Economics: Principles and Policy Essay

September 24, 2022

William J. Baumol, Alan S. Blinder, John L. Solow

14th edition

Powerpoint Slides prepared by: Philip Heap, James Madison University

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in part.

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Part 3

Fiscal and Monetary Policy

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Chapter 12

Money and the Banking System

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An Opening Quote

[Money] is a machine for doing quickly and commodiously what would be done, though less

quickly and commodiously, without it.

John Stuart Mill

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The Circular Flow Diagram

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Why are Banks So Heavily Regulated?

Regulation and deregulation of banks since the 1970s
Banks regulated for two main reasons
Allows better control of the money supply
Concern for safety of depositors
Run on a bank
Many depositors withdraw cash from their accounts all at once
Runs could lead to bank failure, which could spread

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Figure 1 Bank Failures in the United States, 1921–2017

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The Nature of Money 1 of 4

Barter versus Monetary Exchange
Barter
System of exchange in which people trade one good for another
Money is not used as an intermediate step
Requires the double coincidence of wants
Money
Greases the wheels of exchange and makes the economy more productive

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The Nature of Money 2 of 4

Money and its functions:
Medium of exchange
The object or objects used to buy and sell other items such as goods and services
Unit of account
Standard unit for quoting prices
Store of value
Store wealth from one point in time to another
Why may money not be a good store of value?

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The Nature of Money 3 of 4

What serves as money?
Cattle, stones, candy bars, cigarettes, woodpecker scalps, porpoise teeth, giraffe tails, cigarettes, large disk shaped boulders
Commodity money
An object in use as a medium of exchange that also has a substantial value in alternative nonmonetary uses
To be useful as a medium of exchange, a commodity must be:
Easily divisible
Uniform or readily identifiable quality
Storable and durable
High value per unit of volume and weight

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The Nature of Money 4 of 4

Commodity money
Gold and silver
Fiat money
Money that is decreed as such by the government
Little value as a commodity
Maintains its value as a medium of exchange because
People have faith that the issuer will stand behind the pieces of printed paper and limit their production
Evolution of money
Commodity money → Full-bodied paper money → Partially backed money → Fiat Money

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How the Quantity of Money is Measured 1 of 2

Two measures of the money supply:
M 1: Narrowly defined money supply
Coins and paper money in circulation
Traveler’s checks
Conventional checking accounts and other checkable deposit balances
M 2: Broadly defined money supply
M 1
Money market deposit accounts
Money market mutual funds
Savings accounts

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Figure 2 Two Definitions of the Money Supply, Aug 2018

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How the Quantity of Money is Measured 2 of 2

Other measures of the money supply:
M 3 and beyond
Near moneys
Liquid assets that are close substitutes for money
Liquidity – the ease with which it can be converted into cash
Should we include credit cards in the money supply?
We will assume that money consists of coins, paper money, and checkable deposits (most of M 1)

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The Banking System 1 of 6

How banking began
Gold used as commodity money
Gold stored at goldsmiths who issued paper receipts backed by gold
Clever goldsmiths started lending out “gold”
Fractional reserve banking system
A system under which bankers keep only a fraction of deposits as reserves

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The Banking System 2 of 6

Three features of a fractional reserve banking system:

Bank profitability

Interest on loans minus interest on deposits

Discretion over the money supply

By lending, banks essentially create money
Amount of money created depends on how much banks hold in reserve

Exposure to runs

Keep prudent reserves and lend out money carefully

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The Banking System 3 of 6

Principles of bank management: Profit vs. Safety
How do banks maintain a reputation for prudence?
Maintain a sufficient level of reserves to minimize vulnerability to runs
Be cautious in making loans and investments since large losses undermine confidence
Failure during the housing boom of 2003-2006

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The Banking System 4 of 6

What government regulations are in place to ensure the safety of the banking system?
Bank regulations
Rules designed to ensure depositors’ safety and to control the money supply
Deposit insurance
Guarantees that depositors will not lose money even if their bank goes bankrupt
Federal Deposit Insurance Corporation (F D I C 1933)
Why might deposit insurance lead to a system that is less safe?

