MONEY AND THE BANKING SYSTEM

MONEY AND THE BANKING SYSTEM There have been three great inventions since the beginning of time: fire, the wheel, and central banking. [Will Rogers]

The purposes of this chapter are to explain the operation of our banking system and to analyze the determinants of the money supply. Later, we will consider the influence of money on prices, employment, output, and other important economic variables. To many economists, analyzing the determinants of national income without considering money is like playing football without a quarterback. The central moving force has been excluded. Although the majority would assign a somewhat lesser role to money, almost all economists believe that money, and therefore monetary policy, matters a great deal.

WHAT IS MONEY? Money makes the world go around. Although this is an exaggeration, money is nonetheless an important cog in the wheel that makes trade go around. Without money, everyday exchange would be both tedious and costly. Of course, money today is issued and controlled by governments, but the use of money arose thousands of years ago, not because of government decree, but because money simplifies exchange. Money performs three basic functions. J. Money Serves as a Medium of Exchange. If one desires to exchange labor services for a shirt and trousers, he first sells his labor for money and then uses the money to buy the shirt and trousers. Similarly, if a farmer wants to exchange a cow for electricity and medical services, he sells the cow for money, which he then uses to buy the electricity and medical services. In a barter economy, such simple exchange would necessitate finding a buyer for one's goods who was willing to sell precisely those things one wanted to purchase. Exchange would be enormously time-consuming. In an exchange economy with money, money trades in all markets, simplifying exchange and oiling the wheels of trade.

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2. Money Serves as an Accounting Unit. Consumers want to compare the prices of widely differing goods and services so that they will be able to make sensible choices. Similarly, cost-conscious businessmen want to compare the prices of vastly different productive resources. Since money is widely used in exchange, it certainly makes sense that we also use it as the accounting unit, the yardstick by which we compare the value of goods and resources.

Liquid asset: An asset that can be easily and quickly converted to cash without loss of value.

3. Money Is a Store of Value. Money is a financial asset, a form of savings. There are some disadvantages of using money as a vehicle for storing value (wealth). Most methods of holding money do not yield an interest return. During a time of inflation, the purchasing power of money will decline, imposing a cost on those who are holding wealth in the form of money. However, money has the advantage of being a perfectly liquid asset. It can be easily and quickly transformed into other goods at a low transaction cost and without an appreciable loss in its nominal value. Thus, most people hold some of their wealth in the form of money because it provides readily available purchasing power for dealing with an uncertain future. WHY IS MONEY VALUABLE? Neither currency nor deposits have significant intrinsic value. A dollar bill is just a piece of paper. Bank deposits are nothing more than accounting numbers. Coins have some intrinsic value as metal, but it is considerably less than their value as money. From what does money derive its value? The confidence of people is important. People are willing to accept money because they are confident that it can be used to purchase real goods and services. This is partly a matter of law. The government has designated currency as "legal tender"—acceptable for payment of debts. However, the major source of the value of money is the same as that of other commodities. Economic goods are more or less valuable because of their scarcity relative to the amount that people desire. Money is no exception. The value of a dollar is equivalent to the goods and services that it will buy. When the price level increases, a dollar will buy less. If prices double, the value of money will be halved. The value or purchasing power of money is inversely related to the level of prices. If the purchasing power of money is to remain stable over time, the supply of money must be controlled. Assuming a constant rate of use, if the supply of money grows more rapidly than the growth in the real output of goods andservices, prices will rise. Rapid expansion in the supply of money invariably leads to a decline in its value per unit. This point was dramatically illustrated in Germany after World War I. Money lost its value as the German government printed it by the truckload. During 1923 alone, the number of German marks increased from 2 trillion to 608 trillion! As a result, an egg cost 80 billion marks and a loaf of bread 200 billion. Workers picked up their wages in suitcases. Shops closed at lunch hour to change price tags. The value of money was eroded.

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HOW IS THE SUPPLY OF MONEY DEFINED? Determining what should be included in the supply of money is not as easy as it might appear to be. At one time, only gold and silver coins were considered money. Eventually, paper currency and demand deposits (checking-account balances) replaced metal coins as the major means of exchange. In defining money, it makes sense to rely on its basic functions as a medium of exchange, a unit of account, and a store of value. On the basis of these criteria, it is clear that currency (including both coins and paper bills) and demand deposits should be included in the supply of money. Most of the nation's business—more than 75 percent—is conducted by check. Demand deposits are freely convertible to currency. The amount of currency in circulation at any given time is merely a reflection of the public's preferences for "checking-account money" versus cash. Both currency and demand deposits are legally accepted means of payment. Thus, both are counted in the supply of money. The most narrow definition of the money supply includes only demand deposits and currency in the hands of the nonbanking public. Economists use the term JV^ when referring to this narrowly defined money supply. As Exhibit 1 shows, the total money supply (Mj) in the United States was $368 billion in June 1979. Demand deposits accounted for nearly three-fourths of the total. Unless otherwise noted, throughout this text, when we speak of the money supply, we will be referring to the Ml definition. Some economists prefer to use broader definitions of the money supply. As we will soon explain, recent institutional changes have strengthened the case for a broader definition. Since deposits in savings accounts at commercial banks generally can be easily transferred to checking accounts, many economists believe that they should also be considered part of the money supply. Under this definition, the money supply would consist of M, plus time deposits (savings EXHIBIT 1 Composition of the Money Supply in the United States

Amount in Circulation, fune 1979

Components of the money supply Currency (in circulation) Federal Reserve notes Coins and other Treasury currency Demand deposits Personal and commercial checking accounts Total money supply, Mj Total money supply, M 2 Total money supply, M 3

Total (billions of dollars) 88 13

Percentage of total money supply(Mx) 24 3

M

Jl

368 903 1555

100

Source: The Board of Governors of the Federal Reserve System.

Money supply (Μ^: Currency plus demand (checking account) deposits in the hands of the nonbanking public.

