Lecture 6
BEEM119 Economics of Banking
Jan Auerbach
Department of Economics University of Exeter
Contents
1 Financial Institutions and Key Concepts
1 Institutions and Concepts.
2 Understanding Interest Rates.
3 The Risk and Term Structure of Interest Rates.
4 The Efficient Markets Hypothesis.
2 Money
1 What is Money?
2 The Money Supply Process.
3 Quantitative Theory, Inflation, and the Demand for Money.
3 Banking and Financial Intermediation
1 An Economic Analysis of Financial Structure.
2 Banking Industry: Structure and Competition.
4 Banking and Policy
1 Economic Analysis of Financial Regulation.
2 Financial Crises.
The Money Supply Process
(Mishkin, chapter 15)
The Money Supply Process
There are 3 players in the money supply process:
1 Central banks (Federal Reserve System, Bank of England, ECB)
2 Banks (depository institutions; financial intermediaries)
3 Depositors (individuals and institutions)
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The Central Bank’s balance sheet
Liabilities:
• Currency in circulation, i.e., in the hands of the public. • Reserves: bank deposits at the Fed and vault cash:
Currency held by depositary institutions–divided in REQUIRED RESERVES (about 10% of deposits) and EXCESS RESERVES.
Assets:
• Securities: CB holdings affect money supply and earn interest. Usually is only government, but sometimes also other securities.
The Fed provides RESERVES to the bank by buying securities.
• Loans to financial institutions: provide reserves to banks and earn the discount rate.
Also creates reserves. The rate charged is called “discount rate.”
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The Central Bank’s balance sheet
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Control of the Monetary Base
High-powered money: monetary base (MB)
where
MB = C + R
C = currency in circulation
R = total reserves in the banking system
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Control of the Monetary Base
The FED controls the Monetary Base through its purchases or sales of securities in the open market–called Open Market Operations.
Suppose the FED purchases $100 million of bonds from Banks and pays for them with a check for that amount.
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Open Market Purchase from a Bank
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Open Market Purchase from the Nonbank Public–Case 1
Consider the case that the Fed buys securities from a non-financial corporation.
If the corporation selling bonds to the Fed deposits the Fed’s check in the bank, then the result is identical too buying from the bank.
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Open Market Purchase from the Nonbank Public–Case 2
If the seller cashes the Fed’s check, reserves are unchanged.
Currency in circulation increases by the amount of the open market purchase.
Monetary base increases by the amount of the open market purchase.
Notice that now there is more money in circulation!
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Open Market Purchase: Summary
The effect of an open market purchase on. . .
. . .reserves depends on whether the seller of the bonds keeps the
proceeds from the sale in currency or in deposits.
. . .the monetary base always increases the monetary base by the amount of the purchase
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Open Market Sale
Imagine the Fed sells $100 bonds to the nonbank public. Buyers exchanged $100 of currency for $100 of bonds.
This reduces the monetary base by the amount of the sale (there is less money in circulation!). Reserves remain unchanged.
The effect of open market operations on the monetary base is much more certain than the effect on reserves.
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Shifts from Deposits into Currency
Suppose during Christmas season the public wants to hold more currency to buy gifts. They withdraw $100 in cash.
Without any action from the Fed, reserves in the banking system will be affected. But the net effect on monetary liabilities is zero.
“Random” fluctuations move reserves; the monetary base is more stable.
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Loans to Financial Institutions
If the Fed makes a $100 loan to a bank, the bank is credited $100 of reserves. The monetary liabilities of the Fed have increased by $100.
Monetary base also increases by the same amount.
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How are deposits created?
Imagine a $100 open market purchase from “First National Bank.”
The Bank now has $100 more in “excess reserves.” Suppose it doesn’t want to hold extra reserves (because it earns very little interest on it).
So, it may decide to give a $100 loan and creates an account for the borrower and put the proceeds of the loan in that account.
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Multiple Deposit Creation: A Simple Model
After the borrower takes the money out of the First National Bank, the final T-account is:
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Deposit Creation: The Banking System
The borrower pays with a check that is deposited in Bank A.
If the required reserve ratio is %10, Bank A’s required reserves increase by $10. So Bank A has $90 in excess reserves!
