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Lecture 9

Lecture 9 Spring 2014.pdf

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ECON 1132
Andrew Petersen

Ec. 132 Harold Petersen Principles of Economics-Macro Feb. 18, 2014 Lecture 9: Banking and the Supply of Money We looked last time at money and demand for money. Then we began to talk about the banking system. We noted we have two types of banks-- commercial banks and central banks. A commercial bank is a business firm that provides services in the hope of earning a profit. A central bank is a public institution with social responsibilities. Let's begin now to look at commercial banks in some detail. Commercial banks as we know them grew out of the activities of the goldsmiths in the Middle Ages. Goldsmiths worked with gold, as did blacksmiths with iron or coppersmiths with copper. Gold was also the dominant form of money and was valuable. Goldsmiths of necessity developed secure vaults, to forestall robbery. Households and business firms who had gold as money began to bring it to the goldsmiths for safekeeping. They did so, for a fee, much as in checking parcels or parking your car in a garageWhen people needed to make a transaction they came to the goldsmith to get their gold or a part of it. Gradually the goldsmiths discovered that people didn't care if they got back their own gold, so long as what they got was equivalent in weight and purity (and thus purchasing power as money). Thus they could mingle the accounts, or put all the gold in one pile. The goldsmiths would give the depositors a warehouse receipt, which could be redeemed for gold at any time. But this was inconvenient. So depositors began to use the warehouse receipts as a means of payment. The warehouse receipts became a form of paper money, which was accepted because it could be exchanged for gold. Then the goldsmiths began to honor checks, or instructions from one customer to pay money from their account to another. They found that through the use of warehouse receipts as paper money and payment through checks, that the total amount in the vault didn’t change very much. Most people just left their gold with the goldsmiths for safekeeping.And the total stayed pretty much the same. Then they began to lend or invest a portion of the gold, keeping some fraction of deposits on reserve. Thus came fractional reserve banking . The bank is best understood by looking at its balance sheet. Shown below are a goldsmith with 100% reserves and then with fractional reserves: Assets Liabilities Assets Liabilities Gold 1000 Dep 1000 Gold 100 Dep 1000 Loans 900 But what happens to the gold that is loaned to customers? Typically the customer borrows to pay a bill or to buy something. But the recipient of the money brings it back to the bank or to another bank. Thus even the act of 2 lending does not significantly reduce the amount of gold in the vaults, Rather it increases the amount of deposits. Let's look now at expansion of loans and deposits through the banking system. Gold has been replaced by paper money, and reserves can be held either as currency in the vaults or as deposits with the Federal Reserve System. (More about this later.) Let's assume that banks are required by law to hold 10% of their deposits on reserve and that they lend out the rest of it. Assume that all banks hold the legally required reserves. A typical bank Bank A, might initially look like this in terms of its balance sheet: Assets Liabilities and Net Worth Reserves 10,000 Demand Deposits 100,000 Loans 91,000 Other Assets 7,000 Net Worth 8,000 Total Assets 108,000 Liab. & Net Worth 108,000 We call this a balance sheet because the assets, or things of value, are balanced by the claims against them. Think of the reserves as cash. Loans are money due from people who have borrowed. In that sense they are things of value. Other assets might include buildings and equipment. Deposits are the money put in the bank by customers, payable on demand. It is a liability of the bank because it is owed to the customers and must be paid out to them on demand (or paid to others through writing checks). Net Worth is Assets minus liabilities, or it is the owners’ claim against the assets after all debts have been paid. Let’s suppose that the bank is required by law to hold reserves equal to 10% of its demand deposits, and that initially it just meets the requirement. Now some customer of Bank A, Stan Smith, makes a new deposit of $1000 in Bank A. Smith takes the money from his mattress and puts it in the bank. The bank holds 10%, or 100, in reserve and lends the 900 to a customer, Mary Jones. When Jones borrows the money, she signs an IOU (loan contract) and receives a deposit slip noting that $900 has been deposited in her account. 900 Res. Bank A Chk Bank B Res 1000 Dep 1000 (Smith) Chk 900 Dep 900 (O'Leary) Loans 900 Dep 900 (Jones) But Jones does not borrow the money to leave it in a checking account, but rather to pay a bill or to buy something. Jones writes a check for 900 to Gladys O'Leary, who deposits the 900 in her bank, Bank B. Bank B now has the 3 check from M. Jones as an asset and the dep. of G. O'Leary as a liability. Bank B sends the check back to Bank A and gets 900 of Reserves in return. Bank A notes the reduction in its Res of 900 and reduction in dep. (M. Jones) of 900. ___________Bank A____________ ___________Bank B__________ Res 100 Dep 1000 (Smith) Res 900 Dep 900 (O'Leary) Loans 900 The net impact of Bank A's lending has been to create a new deposit, first in its own bank (Jones), and then in Bank B as Jones pays the 900 to O'Leary. But Bank B now has excess reserves and can make new loans. Bank B lends 810 to a customer, Brown, who deposits the 810 in her account, and then pays it out. And the 810 turns up in another bank, Bank C, which now has excess reserves. We can summarize the process in a single table, as in the text on page 180 (p. 526 in the hardcover version). Bank New New New Deposits Loans Reserves Bank A 1000 900 100 Bank B 900 810 90 Bank C 810 729 81 Bank D 729 656 73 Total, all banks 10,000 9000 1000 Note that the original deposit in Bank A has been multiplied throughout the system by a factor of 10. New loans have been expanded by 9000. We call this process the multiple expansion of loans and deposits throughout the banking system. We have a bank multiplier, or money supply multiplier, which is equal to one over the reserve requirement. MSM = 1/RR. In this case the multiplier is equal to 1/.10 = 10 Let's look now at commercial bank behavior, and then at central banking. Recall that the commercial bank is a business firm--it provides services for which it hopes to earn a profit. For the most part it earns its profit by lending out depositor's money and charging interest on the loans. Depositors accept this in return for either free or low-cost checking, and they may even receive interest on their checking accounts. Note that the bank is a thin -equity organization. (It's equity or net worth is a small part of its total assets--perhaps 7% on average.) 4 _Typical Commercial Bank_ Res 10 Deposits 93 L & I 90 Equity 7 100 100 As such it is vulnerable to rather minor fluctuations in the value of its assets. It is well advised to stay away from investments in common stocks and even real estate ventures unless they are protected by substantial investments by the developers as well. It is useful to look at the banker's job as that of managing portfolio , or a collection of assets, in light of three objectives: 1) profitability--the bank
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