ECA 112 The National Eco

nomy
Lecture VI
Money, Banking, the Federal Reserve System and Monetary Policy

GENERAL POINTS
A. The monetary sector of the economy includes an under
standing of:
1. Money
2. Banking (demonstrating the diversity of financial markets and
institutions)
3. Central Banking (the Federal Reserve System as both Participa
nt and Regulator)

FUNCTIONS OF MONEY
A. Standard of Value
B. Unit of Account
C. Unit of Deferred Payment
D. Medium of Exchange
E. Store of Value
12-

originally proposed by Keynes

the store of value is not the interest rate

DECREASING LIQUIDITY

DEFINITIONS OF MONEY
M1= Currency (in circulation)
+ Demand Deposits at Commercial Banks
+ Automatic Transfer (such as Direct Deposit)
+ Credit Union Share Drafts
+ Demand Deposits at Mutual Savings Banks
+ Travelers Checks
M2 = M1 + Savings Accounts
+ Time Deposits (< $100,000)
+ Money Market Mutual Funds (MMDA)

FINANCIAL MARKETS
A. Money Markets
o Securities with maturities of less than 1 year
o Examples
Treasury Bills
Negotiable Certificates of Deposit
Commercial Paper
Bankers Acceptances
Euro-currency Deposits

B. Capital Markets
o Securities with maturities of greater than 1 year
Examples
o Treasury Notes
o Treasury Bonds
o Corporate Bonds
o Municipal Bonds
o Stock

TYPES OF FINANCIAL INSTITUTIONS

A. Deposit
1.
2.
3.
4.

Commercial Banks
Saving Banks
Savings + Loan Associations
Credit Unions

Thrift
Institutions

B. Non- Deposit
1. Insurance Companies
2. Investment Banks
3. Pension Funds

We will focus on Commercial Banks

Credit Creation
A. Since money is credit, the banking system can expand the
money supply by virtue of their normal daily activities, na
mely lending
B. This model has several alternative names
Model of Credit Creation
Model of Demand Deposit Expansion
Monetary Multiplier

D. Assumptions
1- The Banking System is Loaned-up (No Excess Reserves)
2- The Federal Reserve System gives the Banking System
additional $1,000
3- The Reserve Ratio is 15%
{Dollar Value of Required Reserves is determined by the
quired Reserve Ratio and Total Deposits}
Required Reserves= RR ratio x Total Deposits
[Total Reserves = Required Reserves + Excess Reserves]
[Potential Deposit Creation= Excess Reserves x K m]
4- The Cash Drain is 10%

an

Re

BANKING
SYSTEM

EXCESS
RESERVES

RESERVE
RATIO

NEW
LOANS

#1(CITIBANK)

$1,000

$150

$850

#2(CHASE)

$850

127.50

722.5

#3(B of A)

722.50

108.38

614.12

#4

614.12

92.12

522.00

#5

522.00

78.30

443.70

TOTALS

$6,666.67

$1,000

MB: Monetary Base: Total Amount Money On Reserve

$5,666.6

Km = MS

$1,000 Km = $6,666.67
Km = = 6.67

MB: Monetary Base

MS: Money Supply
Km: Monetary
Multiplier

[More simply, the monetary multiplier is the inverse of the

reserve ratio]

Banking
System

Excess
Reserves
(R)

Reserve
Ratio
(15%) (r)

Cash Drain
(10%)

New Loans

#1(Citibank)

$1,000

$150

$100

$750.00

#2(Chase)

750

112.50

75

526.50

#3(B of A)

562.85

84.40

56.25

421.85

#4

421.85

63.30

42.20

316.35

$4,000

$600

$400

Totals

+
$3,000

MB Km = MS
$1,000 Km = $4,000
Km = = 4.0

Without the cash drain: Km= 6.67

With the cash drain: Km = 4.0
The cash drain decreases the size of
Km (in this case by a factor of 2.67)

D. Factors Affecting the Size of the Multiplier

1. The Amount of Excess Reserves
2. Demand For Loans
3. Willingness To Lend
4. Reserve Ratio
5. Annual Cash Drain Fluctuations

The Federal Reserve

System
[The Central Bank of the United States]

FEDERAL RESERVE STRUCTURE

A. Board of Governors (7)
1- Highest administrative body [actions taken are called Monet
ary Policy]
2- Created in 1913 [re-created in 1933]
3- Members are appointed by President (Confirmed by Senate)
4- Term is 14 Years [non-recurring]
5- Chairman (currently Janet Yellen) nominated by President
[term is 4 years){can be re-appointed}
6- Responsibilities
a) Set Margin Requirement
b) Supervise Operation of District Banks
c) Set Reserve Requirement
d) Supervise Issue Destruction of Currency
e) Set Discount Rate

B. FEDERAL OPEN MARKET COMMITTEE (12)

1-Membership
a) Board of Governors (7)
b) President of NY District (1)
c) Presidents of Remaining Districts (4)

2- Chairman of the Board of Governors is the

hairman of FOMC
3- President of NY District is Vice Chairman of
C
4- Responsible for buying and selling Federal
rnment securities
a) Treasury Bills [short-term]
b) Treasury Notes [intermediate-term]
c) Treasury Bonds [long-term]

C
FOM
Gove

C. FEDERAL ADVISORY COUNCIL

1- Membership
a) Federal Advisory Council (12)
I - Prominent Banker

2- Responsible for providing information and

ysis as to the changing economic
itions in their

and financial cond

respective districts.

