made will change the composition of bank deposits, but not the overall level of deposits. Summary of Banking System When a bank issues a new loan: Loans and deposits increase by the amount of the new loan; Reserves are unaffected; Subsequent transactions change the composition of deposits, but not the overall level. Key Questions to Ask: With actual of and a required reserve of %, how many deposits can the bank be liable for? Since loans and deposits change by the same amount when a bank issues a new loan and are unaffected, how many loans should the bank issue? Macro Lab 6.1 allows us to check our logic: Macro Lab 6.1: Banking System Mechanics

7 7 The Money Market and the Nominal Interest Rate Review To illustrate the money market, we place the nominal interest rate (i) on the vertical axis and the quantity of money (M) on the horizontal axis as illustrated in figure 7.2. Like any market, the money market is composed of two parts: demand and supply. i (%) The demand curve is downward sloping; as the nominal MS interest rate rises, the quantity of money demanded decreases. The supply curve is vertical; as we will see, the Federal Reserve Board fixes the quantity of money supplied. The money market is in equilibrium whenever the quantity of money demanded equals the quantity of money supplied; that is, an equilibrium exists whenever the nominal interest rate equals i* as shown in figure 6.2. We will now explore the demand and supply of money. Again, recall that it is imperative to distinguish between money and income. Money refers to the financial assets that we own that can be used to purchase goods and services: the cash in our wallet and balances of our checking and savings accounts. Income refers to how many dollars we earn over the course of a year. i* Figure 6.1: Money market MD M Supply Curve for Money As illustrated above, the supply curve for money is vertical. To understand this we shall study the banking system and the role that the Federal Reserve Board plays in the system. It will take a little work to explain this so please be patient. Recall our simplified bank balance sheet: Reserves 50 Deposits 500 Vault Cash 30 Loans 480 Borrowing 10 Question: Which balance sheet entry counts as money? That is, which entry can we use to purchase goods and services? Answer: We use our deposits. We can purchase goods and services by writing checks account deposits, as long as our checking account balance is sufficient. Also, in the age of smart phones we can transfer funds from our saving accounts to our checking accounts in seconds. So, effectively our savings account deposits also constitute money. As we shall see, by affecting deposits the Federal Reserve Board (Fed) can shift the money supply (MS) curve and therefore influence the interest rate. This is how the Fed can apply the Taylor principle to stabilize the economy.