Bank A doesn’t want to hold excess reserves, so it makes a $90 loan. The borrower expends those $90 with a check deposited in Bank B?
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Deposit Creation: The Banking System
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Multiple Deposit Creation
Assume that banks don’t hold excess reserves so that total reserves (R) equal required reserves (RR). Then RR equals the required reserves ratio times the total amount of deposits (D).
or
r·D=R
D = 1R. r
Thus, changes ∆R in reserves imply that
∆D = 1∆R. r
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Critique of the Simple Model
Holding cash stops the process:
Currency has no multiple deposit expansion effect.
Banks might use only part of their excess reserves in securities/loans.
Depositors’ decisions (how much currency to hold) and bank’s decisions (how much excess reserves to hold) affect the money supply.
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What determines the money supply?
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The Money Multiplier
Define money as currency plus checkable deposits: M1.
Link the money supply (M) to the monetary base (MB) and let m be the money multiplier:
M = m · MB
Assume that the desired holdings of currency C and excess reserves
ER grow proportionally with checkable deposits D. Then, c = C = currency ratio,
D
e = ER = excess reserves ratio. D
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The Money Multiplier
The total amount of reserves (R) equals the sum of required reserves (RR) and excess reserves (ER).
R = RR + ER.
The total amount of required reserves equals the required reserves
ration times the amount of checkable deposits RR = r · D
so that
where r is less than 1.
R = r · D + ER,
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The Money Multiplier
The monetary base MB equals currency (C) plus reserves (R): MB = C + R = C + rD + ER.
MB is the amount of monetary base needed to support the existing amounts of checkable deposits, currency and excess reserves.
Using the ratios
so that
MB = cD + rD + eD = (c + r + e)D,
D= 1 MB. c+r+e
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The Money Multiplier
Since
we have
M = D + C = D + cD = (1 + c)D,
M=(1+c)D= 1+c MB. c+r+e
The money multiplier is
m=1+c. c+r+e
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The Money Multiplier
Intuition: Numerical example with realistic numbers.
1 r = required reserve ratio = 10%
2 C = currency in circulation = $400B
3 D = checkable deposits = $800B
4 Thenc=0.5
5 ER = excess reserves = $0.8B
6 Then e = 0.001
7 M = money supply (M1) = C+D = $1,200B
8 Then, the multiplier m = 2.5
9 $1 increase in the MB leads to a $2.5 increase in M1
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Application 1: The Great Depression Bank Panics, 1930-1933, and the Money Supply
Bank failures (and no deposit insurance) determined:
• Increase in deposit outflows and holding of currency (depositors)
• An increase in the amount of etxcess reserves (banks)
For a relatively constant MB, the money supply decreased due to the fall of the money multiplier.
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Application 1: The Great Depression Bank
Panics, 1930-1933, and the Money Supply
Deposits of Failed Commercial Banks, 1929-1933
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Application 1: The Great Depression Bank Panics, 1930-1933, and the Money Supply
Excess Reserves Ratio and Currency Ratio, 1929-1933
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Application 1: The Great Depression Bank Panics, 1930-1933, and the Money Supply
M1 and the Monetary Base, 1929-1933
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Application 2: The 2007-2009 Financial Crisis and the Money Supply
The monetary base more than tripled as a result of the Fed’s purchase of assets and new lending facilities to stem the financial crisis.
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Application 2: The 2007-2009 Financial Crisis and the Money Supply
The currency ratio fell somewhat during this period.
The money supply model suggests this raises the money multiplier. It also raises the level of deposit expansion and thus money supply.
However, the effects of the decline in c were entirely offset by the extraordinary rise in the excess reserves ratio e.
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Application 2: The 2007-2009 Financial Crisis and the Money Supply
Excess Reserves Ratio and Currency Ratio, 2007-2009
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Application 2: The 2007-2009 Financial Crisis and the Money Supply
M1 Money Multiplier
3.5 3.0 2.5 2.0 1.5 1.0 0.5
2005 2010 Shaded areas indicate US recessions – 2014 research.stlouisfed.org
1985 1990
1995 2000
Source: Federal Reserve Bank of St. Louis
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(Ratio)