Money, Banking, and International Finance ( PDFDrive )

Money, Banking, and International Finance

collapsed, when homeowners stopped buying houses. Then the U.S. housing bubble deflated as housing prices began plummeting.

Surge in mortgage defaults caused the investors to question ABS and CDOs, and they stopped investing in securitized debt. Subsequently, both the commercial and investment banks became stuck with billions in unsold CDOs. Furthermore, the banks and investors of CDOs and ABS foreclosed on homes that are losing value. Unfortunately, if the banks accumulate too many bad mortgages, then they become insolvent. Finally, the 2008 Financial Crisis caused fear, panic, and paranoia to sweep across the financial world. Banks and financial institutions had frozen all credit and loans overnight.

1.Identify a bank’s assets, liabilities, and capital.

2.Explain a bank’s net worth and its importance.

3.Explain liquidity risk.

4.How does a bank become insolvent?

5.Identify methods banks can reduce adverse selection.

6.How did the 2007 Housing Bubble cause banks to become insolvent?

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11.The Money Supply Process

We examine the Federal Reserve’s balance sheet in this chapter and explain how fluctuations in the Fed’s assets and liabilities affect the money supply. Money supply greatly influences the interest rates, exchange rates, inflation, and a country’s production of goods and services. Furthermore, fluctuations in the money supply impact the financial markets, such as bond and stock prices and the economic well-being of society. Unfortunately, the Fed can only influence the money supply because the public and banks also influence the money supply. For this chapter, we use the definitions of money, M1 and M2, to explain how the banking system expands the money supply by the multiple deposit expansion.

The Fed’s Balance Sheet

Monetary base equals the currency in circulation plus reserves held by commercial banks. Currency in circulation is the Federal Reserve Notes the public is holding, i.e. U.S. money, which does not include vault cash at the banks because we already counted the vault cash as bank reserves. Moreover, the Fed can directly influence the monetary base, and in turn, the monetary base influences the money supply. Before understanding how the money supply process works, we introduce the Fed’s balance sheet. Consequently, the currency in circulation and bank reserves are liabilities to the Federal Reserve.

Using a simple example, the Fed sets the required reserve ratio to 10%, which is the percentage of total reserves that banks must hold as reserves at the Fed or as vault cash. If you open a bank account by depositing $100, then the bank must hold 10% of your deposit, which equals $10. Thus, the $10 is the required reserves. A bank could hold more than $10, which are excess reserves. Consequently, the bank holds reserves to meet depositors’ withdrawals. You could return to your bank and withdraw your $100 deposit. Subsequently, the bank returns your money from its reserves. Bank either holds $10 in its vault or deposits the $10 with the Fed. Did you notice bank reserves are assets to the bank, but liabilities to the Fed? On the other hand, the public holding money is an asset, but money is a liability to the Fed.

The Fed has two important assets: government securities and discount loans. When the Fed increases its assets, the monetary base rises When the Fed decreases its assets, the monetary base declines. The Fed can change the monetary base through open-market operations. An openmarket operation is the Fed buying and selling financial securities. Usually the Fed buys and sells U.S. government securities. When the Fed buys U.S. government securities, we call it an open-market purchase because the Fed’s assets increase, expanding the monetary base. The Fed can sell U.S. government securities, called an open-market sale. The Fed’s assets decrease, contracting the monetary base. For example, the Fed buys a $10,000 T-bill from your bank. We list the transaction on the next page in the T-account:

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The Fed buys the T-bill by using a Fed check. When the bank sends the check to the Fed, the Fed increases the reserves at your bank. A Fed check is not backed by money per se. As the Fed clears its own check, it adds numbers to a bank’s accounting books. Afterwards, the bank’s reserves increase and your bank can lend to someone, so the bank earns interest. Consequently, the Fed’s assets increase while both the monetary base and money supply expand.

For the second example, the Fed buys one T-bill from you for $10,000, using a Fed check. Subsequently, you deposit the Fed check at your local bank, and your net assets did not change. Bank’s reserves increase by $10,000, as well as the demand deposit. Finally, the Fed’s T- account becomes identical to the last example.

Money supply has risen because you traded the T-bill for a demand deposit. It makes no difference if the Fed purchased U.S. securities from the public or a bank. Consequently, the Fed’s assets increase, expanding the monetary base. Your bank’s reserves increase, and your bank can lend to earn interest. Then the money supply increases. If the Fed sells U.S. government securities, subsequently, the opposite occurs.

