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Chapter 13 Money, Banking and the Creation of Money
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Some textbooks put this material into two chapters. In
 
McConnell Economics 15th edition its chapters 13 and 14 while in the 18th edition its 31  and 32.

 

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I. Functions of money
    A. Medium of exchange: facilitate exchange eliminating barter which requires people with mutually needs.
    B. Standard of value: allows for the pricing of heterogeneous goods.
    C. Store of value: maintains value and provides liquidity so extra spending power is available as needed.
    D. Standard of deferred payment: makes credit contracts possible so credit transactions are possible.

II. The supply and demand for money
     A. Three categories of the supply of money
          1. M1 = Currency, coins, and demand deposits (checking accounts). 
          2. M2 = M1 plus near monies such as small time deposits (savings accounts) and short-term government securities. 
          3. M3 = M2 plus large time deposits (over $100,000)
     B. What backs the dollar?
          1. It is a debt of the federal government.
          2. Backed by faith in the government's ability to control inflation.
          3. Value is determined by acceptability (it is legal tender and scarce).
          4. It's fiat (by decree of the government) money.
          5. Coins have little intrinsic value (a small % of face value) so they are called token money.
          6. Commodity money such as tobacco used as money in the Virginia colony has intrinsic value of its own.
    C.
The Demand for Money 
        
1. Transaction D, Dt
, results because people hold money, often in a money market account, to use as a medium of exchange.
         2. Asset Demand, Da, results because people accumulate money, often held in an investment account, to buy assets.
         3. The demand for money Dm= D t + Da
         4. Interest rates are set in the money market.
           
                    

            5.  For more information visit Demand for money - Wikipedia, the free encyclopedia

III. Maintaining money's value requires
       A. A sound fiscal policy (a reasonable federal debt)
       B. A sound monetary policy (not using inflation to pay the federal debt)

IV. United States private banking system
      A. Two kinds of banks
          1. Commercial banks offer demand deposits (checking accounts)
          2. Savings and loan associations used to specialize in time deposits (saving accounts) and home mortgages. 
              Now, because of deregulation during the early 1980's, they are similar to commercial banks. 
     B. Federal deregulation contributed to banking difficulties in the 1980's.
     C. Visit
History provided by the Federal Reserve Bank of St. Louis for a time line of the U.S. banking System. 
          Be sure to point at each date to see what happens during that period.

V. The Federal Reserve System
     
A. Organization Chart

 

           1. Board of Governors oversee the Federal Reserve System
                a. Seven governors
                b. Governors are appointed by the President and confirmed by the Senate.
               c. The chair
is appointed by the President for a four-year term.
                   1)  To foster independence, the term does not coincide with the President's term. 
                   2) Other board members are appointed to 14-year terms on a staggered basis to insure an experienced board.
             2. Federal Open Market Committee
                 a. Membership consists of the Board of Governors and 5 of the 12 Federal Reserve bank presidents with the 
                    N.Y. president always a member because
N.Y. City is the financial center for U.S. international trade.
                 b. The Committee tries to affect interest rates by affecting the supply of money by buying and selling U.S. government 
                    bonds (See Chapter 15).
             3. Federal Advisory Council 12 prominent commercial bankers, one from each district, who advise the Board of 
                 Governors
             4. Twelve Federal Reserve Banks 
                
a. The United States is divided into 12 homogenous districts and each has its own bank
                 b. Bank for the federal government
                 c. Bank for member banks
                 d. Graphic is complements of the Board of Governors of the Federal Reserve System.


        

            5. Member commercial banks
            6. Nonmember commercial banks and thrifts are regulated by other government agencies
        B. Functions of the Federal Reserve
            1. Regulate the money supply
            3. Oversea the financial system
            4. Check collection and clearing
            5. Fiscal agent for the government
            6. Supervise (audit) member banks 
            7. Hold reserves (deposits) for member banks
            8. Compile economic statistics such as the Beige book, which is
                a quarterly summary of each districts' recent economic activity.
           9. Many Federal Reserve publications are free.
        C. The Federal Reserve System Purposes and Functions
        D.  Current Events Readings
             1. Philadelphia Reflections: Whither, Federal Reserve? is a well done, concise history of banking in the United States.
             2. The Real Threat to Fed Independence Henry Kaufman, Wall Street Journal. The financial giant cuts the industry no slack.
                 3. The Current Events Internet Library has many up-to-date economic articles.

