Lecture 18
THE BANKING SYSTEM

1. Bank regulation

• Insure depositors against loss
  • Deposit insurance (by FDIC)
  • Problem of moral hazard

• Monitor the financial condition of banks
  • Bank examinations and audits
  • Restrict type of assets that banks can hold
  • Minimum required reserves:
    To control the money supply

2. A bank's balance sheet

• Assets
  • Things of value owned by the bank
  • Loans, reserves, government securities

• Liabilities
  • What the bank "owes" to others
  • Checking deposits

• Net worth = Assets Liabilities

3. Required reserve ratio (m)

• Fraction of checking deposits that commercial banks must keep in reserve
• Reserves may be kept at the Fed (each bank has its own "checking account" at the Fed!)

4. Excess reserves

• Reserves in excess of the required amount
• Banks try to minimize amount of excess reserves (why?)

4.1 Question

What is the effect of a decrease in m on banks?

5. Money creation

• Money is "created" through changes in the banks' excess reserves

5.1 Suppose the Fed lowers the required reserve ratio

• Suppose Bank One starts out with zero excess reserves

• Decrease in m leads to excess reserves at Bank One

• Bank One lends excess reserves to Customer One...
  ... leading to an increase in the currency in circulation

• Customer One deposits the loan amount in a checking account at Bank Two ...
  ... resulting in excess reserves at Bank Two

• Bank Two lends its excess reserves to Customer Two ...
  ... leading to yet another increase in money supply

• Customer Two deposits the loan amount in a checking account at Bank Three ... (you get the picture)

5.2 Maximum increase in money supply

• Increase in M1 = [Increase in excess reserves at Bank One] / m

• Assumptions:
  • Banks maintain zero excess reserves
  • Customers make deposits in their checking accounts

5.3 Question

What is the effect of an increase in the required reserve ratio on the money supply?