The Monetary System

the monetary system many of you will consider this chapter very interesting and most of it is quite straightforward it does contain one analytically challenging topic which is the process of money creation in the banking system we’ll probably proceed somewhat quickly through most of the chapter and we’ll spend more time on the money creation in the banking system T accounts and the money multiplier those are probably the three more challenging concepts here this is really something that you’re somewhat familiar with in terms of hey you know what money is and you like it we’re just putting a little meat on the bones so it’s a real it’s not really a technical chapter it’s more of a definitional chapter so they’re reading this video and attending electric and be pretty huge now so what is money why is it important without money trade would require barter all right so barter trade the exchange of one good or service for another is bartering every transaction would require a double coincidence of wants if you wanted a pound of bacon you and you were a tailor you would have to find someone with a pound of bacon who need to the tailor that’s a double coincidence of wants now that’s an unlikely occurrence that two people each have a good that the other wants most people would have to spend time searching for others to trade with and which is a huge waste of resources and quite inefficient this searching is unnecessary with money now money is the set of assets that people regularly use to buy goods and services from other people okay so again a double coincidence of one simply means that two people have to want each other stuff here’s an example I’m an economics professor but I’m also a consumer too suppose I want to go out for a beer under a barter system I would have to search for a bartender that was willing to give me a beer in exchange for a lecture in economics good luck right as you might imagine spend a lot of time searching on the plus side this would prevent me from you know drinking too much getting a beer gut or something but thanks to money I can go directly to my favorite pub get a cold beer and the bartender doesn’t have to want it you know here my lecture in fact he probably would prefer not to he only has to want my money and so we we trade that way so it’s not a bartering situation it’s a situation where money eases the transaction there are three functions of money the first is medium of exchange and item buyers give medium you exchange is an item that I buyers give to sellers when they want to purchase a good or service the second function of money is as an a unit of account it’s essentially the yardstick people use to post prices and record debts that’s what we measure things by it’s them it’s the unit of account so in addition to be a medium of exchange and unit of account another function of money is a store of value an item people can use to transfer purchasing power from the present to the future okay store a value an item people can use to transfer purchasing power from the present to the future you can save money in a bank account as a store of value for future consumption now in review money is a medium exchange that just means that you use money to buy stuff money is a unit of account the price or monetary value of virtually everything is measured in the same unit and this in the u.s. is dollars okay or you can substitute a different country’s currency if they’re located outside the US imagine how hard it would be to plan your budget or comparison shop if sellers each use their own system of measuring prices lastly money is a store of value money holds this value over time so you don’t have to spend it immediately upon receiving it it’s not something that’s just going to melt away rot you know if you’re bartering things that were perishable it wouldn’t be a store of value money has a store value there’s two kinds of money commodity money which takes the form of a commodity with intrinsic value examples here are gold coins cigarettes were used as currency in powa camps cigarettes reuses currency and current jail situations and then there’s so that’s based on a commodity backed by gold gold coins themselves are worth something it can be melted down they have value based on the commodity they’re made out of now fiat money is money without intrinsic value it’s not based on anything commodity that’s that’s that’s valuable it’s it has intrinsic value that was it does not have intrinsic value I should say it’s used this morning because of government decree

it’s backed by say the United States of America which the US dollar is intrinsic value means that the commodity would have value even if it weren’t used as money so if gold has value even if it wasn’t a gold coin in the film The Shawshank Redemption prisoners used cigarettes as money as an example if you’ve seen that movie if you haven’t you you really need to expand your horizons and see it fiat money is worthless except as money so if it wasn’t money it’s just paper is not worth anything yet people are happy to accept your dollars or euros or yen or whatever wherever you are because they know that you will be able to spin the currency okay it’s something that has a store of value it’s based on fiat it’s backed by the US government for example now the money supply remember money is just a medium of exchange there’s more of it out there it’s less scarce it can be less valuable all right so there’s a money supply or money stocks the number of dollars the money supply or money stock is the quantity amount of money available in the economy what assets should be considered part of the money supply well there are two candidates first there’s currency the paper bills and coins in the hands of the non banking public okay that the currency that’s in circulation not in the bank then there’s demand deposits the balances and bank accounts that depositors can access on demand by writing a check technically they’re not in circulation but they’re in their demand deposits the definition of currency in the textbooks does not include the phrase non-bank I added it here to