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The Money Supply and the Federal Reserve System

Presented by Sanchita Som

An Overview of Money
Money is anything that is generally accepted as a medium of exchange.
Money is not income, and money is not wealth. Money is:
a means of payment,
a store of value, and a unit of account.

What is Money?
Barter is the direct exchange of goods and services for other goods and services.
A barter system requires a double coincidence of wants for trade to take place. Money eliminates this problem. As a medium of exchange, or means of payment, money is generally accepted by buyers and sellers as payment for goods and services.

What is Money?

As a store of value, money serves as an asset that can be used to transport purchasing power from one time period to another. As a unit of account, money is a standard that provides a consistent way of quoting prices. Money is easily portable, and easily exchanged for goods at all times. The liquidity property of money makes money a good medium of exchange as well as a store of value.

Commodity and Fiat Monies

Commodity monies are items used as money that also have intrinsic value in some other use. Gold is one form of commodity money. Fiat, or token, money is money that is intrinsically worthless.

Commodity and Fiat Monies

Legal tender is money that a government has required to be accepted in settlement of debts. Currency debasement is the decrease in the value of money that occurs when its supply is increased rapidly.

Measuring the Supply of Money in the United States


M1, or transactions money is money that can be directly used for transactions. M1 = currency held outside banks + demand deposits + travelers checks + other checkable deposits M1 is a stock measureit is measured at a point in timeon a specific day.

Measuring the Supply of Money in the United States

M2, or broad money, includes near monies, or close substitutes for transactions money. M2=M1 + savings accounts + money market accounts + other near monies The main advantage of looking at M2 instead of M1 is that M2 is sometimes more stable.

The Private Banking System

Financial intermediaries are banks and other financial institutions that act as a link between those who have money to lend and those who want to borrow money.

How Banks Create Money


A Historical Perspective: Goldsmiths
Goldsmiths functioned as warehouses where people stored gold for safekeeping. Upon receiving the gold, a goldsmith would issue a receipt to the depositor. After a time, these receipts themselves began to be traded for goods, and were backed 100 percent by gold. Then, Goldsmiths realized that they could lend out some of this gold without any fear of running out. Now there were more claims than there were ounces of gold.

How Banks Create Money


A run on a goldsmith (or a modern-day bank) occurs when many people present their claims at the same time.

The Modern Banking System


A brief review of accounting: Assets liabilities = Net Worth, or Assets = Liabilities + Net Worth A banks most important assets are its loans. Other assets include cash on hand (or vault cash) and deposits with the central bank. A banks liabilities are its debtswhat it owes. Deposits are debts owed to the banks depositors.

The Modern Banking System


Reserves are the deposits that a bank has at the Reserve bank plus its cash on hand. The required reserve ratio is the percentage of its total deposits that a bank must keep as reserves at the Central Bank.

T-Account for a Typical Bank


The balance sheet of a bank must always balance, so that the sum of assets (reserves and loans) equals the sum of liabilities (deposits and net worth).
T-Account for a Typical Bank (millions of dollars) ASSETS Reserves Loans Total 20 90 110 LIABILITIES 100 10 110 Deposits Net worth Total

The Creation of Money


Banks usually make loans up to the point where they can no longer do so because of the reserve requirement restriction (or up to the point where their excess reserves are zero).
excess reserves actual reserves required reserves

The Creation of Money


When someone deposits $100 in a bank, and the bank deposits the $100 with the central bank, the bank has $100 in total reserves.
Balance Sheets of a Bank in a Single-Bank Economy
In Panel 2, there is an initial deposit of $100. In Panel 3, the bank has made loans of $400.

Panel 1
ASSETS Reserves 0 LIABILITIE S 0 Deposits

Panel 2
ASSETS LIABILITIE S

Panel 3
ASSETS LIABILITIE S

Reserves 100 100 Deposits

Reserves 100 500 Deposits Loans 400

The Creation of Money


If the required reserve ratio is 20%, the bank has excess reserves of $80. With $80 of excess reserves, the bank can have up to $400 of additional deposits. The $100 in reserves plus $400 in loans equal $500 in deposits.
Balance Sheets of a Bank in a Single-Bank Economy
In Panel 2, there is an initial deposit of $100. In Panel 3, the bank has made loans of $400.

Panel 1
ASSETS Reserves 0 LIABILITIE S 0 Deposits

Panel 2
ASSETS LIABILITIE S

Panel 3
ASSETS LIABILITIE S

Reserves 100 100 Deposits

Reserves 100 500 Deposits Loans 400

The Creation of Money


The Creation of Money When There Are Many Banks Panel 1
ASSETS
Reserves 100

Panel 2
ASSETS
Reserves 100 Loans 80

Panel 3
ASSETS
Reserves 20 Loans 80

LIABILITIE S
100 Deposits

LIABILITIE S
180 Deposits

LIABILITI ES
100 Deposits

Reserves 80

80 Deposits

Reserves 80 Loans 64
Reserves 64

144 Deposits

Reserves 16 Loans 64

80 Deposits

Reserves 64

64 Deposits

115.20 Deposits

Reserves 12.80 64 Deposits

Summary: Bank 1 Bank 2 Bank 3 Bank 4 . . . Total

Deposits 100 80 64 51.20 . . . 500.00

How the Federal Reserve Controls the Money Supply


Three tools are available to the Fed for changing the money supply: 1. changing the required reserve ratio; 2. changing the discount rate; and 3. engaging in open market operations.