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EXHIBIT 2 Three Alternative Measures of the Money Supply The graph illustrates the growth of the money supply (1964-1978) according to three alternative definitions. The narrowest and most widely used definition, Mv includes currency plus demand deposits in commercial banks. Definition M2 includes M, plus time (savings) deposits and small certificates of deposit held in commercial banks. The broadest definition, M3, includes currency, both demand and time deposits in commercial banks, and savings deposits in other financial institutions.

M2: A definition of the money supply that includes, in addition to Mj, the time and savings depos­ its in commercial banks and time certificates of deposit of less than $100,000. M,: A definition of the money supply that includes M2 plus de­ posits in mutual savings banks, savings and loan associations, and credit unions.

accounts) and small certificates of deposits held by commercial banks. This second definition of money has been labeled M 2 . Definition M 2 includes time deposits in commercial banks, but clearly similar deposits at other financial institutions are also highly liquid. In some cases, they, too, can be directly used as a means of exchange. Thus, there is a third method of defining the money supply, M 3 , which consists of M 2 plus savings deposits in mutual savings banks, savings and loan associations, and credit unions. Exhibit 2 illustrates the paths of the three measures of the money supply during the period from 1964 to 1978. Although all three have increased substantially in recent years, they have not always moved together. Despite these differences, we will focus our attention on the narrowest measure, Mv RECENT CHANGES IN FINANCIAL INSTITUTIONS AND THE MONEY SUPPLY Until recently, commercial banks, savings and loan associations, and credit unions performed distinctly different functions. In the past, if one wanted a checking account, a personal or business loan, or a credit card, one would go to a commercial bank. For maximum interest on a savings account or to obtain funds to buy a home, one would patronize a savings and loan association. Credit unions specialized in small personal loans, frequently offering the advantage of auto­ matic deductions from one's paychecks. In recent years, changes in the rules issued by the authorities regulating these institutions have blurred their traditional functions and minimized the distinc-

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tion between savings and checking-account deposits. In 1977, federally chartered credit unions were granted the authority to make 30-year mortgage loans, offer bank credit cards, and issue saving certificates. In effect, these draft saving certificates offered by many credit unions are similar to checks. T h e y may be used as a means of payment. It is expected that in the near future most savings and loan associations will be permitted to let their customers write drafts (checks) on their interest-drawing savings accounts. Thus, they, too, will be able to offer services similar to those that have historically been supplied by commercial banks. T h e functions of the commercial banking industry have been affected by other developments. Responding to a wave of bank failures during the Great Depression, Congress passed legislation prohibiting the payment of interest on checking-account funds. However, under new rules issued by regulatory author­ ities in 1978, banks can, in effect, get around this prohibition. Under the new system, individuals with both checking and savings accounts with a commercial bank can have funds automatically transferred from their interest-drawing savings account to their checking account as the need arises. As a result of this innovation, persons can draw interest on the bulk of their funds by maintaining them in a savings account and still have ready access to them through transfer to their checking account. T h e Federal Reserve has also permitted banks in New England and New York to introduce a savings account with withdrawal (checking) privileges. These accounts are called N O W (negotiable order of withdrawal). N O W accounts permit banks to pay interest on checking-account deposits. As a result of these changes, most of which took place in the late 1970s, the

WILL INTEREST-EARNING CHECKING ACCOUNTS HELP YOU?

With the relaxation of certain regu­ lations, commercial banks can now offer consumers an interest yield on all or part of their checking-account funds. How will interest-drawing checking accounts affect consumers? It is important to recognize that banking customers were previously provided valuable services for noth­ ing (or for a nominal fee) when they maintained a checking account with a commercial bank. According to Federal Reserve studies, it costs the

typical bank $63 per year to service an account with an average balance of $1000. The bank service charges on this account are approximately $15. Thus, the consumer is receiving approximately $50 worth of services associated with the maintenance of his checking account. One might say that the checking-account funds are drawing an implicit interest rate of nearly 5 percent ($50 annually on an average balance of $1000). Of course, banks are able to offer these services since, under a fractional re­ serve system, they can earn revenue by extending additional loans against the reserves supplied by the checking-account funds. If banks pay interest on checking-

NOW accounts: Interest-earning savings accounts on which the ac­ count holder is permitted to write checks. As of 1979, they were per­ mitted only in the New England states and New York.

account funds, they will have to charge a higher price for the check­ ing-account services they provide. For persons who maintain a large bank balance, the interest income will most likely exceed the addi­ tional service charges under the new system. They will be net gainers. However, persons with a small aver­ age bank balance (for example, less than $500) will probably find that their interest earnings are insuffi­ cient to compensate completely for the additional bank service charges under the new system. Thus, persons maintaining small balances are un­ likely to find their net bank charges reduced as a result of interest-earn­ ing checking accounts.

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distinction between checking and savings accounts is now blurred.1 This will have an effect on our definition of the money supply. As long as there was a fairly clear distinction between checking-account funds and savings deposits, the narrow MY definition of the money supply seemed appropriate. However, now that the distinction is no longer as clear-cut, we can expect economists in the future to rely more heavily on the broader definitions of money supply, M 2 and M,.