▶ Moral hazard problem

⁃ If insured against consequences of risk people engage in riskier behavior

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The Banking System 5 of 6

Another government regulation in place to ensure the safety of the banking system:
Bank supervision
Periodic bank examinations
Tighter regulation since 2006
Bureau of consumer financial protection
Mechanism for dealing with potential failure of giant banks
Limit the kinds and quantities of assets in which banks may invest

▶ Banks can own only limited amounts of common stock

▶ Limits on proprietary trading

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The Banking System

One more regulation:
Reserve requirements
Minimum amount of reserves required by law
Proportional to the volume of deposits

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Systemic Risk and the “Too Big to Fail” Doctrine 1 of 2

Systemic risk
Risks to the entire system of banks or financial institutions
Arises because these institutions (large) are linked in many ways
banks runs spread
exchanging funds with other banks and non-bank financial institutions
Systemically important (or “too big to fail”)
A financial institution that by virtue of its size or interconnectedness, can threaten the entire system if it runs into trouble
Lehman Brothers and American International Group (A I G)

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Systemic Risk and the “Too Big to Fail” Doctrine 2 of 2

The Dodd-Frank Act, 2010
The Fed given powers to supervise systemically important financial institutions
Tougher regulatory regime than ordinary banks
New procedure in case of failure

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The Origins of the Money Supply

A Banker’s Books
Asset
An item of value that an individual or firm owns
Liability
An item of value that an individual or firm owes
Many liabilities are known as debts
Balance sheet – accounting statement
Left side: values of all assets
Right side: values of all liabilities and net worth
Net worth = Asset – Liabilities
Assets = Liabilities + Net Worth

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Table 1a Balance Sheet of Bank-a-Mythica, Dec 31, 2018

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Banks and Deposit Creation 1 of 12

Suppose someone deposits $100,000 into their checking account. How does that lead to a multiple expansion of the money supply?
Deposit creation:
The process by which a fractional reserve banking system turns $1 of bank reserves into several dollars of bank deposits
Assume the required reserve ratio is 20%. How much excess reserves does the bank have?
Excess reserves are reserves held in excess of the legal minimum

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Table 1b Balance Sheet of Bank-a-Mythica, Dec 31, 2018

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Banks and Deposit Creation 2 of 12

We will use a T Account to trace the $100,000 checking deposit
Shows changes in balance sheets rather than the balance sheets themselves

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Table 2 Changes in Bank-a-Mythica’s Balance Sheet, January 2, 2019

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Table 3 Changes in Bank-a-Mythica’s Balance Sheet, January 3–6, 2019

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Table 4 Changes in Bank-a-Mythica’s Balance Sheet, January 2–6, 2019

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Banks and Deposit Creation 3 of 12

What we have so far:
$100,000 less in cash
$100,000 more in checkable deposits
$80,000 loan so new cash in circulation
So money supply up by $80,000
What happens when that $80,000 is deposited into a different bank: First National Bank?
First National bank has excess reserves
It lends out those reserves, which get deposited at Second National Bank

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Table 5 Changes in First National Bank’s Balance Sheet

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Table 6 Changes in Second National Bank’s Balance Sheet

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Banks and Deposit Creation 4 of 12

We could go on to the Third National Bank, Fourth, Fifth . . .
When does it end?
Assumptions
Each bank holds exactly 20% required reserves
Each loan recipient redeposits entire proceeds into the next bank

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Figure 3 The Chain of Multiple Deposit Creation

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Banks and Deposit Creation 5 of 12

Suppose someone deposits $100,000 into their checking account. How does that lead to a multiple expansion of the money supply?
Putting it all together:
Initial deposit of $100,000 in cash
Led to $500,000 in new deposits
Money supply rises by $400,000

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Banks and Deposit Creation 6 of 12

The math behind expansion of the money supply:
Each column forms a geometric progression
In the last figure, each entry is 80% of the previous entry or 20% less
From before we learned:

▶ 1 + R + R2 + . . . = 1 / (1 – R)

Applying this to the $100,000 initial deposit:

▶ $100,000 + $80,000 + $64,000 + $51,200 +. . .

