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

The Fed's definition of banks:

We use the term "banks" to refer to all depository institutions, a broad class of institutions that includes commercial banks, savings banks, savings and loan associations, credit unions, U.S. branches and agencies of foreign banks, Edge Act corporations, and agreement corporations. In addition to banks, a number of government-sponsored enterprises--such as Fannie Mae, Freddie Mac, and the Federal Home Loan Banks--hold reserve balances at the Fed to facilitate large payment transfers to other institutions.
https://www.federalreserve.gov/monetarypolicy/monetary-policy-what-are-its-goals-how-does-it-work.htm

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?