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Macro Economics

Lecture No. 5

Banking System

Zain Ul Abideen

BBA-M1, M2 (4th)

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The Determination of Interest Rate
What Banks Do
Financial intermediaries are institutions that receive funds
from people and firms, and use these funds to buy bonds or
stocks, or to make loans to other people and firms.
■ Banks receive funds from people and firms who either
deposit funds directly or have funds sent to their checking
accounts. The liabilities of the banks are therefore equal to
the value of these checkable deposits.
■ Bank performs 03 function: Accept Deposits, Make Loans,
Offer Draft (cheque writing privileges)
■ Banks keep as reserves some of the funds they receive.

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The Determination of Interest Rate
What Banks Do
Banks hold reserves for three reasons:
1. On any given day, some depositors withdraw cash from their
checking accounts; and others deposit cash into their accounts.
2. In the same way, on any given day, people with accounts at the bank
write checks to people with accounts at other banks, and people
with accounts at other banks write checks to people with accounts
at the bank.
3. Banks are subject to reserve requirements. The actual reserve ratio
– the ratio of bank reserves to bank checkable deposit.

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The Determination of Interest Rate
What Banks Do
■ Loans represent roughly 70% of banks’ non-reserve assets.
Bonds count for the rest, 30%.
■ The assets of the central bank are the bonds it holds.
■ The liabilities of the central bank are the money it has issued,
central bank money.
■ The new feature is that not all of central bank money is held as
currency by the public. Some of it is held as reserves by
banks.

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The Determination of Interest Rate
What Banks Do

Figure
The Balance Sheet of
Banks and the
Balance Sheet of the
Central Bank,
Revisited

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Bank Runs
• Rumors that a bank is not doing well and some loans will
not be repaid, will lead people to close their accounts at
that bank. If enough people do so, the bank will run out of
reserves—a bank run.
• To avoid bank runs, the U.S. government provides federal
deposit insurance.
• An alternative solution is narrow banking, which would
restrict banks to holding liquid, safe, government bonds,
such as T-bills.

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• Reserve Requirements of banks is to hold liquid assets in the
form of cash and approved securities. SBP requires scheduled
banks to maintain two types of res. req: Cash reserve requirement
and Statutory liquidity requirement.
• Cash Reserve Ratio (CRR) or Cash reserve ratio is a specified
minimum fraction of the total deposits of customers, which
commercial banks have to hold as reserves either in cash or as
deposits with the central bank. CRR is set according to the
guidelines of the central bank.
• Statutory Liquidity Ratio or SLR is the minimum percentage of
deposits that a commercial bank has to maintain in the form of
liquid cash, gold or other securities. It is basically the reserve
requirement that banks are expected to keep before offering credit
to customers.

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• Increase in CRR ratio reduces the funds available with the banks for
lending (to public and private sector) as banks have to hold
additional cash in the form of reserves with the SBP. Thus, assuming
all else equal, the increase in CRR reduces the money multiplier and
money supply in the economy, and tends to increase the interest
rates in the economy (Least frequently used instrument by SBP)
• Increase in SLR ratio implies that banks are required to hold a
larger share of their funds into liquid assets approved/notified by the
Govt. for this purpose. Changes in SLR may change the composition
of banks’ assets (Least frequently used instrument by SBP)
• Foreign Exchange (Forex) Swaps: Another instrument that SBP
may utilize for liquidity management in the interbank money market
to supplement its OMO. It involves SBP’s purchase or sale of
foreign currency at a certain value date (normally spot) with a
simultaneous agreement to reverse the transaction at an agreed rate
on a specified date in the future.
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 Concepts
• Money is a tool that greatly simplifies market transactions.
OR Anything generally accepted as a medium of exchange.
• Money has three functions: Store of value, unit of account
and medium of exchange.
• Cash is obviously money because it fills all three purposes.
• Checking accounts perform the same market functions as
cash. Debit cards act much like a check, so they are money.
• Online payment systems and credit cards do not. They can
be a medium of exchange but do not fulfill the other
purposes.
• The essence of money is not its physical form, but its
ability to purchase goods and services.
• Most money is in the form of electronic data. 11
 Composition of the Money Supply
• M1: cash and transactions accounts
– Transactions accounts include checking accounts and
travelers checks.
– Money supply (M1): currency held by the public, plus
balances in transactions accounts.
• M2: M1 plus savings accounts, etc.
– Savings account balances and money market mutual funds are
almost as good a substitute for cash as transactions accounts.
– Money supply (M2): M1 plus balances in most savings
accounts and money market mutual funds.
– M2 must be turned into M1 before it can be used to purchase
goods and services.
• M3
• L = M3 plus other liquid assets e.g. T.Bills, savings bonds etc.
• M4: Includes the volume of currency in use, the overall amount
of loans given out by banks, and government loans. It is
considered to be a good indicator of inflation level (UK) 12
 Creation of Money
• Cash is either printed or coined. But it is a very small part of M2.
• Money supply is determined by: (a) Behaviour of households
which hold money) and (b) banks (in which money is held).
• How is the money in bank accounts created?
– Bank accounts are not physical lumps of cash. They are
computer data entries.
• Banks create money by making loans.
– Grant a loan and increase the borrowers’ checking account
with a few keystrokes.
– Money is “created.”
• The bank’s ability to create money is limited by the Central
Bank. Thus, the Central Bank controls the basic money supply.

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Money Supply
To understand the money supply, we must understand the
interaction between currency and demand deposits and how
the Fed policy influences these two components of the
money supply.