▶ = $100,000 x (1 + 0.80 + 0.802 + 0.803 + . . .)

▶ = $100,000 x 1/(1 – 0.80)

▶ = $500,000 in new deposits

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Banks and Deposit Creation 7 of 12

In general
If the required reserve ratio = m
Deposit multiplier = 1/m
Banking system can convert each $1 of reserves into $1/m in new deposits
Oversimplified Deposit Multiplier
Ratio of newly created bank deposits to new reserves
Change in deposits = (1/m) ˣ change in reserves

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Banks and Deposit Creation 8 of 12

Oversimplified Deposit Multiplier
Ratio of newly created bank deposits to new reserves
Change in deposits = (1/m) ˣ change in reserves
Our example:
m = 20%
Change in reserves: $100,000
Change in deposits = (1/0.20) x $100,000
= $500,000

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Banks and Deposit Creation 9 of 12

What has happened to to the money supply?
Cash: – $100,000
Deposits created: + $500,000
Money supply: + $400,000
What happens if someone withdraws $100,000 from Bank A Mythica?

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Table 7 Changes in the Balance Sheet of Bank-a- Mythica

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Banks and Deposit Creation 10 of 12

At Bank Mythica:
Loses $100,000 in checkable deposits
Required reserves fall by $20,000
Actual reserves fall by $100,000
Excess reserves short by -$80,000
Outstanding loans paid off and no new loans until bank has accumulated enough reserves
Where did the borrowers get the money to pay off the loans?
They made withdrawals from other banks: First National

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Table 8 Changes in the Balance Sheet of First National Bank

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Banks and Deposit Creation 11 of 12

At First National Bank:
Loses $80,000 in checkable deposits
Required reserves fall by $16,000
Actual reserves fall by $80,000
Excess reserves short by -$64,000
Outstanding loans paid off until bank has accumulated enough reserves
And the process continues:
Change in deposits = -$100,000 – $80,000 – $64,000 – . . .

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Banks and Deposit Creation 12 of 12

What is the overall effect?
Deposits: -$500,000
= (1/ 0.20) x – $100,000
Loans: -$400,000
Reserves: -$100,000
Money supply: -$400,000

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Why the Deposit-Creation Formula Is Oversimplified

Our money multiplier only accurate under two circumstances
Every recipient of cash must redeposit cash to another bank rather than hold it
Every bank must hold reserves no larger than the legal minimum
What happens if individuals and business firms hold more cash?
Fewer dollars of cash available for use as reserves
Limits the multiple expansion of bank deposits
Smaller money supply

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Figure 3 Chain of Multiple Deposit Creation

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Why the Deposit-Creation Formula Is Oversimplified 1 of 3

What happens if individuals and business firms hold more cash?
Fewer dollars of cash available for use as reserves
Limits the multiple expansion of bank deposits
Smaller increase in the money supply

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Why the Deposit-Creation Formula Is Oversimplified 2 of 3

What happens if banks decide to hold on to some excess reserves?
Limited multiple expansion of bank deposits
Smaller supply of money
Excess reserves after September 2008
Failure of Lehman Brother led to financial panic
Banks held excess reserves at a massive scale

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Figure 4 Excess Reserves in the U.S. Banking System, 2008–2018

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Why the Deposit-Creation Formula Is Oversimplified 3 of 3

Excess reserves after September 2008
From $2 billion to $267 billion by October 2008, $800 billion by January 2009.
Currently at $1.9 trillion
10 fold increase in excess reserves, but M1 less than tripled
Banks holding on to excess reserves reduces the multiplier effect

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The Need for Monetary Policy 1 of 2

Government regulates money supply to maintain stability
During a recession
Banks prone to reduce money supply
Increase excess reserves
Decrease lending to less creditworthy applicants
Without government intervention contraction in money supply would aggravate recession
Federal Reserves during the Great Depression
and the recent financial crisis and Great Recession

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The Need for Monetary Policy 2 of 2

During an economic boom
Banks expand money supply
Undesirable momentum to economy
Without government intervention rapid money growth could lead to inflation

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