avoid confusion later so when you’re asked to think about what happens to the money supply when I can decides to deposit a $50 bill into his or her checking account you can think about it that way is it currency or is it a demand deposit at that point now there’s a few measures of the US money supply this sources the Federal Reserve Board of Governors there’s M one and M two M one is currency demand deposits traveler’s checks and other checkable deposits those are things in circulation and one as of September 2013 was two point six trillion dollars okay M two is everything in m1 so everything we just talked about plus savings deposits small-time deposits money market mutual funds and a few other minor categories as of September 1 hours of September 2013 again including m1 to m2 m1 plus m2 is ten point eight trillion dollars the distinction between m1 and m2 will often not matter when we talk about quote-unquote the money supply on this course I don’t don’t read too much into it it’s just you have an m1 and you have an m2 is different categorizations much more importantly our central bank’s in monetary policy a central bank is an institution that oversees the banking system and regulates the money supply in the u.s we’re talking about the Federal Reserve which is a central bank the United States now monetary policy is the setting of the money supply but policymakers in the Central Bank and again the central bank in the u.s. is the Federal Reserve many times Reserve referred to as the Fed now here’s the structure of the Fed the Federal Reserve System consists of the Board of Governors which is seven members located in Washington DC in twelve regional fed banks located all around the US the Federal Open Market Committee which is the FOMC includes the Board of Governors and the presidents of some of the regional regional Federal Banks Fed banks I should say the Fmoc decides on monetary policy so they make decisions on so it has the border governors the seven members up in Washington DC and then I select membership from the twelve Fed banks across the country one permanent member on the FOMC and actually also on the board of governors if I remember correctly is the regional bank representative from New York City because that is the financial hub of the United States and really for a large part of the world up around Wall Street now subsequent chapters including the chapter men immediately following this one we will learn that the Federal Reserve’s monetary policy can have huge effects on the macroeconomic variables like inflation interest rates unemployment even stock prices indexes and exchange rates now in this chapter we’re learning what all these things mean so we’re setting the foundation for monetary policy here we’ll talk more about the implications of monetary policy in the next chapter so what are bank reserves in a fractional reserve

banking system banks keep a fraction of deposits as reserves and use the rest to make loans that’s how banks make their money they loan out the money that comes in charge those folks those investors an interest rate and it’s higher than the interest rate they’re paying the people who are saving there and they keep the difference but in a fractional reserve banking system they’re required to hold some of that money back those deposits back as reserves now the Fed establishes the reserve requirements which are regulations on the minimum amount of reserves that Beggs must hold against deposits what they need to keep in the vault what they can’t loan out banks may hold more than the minimum amount if they choose now a lot of them do it because you know it’s loanable funds if you get a good loan you can get a return on you send it out but you are you are required to have a certain reserve on hand now the reserve ratio abbreviated here is capital R here and moving forward it equals the fraction of deposits that banks hold as reserves so it can also equal the total reserves as a percentage of total deposits now segue from the last slide the Fed and controls the money supply and regulates banks banks clearly played an important role in the money supply because bank deposits are a part of the money supply now recall that m1 includes checking account deposits and m2 includes savings accounts deposits so when you’re moved from m1 to m2 you’re really just talking about liquidity obviously you can get to your money a little easier in a checking account that’s m1 it’s a little more liquid and then m2 sent a savings account sometimes you have to wait until it matures to get it without penalty so it’s a little less liquid so m1 is more liquid and m2 is less liquid liquid means how easily can you get a hold of it to spend it now in the interest of just persimmon a year I have combined the definitions of fractional reserve banking system and reserves as shown in the first bullet point here I believe it’s sufficient to convey that the meaning of the meaning of both terms here so fractional reserve banking system implies that there’s some sort of reserve requirement so banks have to keep some reserves on hand so that that sort of goes hand in hand there excuse me now a bank t account T account is a simplified accounting statement that shows a bank’s assets and liabilities for example let’s look at the fictitious First National Bank here are their assets on the left here they have reserves of ten dollars and they’ve made loans out to the public to their customers of $90 that’s the assets they have they have the rights that loan that can call the note on it they have money coming in every month on that loan they’re earning interest on that loan and then of course the reserve requirements they’re holding back ten bucks okay very simplified example here now their liabilities are $100 okay people have made $100 worth of deposits they’ve kept ten in the vault and loaned out 90 of it okay that’s their simplified accounting statement they’re t-account okay got 100 on this side got 100 on that side they’re holding $10 back in reserves they’ve loaned out 90 of it um they have a liability that the depositors have put $100 in there so