Chapter 30Part 2

The Monetary System

Bank Capital

The money the bank’s shareholders have put in

to the bank

Leverage

OPM

Using other people’s money

Leverage1. I have 10

2. I borrow 90 from you

3. I buy something for 100

4. I resell the item for 150

5. I pay back your 90

6. I keep the 60

7. I earned 50 profit on my 10

Leverage Ratio

The ratio of assets to bank capital

AssetsBank Capital

Bank Balance Sheet

AssetsLiabilities and Owner Equity

Reserves 200 Deposits 800

Loans 700 Debt 150

Securities 100 Capital 50

Total 1000 Total 1000

Totals must balance or be equal

What is the leverage ratio?

AssetsLiabilities and Owner Equity

Reserves 200 Deposits 950

Loans 800 Capital 50

Total 1000 Total 1000

Assets ÷ Capital1000 ÷ 50 = 20

Leverage Ratio of 20

Owners put up 1

Depositors put up 19

Leverage is Risky!If leverage ratio is 20,

5% increase in asset value = 100% return to owners

5% decrease in asset value = 100% loss to owners

Capital Requirement

Government rule on minimum amount of

bank capital

Insolvent

Liabilities are more than the assets

You owe more than you own

Three Tools of Central Banks

Open-Market Operations

Discount Rate

Reserve Ratio

Open-Market Operations

Purchase and sale of government bonds

Buy bonds increases supply

Sell bonds decreases supply

Banksnow have

more cash to loan

Central Bank

Public Banks

Increase Money Supply?Buy bonds for cash

Banksnow have less cash to loan

Central Bank

Public Banks

Decrease Money Supply?Sell bonds for cash

Discount RateThe rate the central bank charges to make loans to

member banks

Called the Official Repo Rate or ORR rate in Saudi Arabia

Official Repurchase Rate or Discount Rate

2.0%

Dropped from 2.5% on January 19, 2009

SAMA Official Repo Rate

Dropped from5.5% October 2008

to 2.0% by January 20093 month period of

global financial crisisRate increased

as economyheated up

Reserve Ratio

Increase reserve ratio will reduce money multiplier

Decrease reserve ratio will increase money multiplier

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1 2 4 6 8 10 12 14 16 18 20

ReserveRatio

Money Multiplier

The Power of the Reserve Ratio to Multiply Money

Reserve RatioNot changed very often

What is the current reserve ratio in Saudi Arabia? 7%

What is the Money Multiplier?

1÷7% = 14.28

Bank Deposit Insurance

Protects against bank runs

Moral Hazard to take more risk because government

will pick up losses

Bank RunCustomers all want their money at the same time

Many banks runs at once

Bank Panic

Quiz 5 Name______________ ID_________

1. What is financial leverage?

2. How do you calculate a bank’s leverage?

3. What are the three tools that SAMA can use to manage the money supply?

4. If SAMA buys bonds, what happens to the money supply?

5. If SAMA lowers the ORR what happens to the money supply?

6. If SAMA lowers the reserve requirement what happens to the money supply?

7. Does deposit insurance make bankers more or less risky?

Zimbabwe, Nov. 2008 Highest monthly inflation: 79,600,000,000%Prices doubled every: 24.7 hours

The Meaning of MoneyThree Functions of Money

Medium of ExchangeUnit of AccountStore of Value

Two Kinds of MoneyCommodityFiat

Money in the EconomyCurrencyDemand Deposits

Central BanksSAMA

Banks and the Money Supply100-Percent Reserve BankingFractional-Reserve BankingReserve RatioMoney MultiplierLeverageCapital Requirement

Tools of Monetary ControlOpen-Market OperationsDiscount Rate - ORRReserve RatioBank Runs and Deposit Insurance