Banks, Money, and the Federal Reserve System: Chapter 14 Study Notes

Chapter 14: Banks, Money, and the Federal Reserve System

14.1 What Is Money, and Why Do We Need It?

Money is a fundamental economic invention that facilitates trade, specialization, and economic development. Before money, barter systems required a double coincidence of wants, making trade inefficient. The introduction of money allowed for easier transactions and economic growth.

• Definition of Money: Any asset that people are generally willing to accept in exchange for goods and services or for payment of debts.

• Functions of Money:

  • Medium of Exchange: Widely accepted for payment.

  • Unit of Account: Standard measure of value.

  • Store of Value: Can be saved and used later; highly liquid.

  • Standard of Deferred Payment: Facilitates future payments with predictable value.

• Characteristics of Money:

  • Acceptable to most people

  • Standardized quality

  • Durable

  • Valuable relative to weight

  • Divisible

• Commodity Money: Has intrinsic value (e.g., gold, cowrie shells, animal pelts) (before paper money was invented)

• Fiat Money: is government-issued currency that is not backed by a physical commodity like gold. It derives its value from the public's trust in the issuing government and its status as legal tender for paying taxes and debts. Most modern global currencies, such as the US Dollar, Euro, and British Pound, are fiat.

• Paper money is usually printed by the central bank of the economy (The Federal Reserve is the central bank of the United States)

• Fiat money is used to purchase gold

• If people stop "believing" in fiat money, it will cease to be useful

Example: The transition from commodity money (gold coins) to fiat money (paper currency) in modern economies.

Apply the Concept: Cashless Payments

Some businesses, such as Dig Inn, have adopted cashless payment systems to improve efficiency and security. Firms are not legally required to accept cash for purchases, though debts may be treated differently.

14.2 How Is Money Measured in the United States Today?

The money supply is measured using two main aggregates: M1 and M2. These definitions help economists and policymakers understand the liquidity and availability of money in the economy.

• M1: Currency in circulation, checking account deposits, and savings account deposits.

• M2: Includes M1 plus small-denomination time deposits and noninstitutional money market fund shares.

• Money Supply Data (September 2023):

  • M1: $18.1 trillion

  • M2: $20.8 trillion

  • 75% of U.S. paper currency is $100 bills

• Recent changes in how the Fed defines M1 and M2 mean that

  they are quite similar, so it doesn’t matter which monetary

  aggregate we use.

• Debit Cards: Access checking accounts, but the card itself is not money.

• Credit Cards: Provide short-term loans; not considered money until paid off.

• In our discussion of money, we will keep in mind that:

  1. The money supply includes both checking and savings account balances as well as currency.

  2. Banks play an important role in the money supply, since they control what happens to money when it is in a checking account or savings account (regarding commercial banks)

Apply the Concept: Is Bitcoin Money?

Bitcoin and other digital currencies are not currently included in official measures of the money supply. They are decentralized and can be traded for goods, but their acceptance and stability are limited compared to traditional money.

14.3 How Do Banks Create Money?

Banks play a crucial role in the economy by creating money through lending. Most money exists as deposits rather than physical currency, and banks operate as profit-seeking firms.

• Bank Balance Sheet: Assets (loans, reserves, securities) vs. Liabilities (deposits, equity).

Assets = Liabilities + Net Worth (stockholders' equity)

• Reserves: Cash held in vaults or with the Federal Reserve. Since March 2020, reserve requirements are 0% for checking deposits (commercial banks no longer hold a % of the deposit.) Previously, they were required to hold 10% of all checking deposits, plus a little depending on the size of the bank.

• Fractional Reserve Banking: Banks lend out most deposits, keeping only a fraction as reserves.

The Economic Importance of Bank Lending

• Depositors earn a low rate of interest on their deposits, while borrowers may a higher rate of interest.

  Why do we need banks?

  1. Banks reduce transactions costs, the costs in time and other resources that parties incur in the process of agreeing to and carrying out an exchange of goods or services. They do this by using economies of scale, allowing their employees to specialize in tasks like loan evaluation, processing, or legal documentation

  2. Banks reduce information problems, particularly those of asymmetric information, a situation in which one party to an economic transaction has less information than the other party.

