Nicholson- AP MACRO REVIEW
Money and Banking
15-20% Financial Sector(Money and Banking)
A. Money, banking, and financial markets
1. Definition of financial assets: money, stocks, bonds
2. Time value of money (present and future value)
3. Measures of money supply
4. Banks and creation of money
5. Money demand
6. Money market
7. Loanable funds market
B. Central bank and control of the money supply
1. Tools of central bank policy
2. Quantity theory of money
3. Real versus nominal interest rates
•Money is anything that can be used as:
–A medium of exchange
–A store of value
–A unit of account / Standard of Value
•Money works best when it meets these criteria:
The Supply of Money
•In the United States, the Federal Reserve System is the sole issuer of currency.
–This means the Fed has monopoly control over the money supply.
•There are two important measures of the Money Supply today.
•M1 serves primarily as a medium of exchange. It includes:
–Currency and Coin
•M2 serves as a store of value. It includes:
–Money Market Mutual Funds
M1 & M2
•M1= Checkable Deposits and Currency
•M2= M1 + Savings deposits, money market accounts, small time deposits (less than $100,000)
•Velocity of Money Equation:
MV = PQ ( GDP) (M= Money Supply and V = Velocity (number of times per year the average dollar is spent on goods and services
Value of Money
- Acceptability: if people lose faith in a currency, then it’s value as money is limited.
- Legal Tender: government declaring it to be “money”
- Relative Scarcity: If money becomes too commonplace – it loses it’s value. If it isn’t scarce – nobody is in need of it, therefor they aren’t willing to trade what they have for more of it.
Money and Prices
- The Purchasing Power of the Dollar: The value of money is related to the price level in the economy. As the price level rises (prices are rising) and each dollar will buy less of everything. The higher that price level gets, the less value the dollar has.
Value of the Dollar = 1 / Price Level
- Inflation and Acceptability: If the price level rises rapidly (inflation), then people may wish to hold their savings in something other than money. This is why many people buy gold or other commodities – instead of holding money as money, when the economy is experiencing inflation.
Stabilization of Money’s Value
It is in the best interest of the government and the agency charged with controlling the money supply (in the U.S. that agency is the FED – the Federal Reserve) to make sure that the value of the money supply is stable. They can use fiscal policy (government) and monetary policy (the FED) to help stabilize the value of the currency.
The curve for Money Supply
The curve for Money Supply is a straight vertical line – at whatever level of Money Supply that happens to exist at the time.
The demand for money that depends on the interest rate on savings accounts (and other investments). The higher the rate of interest on the investment, the more of our money we want to stay invested (to get the most out of the high rate we want most of our money earning interest). If the interest rates are low – there is less opportunity cost of holding money as cash, so we hold more money as cash.
Total Money Demand
Adding the two types of Money Demand you get a curve that looks like the Asset Demand for Money curve – it reacts to the change in the interest rate. It is further to the right than Asset Demand because it also includes the money we demand for transactions.
The Money Market
The Money Market is the interaction of the Money Demand Curve and the Money Supply Curve. The intersection of these curves is the equilibrium point and determines the interest rate in the economy (i*).
Adjustment to a Decline in the Money Supply: If Money Supply decreases then the MS curve shifts left – and the new equilibrium is at a higher interest rate (i’). Why does the interest rate rise? As money becomes scarcer, banks need to attract money to the bank in order to make loans (and earn money). As people keep more money in the bank, they will have less on hand (the level of MD is lower).
Adjustment to an Increase in the Money Supply: If the money supply increases (from MS to MS’’) and the interest rate drops to i’’. What happens is that the flood of easy money makes it unnecessary for banks to offer high interest rates to attract money to make loans. They offer lower interest rates on savings and fewer dollars come to the bank (low opportunity cost of holding money).
THE FEDERAL RESERVE
The Federal Reserve and the Banking System -
Historical Background: In the early 20th century there was a particularly bad bank panic (lots of bank failures) in 1907 (1907 Banking Crisis) and Congress decided they should take steps to make sure it didn’t happen again. They passed the Federal Reserve Act of 1913 – which created the Federal Reserve Bank System.
Board of Governors: The FED (Federal Reserve System) is run by a 7 person board called the Board of Governors. Each member is appointed to a 14 year term – and the terms of office are staggered (one governor is appointed every two years). The Governors are appointed by the President and confrimed by the Senate.
Federal Open Market Committee (FOMC): This committee is responsible for performing what is called Open market Operations (OMO). It consists of 12 members:
- The 7 members of the Board of Governors
- the President of the NY Regional Fed
- 4 of the other 11 regional Fed Presidents on a rotating basis
The 12 Federal Reserve Banks: The FED has 12 regional branches – which perform the duties of the FED. Those branches are located in:
- St. Louis
- Kansas City
- San Francisco
Central bank: While the FED is our central bank – it isn’t a central bank in the traditional sense. It isn’t one bank – it’s a system (part of our traditional American resistance to big centralized government).
Quasi-Public Banks: The Regional FEDs are owned by the banks they serve – but are led by administrators appointed by government.