they’re liable for that $100 should everyone come in and want it now banks liabilities include deposits they include loans and reserves now in this example we can notice that our okay remember our is our reserve ratio R in this example equals the $10 reserves divided by their total liabilities and so they have a 10% reserve on hand the deposits are liabilities to the bank because they represent the depositors claim on the bank okay depositors money bank owes it to them and loans are an asset because bank the bank can make because they can excuse me big they can represent the banks claims on bars okay they can call the note on those reserves are an asset because they are funds that are available to the bank in this example let’s say the reserve requirement was 10 bucks well it’s 10% reserve requirement ratio now suppose $100 of currencies in circulation to determine the bank’s impact on the money supply we calculate the money supply in three different cases one if there’s no banking system two if there’s a hundred percent reserve banking system and the bank holds 100% of depositors reserves and makes no loans bank would make any money just holding on the money like that not able to learn it out and then third there’s a fractional reserve banking system so we’re looking if there was no bank if there was no ability to make loans and then lastly and much more realistically

if there’s a fractional reserve banking system now case one with no banking system the public holds a hundred dollars in currency the money supplies $100 okay there’s no banking system it’s just $100 floating around between people out their case to 100% reserve okay public deposits $100 in our fictitious First National Bank First National Bank F and B that Bank holds a hundred percent the deposits is reserves the money supplies the currency plus deposits will the currency is zero the deposits is $100 because the bank has every bit of it and its vault the money supplies $100 and 100% reserve banking system banks do not affect the size of the money supply they’re just a piggy bank now case three fractional reserve banking system take a look at this suppose the reserve requirements 10% first national bank loans out all but 10% of the deposit they keep ten dollars on hand as an asset in reserves and they loan out $90 okay now their liabilities obviously is the entire hundred dollars they’ve had deposit their depositors have $100 in deposits borrowers have $90 in currency so the money supply is the currency plus the deposits which is that $90 that they’ve loaned out plus the $100 in liability okay now that equals $190 the notions that banks create money this is our first kind of abstract thing that you might have to wrap your mind around the notion that banks create money by making loans is new and perhaps awkward idea for you the following slide may help though just keep in mind though these depositors depositors in their mind say well my hundred dollars is in the bank well the bank says well we’re only required to keep ten dollars on hand so we’re going to loan out 90 more to the depositors their money’s in the bank to the borrower’s they get 90 new dollars so you got the depositors thinking hey I got $100 in the bank you get the bank loaning out 90 of it and the borrower’s thinking well hot dog I got 90 new bucks to invest in my business and make more money theoretically you just created 90 more dollars so the money supply goes from 100 to 190 in theory now there’s some overlap here obviously 90 of this dollars belongs to the liability folks over here in their deposits but the positives are happy keeping that money in the bank collecting interest and the investors are happy to take out the loans paying interest on that back to the bank to invest and save their businesses and create growth opportunities now hopefully this this will help under the case three fractional reserve banking system how did the money supply suddenly grow I mean technically still dishonorable but we grew it under the fractional reserve banking system well when banks make loans they create money the borrower gets 90 dollars in currency an asset counted in the money supply so there’s money out there being spent as through investors and $90 in new debt a liability that does not have an offsetting effect on the money supply thus the fractional reserve banking system creates money but not wealth what you’re thinking it was $100 is wealth it does technically kind of grease the wheels and allow the investors to have that 90 bucks while the depositor is thinking hey man I got my 100 bucks back in the bank so theoretically grease the wheels a little bit we get growth going on we got investment going on the bank essentially created 90 bucks now hopefully you can more easily accept the idea of banks creating money when you see that banks do not create wealth that little alarm that’s going off in your head is that it’s still $100 overall well that’s well that’s the amount of wealth in the system the bank has just facilitated the ability to have 90 more dollars spending with the reassurance in the minds of the depositors that the deposits are back saved by the FDIC so if the the if the bank went under the the government is going to support it anyway but they know they’re earning money on that deposits they’re not really you know wanting to take that money out so it allows the bank to reassure them that they’re earning deposits while they earn interest on the loans while the investors take the loans that they borrowed the funds that they’ve borrowed and invested back in their business so all leads to production and growth which increases GDP which increases incomes increases growth and economy and makes things better off overall now borrower deposits 990 dollars at the second National Bank so it looks like we’re moving on from the first National Bank the second National Bank initially second National Bank’s T account looks like this the 90 bucks the 10 percent reserve you remember is only 9 bucks they’re going to loan out then the remaining 81 if the reserve is 10 percent for second National Bank and then we loan out all but 10 percent of the deposit so so on and so forth all right let’s look at the third National Bank