VI. Recent Developments
        A. Banks and thrifts are the only institutions whose checking accounts are not restricted as to check size and number
            1. A liberalized of banking laws,
Financial Institutions Reform, Recovery and Enforcement Act of 1989,
                has caused a declined in their importance although reforms resulting from the Great Recession beginning in 2007 cold change this.
            2. Consolidation has caused their numbers to decline and their size to increase.
            3. Many bank/thrift services are now performed by insurance companies, pension, and securities companies.
        B. Globalization of financial markets.
       
C. Some politicians think the Federal Reserve system is too independent.   
             1.
Congress Is Politicizing the Fed Jan 25, 2010

 
2. Central bank independence versus inflation. This often cited  [49] research published by Alesina and Summers (1993)[50] is used to show why it is important for a nation's central bank (i.e.-monetary authority) to have a high level of independence. This chart shows a clear trend towards a lower inflation rate as the independence of the central bank increases. The generally agreed upon reason independence leads to lower inflation is that politicians have a tendency to create too much money if given the opportunity to do it.[50] The Federal Reserve System in the United States is generally regarded as one of the more independent central banks.

  

VII. The fractional reserve system and the creation of money
      A. Commercial banks are required to keep a reserve (cash) of about 12% of their demand deposits (checking accounts)
           at their bank or on
deposit with the Federal Reserve (required reserves). The remainder, (Excess Reserves) may 
           be loaned out even though they support deposits.
      B. Money is created by these loans as long as the demand deposits (DD) created by them stay within the banking system, 
           that is, the money loaned is redeposit as a DD into a bank within the system. The banks owe the demand deposits created
           by the loans to each other. These inter-brain debts  are canceled with a bookkeeping entry. It should be
pointed out that the 
           demand deposits created by such loans are spent, and goods transferred, just as if the transaction involved currency.
      C. Example: Bank A has $50,000 in demand deposits. A reserve requirement of 10% would yield required reserves of 
           .10 x $50,000 = $5,000. If Bank A had $7,000 in reserve, it could loan up to $2,000 in the form of demand deposits. 
           Suppose Bank B does exactly the same with both banks' customers depositing their DD in the other bank. Banks would 
           owe cashed checks to each other, would cancel interbank debts,
and money  has been created.
      D. The system works in reverse with money destroyed if reserves leave the system.
      E. Required reserves, reserves not loaned, and loans of cash (reserves) represent a leakage which eventually stops money
          supply growth.

VII. The monetary multiplier
        A. An infusion of reserves into the system by the Treasury as directed by the Federal Reserve can be loaned a number of times
             by the commercial banking system. For example, the Federal Reserve may buy a $100 Treasury bond from Ms. A who
 
             deposits the Federal Reserve check (reserves) into Bank A.
        B. Bank A's new DD of $100 requires them to keep $10 (10%) in reserve leaving $90 excess to loan to Mr. B who 
            deposits it in Bank B.
        C. Bank B needs to keep only $9 ($90 x .1) in reserve and may loan out $81. 
        D. This process continues and as long as the demand deposits being created by the loans stay within the commercial 
             banking system,
interbank debts are canceled and money has been created
        E. Monetary multiplier (M) sets the upper limit of the expansion
           1. R = reserve requirement = 10% = .1
           2. M = 1/R = 1/.1 = 10
        F. In the above example the total amount of DD created beginning with Bank A's $90 in excess reserves would equal 
            Excess
Reserves x M = $90 x 10 = $900. If the $100 infusion by the Federal Reserve is included, the increase is 
           10 x 100 = $1,000.
        G. For more Information visit
The Banking System and the Money Multiplier from Jay Kaplan of the University of Colorado at Boulder.

    VIII. Additional reading
         1. Money creation - Wikipedia
         2.
Banks Create Money

      

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