The Fed loans are the second most important asset. The Fed lends to banks, helping the banks survive liquidity problems. The Fed loans are called discount loans. Furthermore, we call the interest rate the Fed charges for these loans the discount rate. The Fed does not use loans to influence the monetary base. Instead, the Fed relies on open-market operations because the Fed

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Money, Banking, and International Finance

has complete control over how many securities, it buys and sells. With discount loans, the banks determine whether they want to borrow from the Fed. The Fed cannot force a bank to accept a loan. However, if the Fed makes more discount loans, subsequently, the Fed’s assets increase, expanding both the monetary base and money supply. For example, a bank asks the Fed for a loan of $1 million.

Bank’s reserves increased by $1 million, and the bank can grant more loans, expanding the money supply. When the bank repays the Fed loan, subsequently, the Fed’s assets become smaller. Furthermore, both the monetary base and the money supply decrease. We show the transaction below in the T-accounts:

Multiple Deposit Expansion and Contraction

Banking system creates the money supply through multiple deposit expansion. This means if the Fed increases the monetary base by $1, then the amount of checkable deposits in the banking system will increase by more than $1. Checkable deposits are a component of the M1 definition of money, consequently, the money supply increases by more than $1. We show the multiple deposit expansion by using an example.

The Federal Reserve increases the money supply, so the Fed buys a $10,000 U.S. T-bill from you. You take the Fed check and deposit the whole $10,000 at your bank into your checking account. We record the transaction in the T-account on the next page.

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Money supply immediately expands by $10,000. Bank must hold 10% of its deposits as required reserves. Thus, the bank holds $1,000 of reserves against your account as a deposit at the Fed or as vault cash. However, the bank has $9,000 in excess reserves. These reserves earn no interest, and consequently, the bank loans them out. For instance, your bank grants a $9,000 car loan to your friend. We display the transaction below:

Bank sends your friend a check for $9,000. Your friend takes this check to a car dealership and buys a car. Car dealer deposits this check at his bank, and we record this transaction below:

Did you notice the change in the money supply? Money supply expanded by $19,000 because you have $10,000 sitting in your account, and the car dealership has $9,000 in his account. Car dealer’s bank must hold 10% of the deposit, equaling $900. Remaining funds, $8,100, earn no interest. Consequently, the car dealer’s bank lends this out. Car dealer’s bank grants $8,100 business loan. We record this transaction below:

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Small business contracts with a construction company to renovate his business. Construction company receives a check for $8,100 and deposits this check in its bank. We record the transaction below:

Construction company’s bank must hold 10% of this deposit, equaling $810. Remaining reserves, $7,290, earn no interest, and consequently, this bank grants a loan. Did you notice the change in the money supply? Money supply has expanded by $27,100, which includes the $10,000 in your account, $9,000 in the car dealer’s account, and $8,100 in the construction company’s account. When the construction company’s bank grants a loan, then the money supply would increase again, and multiple deposit expansion occurs infinitely.

We can derive the maximum change in the money supply when the monetary base changes. First, we start with the formula for total reserves in Equation 1.

In this case, excess reserves equal zero because banks earn no interest. Banks grant loans using their excess reserves. Second equation calculates required reserves. When a bank accepts a new checking account, the bank must hold a percentage of the deposit, which is Equation 2.

We substitute Equation 2 into Equation 1 and set the excess reserves equal to zero, which yields Equation 3.

Did you notice the money supply changes when the Federal Reserve changes the bank reserves? We show reserve changes in Equation 4 and deposit changes in Equation 5. The symbol means change, and we take the difference between two adjacent time periods. First time period is t, while the future time period is t+1.

Money, Banking, and International Finance

Bank pays your $200 from required reserves. Bank does not have any excess reserves because it loaned the excess reserves out. Consequently, your deposit becomes $9,800, and the bank must hold $980 in required reserves. However, it only has $800, so the bank is short $180. Bank calls in loans, causing other banks to lose deposits. Thus, the money supply contracts by Equation 8.

rr 0.10

We do not include your $200 because you converted $200 from a checkable deposit into currency. Remember the M1 definition of money, as defined by Equation 9. We start at the $180 because you switched the first $200 from a checkable deposit into currency, and unfortunately, we cannot count the same money twice.

The Money Supply Multipliers

People, who hold more currency and fewer deposits, can cause bank reserves to fall, contracting the money supply. Thus, the public determines the level currency to hold relative to the bank deposits. Economists examine the proportion of cash (C) to checkable deposits (D) as the currency-deposit ratio (C/D). Consequently, four factors influence this ratio over time, which are:

Higher wealth causes the currency-deposit ratio to fall. When a country becomes wealthier, people have greater income. Thus, people would deposit their money into banks because holding large amounts of currency is risky.

Higher interest rates lower the currency-deposit ratio. Banks pay interest rates on deposits while currency does not. When interest rates rise, people begin depositing money into banks to earn the greater interest rate.

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