fractional reserve banking system okay now let me go back make something clear so in the First National Bank they loaned out 90 bucks where is that 90 bucks ago well it goes into the bank account of the person who borrowed it right and then they go spend it well they deposit the bank account they’re going to then that Bank is going to keep ten percent on hand excuse me ten percent on hand and then loan out eighty one well that 81 that’s loaned out comes into another Bank see where this is heading their reserves is ten percent so they put eight ten in in reserves and then loan out seventy to ninety it’s kind of like a big snowball rolling downhill okay second national banks borrow deposits eighty one dollars at third National Bank the initial of the third National Bank T account looks like this and then somewhere somebody’s depositing seventy to ninety and we go on and on and on and on so if the reserve requirement for the National Bank is ten percent it will loan out all but ten percent of the deposit and the economy starts growing now the process continues and the money created with each new loan so you have original posit at the First National Bank of one hundred dollars they keep ten dollars on hand loan out ninety second National Bank keeps ten percent online on on hand which is nine bucks and loans out eighty-one second National Bank then again is loaning out eighty one third national bank keeps ten percent on hand and then loans out seventy to ninety so on and so forth and then we get to a point where we had started one hundred bucks in the total money supply the effect of the total money supply if that makes you more comfortable is a thousand dollars in this example hundred dollars of reserves generates a thousand dollars of money and money because we have continuous loans banks are making money on the interest the ideal situation is those that are borrowing invested in their business and find ways to make new money and that big ol snowball rolling downhill creates new money as it goes and eventually creates new wealth okay now originally the wealth here is a hundred dollars what we’re creating here is is an increase in the money supply and momentum through a fractional reserve banking system that we can do if we had no banking system at all or if we had a banking system that had 100% reserve requirement this is called the money multiplier the money multipliers the amount of money that banking system generates with each dollar of reserves the money multiplier equals one divided by that are the reserve ratio in our example R equals 10% thus the money multiplier is 1 divided by R equals 10 okay um and us– multiply that by that 100 so the $100 of reserves creates a $1,000 in money okay so we could look at it and calculate it all the way out like this all the way out to where we have no more deposits KCA school from 100 90 80 170 to eventually get down here to like the 16th National Bank or whatever it would be and it would be zero okay and then we add it all up and hey our money multiplier was a thousand now you could do that step by step let’s say here 16 steps I’m not sure exactly how many steps it would be to be something like that okay or you could just know hey there’s something called a money multiplier all I have to do is take one and divide it by that reserve ratio okay and that ten percent one divided by R R is ten percent money multipliers ten so if we start out with a hundred dollars in deposits we know our money multipliers could be a thousand dollars in money much easier approach here right okay you take a choice you could do it like this or you could just say hey whenever R okay you should need no reserve requirement and you will know the initial deposit times the reserve requirement and you will create a thousand dollars of money hopefully that helps money multipliers are great shortcut now let’s take a look at an active learning activity the banks and the money supply while cleaning your apartment you look under the sofa cushion and find a $50 bill yay and a half-eaten taco that’s what’s not you deposit the bill into your checking account hopefully don’t eat the taco and the Federal Reserve’s requirement is 20% of all deposits what is the maximum amount that the money supply could increase what is the minimum amount that money supply could increase mmm interesting let’s take a look at the first one he deposit $50 in your checking account what is the maximum amount that the money supply could increase if the bank holds no excess reserves then the money multiplier 1 divided by R equals 1 divided by 0.2 okay they’re holding no excess reserves they’re doing the minimum okay the bank says hey Fed says we only have to hold 20 percent we’re only going to hold 20 percent remember it’s 20 percent so zero point two zero okay don’t divide one by 20 you’ll be confused one divided by 20 percent zero point two equals five so the maximum possible increase in deposits is five times the original 50

money multiplier is 250 but the money supply also includes currency which falls by 50 hence the maximum increase in money supply is 200 okay here’s the tricky part if you took that 50 and put it in the bank the original 50 and put it into the bank right so you have to take that back out okay if you take that back out so 5 times 50 money multiplier is 250 but when I asked you about the max increase in the money supply I’m not asking what the money multiplier is here’s your money multiplier I’m asking you where’s the max increase in the money supply well you have to take out the 50 that you put into the bank right you took that out of circulation you put it in the bank hence the max increases the money multiplier minus the amount you put into the bank pardon me minus the amount you put into the bank okay here’s the max increase in money supply is $200 and that’s something you’re not going to get intuitive we’re going to go through it in class you got it right here and then you also need to see it in the reading don’t let me fool you there okay money