3- Meetings: Quarterly

anal

Federal Reserve District Ban

ks
District

Location

#1

Boston, Massachusetts

#2

New York, New York

#3

Philadelphia, Pennsylvania

#4

Cleveland, Ohio

#5

Richmond, Virginia

#6

Atlanta, Georgia

#7

Chicago, Illinois

#8

St. Louis, Missouri

#9

Minneapolis, Minnesota

#10

Kansas City, Kansas

#11

Dallas, Texas

D. DISTRICT BANKS
1-System designed to service member banks
2- Administered by a Board of Directors (9
mbers)

Me

a) A Directors [Banking] [3]

b) B Directors [Agriculture; Commerce and
ndustry; Education] [3]
c) C Directors [Not Specified] [3]

3- Chairman and Vice Chairman

a) Appointed by the Board of Governors
b) Only C Directors

4- Manage reserve account for members

E. MEMBERS
1- Although the Federal Reserve was originally created to regulate n
ationally chartered commercial banks, state chartered banks can also jo
in.
2- Currently, non-bank depository institutions are also subject to re
serve requirements and have access to the Feds payment system.
3- In 1929 there were 24, 970 commercial banks in the United State
s. By 1933 only 10, 407 were left.
4- As of June, 2015 there are 5,441 commercial banks in the United
States.

Conclusions
[Regarding the Federal Reserve System]
1. Monetary Policy decisions are highly centralized
2. The organizational structure is highly decentralized

FUNCTIONS
I. Service Function
A. Handling Reserve Accounts of banks
B. Furnishing currency in circulation
C. Acting as banker for U.S. Government; U.S. Governmen
t Agencies; Foreign Governments; Foreign Central Bank
s and International Organizations
D. Clearing and collecting checks

FLOAT: the length of time

it takes to clear a check.
Lord
& Citibank #2 #12 FNBSF Mr. Smith
Taylor
Check
$100,000
FUNDS
Artificial Expansion in the Money supply

II. Control Function (affect the quantity of money)

A. Open Market Operations [FOMC] (buying &

selling G

overnment Securities)
a) Purchase [expands the Ms and therefore the economy]
b) Sale [contracts the Ms and therefore the economy]

B. Variable Reserve Requirement

C. Discount Rate

Open Market Operations

a) Purchase (i.e. $10M of Government Security)
$10M Reserves

FEDERAL
RESERVE

BANKS

$10M Government Security

Assuming
KM = 2.0

MB KM = MS
$10M 2.0 = $20M
[Expansionary]

Expands
Reserve
Accounts

Loans

$10M

MB: Funds
on Required
Reserve

b) Sale (i.e. $10M of Government Security)

$10M Government Security

FEDERAL
RESERVE

BANKS

$10M Reserves

Assuming
Km = 2.0

MB KM = MS
$10M 2.0 = $20M
[Contractionary]

Replenishes Loans
Reserve
$10M
Accounts

c) Conclusions
1. Most frequently used tool
2. Vague in its effects
3. Designed to affect MB (and therefore MS) directly
4. Open Market Operation affects the Federal Funds Rate
MS GDP

Variable Reserve Requirement (t

he % banks keep on reserve)
BANKING SYSTEM (r = 15%)
ASSETS
REQUIRED RESERVES

EQUITIES
$15M

D/D
85M $100M
TOTAL

EXCESS RESERVES
TOTAL

$100M

Loan Portfolio
Investment Portfolio

$100M

BANKING SYSTEM (r = 20%)

ASSETS
REQUIRED RESERVE S
EXCESS RESERVES
TOTAL

EQUITIES
$20M D/D
80M $100M
TOTAL

$100M

$100M

[As the r-ratio s, excess reserves decreases Loans(& MS) ]

Reserve Required MS GDP

Conclusions
1. Least frequently used tool
2. Most powerful tool
3. Designed to affect Mb (and therefore MS) directly.

Discount Rate
a) The interest rate that the Federal Reserve charges bank
s
b) If this interest rate increases, this theoretically discour
ages borrowing and MS
c) If the interest rate decreases, this theoretically encoura
ges borrowing and MS

Conclusions
1. Designed to affect MB (and therefore MS) indirectly
2. Weakest tool (because borrowing from FED is a pri
vilege. The Federal Reserve is regarded as the Lend
er of Last Resort)
3. At best, this tool is an indicator of a policy change

Demand for Money

Transactions Demand: That amount of Income held as idle money

for the purchase of Goods and Services.

Precautions Demand: That amount of Income that is held as idle

money just in case.

Speculative Demand: That amount of Income held as idle money i

n anticipation of an increase in the market interest rate.

Together the Transaction and Precautions Demand explain the left

side of the next graph while the Speculations Demand explain the r
ight side of the graph

Co-ordination
i%

(i%)1

(MS)1

E1

(i%)2

Q1

(MS)2

(i%)1

E2

Q2

Quantity of
money

i%

MD

AgS

(i%)2

QM

I1

E1

P2
E2

I2

ID
I($)

Cumulative
Investment

MS i% I GDP
MS i% I GDP

P1

E1

E2
AD2

AD1

Y1

Income

Y2

Y($
)

Monetary Policy Constra

ints
A. Short-term vs. Long-term Interest Rates
o In order for Monetary Policy to be effective Long-Term interest rates must mirro
r Short-Term interest rates
o At the start of the Great Recession they werent, consequently the FED wasnt ab
le to alter the position of the mortgage market

B. Liquidity Trap and Low Expectations

o Can be seen on the graph on the left and the graph on the right respectively

C. Time Lags
o Even if the policy decision is correct, it will still not effect the variables in the sys
tem immediately

D. Effectiveness of Monetary Policy

o The effectiveness of Monetary Policy is complicated by the following:
All the members in the financial system do not react to the same scenarios
in the same way
Members of the United States financial markets are not restricted to domes
tic markets
There are leakages out of the financial system
o Reserve ratio
o Cash drain
o Lack of demand for loans
o Willingness to lend