Money and the Banking System

Transcription

1 12 Money and the Banking System [Money] is a machine for doing quickly and commodiously what would be done, though less quickly and commodiously, without it. JOHN STUART MILL

2 Contents The Nature of Money How the Quantity of Money is is Measured The Banking System The Origins of the Money Supply Banks and Money Creation Why the Deposit Creation Formula Is Oversimplified The Need for Monetary Policy Copyright 2006 South-Western/Thomson Learning. All rights reserved.

3 The Nature of Money Barter versus Monetary Exchange A barter system (with no money) would be awkward and extremely inefficient. Money greases the wheels of exchange and, thus, makes the whole economy more productive.

4 The Nature of Money The Conceptual Definition of Money The functions of money: Medium of of exchange Unit of of account Store of of value Money = whatever serves as the medium of exchange

5 The Nature of Money What Serves as Money? Societies have gradually moved from the use of commodity monies to the use of money that has no commodity backing at all.

6 How the Quantity of Money is Measured There is is no single, obvious place to draw the line between money and near money. M1 = coins and paper money in circulation, plus checkable deposits M2 = M1 + money market deposit accounts, money market mutual funds, and savings accounts

7 FIGURE 2: Two Definitions of the Money Supply, January 2005 Currency Outside banks $710 billion Checking deposits In commercial Banks $330 billion M1 $1361 billion Other checkable deposits $321 billions Savings deposits $4378 billion M1 = $1361 billion M2 = $6443 billion Money market mutual funds $704 billion Copyright 2006 South-Western/Thomson Learning. All rights reserved.

8 The Banking System How Banking Began Fractional reserve banking began when goldsmiths realized they could profitably lend out a portion of the gold that had been deposited with them for safekeeping.

9 The Banking System How Banking Began Three important features of the fractional reserve banking system: Bank profitability Banks discretion over the money supply Exposure to to bank runs

10 The Banking System Principles of Bank Management: Profits versus Safety To make a profit, a banker must take risks. But because the business is is risky, the same banker must also emphasize safety. The heart of banking is is to be torn between the two principles.

11 Numberof BankFailures Numberof BankFailures FIGURE 1: Bank Failures in the United States, ,200 2,000 FDIC established 1,800 1,600 1,400 1,200 1, Great Depression begins Year (a) (b) 1995 '03 Copyright 2006 South-Western/Thomson Learning. All rights reserved.

12 The Banking System Bank Regulation Deposit insurance (FDIC) Eliminates the motive for customers to to withdraw funds because of of bad news regarding the bank s finances Moral hazard When an individual is is insured against risk, he/she puts forth little effort to to avoid risk FDIC could make the banking system less safe

13 The Banking System Bank Regulation Bank Supervision Needed to to reduce moral hazard problem Ensures banks take only sensible, defensible risks Controls the money supply Reserve Requirements Helps control the money supply

14 The Origins of the Money Supply How Bankers Keep Books Banks keep balance sheets Assets = liabilities + net worth Assets include: Reserves Loans Liabilities include: Deposits owed to to customers.

15 TABLE 1: Balance Sheet of Banka-mythica, Dec. 31, 2004 Copyright 2006 South-Western/Thomson Learning. All rights reserved.

16 Banks and Money Creation The Limits to Money Creation by a Single Bank Banks can lend money in their vault that is is above the minimum required reserve ratio. In doing so, they create new money.

17 TABLE 2: Bank-a-mythica s Balance Sheet, Jan. 2, 2005 Copyright 2006 South-Western/Thomson Learning. All rights reserved.

18 TABLE 3: Bank-a-mythica s Balance Sheet, Jan. 3-6, 2005 Copyright 2006 South-Western/Thomson Learning. All rights reserved.

19 TABLE 4: Bank-a-mythica s Balance Sheet, Jan. 2-6, 2005 Copyright 2006 South-Western/Thomson Learning. All rights reserved.

20 Banks and Money Creation Multiple Money Creation by a Series of Banks When all banks make loans with funds they have that are above the required reserve ratio, the society s money supply expands.

21 Banks and Money Creation Multiple Money Creation by a Series of Banks deposits = (1/m) x reserves Assumes banks keep the minimum reserve ratio, m Assumes all new money held in in the form of of deposits Oversimplified deposit multiplier formula

22 TABLE 5: Changes in First National Bank s Balance Sheet Copyright 2006 South-Western/Thomson Learning. All rights reserved.

23 TABLE 6: Changes in Second National Bank s Balance Sheet Copyright 2006 South-Western/Thomson Learning. All rights reserved.

24 FIGURE 3: The Chain of Multiple Deposit Creation Running Sums (1) (2) Reserves Deposits (3) Loans $100,000 deposit $100,000 $20,000 on reserve $80,000 lent out $20,000 $80,000 $80,000 deposit $180,000 $16,000 on reserve $64,000 lent out $36,000 $144,000 $64,000 deposit $244,000 $12,800 on reserve $51,200 lent out $48,800 $195,200 $51,200 deposit $295,200 $10,240 on reserve $40,960 lent out $59,040 $236,160 $40,960 deposit $336,160 $8,192 on reserve $32,768 lent out $67,232 $268,928 And so on... $100,000 $500,000 $400,000 Copyright 2006 South-Western/Thomson Learning. All rights reserved.

25 Banks and Money Creation The Process in Reverse: Multiple Contractions of the Money Supply Deposits, and with them the money supply, contract when reserves are reduced. Banks reduce their loan commitments. Calculation of of the contraction in in the money supply utilizes the same formula as as for money expansion.

26 TABLE 7: Changes in Balance Sheet of Bank-a-mythica Copyright 2006 South-Western/Thomson Learning. All rights reserved.

27 TABLE 8: Changes, Balance Sheet of First National Bank Copyright 2006 South-Western/Thomson Learning. All rights reserved.

28 Why the Deposit Creation Formula Is Oversimplified Individuals hold some portion of additions to their money in the form of cash. Banks sometimes hold reserves above the required minimum.

29 The Need for Monetary Policy Left uncontrolled, banks would: Reduce the money supply in a recession Increase the money supply during boom periods Changes in the money supply would exacerbate the business cycle. One reason for monetary policy, therefore, is is to prevent this behavior on the part of banks.