THE BUSINESS OF BANKING We must understand a few things about the business of banking before we can explain the factors that influence the supply of money. There are nearly 14,000 commercial banks in the United States. About one-third of them are national banks chartered by the federal government. National banks are required to belong to the Federal Reserve System and adhere to its regulations. The remaining two-thirds of all banks are chartered and regulated by the states. Because many state banks also belong, approximately 40 percent of all com­ mercial banks are members of the Federal Reserve System. Federal Reserve System member banks hold nearly 75 percent of all banking assets. Since 1933, almost all commercial banks—state and national—have had their deposits insured with the Federal Deposit Insurance Corporation (FDIC). The FDIC fully insures each account up to $40,000 against losses due to bank failure. Since the establishment of the FDIC, bank failures have become a rare, although not impossible, occurrence. Banks are in business to make a profit. The major service provided by banks is to hold demand deposits and honor checks drawn on them. Banks also act as savings institutions, paying depositors interest on funds maintained as time deposits (savings accounts). Commercial banks use a sizable share of both demand and time deposits for interest-earning purposes—extending loans and making financial investments. The consolidated balance sheet of banks that belong to the Federal Reserve System (Exhibit 3) illustrates the major banking functions. It shows that the major liabilities of banks are demand and time deposits. From the viewpoint of a bank, these are liabilities because they represent an obligation of the bank to its depositors. Outstanding interest-earning loans comprise the major class of banking assets. In addition, most banks own sizable amounts of interest-earning securities, both government and private. Banking differs from most businesses in that a large portion of its liabilities are payable on demand. However, even though it would be possible for all depositors to demand the money in their checking accounts on the same day, the probability of this occurring is quite remote. Typically, while some individuals are making withdrawals, others are making deposits. They tend to balance out, eliminating sudden changes in demand deposits. •At least for a time, these changes will make comparisons of the money supply during different periods more difficult. Since most of the money supply data in this text are for periods before these developments, the Mx definition will be acceptable for our purposes.

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11 / MONEY AND THE BANKING SYSTEM EXHIBIT 3

The Functions of Commercial Banks .

Banks provide services and pay interest to attract demand and time deposits (liabilities). A portion of their assets is held as reserves (either cash or deposits with the Fed) to meet their daily obligations toward their depositors. Most of the rest is invested and loaned out, providing interest income for the bank.

Consolidated Balance Sheet of Member Banks—September 30, 1978 (in billions of dollars) Assets Liabilities Reserves Loans outstanding U.S. government securities Other securities Other assets Total

36.8 500.8 91.2 88.7 186.7

Capital accounts Demand deposits Time deposits Other liabilities

904.2

Total

63.2 282.5 418.7 139.8 904.2

Source: Board of Governors of the Federal Reserve System.

Therefore, banks maintain only a fraction of their assets in reserves to meet the requirements of depositors. As Exhibit 3 illustrates, on average, reserves—vault cash and deposits with Federal Reserve—were less than 15 percent as large as the demand deposit obligation of member banks in 1978.

FRACTIONAL RESERVE GOLDSMITHING Economists often like to draw an analogy between the goldsmith of the past and our current banking system. In the past, gold was used as the means of making payments. It was money. People would store their money with a goldsmith for safekeeping, just as many of us open a checking account for safety reasons. Gold owners received a certificate granting them the right to withdraw their gold any time they wished. If they wanted to buy something, they would go to the goldsmith, withdraw gold, and use it as a means of making a payment. Thus, the money supply was equal to the amount of gold in circulation plus the gold deposited with goldsmiths. The day-to-day deposits of and requests for gold were always only a fraction of the total amount of gold deposited. A major portion of the gold simply lay idle in the goldsmiths' 'Vaults/' Taking notice of this fact, goldsmiths soon began loaning gold to local merchants. After a time, the merchants would pay back the gold plus an interest payment for its use. What happened to the money supply when a goldsmith extended loans to local merchants? The deposits of persons who initially brought their gold to the goldsmith were not reduced. Depositors could still withdraw their gold any time they wished (as long as they did not all try to do so at once). The merchants were now able to use the gold they borrowed from the goldsmith as a means of payment. As the goldsmith lent gold, he increased the amount of gold in circulation, thereby increasing the money supply. It was inconvenient to make a trip to the goldsmith every time one wanted to

Reserves: Vault cash plus deposits of member commercial banks with Federal Reserve Banks.

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buy something. Since people knew that the certificates were redeemable in gold, they began circulating as a means of payment. The depositors were pleased with this arrangement because it eliminated the need for a trip to the goldsmith every time something was exchanged for gold. As long as they had confidence in the goldsmith, sellers were glad to accept the gold certificates as payment. Since depositors were now able to utilize the gold certificates as money, the daily withdrawals and deposits with goldsmiths declined even more. A local goldsmith would keep about 20 percent of the total gold deposited with him so he could meet the current requests to redeem gold certificates that were in circulation. The remaining 80 percent of his gold deposits would be loaned out to business merchants, traders, and other citizens. Therefore, 100 percent of the gold certificates were circulating as money. In addition, another 80 percent of the total deposits, that portion of gold that had been loaned out, was circulating as money. The total money supply, gold certificates plus gold, was now 1.8 times the amount of gold that had been originally deposited with the goldsmith. Since the goldsmith issued loans and kept only a fraction of the total gold deposited with him, he was able to increase the money supply. As long as the goldsmith held enough reserves to meet the current requests of his depositors, everything went along smoothly. Most gold depositors probably did not even realize that the goldsmith did not have their gold and that of other depositors precisely designated by name sitting in his 'Vaults." Goldsmiths derived income from loaning gold. The more gold they loaned, the greater their total income. Some goldsmiths, trying to increase their income by extending more and more interest-earning loans, depleted the gold in their vaults to imprudently low levels. When an unexpectedly large number of depositors wanted their gold, these greedy goldsmiths would be unable to meet their requests. They would lose the confidence of their depositors, and the system of fractional reserve goldsmithing would tend to break down.

FRACTIONAL RESERVE BANKING Fractional reserve banking: A systern that enables banks to keep less than 100 percent reserves against their deposits. Required reserves are a fraction of deposits. Required reserves: The minimum amount of reserves that a bank is required by law to keep on hand to back up its deposits. Thus, if re­ serve requirements were 15 percent, banks would be required to keep $150,000 in reserves against each $1 million of deposits.