     • Banks can evaluate the characteristics of borrowers to identify who is a good risk to lend

     • They do this through statistical analysis and relationship banking (VERY IMPORTANT), the ability of banks to assess credit risks on the basis of private information about borrowers.

Financial technology or Fintech Companies

• LendingClub and UpStart—have emerged to offer peer-to-peer lending on the Internet.

  These firms earn flat fees for facilitating a loan and charge fees for collecting payments but take none of the risk of the loans defaulting.

  Will these firms facilitate too many risky loans? Early evidence suggests “yes

Do Banks Create Money?

• A T-account is a stripped-down version of a bank balance sheet, showing only how a transaction changes a bank's balance sheet

  • The money you deposit becomes a liability to the bank b/c the bank owes you that money

• A fractional reserve banking system, in which banks keep less than 100 percent of deposits as reserves.

• Money Creation Process:

  • Depositing currency increases reserves and deposits.

  • Banks lend out a portion, creating new deposits.

  • This process multiplies the money supply.

    • Banks create money in the form of new deposits

• Money Multiplier: Ratio of money supply to monetary base ($M/B$). It fluctuates based on reserve holdings and currency preferences.

Interest Rate on Reserve Balances (IORB)

• Prior to 2008, the Fed did not pay banks interest on their reserves, resulting in a scarce-reserves regime, in which banks hold few reserves beyond those the central bank

  requires them to hold

• Since October 2008, the Fed pays interest on reserves, encouraging banks to hold more reserves.

• Now, we are in an ample-reserves regime, in which banks hold substantially more reserves than the central bank requires them to hold.

Example: A $1,000 deposit can lead to $1,900 in deposits through multiple rounds of lending.

Why Does the Money Multiplier Fluctuate?

1. Fluctuations in the amount of reserve banks hold relative to their deposits

   • In short, banks play a key role in money creation by lending, which increases demand deposits and amplifies the money supply through the money multiplier effect.

2. Fluctuations in the amount of currency households and firms hold relative to their deposits

   • If they choose to hold more currency, less money is available for banks to create new deposits by lending their reserves, so the monetary base (the sum of currency in circulation and bank reserves) is smaller.

   • A smaller monetary base means the money multiplier (the money supply (M) divided by the monetary base (B)) is larger. (inverse relationship)

14.4 The Federal Reserve System

The Federal Reserve (the Fed) is the central bank of the United States, established to prevent bank panics and manage the money supply. It acts as a lender of last resort and conducts monetary policy.

• Fractional Reserve Banking System: Banks keep less than 100 percent of deposits as reserves

• Bank Runs : Occur when many depositors withdraw funds simultaneously. The Fed can prevent these by providing emergency loan (lost confidence in the bank)

• Bank Panic: If many banks experience bank runs at the same time

The Establishment of the Federal Reserve System

• In 1914, the Federal Reserve system started. “The Fed” makes loans to banks called discount loans, charging a rate of interest called the discount rate.

• During the Great Depression of the 19 30s, many banks were hit by bank runs. Afraid of encouraging bad banking practices, the Fed refused to make discount loans to many banks, and more than 9,000 banks failed.

• Federal Deposit Insurance Corporation (FDIC): Insures deposits up to $250,000, reducing the risk of bank runs.

• Structure of the Fed:

  • Board of Governors: Seven members, appointed for 14-year terms by the President (nonrenewable terms. One member is appointed chair and serves a 4-year renewable term (also serves as chair of the FOMC)

  • In 1913, Congress divided the Country into 12 Federal Reserve District

  • Federal Open Market Committee (FOMC): Twelve members, responsible for open market operations (7 members of the Board of governors, the president of the deferral reserve bank of New York and 4 presidents of the other 11 district banks who serve rotating 1-year terms)

• Monetary Policy: The actions the fed. reserve takes to manage interest rates and pursue macroeconomic objectives.

• Open Market Operations: Buying and selling Treasury securities by the Fed. reserve to control the money supply.

How the Fed Can Control the Money Supply:

The Federal Reserve (Fed) controls the money supply mainly through open market operations (buying and selling government securities).

• Open market purchase (Fed buys bonds) → Banks have more reserves → They can lend more → Money supply increases.

