University:
California State University, Northridge
Course:
ECON 500 | Survey of Economics
Academic year:

2024
Views:

472

Pages:

18
Author:

Jaxson Whitney

Lecture 10 Money and the Banking System & Monetary Policy Part 1 Overview • • • • • Why are Banks so Heavily Regulated? Nature of Money How Quantity of Money is Measured Banking System Origins of the Money Supply Why are Banks so Heavily Regulated? • Major “output” of banking industry is the nation’s MS --important determinant of AD. • 1. Bank managers are paid to max shareholder value & not what is in the best interests of the economy. – Gov does not allow banks to determine MS & interest rates strictly on profit considerations. • 2. Concern for the safety of depositors – If banks are allowed to fail, then depositors would lose their money whenever one went bankrupt. – “Run on a bank:” if depositors get nervous, they may all rush to cash their accounts which causes the bank to fail. This is highly contagious! 3 Figure 1 (a) Bank failures in the United States, 1915–2009 Bank failures have been less common since 1930s –until recently. 4 Figure 1 (b) Bank failures in the United States, 1915–2009 ‘09 5 The Nature of Money • Barter – System of exchange where people directly trade goods for goods without using money as an intermediate step – Requires: “double coincidence of wants” • Money – Greases the wheels of exchange & makes the whole economy more productive • Dramatically reduces search costs under a barter system 6 The Nature of Money • What is Money? – Medium of exchange • Standard object used in exchanging goods & services – Unit of account • Standard unit used for quoting prices – Store of value • Store wealth from one point in time to another – Money is not a good hedge against inflation! 7 The Nature of Money • What Serves as Money? – Commodity money • An object (like cattle, stones, cigarettes, gold) used as a medium of exchange that also has substantial value in alternative uses – Paper money = Fiat money • Decreed as money by gov & has little value as a commodity • Maintains its value as a medium of exchange because people have faith that the issuer will back the paper & limit its production 8 How Quantity of Money is Measured • One measure of MS: M1 – Narrowly defined – Includes coins, paper money, traveler’s checks, conventional checking accounts, & certain other checkable deposits in banks & savings institutions – M1 = $1,693 billion in 2009 9 How Quantity of Money is Measured • Another measure of MS: M2 – Broadly defined – Includes M1 plus money market deposit accounts, money market mutual funds, & savings accounts – M2 = $8,524 billion in 2009 – Everything in M1 is completely “liquid.” • Liquidity refers to the ease with which an asset can be converted into cash. 10 How Quantity of Money is Measured • Credit cards are not included in MS – How much money does your credit card represent? • Should we count what you owe or your available credit? • We will stick with a conventional definition of money – Coins, paper money, & checkable deposits 11 The Banking System • Fractional reserve banking – is a system under which bankers keep as reserves only a fraction of the funds they hold on deposit • Features – Bank profitability • Banks get deposits at zero interest & lend some of them out at positive interest rates. 12 The Banking System • Features (cont.) – Bank discretion over money supply • Create money by keeping only a fraction of their total deposits on reserve & lending out the balance • Bankers’ decisions on how much to hold in reserves influence the supply of money – Exposure to bank runs • Danger of a run on the bank has induced bankers to keep prudent reserves & lend out money carefully The Banking System • Banking is an inherently risky business – Safe only by cautious & prudent management – Recent events (e.g., subprime mortgage meltdown) showed that bank managers were neither cautious nor prudent. Why? – Caution is not the road to high profits • Max profits by keeping low reserves & earning high interest rates on risky borrowers – Banks need to strike a balance between the lure of profits & the need for safety 14 The Banking System • Bank regulations • Deposit insurance - guarantees the safety of bank deposits – FDIC • Established in 1933 –reduced the # of bank failures • Your account is insured up to $250,000 • Prevents bank runs – Moral hazard problem • If depositors are freed from risk of loss from a failing bank, then they will not shop around for safer banks. • People who are insured against the consequences of risk will engage in riskier behaviors. 15 The Banking System • Bank regulations (cont.) • Bank supervision – Various regulatory authorities conduct periodic bank examinations – Laws & regulations limit the kinds & qualities of assets in which banks may invest • Reserve requirements – Minimum amount of reserves • Proportional to volume of deposits • Not really for safety but to control the MS The Origins of the Money Supply • Asset of a bank: item of value that is owned by the bank (e.g., bank building or loan) • Liability of a bank: item of value that the bank owes (e.g., your bank balance) • Balance sheet: is an accounting statement • Left side: lists values of all assets • Right side: values of all liabilities & net worth – Net worth = value of assets – value of liabilities – Assets = Liabilities + Net worth 17 Table 1 Balance sheet of Bank-a-mythica, December 31, 2007 Assets Assets Reserves Loans outstanding Total Addendum: Bank Reserves Actual reserves Required reserves Excess reserves Liabilities and Net Worth Liabilities $1,000,000 Checking deposits $4,500,000 $5,500,500 Net Worth Stockholder’s $1,000,000 equity $1,000,000 Total 0 $5,000,000 $500,000 $5,500,000 Example of a balance sheet. Bank has only two kinds of assets: $1M in cash reserves & $4.5M in outstanding loans. One kind of liability: $5M in checking deposits. Net worth = total assets – total liabilities = $500,000. 18

Money and the Banking System, Part 1

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