In principle, our fractional reserve banking system is very similar to goldsmithing. The early goldsmiths did not have enough gold on hand to pay all of their depositors simultaneously. Nor do our banks have enough cash and other reserves to pay all of their depositors simultaneously (see Exhibit 3). The early goldsmiths expanded the money supply by issuing loans. So do present-day bankers. The amount of gold held in reserve to meet the requirements of depositors limited the ability of the goldsmiths to expand the supply of money. The amount of cash and other required reserves limit the ability of present-day banks to expand the supply of money. HOW OUR FRIENDLY BANKERS CREATE MONEY How do banks expand the supply of money? In order to answer this question, let us consider a banking system without a central bank and in which only currency acts as reserves against deposits. Initially, we will assume that all banks are

11 / MONEY AND THE BANKING SYSTEM

required by law to maintain vault currency equal to at least 20 percent of the checking accounts of their depositors. Suppose that you found $1000, which apparently your long-deceased uncle had hidden in the basement of his house. How much would this newly found $1000 of currency expand the money supply? You take the bills to the First National Bank, open a checking account of $1000, and deposit the cash with the banker. First National is now required to keep an additional $200 in vault cash, 20 percent of your deposit. However, they received $1000 of additional cash, so after placing $200 in the bank vault, First National has $800 of excess reserves, reserves over and above the amount they are required by law to maintain. Given their current excess reserves, First National can now extend an $800 loan. Suppose that they loan $800 to a local citizen to buy a car. At the time the loan is extended, the money supply will increase by $800 as the bank adds the funds to the checking account of the borrower. No one else has less money. You still have your $1000 checking account, and the borrower has his $800 for a new car. When the borrower buys his new car, the seller accepts a check and deposits the $800 in his bank, Citizen's State Bank. What happens as the check clears? The temporary excess reserves of the First National Bank will be eliminated when it pays $800 to the Citizen's State Bank. But when Citizen's State Bank receives $800 in currency, it will now have excess reserves. It must keep 20 percent, an additional $160, in the reserve against the $800 checking-account deposit of the automobile seller. The remaining $640 could be loaned out. Since Citizen's State, like other banks, is in business to make money, it will be quite happy to "extend a helping hand" to a borrower. As the second bank loans out its excess reserves, the deposits of the persons borrowing the money will increase by $640. Another $640 has now been added to the money supply. You still have your $1000, the automobile seller has an additional $800 in his checking account, and the new borrower has just received an additional $640. Because you found the $1000 that had been stashed away by your uncle, the money supply has increased by $2440. Of course, the process can continue. Exhibit 4 follows the potential creation of money resulting from the initial $1000 through several additional stages. In total, the money supply can increase by a maximum of $5000, the $1000 initial deposit plus an additional $4000 in demand deposits that can be created by the process of extending new loans. The multiple by which new reserves increase the stock of money is referred to as the deposit expansion multiplier. In our example, the potential deposit expansion multiplier is 5. The amount by which additional reserves can increase the supply of money is determined by the ratio of required reserves to demand deposits. In fact, the deposit expansion multiplier is merely the reciprocal of the required reserve ratio. In our example, the required reserves are 20 percent, or 1/5, of total deposits. Thus, the potential deposit expansion multiplier is 5. If only 10 percent reserves were required, the deposit expansion multiplier would be 10, the reciprocal of 1/10. The lower the percentage of the reserve requirement, the greater is the potential expansion in the supply of money resulting from the creation of new reserves. The fractional reserve requirement places a ceiling on potential money creation from new reserves.

239

Excess reserves: Actual reserves that exceed the legal requirement.

Deposit expansion multiplier: The multiple by which an increase (de­ crease) in reserves will increase (decrease) the money supply. It is inversely related to the required reserve ratio.

240 EXHIBIT 4

PART 2 / MACROECONOMICS Creating Money from New Reserves

When banks are required to maintain 20 percent reserves against demand deposits, the creation of $1000 of new reserves will potentially increase the supply of money by $5000.

Bank

New cash deposits (actual reserves) (dollars)

Initial deposit Second stage Third stage Fourth stage Fifth stage Sixth stage Seventh stage All others

1000.00 800.00 640.00 512.00 409.60 327.68 262.14 1048.58

200.00 160.00 128.00 102.40 81.92 65.54 52.43 209.71

800.00 640.00 512.00 409.60 327.68 262.14 209.71 838.87

Total

5000.00

1000.00

4000.00

New required reserves (dollars)

Potential demand deposits created by extending new loans (dollars)

THE ACTUAL DEPOSIT EXPANSION MULTIPLIER Will the introduction of the new currency reserves necessarily have a full deposit expansion multiplier effect? The answer is no. The actual deposit multiplier may be less than the potential for two reasons. First, the deposit expansion multiplier will be reduced if some persons decide to hold the currency rather than deposit it in a bank. For example, suppose that the person who borrowed the $800 in the preceding example spends only $700. He stashes the remaining $100 away for a possible emergency. Then only $700 can end up as a deposit in the second stage and contribute to the excess reserves necessary for expansion. The potential of new loans in the second stage and in all subsequent stages will be reduced proportionally. When currency remains in circulation, outside of banks, it will reduce the size of the deposit expansion multiplier. Second, the deposit multiplier will be less than its maximum when banks fail to utilize all the new excess reserves to extend loans. However, banks have a strong incentive to loan out most of their new excess reserves. Idle excess reserves do not draw interest. Banks want to use most of these excess reserves so they will

Banking and Excess Reserves

Profit-maximizing banks use their excess reserves to extend loans and other forms of credit. Thus, excess reserves are very small, less than 1 percent of the total in recent years.

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w£ _ « o 5 co **

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EXHIBIT 5

^^^

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54

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1958

1962

^ E x c e s s reserves

1966

1970

1974

1978

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11 / MONEY AND THE BANKING SYSTEM

generate interest income. Exhibit 5 shows that this is indeed the case. In recent years, excess reserves have comprised only 1 or 2 percent of the total reserves of banks. Currency leakages and idle excess bank reserves will result in a deposit expansion multiplier that is less than its potential maximum. However, since most people maintain most of their money in bank deposits rather than as currency and since banks typically eliminate most of their excess reserves by extending loans, strong forces are present that will lead to multiple expansion.