• Open market sale (Fed sells bonds) → Banks have fewer reserves → They lend less → Money supply decreases.

Treasury securities:

• Treasury bills, notes and bonds , which are short-term ( 1 year or less), medium term (2-10 years), or long term (30 years) tradable loans to the U.S Treasury

• Regulation: Banks are regulated by the Fed, FDIC, and other agencies to ensure stability and liquidity.

  • Banks must follow rules from Congress, including maintaining a Liquidity Coverage Ratio (LCR): means banks must keep enough high-quality liquid assets (cash or assets that can quickly be turned into cash)to cover expected cash needs during a financial crisis.

• Moral Hazard: Protecting depositors can encourage risky behavior by banks. Regulators must balance stability and risk.

  When a bank fails, regulators must balance two goals:

1. Prevent bank panics by protecting the financial system.

2. Avoid moral hazard, where banks take excessive risks because they expect the government to rescue them.

Moral hazard = People take more risks because they think they won't face the full consequences.

When the FDIC takes over a failed bank:

• It sells the bank's assets.

• Pays creditors and depositors as efficiently as possible.

• Bank owners usually lose their investment.

• Some large depositors may lose part of their money.

• Shadow Banking System: The shadow banking system is made up of nonbank financial firms that help move money through the economy, even though they aren't traditional banksThese are less regulated NOT FDIC-insured and more leveraged (relied heavily on borrowed money--> investments had more risk, both of gaining and losing value), contributing to financial crises.

  • 🏦 Investment banks → Give investment advice and create/trade securities (like mortgage-backed securities). They don't usually take deposits or make regular loans.

  • 💵 Money market mutual funds → Collect money from investors and invest it in safe, short-term assets like Treasury bills and corporate loans.

  • 📈 Hedge funds → Pool money from wealthy investors and make higher-risk, more complex investments.

• Securitization: Transforming loans or other financial assets into securities that can be traded.

Example: The Fed's response to the 2007–2009 financial crisis included lending to nonbank firms and buying commercial paper.

14.5 The Quantity Theory of Money

The quantity theory of money connects the money supply to the price level and inflation. It is based on the quantity equation, which relates money, velocity, price level, and real output.

Irving Fisher formalized the relationship between money and prices as the quantity equation

Quantity Equation: $M \times V = P \times Y$

• Variables:

  • $M$: Money supply

  • $V$: Velocity of money (the average number of times each dollar in the money supply is used to purchase goods and services included in GDP)

  • $P$: Price level

  • $Y$: Real output

V = (P x Y)/ M

Calculating the Velocity of Money

• Use GDP Deflator to measure the price level of the economy (you can also use CPI or PPI)

  GDP Deflator= (Nominal GDP/Real GDP times 100)

• Real GDP= nominal GDP/price level

• Measuring the:

  • Money supply (M) with M2,

  • Price level (P) with the GDP deflator, and

  • Level of real output (Y) with real GDP, so P x Y is nominal GDP

• Growth Rate Equation: $\text{Growth rate of } M + \text{Growth rate of } V = \text{Inflation rate} + \text{Growth rate of } Y$

• Inflation rate is the growth rate of the price level

Inflation rate = Growth rate of the money supply - Growth rate of real output

Change in Y/ Y = Growth rate in GDP

Change in P/P= Inflation rate

• Quantity Theory of Money: Assumes velocity is constant; predicts inflation when money supply grows faster than real GDP.

• Hyperinflation: Extremely high inflation rates, often caused by excessive money supply growth far in excess of the real GDP growth rate(e.g., Zimbabwe, Venezuela, Germany in the 1920s).

Example: In Germany (1922–1923), massive expansion of the money supply led to hyperinflation, making the currency worthless.

Summary Table: Functions and Types of Money

Function	Description	Example
Medium of Exchange	Accepted for payment	U.S. dollar bills
Unit of Account	Standard measure of value	Price tags in stores
Store of Value	Can be saved and used later	Savings account
Standard of Deferred Payment	Facilitates future payments	Loans, bonds

Summary Table: Types of Money

Type	Description	Example
Commodity Money	Has intrinsic value	Gold coins
Fiat Money	Value by government decree	U.S. dollar bills
Digital Money	Electronic, decentralized	Bitcoin

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