M=C+D
Money Supply Currency Demand Deposits

In this lecture, we’ll see that the money supply is determined

not only by the Central Bank / Federal Reserve, but also by
the behavior of households (which hold money) and banks
(where money is held). 14
100 Percent Reserve Banking
The deposits that banks have received but have not lent out
are called Reserves. Consider the case where all deposits
are held as reserves: banks accept deposits, place the money
in reserve, and leave the money there until the depositor
makes a withdrawal or writes a check against the balance.
In a 100-percent-reserve banking system, all deposits are
held in reserve; thus the banking system does not affect the
supply of money.
A Sample 100-Percent-Reserve Bank Balance Sheet
Assets Liabilities
Reserves Deposits
$1,000 $1,000
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Fractional Reserve Banking
As long as the amount of new deposits approximately equals
the amount of withdrawals, a bank need not keep all its
deposits in reserves. Note: a reserve-deposit ratio is the
fraction of deposits kept in reserve. Excess reserves are
reserves above the reserve requirement.
Fractional-reserve banking, a system under which banks keep
only a fraction of their deposits in reserve. In a system of
fractional-reserve banking, banks create money.
A Sample Fractional-Reserve Bank Balance Sheet
Assets Liabilities
Reserves $200 Deposits $1,000
Loans $800
Financial Intermediation: The process of transferring funds
from savers to borrowers. E.g. stock market, banks etc. 16
Banks increases money supply, not wealth
A Model of the Money Supply
Three variables:
The monetary base B is the total number of dollars held by the
public as currency C and by the banks as reserves R.
The reserve-deposit ratio rr is the fraction of deposits D that
banks hold in reserve R.
The currency-deposit ratio cr is the amount of currency C people
hold as a fraction of their holdings of demand deposits D.
Definitions of the money supply and the monetary base:
M =C+D
B =C+R
Solving for M as a function of the 3 variables:
M/B = C/D + 1
C/D + R/D
Making the substitutions for the fractions above, we obtain:
cr + 1
M= B
cr + rr 17
Let’s call this the money multiplier, m.
The Money Multiplier.

M=mB

Money Supply Money multiplier Monetary Base

Money Multiplier: The increase in the money supply resulting

from a one dollar increase in the monetary base.
Because the monetary base has a multiplied effect on the money
supply, the monetary base is sometimes called high-powered
money.

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Let’s go back to our three exogenous variables to see how
their changes cause the money supply to change:
• The money supply M is proportional to the monetary base
B. So, an increase in the monetary base increases the
money supply by the same percent.
• The lower the reserve-deposit ratio rr (R/D), the more
loans banks make, and the more money banks create from
every dollar of reserves.
• The lower the currency-deposit ratio cr (C/D) , the fewer
dollars of the monetary base the public holds as currency,
the more base dollars banks hold in reserves, and the more
money banks can create. Thus, a decrease in the currency-
deposit ratio raises the money multiplier and the money
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supply.
 Changes in the Money Supply
• When a bank makes a loan, money is created.
– The borrower spends the money; the seller deposits it
into the firm’s bank account.
– That bank now has more excess reserves and can make
a loan on it, creating more money.
– When the new borrower spends the loan, this cycle
continues to repeat itself.
– Each time a new loan is made, the money supply
increases.

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 Banks and the Circular Flow
• Banks perform two essential functions for the
macro economy:
– Banks transfer money from savers to spenders by
lending funds held on deposit.
– The banking system creates additional money by
making loans in excess of required reserves.
• Changes in the money supply may in turn alter
spending behavior.
• If the banks do not lend out excess reserves, they
do not fulfill the function outlined in the first
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 Constraints on Deposit Creation
• Deposits. If people prefer to hold onto cash, the
deposit creation process will be severely hindered.
• Willingness to lend. If banks are reluctant to take
risks in lending, they will not fully lend out their
excess reserves.
• Willingness to borrow. If borrowers are reluctant
to take on more debt, fewer loans will be made.
• Regulation. The Fed may limit deposit creation by
changing reserve requirements.

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 The Three Instruments of Monetary Policy
1) Open-market operations (buying and selling the Govt
bonds / Treasury bonds by the central bank).
2) Change in Reserve requirements (least frequently used
instrument).
3) Change in Discount rate at which member banks (not
meeting the reserve requirements) can borrow from the
Fed Reserve / Central Bank.

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Bank Capital, Leverage & Capital Requirements
1.Starting a bank requires financial resources to get the bank started; the
equity of the bank’s owners is called bank capital.
2.This business strategy relies on a phenomenon called leverage, which
is the use of borrowed money to supplement existing funds for
purposes of investment. The leverage ratio is the ratio of the bank’s
total assets to bank capital.
3.The implication of leverage is that, in bad times, a bank can lose much
its capital very quickly. The fear that bank capital may be running out,
and thus that depositors may not be fully repaid is typically what
generates bank runs when there is no deposit insurance.
4.One of the restrictions on banks is that the banks must hold sufficient
capital to make it sure that they will be able to pay off their depositors.
The amount of capital required depends on the kind of assets a bank
holds. If the bank holds safe assets such as govt. bonds, regulators
require less capital than if the bank holds risky assets such as loans to
borrowers whose credit is of dubious quality. The shortage of bank
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capital reduced bank lending, contributing to a severe economic
Financial Innovation and Near Money
Assets are grouped into two categories:
1) MONEY: Assets used as a medium of exchange as well as
a store of currency (currency, checking accounts)
2) NEAR MONEY: Assets used a store of value (stocks,
bonds, and savings accounts).

Near money consists of assets that have acquired the liquidity

of money (e.g., checks that can be written against mutual
fund accounts).

Near money causes instability in money demand and can give

faulty signals about aggregate demand.

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Thanks to Allah

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