THE FEDERAL RESERVE SYSTEM The Federal Reserve System is the central monetary authority or "central bank" for the United States. Every major country has a central banking authority. For example, the Bank of England and Bank of France perform central banking functions for their respective countries. Central banks are charged with the responsibility of carrying out monetary policy. The major purpose of the Federal Reserve System (and other central banks) is to regulate the supply of money and provide a monetary climate that is in the best interest of the entire economy. The Fed, a term often used to refer to the Federal Reserve System, was created in 1913. As Exhibit 6 illustrates, the policies of the Fed and the commercial banking system are determined by the Board of Governors. This powerful board consists of seven members, each appointed to 14-year terms by the president with the advice and consent of the Senate. The Board of Governors establishes the rules and regulations by which member banks must abide. For example, it sets the reserve requirements for member banks. It regulates the types of loans that member banks may extend and the composition of their investment portfolios. The board is the rule-maker, and often the umpire, of the U.S. banking system. Two important committees assist the Board of Governors in carrying out monetary policy. First, the Open Market Operations Committee, made up of the seven members of the Board of Governors plus five (of 12) of the presidents EXHIBIT 6 Open Market —► Committee

Board of ^— Governors

♦

Federal Advisory Council

Twelve Federal Reserve Banks (24 branches)

14,000 commercial banks

The Structure of the Federal Reserve System

The Board of Governors of the Federal Reserve System is at the center of the banking system in the United States. The board sets the rules and regulations for the banking system, thereby controlling the supply of money.

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of Federal Reserve Banks, determines the Fed's policy with respect to the purchase and sales of government bonds. As we shall soon see, this is the Fed's most frequently used method of controlling the money supply in the United States. Second, the Federal Advisory Council meets periodically with the Board of Governors to express its views on monetary policy. The Federal Advisory Council is composed of 12 commercial bankers, one from each of the 12 Federal Reserve District Banks. As the name implies, this council is purely advisory. The 12 Federal Reserve District Banks operate under the control of the Board of Governors.2 These district banks handle approximately 85 percent of all check-clearing services of the banking system. Federal Reserve District Banks differ from commercial banks in several important respects. J. Federal Reserve Banks Are Not Profit-Making Institutions. Instead, they are an arm of the government. All of their earnings, above minimum expenses, belong to the Treasury. 2. Unlike Other Bankst Federal Reserve Banks Can Actually Issue Money. Approximately 85 percent of the currency in circulation was issued by the Fed. Look at the dollar bill in your pocket. Chances are that it has "Federal Reserve Note" engraved on it, indicating that it was issued by the Federal Reserve System. The Fed is the only bank that can issue money. 3. Federal Reserve Banks Act as a Bankers' Bank. Private citizens and corporations do not bank with Federal Reserve Banks. Commercial bankers and the federal government are the only banking customers of the Fed. Most commercial banks, both members and nonmembers, usually maintain some deposits with the Federal Reserve System. Deposits with the Fed count as reserves for member commercial banks. The Fed also plays an important role in the clearing of checks through the banking system. Since most banks maintain deposits with the Fed, the clearing of checks becomes merely an accounting transaction. Initially, the Fed was made independent of the executive branch so that the Treasury would not use it for political purposes. However, the policies of the Treasury and the Fed are usually closely coordinated. For example, the chairman of the Board of Governors of the Federal Reserve, the Secretary of the Treasury, and the chairman of the President's Council of Economic Advisers meet weekly to discuss and plan macroeconomic policy. In reality, it would be more accurate to think of the Fed and the executive branch as equal partners in the determination of policies designed to promote full employment and stable prices.

2

Federal Reserve District Banks are located in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco. There are also 24 district "branch banks" in 24 other cities.

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11 / MONEY AND THE BANKING SYSTEM

WILL FUTURE MONEY BE ELECTRONIC?

Checking-account money is, of course, nothing more than an ac­ counting entry. In this age of the computer, the use of electronic funds-transfer systems (EFTS) is clearly a possibility. Technically speaking, it would be possible for every major business to have the weekly earnings of each employee automatically deposited into a per­ sonal, computerized account. Simi­ larly, a retail establishment hooked into the system could automatically have funds transferred from the ac­ count of the purchaser to its own account each time a sale took place. Regular bills, such as insurance pre­ miums, utilities, and interest pay­ ments, could automatically be de­ ducted from one's account as authorized. All of this could take

place without the use of paper checks, which are becoming increas­ ingly expensive to process. Conceiv­ ably, cash could become virtually obsolete once a full-fledged network of electronic money were estab­ lished. From the standpoint of efficiency, such a system might soon be costeffective. Paperwork and accounting costs could be reduced. Losses in­ curred from the passage of bad checks would be reduced, if not completely eliminated. Experimentation with limited computerized EFTS is currently un­ derway in several areas of the country. Just as the nationwide credit cards revolutionized our methods of payment during the period from 1967 to 1975, EFTS may well do so during the 1980s. Nonetheless, such a system faces obstacles. The convenience to the customer increases as the number of

establishments and banks involved in the system expands. An electronic hookup tying together many or most of the 14,000 banks in the United States raises serious antitrust ques­ tions. Under such a system, presum­ ably the customer would lose the ability to stop a specific check, a safeguard that provides protection against shoddy merchandise. Feeling that the potential for abuse by pri­ vate and political authorities is a threat, many persons might object to conducting all or most of their business via such a centralized rec­ ord-keeping mechanism. Clearly, cash transactions provide one thing that might be lost under a central­ ized computer transaction system — privacy. Given the current level of confidence that Americans have in political authorities and large pri­ vate institutions, it is unlikely that "electronic money" will completely replace cash in the near future.

HOW THE FED CONTROLS OUR MONEY SUPPLY The Fed has three major means of controlling the money stock: (a) establishing reserve requirements for member banks, (b) buying and selling U.S. government securities in the open market, and (c) setting the interest rate at which it will loan funds to commercial banks. We will analyze specifically how each of these tools can be used to regulate the amount of money in circulation.

RESERVE REQUIREMENTS The Federal Reserve System requires its members to maintain reserves against the demand deposits of its customers. The reserves of commercial banks are composed of (a) currency held by the bank and (b) deposits of the bank with the Federal Reserve System. A bank can always obtain additional currency by drawing on its deposits with the Federal Reserve. Thus, both cash on hand and the bank's deposits with the Fed can be used to meet the demands of depositors. Therefore, both count as reserves.