multiplier is different from the max increase in money supply because you have to take out the original amount you put into your checking account make sense okay good now so you’re you deposit 50 dollars in your checking account a what is the maximum amount you can increase in the money supply with no money multipliers 250 but we know we put 50 in the banks you have to take that out so the answer is 200 what is the minimum amount that the money supply could increase well it could be zero if your bank makes no loans from your deposit currency falls by 50 and deposits increase by 50 the money supply does not change okay the minimum is always zero that’s a pretty easy one low-hanging fruit there there if I ask you that on the test so let’s take a look at a more realistic balance sheet assets besides reserves and loans banks also hold securities okay they held down some things that have asset value and securities they also have liabilities besides DANC the size excuse me besides deposits banks can also obtain funds from issuing debt and equity now let’s take a look at Bank capital which is the resources a bank obtains by issuing equity to its owners also you can look at Bank acts acts assets if I could speak English today – bank liabilities see you know what the problem here is I can’t speak you know that half-eaten taco you found in their couch yeah I saw and I ate it and that’s why I can’t speak English right now let’s start over assets besides reserves and loans your t balance here your t accounts there’s some things other than the reserves in – banks also hold securities they invest in things other additional liabilities so adding to that very basic First National Bank T account besides deposits banks also obtain funds from issuing debt and equity so they make some money obviously their assets their liabilities on based on debt and equity now bank capital or the resources a bank obtains by issuing equity to its own owners you can also have bank assets – the bank liabilities so there there may be a balance there if you have more assets than you have liabilities that gives in the bank capital category you have more capital there’s leverage also it’s used to borrow funds to supplement existing funds for investment purposes so a bank can borrow say from another bank or bank and borrow from the Fed to make an investment itself this in the next few slides correspond with the section in the text called bank capital leverage in the financial crisis through 2008 through 2009 which is an interesting read so here’s a much more realistic assets and liabilities here you have reserves give loans that you sent out and let’s say you have some value in securities you’ve invested in liabilities you have deposits okay of $800 so you’re liable for those deposits you have debt achieve incurred of $150 perhaps you’ve invested in something taken all alone as a bank banks do that and you also have capital of $50 the leverage ratio is the ratio of assets to bank capital in this example the leverage ratio then pardon me the leverage ratio will keep topping around on me sorry the leverage ratio is 1,000 divided by 50 which equals 20 now here’s an interpretation of that for every 20 dollars in assets $1 is from the banks owners ok $19 is financed with borrowed money so for every $20 they have and assets $1 is from the banks owners and $19 as financed with borrowed money okay so Bank has borrowed money that they used to finance their leverage ratio okay excuse me now leverage amplifies profits and losses in our example suppose bank assets appreciate by 5% from $1000 5% increase will be

$1,050 this increases the bank’s capital from 50 to 100 okay doubling the owners equity instead if a bank’s assets decreased by 5% which can happen Bank capitals Falls from 50 to 0 okay if bank assets decrease more than 5% the bank capital is negative in the bank is insolvent Retro a capital requirement banks can’t become insolvent their businesses as well capital requirement is government regulation that specifies the minimum amount of capital intended to insure banks will be able to pay off depositors and their debts okay so government regulates what the bank can have in terms of capital so they try to avoid Bank insolvency now in the financial crisis from 2008-2009 banks suffered some losses on mortgage loans remember the housing bubble people were buying a lot of houses prices kept going up and up and up sand banks were happy to to keep financing all those houses people buying everybody was investing in real estate they’re happy to be all over they were making some crazy loans right there like it was a very competitive market they were charging a low price low interest rate and doing like arms which is adjustable rate mortgage at crazy lower rates for like five years and they’re shot way up well people got to where they couldn’t pay them when you can’t pay the bank the bank can’t make money they’re not making money to quickly become insolvent so banks suffered losses on these mortgage loans and mortgage and mortgage-backed securities where they bought investments across a wide range of loans due to widespread defaults the bubble burst okay people were upside down in homes they owned five hundred thousand they owed five hundred thousand dollars on homes that were only now of a sudden worse two-fifty things like that many banks became insolvent and in the u.s 27 banks fail from 2000 2007 that’s unheard of okay 27 banks in a seven-year span that’s a lot well guess what in a bank basically like a year year and a half in 2008-2009 166 banks went insolvent that’s a big problem many other banks found themselves with too little capital they were in a credit crunch they reduced they reduced lending and that caused a credit crunch okay when you have very little capital you have a whole lot of money to loan out when you have banks going and solving obviously you don’t have a whole lot of money to loan out well when there’s not a whole lot of money being loaned out by a lot of banks across a long time that’s a credit crunch people cannot get new loans to buy what they need that’s slows growth