Chapter 14- Money and Banking

MONEY AND BANKING * A bank run on American Union Bank during the Great Depression OVERVIEW / Questions of the Day What do economists mean by ?money?? How is it different from other assets? What does money do for you? What is the money supply? How do banks ?create? and ?destroy? money? * MONEY ? Kinds Commodity Money ? a It has value in and of itself as well as serving as money Examples Fiat Money ? commodity that serves the function of money but has no intrinsic value It serves as money only because of government decree; it has no other value and serves no other purpose Examples MONEY ? Functions All Assets (items of value) Money ? the Money ? the commodity that is generally accepted as a means of payment Money All other assets What is the distinction? What is the cutoff? What actually counts as money? MONEY ? Functions (cont) Money serves a variety of functions that separate it from other assets be generally accepted as a means of payment Unit of Account serves as a can be held and exchanged later for goods and services An asset that performs these 3 functions is therefore considered ?money? * SUPPLY OF MONEY How much money is actually out in the economy? M1 ? M2 ? slightly more broad and inclusive but less liquid M3 ? more broad still, more inclusive than M2 and less liquid (discontinued by FED as of spring 2006) Liquidity ? the * Money Supply ? M1 M1 = C coin (token money) + D + Traveler?s Checks + Other checking accounts in thrifts ? credit unions, savings and loans NOW accounts ? negotiated order of withdrawal ATS accounts ? automatic transfer service * U.S. Current Money Supply (M1) Source: www.federalreserve.gov; Numbers in billions; Data as of June 2008 Total M1: $1,385.6 B * Money Supply ? M2 M2 = M1 + + Small-denomination certificate + Retail Money Market Mutual Funds (MMMF) deposits invested in short term securities w/limited check writing capabilities * U.S. Current Money Supply (M2) Source: www.federalreserve.gov; Numbers in billions; Data as of June 2008 Total M2: $7,687.2 B * Money Supply ? M1 and M2 M1 Includes: Cash and coin (outside of bank vaults); Checking accounts; Travelers checks Generally, the distinction in this class between M1 and M2 will usually not matter when we talk about the ?money supply?. * U.S. Historical Money Supply ? M1 Source: www.federalreserve.gov; Numbers in billions * U.S. Historical Money Supply ? M2 Source: www.federalreserve.gov; Numbers in billions * For each of the following assets, determine if they would be included into M1, M2, both, or neither A certificate of deposit for $50,000 A checking account A U.S. Savings Bond A $20 bill A savings account * BANKING Federal Depository Institutions (FDI?s) ? any institution that: Commercial Banks Bank of America, SunTrust, AmSouth/Regions, etc Thrift Institutions credit unions savings banks savings and loans associations * FDI?s and the Economy FDI?s play a crucial role in the economy ? they serve to discussed in the Savings and Investment chapter In addition, they play a role in the supply of money by ?creating? and/or ?destroying? money; they do this through * Balance Sheet of a Bank * Banks use a T-account as a balance sheet assets go on the left liabilities and equity go on the right the two sides must equal Balance Sheet (cont) The assets, liabilities and equity are from the bank?s point of view! Assets Reserves Loans to customers (money owed TO the bank) Liabilities * Banks and Money Creation ? Example How do banks ?create? money? Fractional Reserve Banking - banks hold only a portion of their deposits as reserves and loan the rest out Required Reserve Ratio (rr or R) The % of deposits that Set by If rr = 10%, for every $100 deposited: banks must hold at least They can loan out at * Banks and Money Creation ? Example Suppose Albert deposits $1,000 cash into his checking account in Bank A What happens to the balance sheet of Bank A? What happens to the money supply (M1)? * deposits reserves Liabilities Assets Bank A?s Balance Sheet What has happened to the money supply? Effect on Bank A * started with $1,000 M1 Albert deposited cash into Bank A Currency ? by $1,000 while checkable deposits ? by $1,000; no change so far What does Barbara do with her new $900? Effect on Money Supply (M1) * loans deposits +$90 reserves Liabilities Assets Bank B?s Balance Sheet Barbara takes her $900 and deposits it into her checking account at Bank B? What happens to Bank B? What has happened to the money supply? Effect on Bank B * created by Bank A + $900 started with $1,000 M1 Effect on Money Supply (M1) * loans deposits reserves Liabilities Assets Bank C?s Balance Sheet Cindy takes her $810 and deposits it into her checking account at Bank C? What happens to Bank C? What has happened to the money supply now? Effect on Bank C * Final Money Supply + ? created by Bank A + $900 started with $1,000 M1 Effect on Money Supply (M1) * Money Multiplier Formula Money multiplier (or deposit multiplier) = Used to determine the final amount of the money supply after the entire process is completed Final money supply (checkable deposits) = (initial change in checkable deposits) * money multiplier + ? created by Bank C + $729 created by Bank B + $810 created by Bank A + $900 started with $1,000 M1 We started with Albert and $1,000 in cash Effect on Money Supply (M1) * $1,000 Total M1 0 Other Checking 0 Traveler?s Checks 0 Commercial Checking $1,000 Currency M1 After M1 Before Effect on Money Supply (M1) * Suppose you find $25 in change in your couch cushions, which you quickly deposit into your checking account. The required reserve is 10%. What is the final amount of the money supply, after the lending process is completed? How much money did banks ?create?? Suppose that the required reserve ratio is 20%. How does that change your answers above? * Key Terms and Concepts Key Terms fiat money vs. commodity money money supply: M1 and M2 balance sheet of a bank required reserve ratio (rr) and the money multiplier Key Ideas Money serves several specific functions that separate it from other assets Banks can ?create? and ?destroy? money due to the fractional reserve banking system Multiply the change in bank deposits by the money multiplier to find the final change in bank deposits * Friday morning, Sept. 14th 2007, worried British customers of Northern Rock PLC began lining up outside all branches in order to cash out their accounts Northern Rock is the U.K.?s 5th largest mortgage lender * Can what happened recently in Britain also occur in the U.S.? Since we operate under a fractional reserve banking system, it is always possible; but highly unlikely This is because the U.S. and Britain have different rules to guarantee deposits The U.S. has had bank runs in the past, notably during the Great Depression before the FDIC was created; before then if a bank went bankrupt, depositors typically lost everything Today in the U.S., the Federal Deposit Insurance Corp. (FDIC) guarantees up to $100,000 per account per bank, and $250,000 in retirement accounts In the U.K., the government guarantees only up to 2,000 pounds ($4,000) , 90% of deposits up to 35,000 pounds ($70,000), and nothing over that MSNBC; September 19, 2007 www.msnbc.msn.com/id/2084099 * What generally happens when a bank fails? Usually, the FDIC (Federal Depository Insurance Corporation) will find a buyer The bank closes on Friday and will open on Monday as a new, acquired institution Do you have access to your money during the weekend? Generally, you still have access to ATM?s and debit cards What happens if no one buys the bank? ATM?s, debit cards and checks all become cancelled; the FDIC will mail checks for the insured amount to customers What if you have more than the insured amount with the failed bank? Generally, you become a creditor, the FDIC will pay off creditors as they sell the failed bank?s assets * From bankrate.com, by Laura Bruce; July 2008