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EXHIBIT 7 The Required Reserve Ratio of Banks As of June 1979, banks were required to maintain reserves of 7 percent against deposits of less than $2 million. This chart shows how the required reserve ratio increases with additional deposits. Note that the required reserves against time deposits are much lower than those for demand deposits.

Time Deposits (millions of dollars) Demand deposits (millions of dollars) Under 2

2-10

10-100

100-400

Other time Over 400

Saving deposits

Under* 5

Over* 5

Percentage of 12% 16% 11% 3 required reserves 3 9y2 a Source: Federal Reserve Bulletin. Reserve requirements are lower for deposits maturing in 180 days or more in the future.

Required reserve ratio: The re­ serves that banks are required to hold, expressed as a percentage of their demand and time deposit liabilities.

Exhibit 7 indicates the required reserve ratio —the percentage of total demand deposits that banks are required to keep in reserve (that is, their cash plus deposits with the Fed). As the demand deposits of a bank increase, the percentage of additional deposits that must be held in reserves also increases. W h y are commercial banks required to maintain assets in the form of reserves? One reason is to prevent imprudent bankers from overextendng loans and thereby placing themselves in a poor position to deal with any sudden increase in withdrawals by depositors. T h e quantity of reserves needed to meet such emergencies is not left totally to the judgment of individual commercial banks. T h e Fed sets the rules. However, the Fed's control over reserve requirements is important for another reason. By altering them, the Fed can alter the money supply. T h e law does not prevent commercial banks from holding reserves over and above those required by the Fed, but, as we have noted, profit-seeking commercial banks prefer to hold interest-bearing assets such as loans rather than large amounts of excess reserves. Since reserves draw no interest, commercial banks seek to minimize their excess reserves. Exhibit 8 shows the actual reserve position of banks that belong to the Fed EXHIBIT 8 The Reserves of Banks (see also Exhibit 5). N o t surprisingly, the actual reserves of these banks are very In 1978, the actual reserves of banks close to the required level. Since the excess reserves of banks are very small, when were only slightly in excess of their the Fed changes the required reserve ratio, banks respond in a manner that required reserves. The required reserves average out at approximately changes the money supply. 12 percent against demand and 3 If the Fed reduced the required reserve ratio, it would free additional reserves percent against time deposits. that banks could loan out. Profit-seeking banks would not allow these excess Federal Reserve member bank reserves to lie idle. They would extend additional loans. T h e extension of the reserves—March 1979 (millions of new loans would expand the money supply. dollars) W h a t would happen if the Fed increased the reserve requirements? Since banks typically have very few excess reserves, they would have to extend fewer Total demand deposits 253,200 loans in the future. This reduction in loans outstanding would cause a decline in 434,500 the money supply. Total time deposits Reserve requirements are an important determinant of the money supply Actual reserves 40,316 Required reserves 40,059 because they influence both the availability of excess reserves and the size of the Excess reserves 257 deposit expansion multiplier. Higher reserve requirements will reduce the size of Source: Federal Reserve Bulletin, May the deposit expansion multiplier and force banks to extend fewer loans. Therefore, an increase in the required reserve ratio will reduce the money supply. 1979.

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On the other hand, a decline in the required reserve ratio will increase the potential deposit expansion multiplier and the availability of excess reserves. Banks will tend to extend additional loans, thereby expanding the money supply. In recent years, the Fed has seldom changed the required reserves of member banks. The changes that have been made have been marginal. Because of the deposit expansion multiplier, small changes in reserve requirements can cause large changes in the money supply. In addition, the precise magnitude and timing of a change in the money stock that will result from a change in reserve requirements are difficult to predict. For these reasons, the Fed has usually preferred to use other tools in its efforts to control the supply of money. OPEN MARKET OPERATIONS Open market operations, the buying and selling of U.S. securities in the open market, is by far the most important mechanism that the Fed utilizes to control the stock of money. When the Fed enters the market and buys U.S. government securities, it expands the reserves of commercial banks. The sellers of the securities receive a check drawn on a Federal Reserve Bank. As the check is deposited in a commercial bank, the bank acquires a deposit or credit with the Federal Reserve. The commercial banking system has increased its reserves while the Fed has purchased part of the national debt. Since the deposit with the Fed, like currency, counts as reserves, banks can now extend more loans. The money supply will eventually increase by the amount of the securities purchased by the Fed times the actual deposit expansion multiplier. Let us consider a hypothetical case. Suppose that the Fed purchases $10,000 of U.S. securities from commercial bank A. Bank A has fewer securities, but it now has additional excess reserves of $10,000. The bank can extend new loans of up to $10,000 while maintaining its initial reserve position. This $10,000 expansion of loans will contribute directly to the money supply. Part of it will eventually be deposited in other banks, and they will also be able to extend additional loans. The creation of the $10,000 of new bank reserves will cause the money supply to increase by some multiple of the amount of U.S. securities purchased by the Fed. The reserve requirements in effect in the mid-1970s (see Exhibit 7) suggest that the potential deposit multiplier could be 5 or 6. Of course, as new reserves are injected into the banking system, there is some leakage either because of potential currency reserves circulating as cash or because some banks may be accumulating excess reserves. Exhibit 9 shows that the money supply since 1968 has been approximately 2.7 times greater than the potential reserves3 suggesting that the actual deposit expansion multiplier is about 2.7. Therefore, when the Fed purchases U.S. securities, injecting additional reserves into the system, on average, the money supply tends to increase by approximately $2.70 for each dollar of securities purchased.

3

Currency in circulation plus the actual reserves of commercial banks comprise the total potential reserves. Economists often use the term "monetary base" when referring to the total potential reserves.

Open market operations: The buying and selling of U.S. government securities (national debt) by the Federal Reserve.

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PART 2 / MACROECONOMICS EXHIBIT 9

How Big Is the Actual Money Deposit Multiplier?