and production which hurts GDP which hurts income which hurts help so on and so forth now the government’s response to ease the credit crunch the Federal Reserve and the US Treasury injected hundreds of billions of dollars worth of capital to the banking system as a form of a bailout okay this unusual policy temporarily made US taxpayers part owners and mini banks interesting right the policies succeeded in recapitalizing the banking system and help restore lending to normal levels there’s a couple ways you can look at this it was a bailout right okay there’s a lot of companies they deem too big to fail a lot of big banks all right had they failed yes we’d have a problem absolutely insolvency credit crunch like you could not believe perhaps even financial collapse so perhaps there’s a role for government there to make it better there are some there are some economists and I can see the argument I’m somewhere on the fence on this that said well if you make bad loans you should be punished by the market if a business goes out of business because they make bad business then more efficient businesses will emerge the problem is when we had so much consolidation we had so many banks say from 2000 to 2007 consolidate and a lot of banks go and solve it and then all of a sudden boom we had like 166 go insolvent in one year we’re running out of banks so there was a big big problem there we had to recapitalize the banks to keep something afloat now the feds tools for monetary control and again we’re going to get a lot more in depth on this in the next chapter but earlier we learned the money supply is the money multiplier times those bank reserves the Fed can change the money supply by changing bank reserves or changing the money multiplier okay so they can change let’s say if you had a reserve of 20% they could lower to 10% and then banks could loan out more that could spawn some growth they can also change the money multiplier now how the Fed influences reserves or through open market operation om zeroes that’s the purchase or sale of US government bonds by the Fed now remember from previous chapters a bond is a note indebtedness

okay the Fed can sell those if the Fed buys government bonds from from a bank it pays by depositing new reserves in the bank’s account so it releases money back to the banks with more reserves than more money the bank can then make more loans which increases the money supply so the Fed can manipulate the money supply positively by buying government reserves they take a they take a non-monetary item a bond and they send money to the bank for that item so they’re pumping money into the economy the bank’s put that in the reserves thus they can make more loans which increases the money supply now just the opposite of the true if you want to decrease the money supply to decrease bank reserves the money’s in the money supply the feds sell government bonds so banks buy these notes richer blorph I’d I will use as an investment for the bank thus they make the rate of return on the bonds much more attractive for banks to buy them in instances where they want to sell more government bonds so if you sell on the bonds you’re pulling in cash as a Federal Reserve you’re pulling in cash out from the market which reduces reserves which many banks are going to make less loans so you can manipulate the money supply in that manner so the Fed makes loans to banks as well they can increase increasing their reserves the traditional method method is adjusting what’s called the discount rate now the discount rate is nothing more than the interest rate so it’s an interest rate but it’s the interest rate on loans the Fed makes to banks so when a bank needs more money to go to the feds and they report to their local area Federal Reserve whether it’s in New York Atlanta San Francisco so on and so forth Shikha go there are feds in 12 major cities in the regional so a bank in Georgia will deal with the one in Atlanta a bank in DC would deal with them on a DC bank in New York with dilib one in New York and they have all these different regions and territories this interbank loaning influences the amount of reserves that banks have reserves or it is influenced by banks borrowing now there’s a new method called term auction facility the Fed chooses the quantity of reserves it will loan and then banks bid against each other for these loans thus it makes a bit of a free-market trade on reserves okay the big thing you need to know here is in red the discount rate is this is the interest rate on loans the Fed makes to banks so the discount rate is the interest rate in which banks loan among themselves the more banks borrow the more reserves they have for funding new loans and increase seeing the monies blah basically if they have more reserves whether it’s through loans whether it’s through money creation whether it’s through increased deposits the more reserves a bank has the more that they can make loans okay and the more investors can spend on their businesses you need to make sure that you’re making good loans and not on bubble items like the housing market and soon to be the bubble that is educational loans stay tuned on that when we can talk more about it in class now how they can influence the reserve ratio the Fed that is recalled the reserve ratios your reserves divided by your deposits which inversely affects the money multiplier remember those things were linked as we derive them earlier in this chapter everyone if you don’t remember do the reading the Fed set reserve requirements remember those are the regulations on on the minimum amount reserves that must be held against deposits by banks reducing the reserve requirements would lower the reserve ratio and increase the money multiplier it would allow banks to loan more money and thus that hundred dollars we originally put in if it goes now for twenty to ten percent that’s more money that they can loan out and thus increasing the money multiplier since about September 2008 the Fed has paid interest on reserves banks keeping the accounts at the Fed so they’ve kept some money at the Fed themselves the