The Required Reserve Ratio


The required reserve ratio establishes a link between the reserves of the commercial banks and the deposits (money) that commercial banks are allowed to create. If the Economy wants to increase the money supply, the Economy can decrease the required reserve ratio, which allows the bank to create more deposits by making loans.

The Required Reserve Ratio


A Decrease in the Required Reserve Ratio From 20 Percent to 12.5 Percent Increases the Supply of Money (All Figures in Billions of Dollars)

PANEL 1: REQUIRED RESERVE RATIO = 20%


Federal Reserve Assets Government $200 securities Liabilities $100 Reserves $100 Currency Reserves Loans Commercial Banks Assets $100 $400 Liabilities $500 Deposits

Note: Money supply (M1) = Currency + Deposits = $600.

PANEL 2: REQUIRED RESERVE RATIO = 12.5%

Federal Reserve
Assets Government $200 securities Liabilities $100 Reserves $100 Currency Reserves Loans (+ $300)

Commercial Banks
Assets $100 $700 Liabilities $800 Deposits (+ $300)

Note: Money supply (M1) = Currency + Deposits = $900.

The Discount Rate

The discount rate is the interest rate that banks pay to the RBI to borrow from it. Bank borrowing from the RBI leads to an increase in the money supply. The higher the discount rate, the higher the cost of borrowing, and the less borrowing banks will want to do.

The Discount Rate


The Effect On the Money Supply of Commercial Bank Borrowing from the Fed (All Figures in Billions of Dollars) PANEL 1: NO COMMERCIAL BANK BORROWING FROM THE RBI Federal Reserve Assets Liabilities Commercial Banks Assets Liabilities

Securities

$160

$80 Reserves
$80 Currency

Reserves
Loans

$80
$320

$400 Deposits

Note: Money supply (M1) = Currency + Deposits = $480.

PANEL 2: COMMERCIAL BANK BORROWING $20 FROM THE FED

Federal Reserve Assets Liabilities


Securities Loans $160 $20 $100 Reserves (+ $20) $80 Currency

Commercial Banks Assets Liabilities


Reserves (+ $20) Loans (+ $100) $100 $420 $500 Deposits (+ $300) $20 Amount owed to Fed (+ $20)

The Discount Rate


Moral suasion is the pressure that was exerted in the past by the Fed on member banks to discourage them from borrowing heavily. On January 9, 2003, the Fed announced a new procedure that sets the discount rate above the rate that banks pay to borrow in the private market. It is thus clear that the Fed is not using the discount rate as a tool to try to change the money supply on a regular basis.

Open Market Operations


Open market operations is the purchase and sale by the RBI of government securities in the open market; a tool used to expand or contract the amount of reserves in the system and thus the money supply. Open market operations is by far the most significant tool of the RBI for controlling the supply of money.

The Mechanics of Open Market Operations


Open Market Operations (The Numbers in Parentheses in Panels 2 and 3 Show the Differences Between Those Panels and Panel 1. All Figures in Billions of Dollars) PANEL 1
Federal Reserve Assets Securities $100 Liabilities $20 Reserves $80 Currency Commercial Banks Assets Liabilities Reserves $20 $100 Deposits Loans $80 Jane Q. Public Assets Deposits $5 Liabilities $0 Debts $5 Net Worth $80 Currency

Note: Money supply (M1) = Currency + Deposits = $180.

PANEL 2
Federal Reserve Assets Liabilities Securities $95 $15 Reserves (- $5) (- $5) $80 Currency Commercial Banks Assets Liabilities Reserves $15 $95 Deposits (- $5) (- $5) Loans $80 Jane Q. Public Assets Liabilities Deposits $0 $0 Debts (- $5) Securities $5 $5 Net (+ $5) Worth

Note: Money supply (M1) = Currency + Deposits = $175.

PANEL 3
Commercial Banks Assets Liabilities Reserves $15 $75 Deposits (- $5) (- $25) Loans $60 (- $20) Note: Money supply (M1) = Currency + Deposits = $155. Federal Reserve Assets Liabilities Securities $95 $15 Reserves (- $5) (- $5) $80 Currency Jane Q. Public Assets Liabilities Deposits $0 $0 Debts (- $5) Securities $5 $5 Net (+ $5) Worth

Open Market Operations

An open market purchase of securities by the RBI results in an increase in reserves and an increase in the supply of money by an amount equal to the money multiplier times the change in reserves.

Open Market Operations


An open market sale of securities by the RBI results in a decrease in reserves and a decrease in the supply of money by an amount equal to the money multiplier times the change in reserves.

Open Market Operations


Open market operations are the RBIs preferred means of controlling the money supply because:
they can be used with some precision, are extremely flexible, and are fairly predictable.

The Supply Curve for Money


Through open market operations, the RBI can have the money supply be whatever value it wants.

Review Terms and Concepts


barter commodity monies currency debasement discount rate excess reserves Federal Open Market Committee (FOMC) Federal Reserve System (the Fed) fiat, or token, money M1, or transactions money M2, or broad money medium of exchange, or means of payment money multiplier near monies

Open Market Desk


open market operations required reserve ratio reserves

financial intermediaries
legal tender lender of last resort liquidity property of money

run on a bank
store of value unit of account

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