In recent years the actual deposit expansion multiplier has been between 2.6 and 2.9. Of course, if the reserve requirements were lowered (raised), the deposit expansion multiplier would rise (fall).

Year (December) 1968 1970 1972 1974 1975 1976 1977 1978

Money supply"

Total potential reservesa,h

Money deposit multiplier

201.5 221.2 255.7 283.1 294.5 313.8 338.7 361.5

70.5 78.2 88.1 104.4 108.4 115.5 124.7 139,0

2.86 2.83 2.90 2.71 2.72 2.71 2.72 2.60

Source: Board of Governors of the Federal Reserve System. a

Billions of dollars.

economists refer to the total potential reserves as the monetary base.

Open market operations can also be used to reduce the money stock, or its rate of increase. If the Fed wants to reduce the money stock, it will sell some of its current holdings of government securities. When the Fed sells securities, the buyer will pay for them with a check drawn on a commercial bank. As the check clears, the reserves of that bank with the Fed will decline. The reserves available to commercial banks are reduced, and the money stock will fall. Since open market operations have been the Fed's primary tool in recent years, the money stock and the Fed's ownership of U.S. securities have followed similar paths. When the Fed increases its purchases of U.S. securities at a rapid rate, the money stock will grow rapidly. A slowdown in the Fed's purchases of government bonds will tend to reduce the rate of monetary expansion. As we indicated earlier, the Federal Open Market Committee (FOMC), a special committee of the Fed, decides when and how open market operations will be used. The members meet every three or four weeks to map out the Fed's future policy concerning the purchase and sale of U.S. securities. THE DISCOUNT RATE-THE COST OF BORROWING FROM THE FED

Discount rate: The interest rate that the Federal Reserve charges member banks that borrow funds from it.

Member banks can borrow from the Federal Reserve, but when they do they must pay interest on the loan. The interest rate that commercial banks pay on loans from the Federal Reserve is called the discount rate. When the newspapers announce that thé discount rate has increased by 0.5 percent, many people think this means their local banker will (must?) now charge them a higher interest rate for a loan.4 This is not necessarily so. The major source of loan funds of commercial banks is reserves acquired through demand and time deposits. 4

The discount rate is also sometimes confused with the prime interest rate, the rate at which banks will loan money to low-risk customers. The two rates are different. A change in the discount rate will not necessarily affect the prime interest rate.

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Borrowing from the Fed contributes less than 0.5 of 1 percent to the available loan funds of commercial banks. Thus, an increase in the discount rate does not necessarily cause your friendly banker to raise the rate at which he will lend money to you. Borrowing from the Fed is not a right. The Fed does not have to loan funds to commercial banks. Therefore, member banks rely on this source primarily to meet a short-run shortage of reserves. They are most likely to turn to the Fed as a temporary method of meeting their reserve requirements while they are making other adjustments in their loan and investment portfolios. An increase in the discount rate makes it more expensive for commercial banks to borrow from the Fed. Borrowing is discouraged, and banks are more likely to build up their reserves to ensure that they will not have to borrow from the Fed. Thus, an increase in the discount rate is restrictive. It will tend to discourage banks from shaving their excess reserves to a low level. In contrast, a reduction in the discount rate is expansionary. At the lower interest rate, it costs commercial banks less if they have to turn to the Fed to meet a temporary emergency. Thus, banks are more likely to reduce their excess reserves to a minimum, extending more loans and increasing the money supply, as the cost of borrowing from the Fed declines. If a commercial bank has to borrow in order to meet its reserve requirements, it need not turn to the Fed. Instead, it can go to the federal funds market. In this market, banks with excess reserves extend short-term (sometimes for as little as a day) loans to other banks seeking additional reserves. If the federal funds rate (the interest rate in the federal funds market) is less than the discount rate, banks seeking additional reserves will tap this source rather than borrowing from the Fed. Rather than rely on arbitrary decision-making, in recent years the Fed has kept member bank borrowing at a low level by altering the discount rate. As a result, the federal funds rate and the discount rate tend to move together. If the federal funds rate is significantly above the discount rate, member banks will attempt to borrow heavily from the Fed. Typically, when this happens, the Fed will raise its discount rate, removing the incentive of banks to borrow from the Fed rather than from the federal funds market. The general public has a tendency to overestimate the importance of a change in the discount rate. Since it applies to such a small share of total reserves, a 0.5 percent change in the discount rate has something less than a profound impact on the availability of credit and the supply of money. The influence of a change in the discount rate is not completely negligible, but usually the open market operations of the Fed are a much better index of the direction and magnitude of monetary policy. SUMMARIZING THE TOOLS OF THE FED Exhibit 10 summarizes the monetary tools of the Federal Reserve. If the Fed wants to follow an expansionary policy it can decrease reserve requirements, purchase additional U.S. securities, and/or lower the discount rate. If the Fed wants to reduce the money stock, it can increase the reserve requirements, sell U.S. securities, and/or raise the discount rate. Since the Fed typically seeks only small changes in the money supply (or its rate of increase), it usually utilizes only one or two of these tools to accomplish a desired objective.

247

Federal funds market: A loanable funds market in which commercial banks seeking additional reserves borrow short-term (generally for seven days or less) funds from banks with excess reserves. The interest rate is called the federal funds rate.