Bankers’ Banks: The FED is a bank for banks – and does not have private citizens as customers. The accounts at the FED banks are banks’ bank accounts. They make loans to banks – not corporations or individuals.
Commercial Banks and Thrifts:
- 7,800 commercial banks (3/4 state-chartered banks, ¼ federally chartered banks)
- 11,800 thrifts (mostly CU’s (10,300), plus S&L’s and Mutual Savings banks)
Fed Functions and the Money Supply
- issuing currency – the FED is responsible for providing the necessary currency to run the economy. They use issuing currency as one way to perform monetary policy.
- setting Reserve Requirement and holding reserves – the FED requires Banks to hold a portion of each deposit at the FED to help stabilize the banking system. They can change the rate required to be held at the FED as a tool of Monetary Policy
- lending money to bank and thrifts – the FED lends money to banks and thrifts to make loans or to use as reserves at the FED. They charged an interest rate for this loan – called the discount rate (often incorrectly called the prime rate in the press). Changing this discount rate is another tool for performing monetary policy.
- providing check collections – the FED’s collect checks and clear them by transferring funds from one banks account at the FED to another bank’s account. The banks then technically have received that money from the bank the check was written from – and can then deposit that money in the account of their customer.
- acting as fiscal agent for federal government – the Federal government has it’s accounts at the FED rather than a private bank.
- supervising banks – the FED checks the books of banks to make sure that they are making a wise economic choices – a balanced loan portfolio etc. If they are not, they can refuse to make loans to these banks as well as other measures to make the bank want to change their loan portfolio.
- controlling the money supply – the FED uses the Money Supply to effect the interest rates and through that to make monetary policy.
The Balance Sheet of a Commercial Bank
Formation of a Commercial Bank
Transaction 1: Creating a Bank:
Transaction 2: Acquiring Property and Equipment:
These two transactions are pretty self explanatory, but I put in a “T” account for them anyway. The basic premise of a “T” account is that the total in the left column must always equal the total in the right column. Other than that, we don’t need to delve into accounting any more than that. Our investor (vault owner) is going to invest $150,000 and use $100,000 of it to buy a vault and a building. The money invested (Capital Stock) is a liability to the firm – they owe it back to the investor. The cash and the building are going to be used to create money – so they are assets.
Transaction 3: Accepting Deposits
Here is our vault owner accepting gold into his vault. Let’s let him accept $100,000 worth of deposits. The deposits are his liabilities – he owes them to someone (the customers), but the cash in the vault is an asset to him (can be used to create money and profits).
Transaction 4: Depositing Reserves in a Federal Reserve Bank:
Next we have to add that a modern bank must keep reserves (some of the deposits) at the FED (Federal Reserve Bank) but in the old west – we could just say this is the cash kept in the vault in case someone wants to withdraw some of their money. He doesn’t need to keep all the gold in the vault since most people only come in occasionally.
Today, the FED requires banks to hold some of their cash as reserves at the FED (called Required Reserves). The proportion they must keep at the FED is known as the Required Reserve Ratio (RRR) – and we’ll assume that it’s 10%.
Excess Reserves: This is the cash available to be loaned out by the bank. It is there and is not required to be at the FED – therefore it can be loaned out. This is the $140,000 we were calling cash reserves.
Profits Liquidity, and the Federal Funds Market
Banks have two objectives
- make a profit: to do this they need to make loans and charge interest, but that means fractional reserve banking and that’s risky.
- Be liquid: to do this they need to retain reserves in case people come to make a withdrawal – but that means less is available to be lent out, decreasing profits.
Banks have an incentive not to hold extra reserves at the FED since FED reserves earn no interest. If a bank guesses poorly how much reserves itr will nee – It can borrow from other banks looking to make some money off the extra they mistakenly left at the FED. The rate banks charge other banks for borrowing FED Reserves is called the Federal Funds Rate.
The Banking System: Multiple Deposit Expansion
So how much money can banks create? If they loaned out every dollar they had – there is no limit to how much money the banking system could create – but they would be running a very risky bank system. One person coming in would constitute a bank panic. If they loan out none – then they create none. The ability to create money depends on how much they loan out.
Required Reserve and Excess Reserves
RRR – the required reserve ration (minimum reserve ratio set by the FED). The money set aside to meet this requirement is not on hand to be loaned out. The more the FED requires them to sdet aside – the less they have to loan out and the less money gets created.
Excess Reserves are the reserves a bank keeps over and above the minimum RRR. This is often referred to as Vault Cash. ( ER= deposit - RR)
RR = is the ratio of total reserves (required and excess) to deposits ( RR = deposit x RRR)
The Banking System’s Lending Potential
At a maximum, banks could create 1/RRR times the deposits worth of Money Supply. To do this, they would have to loan out every dollar they could (excess reserves = 0)
MS = 1/RRR * deposits
If the RR was 10% and there was $100 worth of gold in our gold rush town, we could have:
MS = (1/.10)*100 = 1000
The Money Multiplier: at a maximum it is 1/RRR – but if banks keep excess reserves, then it’s 1/RR.
Policy Practice- Game
Money Market Graph Practice
Manipulating the Graph
Practice the Bank Balance Sheet