banks can keep reserves both in their vault and also at the Fed raising this interest rate would increase the reserve ratio and lower the money multiplier okay so that to be careful how they do those rates you can take money in and out of the economy the problems with controlling the money supply if households hold more of their money as currency banks have fewer reserves and make fewer loans in the money supply Falls the more money you stuff on your mattress the less money that’s being traded they have fewer reserves in the bank there’s make fewer loans and the money supply Falls money multiplier dips too if banks hold more reserves than required they make fewer loans in the money supply Falls so if a bank for some reason decides to hold more reserves perhaps they have a affected expectation that they’ll need that money for some reason to rush on the bank or something like that that’s less loans in the money supply Falls yet the Fed can compensate for how

hold and fed behave excuse me in Bank behavior to retain fairly precise control over the money supply so the Fed at least in its own mind can manipulate the money supply in technicality they can they can take the money supply up and down now philosophically a lot of people have a question as whether they should be manipulating my money supplier should the free market be going it that’s an ongoing debate now here’s the thing what about a bank run okay bank runs in the money supply a run on banks when people suspect their banks are in trouble they may run to the bank to withdraw their funds holding more currency in less deposits under fractional reserve banking banks don’t always have enough reserves to pay off all their depositors at once hence banks may have to close think about that bank that had $100 coming in first National Bank well they loaned out 90 of it if everybody showed up at the same time willing they’re a hundred dollars they’ve got a problem they only have ten on hand because it was 10% reserve banks in that situation which is close their doors and say listen we don’t have that all $100 we’re going to close not permanently your closing for the day until they can get that perhaps a week until they perhaps a month until they can get all that money back the whole depositors want it for at once also banks may have fewer may make fewer loans and hold reserves to satisfy the pause so if they feel like again economics is half psychological and in suck a lot in psychology we have a thing called expectations so if you expect it or be a bank run the banks not going to learn as much money if they don’t want as much money there’s not as much money to invest and we’re not growing so expectations can affect your growth rate these events increase our which is the reserve ratio and reverse the process of money creation causing money supply to fall there’s less money in circulation now during 1929 to 1933 a wave of bank runs and Bank closings called the money supply to fall by 28% mean any comments blue this contributed to the severity of the Great Depression it certainly didn’t help since then the Federal Deposit since then Federal Deposit Insurance has helped prevent bank runs in the US okay FDIC means the government is guaranteeing your deposits at a bank you may not be able to go in there and get it all at once but the FDIC assures you that the money will be there they guarantee it to you in the UK though Northern Rock Bank experienced a classic bank run in 2007 and was eventually taken over by the British government interesting now the federal funds rate on any given day pardon me on any given day banks with insufficient yep and on any given day banks with insufficient reserves can borrow from banks with excess reserves so banks can borrow mine themselves the interest rate on these loans are called federal funds rate now remember the discount rate was the rate that banks that borrowed from the Fed that was the interest rate they paid their the interest rate on bank to bank loans so say a bank has a run but the bank down the street does not they can borrow funds from the bank down the street and the price of that borrowing will be the interest rate on those loans is the federal funds rate the FOMC uses the Oh mm OH to target the Fed Funds rate okay changes in the Fed Funds rate causes changes in the other rates and have a big impact on the economy they trickle down at the feds change how you can use open market operations you know how the two banks can trade amongst themselves in terms of loans that will change all the other rates that they charge say for their what the positives get and also what borrowers get if they go up they’re all going up they go down they’re all going down and kind of a big impact on the economy in terms of whether people are saving or borrowing here are the federal funds rates and other rates from 1970 2013 you can obviously see some some some movement here in the 1980’s the prime rate which is the rate banks charged on loans to their best customers again the prime rate this is something is in reading you need to you need to know prime rate is the rate that banks charge on loans to their best customers and the three-month t-bill Treasury bill rate are very highly correlated with the federal funds rate they tend to chase one another you can see the same overall pattern here the mortgage rates shown here is a 30-year fixed rate it’s less correlated with the federal funds rate but that is to be expected federal funds rates fed funds are night loans between banks while mortgages are 30-year loans with consumers so obviously the bank to bank loan process moves a lot quicker than it does the bank to consumer process just a good to know just to see how they correlate now um move this out of the way the way to raise federal Fed Funds to raise the federal Fed Funds rate the Fed sales government bonds their open market operations this removes the reserves from the banking system and reduces the supply federal funds and