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PART 2 / MACROECONOMICS EXHIBIT 10

Summary of the Monetary Tools of the Federal Reserve

Federal Reserve policy 1. Reserve requirements

Expansionary monetary policy Reduce reserve requirements, because this will free addi­ tional excess reserves and induce banks to extend ad­ ditional loans, which will expand the money supply

2. Open market operations

Purchase additional U.S. se­ curities, which will expand the money stock directly while increasing the re­ serves of banks, inducing bankers to extend more loans and indirectly ex­ panding the money stock Lower the discount rate, which will encourage more borrowing from the Fed by commercial banks; banks will tend to reduce their re­ serves and extend more loans because of the lower cost of borrowing from the Fed if they temporarily run short on reserves

3. Discount rate

Restrictive monetary policy Raise reserve requirements, because this will reduce the excess reserves of banks, causing them to make fewer loans; as the outstanding loans of banks decline, the money stock will be reduced Sell U.S. securities, which will reduce both the money stock and excess re­ serves; the decline in excess reserves will indirectly lead to an additional reduction in the money supply Raise the discount rate, thereby discouraging bor­ rowing from the Fed; banks will tend to extend fewer loans, and build up their reserves so they will not have to borrow from the Fed

THE FED AND THE TREASURY Many students have a tendency to confuse the Federal Reserve and the U.S. Treasury, probably because both sound like monetary agencies. The Treasury is a budgetary agency. If there is a budgetary deficit, the Treasury will issue U.S. securities as a method of financing the deficit. Newly issued U.S. securities are almost always sold to private investors (or invested in government trust funds). Bonds issued by the Treasury to finance a budget deficit are seldom purchased directly by the Fed. In any case, the Treasury is interested primarily in obtaining monetary funds so it can pay Uncle Sam's bills. Except for nominal amounts, mostly coins, the Treasury does not issue money. Borrowing, the public sale of new U.S. securities, is the primary method used by the Treasury to cover any excess of expenditures relative to tax revenues. Whereas the Treasury is concerned with the revenues and expenditures of the government, the Fed is concerned primarily with the availability of money and

11 / MONEY AND THE BANKING SYSTEM

credit for the entire economy. The Fed does not issue U.S. securities. It merely utilizes the purchase and sale of government securities issued by the Treasury as a means to control the money supply of the economy. The Fed does not have an obligation to meet the financial responsibilities of the U.S. government. That is the domain of the Treasury. The Fed's responsibility is to provide a stable monetary framework for the entire economy. Thus, although the two agencies cooperate with each other, they are distinctly different institutions established for different purposes.

DYNAMICS OF MONETARY POLICY We have discussed the tools with which the Federal Reserve can increase or decrease the money supply. With the passage of time, the money supply, like the GNP, generally expands. In a dynamic setting, therefore, monetary policy might better be gauged by the rate of change in the money supply. When economists say that monetary policy is expansionary, they mean that the rate of growth of the money stock is rapid. Similarly, restrictive monetary policy implies a slow rate of growth or a decline in the money stock.

CHAPTER LEARNING OBJECTIVES 1. Money is anything that is widely accepted as a medium of exchange. It also acts as a unit of account and provides a means of storing current purchasing power into the future. Without money, exchange would be both costly and tedious. 2. There is some debate among economists as to precisely how the money supply should be defined. The narrowest and most widely used definition of the money supply (Mj) includes only (a) currency in the hands of the public and (b) demand deposits with commercial banks. Neither has significant intrinsic value. Money derives its value from its scarcity relative to its usefulness. 3. In recent years, institutional changes have blurred the distinction between demand (checking) and time (savings) deposits. As a result, future economists will no doubt place greater emphasis on broader definitions of the money supply that incorporate time deposits and savings deposits in nonbanking financial institutions. 4. Banking is a business. Commercial banks provide their depositors with safekeeping of money, check-clearing services on demand deposits, and interest payments on time deposits. Banks derive most of their income from the extension of loans and investments in interest-earning securities. 5. The Federal Reserve System is a central banking authority designed to provide a stable monetary framework for the entire economy. It establishes regulations that determine the supply of money. It issues most of the currency in the United States. It is a banker's bank. 6. The Fed has three major tools with which to control the money supply. (a) Establishment of the Required Reserve Ratio. Under a fractional reserve banking system, reserve requirements limit the ability of commercial banks to expand the money supply by extending more loans. When the Fed lowers the required reserve ratio, it

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creates excess reserves and allows banks to extend new loans, expanding the money supply. Raising the ratio has the opposite effect. (b) Open Market Operations. The open market operations of the Fed can directly influence both the money supply and available reserves. When the Fed buys U.S. securities, the money supply will expand because bond buyers will acquire money and the reserves of banks will increase as checks drawn on Federal Reserve Banks are cleared. When the Fed sells securities, the money supply will contract because bond buyers are giving up money in exchange for securities. The reserves available to commercial banks will decline, causing them to issue fewer loans and thereby reducing the money supply. (c) The Discount Rate. An increase in the discount rate is restrictive because it discourages banks from borrowing from the Fed in order to extend new loans. A reduction in the discount rate is expansionary because it makes borrowing from the Fed less costly. 7. The Federal Reserve and the U.S. Treasury are two different, distinctive agencies. The Fed is concerned primarily with the money supply and the establishment of a stable monetary climate. The Treasury focuses on budgetary matters —tax revenues, govern­ ment expenditures, and the financing of government debt.

THE ECONOMIC WAY OF THINKING-DISCUSSION QUESTIONS 1. Why can banks continue to hold reserves that are only a fraction of the demand deposits of their customers? Is your money safe in a bank? Why or why not? 2. What makes money valuable? Does money perform an economic service? Explain. Could money better perform its function if there were twice as much of it? Why or why not? 3. "People are poor because they don't have very much money. Yet central bankers keep money scarce. If poor people had more money, poverty could be eliminated." Explain the confusion of this statement. 4. In your own words, explain how the creation of new reserves would cause the supply of money to increase by some multiple of the newly created reserves. 5.

How will the following actions affect the money supply:

(a)

A reduction in the discount rate

(b)

An increase in the reserve requirements

(c)

Purchase by the Fed of $10 million of U.S. securities from a commercial bank

(d) Sale by the U.S. Treasury of $10 million of newly issued bonds to a commercial bank (e)

An increase in the discount rate

(f)

Sale by the Fed of $20 million of U.S. securities to a private investor

6. What's Wrong with This Way of Thinking? "When the government runs a budget deficit, it simply pays its bills by printing more money. As the newly printed money works its way through the economy, it waters down the value of paper money already in circulation. Thus, it takes more money to buy things. The major source of inflation is newly created paper money issued by the government."