causes the are to rise okay so here your federal funds rate goes from one point five to one point seven there’s a decrease in supply we know the price is going up to the federal funds rate the trading between banks the cost the interest rate is going up okay and then the quantity of funds is going down from f1 to f2 so this graph is not in the textbook so it’s not supported with the material in the study guide or even in the test Bank so so not something we’re seeing you know the tests I just thought it’d be interesting to graph it you know really I could have I made this slide for my presentation if I wanted to but I really wanted to keep it it uses a simple supply and demand diagram to illustrate something described verbally in the text how the Federal Reserve targets the federal funds rate so it’s simple supply and demand man the demand for federal funds comes from the banks that find themselves with insufficient reserves okay so they need to borrow some money from the Fed perhaps they made too many loans or had higher than expected withdrawals maybe a little bit of a run on the bank the supply federal funds comes from the banks that find themselves for more reserves and then what they want perhaps because they had a lower than expected withdrawals and because for your frustum customers took out loans so they have money to loan to other banks and make a little money like that as an investment the federal funds rates adjusts to the balance the just to balance the supply and demand of the federal funds the Federal Reserve can use om OS to target the federal funds rate whenever the rate starts to fall below the feds target the Fed sells government bonds in the open market in order to pull reserves of the banking system this raises the rate as shown in the diagram on from point one point five to one point seven if that rate raises above the feds target the federal the Fed will buy government bonds in the open market injecting reserves into the banking system and that’s pushing the rate down basically they oil the wheels in this situation you see the money supply is actually going down the feds going to respond by buying government bonds out there and injecting some cash into the economy to make this supply go back out rates are going to go down back down the funds are going to go up and spending will be higher for the Fed om o–‘s are quick easy and effective so the Fed can keep the Fed rates very close to target so they can manipulate by buying and selling government bonds and thus influencing discount rates and the federal rates charged between banks for loaning to one another basically they want to make spending easy problem is here late in our country we’ve made going into debt easy which is a real problem which hurts investment so the whole point of the Fed is to protect the value the dollar we haven’t done a great job of that but one thing the Fed does pride itself on is making sure there’s loans out there to our funds out there to make loans because if you’re making loans you’re making investments people are making investments in their business hopefully they’re growing it become more productive to grow anymore become more productive you GDP is going up your production is going up your incomes are going up your help figure is going to get better your education is going to get better in your crime rates going to go down all good things for the economy now some people will argue that the market could do this on its on okay this supply could adjust because you couldn’t higher rate more banks are going willing to loan funds to other banks okay so eventually it would work its way out to supply increasing we do that quite manually in this country with the central bank all right it’s up for debate as to whether or not that’s the right thing to do personally I think the free market could adjust quite well some people don’t see it that way so it’s one of those things that even the brightest economists argue about to this day so it’s an ongoing two so not to drag you into that debate let’s talk about a summary of the chapter money serves three functions and these are things you’re going to need to know money serves three functions medium of exchange okay it’s a unit of account it’s a store value there are two types of money money based on commodity okay that has intrinsic value and fiat money which does not have intrinsic value but it’s backed by things like the US government the u.s. use the u.s. uses fiat money which includes currency in various types of thanks deposits we talk about m1 and m2 now in the fractional reserve banking system banks create money when they make loans a bank reserves have molted the multiplier effect on the money supply start with 100 we end up having a multiplier effect of 10 1 times 10 Inc is $1,000 in the money supply that was pretty neat how we did that right because banks are highly leveraged a small change in the value of bank’s assets causes a large change in bank capital to protect depositors from Bank insolvency regulators impose a minimum capital requirements k be overly leveraged you gotta have a certain amount in reserves and you’re going to have a certain amount of capital on hand

the Federal Reserve is a central bank in the United States the federal responsible regulating monetary system the monetary system the Fed controls the money supply mainly through open market operations ok purchasing government bonds increases the money supply purchasing bonds you’re buying the bonds sending cash out in the economy selling bonds decreases it by selling bonds you’re taking cash out and giving out pieces of paper that say they’re indebted so you’re taking money out of the economy so you decrease the money supply in recent years the Fed has set monetary policy by choosing a target for the federal funds rate the rate at which banks loan to one another ok pretty straightforward chapter a lot of stuff is going to tell you got to make sure you’re doing the reading if you’re going to be able to nail it on the test okay um as always if you have any questions feel free to stop by send me an email give me a call I’ll be happy to discuss these with you we will get much more in-depth into the impact of monetary policy in the next chapter so look forward to that thank you so much