11 money creation
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  • 1. Chapter 25Money Creation • Key Concepts • Summary • Practice Quiz • Internet Exercises ©2000 South-Western College Publishing 1
  • 2. In this chapter, you will learn to solve these economic puzzles: Exactly how is money theWhat are is there nothing Why thethe economy? created in major tools Federal Reserve uses to ‘federal’ about the That is, supply of money? how does thecontrol the funds rate? federal money supply increase? 2
  • 3. In the Middle Ages, what was used for Money? Gold was the money of choice in most European nations 3
  • 4. Who were the Founders of ourModern-day Banking?Goldsmiths, people who would keep other people’s gold safe for a service charge 4
  • 5. What was the first Currency?People would use the receipts they received from goldsmiths as paper money 5
  • 6. How did the early Goldsmiths act as the First Banks?Some goldsmiths made loans and received interest for more gold than the actual gold held in their vaults 6
  • 7. What is Fractional Reserve Banking?A system in which banks keep only a percentage of their deposits on reserve as vault cash and deposits at the Fed 7
  • 8. What are Required Reserves?The minimum balance that the Fed requires a bank to hold in vault cash or on deposit with the Fed 8
  • 9. What is aRequired Reserve Ratio?The percentage of deposits that the Fed requires a bank to hold in vault cash or on deposit with the Fed 9
  • 10. What are Excess Reserves?Potential loan balances held in vault cash or on deposit with the Fed in excess of required reserves 10
  • 11. Typical Bank - Balance Sheet 1 Assets LiabilitiesRequired $5 million Checkable $50 millionReserves DepositsExcess 0ReservesLoans $45 millionTotal $50 million Total $50 million Note: The Fed requires the bank to keep 10% of its checkable deposits in reserve. 11
  • 12. What are Total Reserves?Total Reserves = required reserves + excess reserves 12
  • 13. Required Reserve Ratio of the Fed Required Reserve Type of Deposit RatioCheckable deposits 0 - $46.5 million 3%Over $46.5 million 10% Source: Federal Reserve Bulletin, April 1999, Table 1.15, p. A8 13
  • 14. Best National Bank - Balance Sheet 2 Assets Liabilities ∆ in M1Required $10,000 Brad Rich $100,000 0Reserves Account ExcessReserves +$90,000 Total $100,000 Total $100,000 Note: The Fed requires the bank to keep 10% of its checkable deposits in reserve. 14
  • 15. Best National Bank - Balance Sheet 3 Assets Liabilities ∆ in M1Required $19,000 Brad Rich $100,000Reserves Account Excess $81,000 Connie Jones +$90,000Reserves Account $90,000 Loans +$90,000 Total $190,000 Total $190,000 Note: The Fed requires the bank to keep 10% of its checkable deposits in reserve. 15
  • 16. Best National Bank - Balance Sheet 4 Assets Liabilities ∆ in M1Required $10,000 Brad Rich $100,000 0Reserves Account Excess 0 Connie Jones 0Reserves Account Loans $90,000 Total $100,000 $100,000 Note: The Fed requires the bank to keep 10% of its checkable deposits in reserve. 16
  • 17. Yazoo Bank - Balance Sheet 5 Assets LiabilitiesRequired +$9,000 Better Health +$90,000Reserves Span AccountExcess +$81,000ReservesTotal $90,000 Total $90,000 Note: The Fed requires the bank to keep 10% of its checkable deposits in reserve. 17
  • 18. Expansion of the Money Supply Increase in Increase in Increase in # Bank Deposits Required Reserves Excess Reserves 1 Best Nat’l Bank $100,000 $10,000 $90,000 2 Yazoo Nat’l Bank 90,000 9,000 81,000 3 Bank A 81,000 8,100 72,900 4 Bank B 72,900 7,290 65,610 5 Bank C 65,610 6,561 59,049 6 Bank D 59,049 5,905 53,144 7 Bank E 53,144 5,314 47,830Total all other banks 478,297 47,830 430,467 Total increase $1,000,000 $100,000 $900,000 18
  • 19. What is the Money Multiplier?The maximum change in the money supply due to an initial change in the excess reserves banks hold 19
  • 20. What is the Money Multiplier equal to?1 / required reserve ratio 20
  • 21. Actual money supply change ∆ M1 = ∆ER x mInitial change in excess reserves Money multiplier 21
  • 22. Can the Multiplier besmaller than indicated?Yes, because of cash leakages and the chance that banks will not use all of their excess reserves to make loans 22
  • 23. What would the Fed do if we had Inflation? Decrease the money supplyWhat would the Fed do ifwe had unemployment?Increase the money supply 23
  • 24. What is Monetary Policy? The Fed’s use of - • open market operations ∀∆ in discount rate ∀∆ in required reserve ratio 24
  • 25. What are Open Market Operations?The buying and selling of government securities by the Federal Reserve System 25
  • 26. Federal Reserve System - Balance Sheet 6 Assets Liabilities Government Fed notes securities $472 $492 Loans to banks Deposits 34 1 Other liabilities Other assets 75 and net worth 22 Total $548 Total $548Source: Federal Reserve Bulletin, April 1999, Table 1.18, p. A10 26
  • 27. Federal Reserve Bank - Balance Sheet 7 Assets Liabilities Initial ∆ in M1Government +$100,000 Reserves of +$100,000 +$100,000 securities Best Nat’l bank Note: The Fed conducted open market operations in order to increase the money supply by purchasing $100,000 in government securities. 27
  • 28. Federal Reserve Bank - Balance Sheet 8 Assets Liabilities Initial ∆ in M1Government -$100,000 Reserves of -$100,000 -$100,000 securities Best Nat’l bank Note: The Fed conducted open market operations in order to decrease the money supply by selling $100,000 in government securities. 28
  • 29. Fed Fed buys governmentFed sells government $ $ securities and bankssecurities and banks gain reserves loose reserves Banks $ $ Public 29
  • 30. What is the Discount Rate?The interest rate the Fed charges on loans of reserves to banks 30
  • 31. What would the Fed do if we have Inflation? A higher discount rate discourages banks from borrowing reserves and making loans 31
  • 32. What would the Fed do ifwe have Unemployment? A lower discount rate encourages banks to borrow reserves and make more loans 32
  • 33. What is the Federal Funds Market?A private market in which banks lend reserves to each other for less than 24 hours 33
  • 34. What is the Federal Funds Rate?The interest rate banks charge for overnight loans to other banks 34
  • 35. What would the Fed do if we had Inflation? A higher federal funds rate discourages banks from borrowing reserves and making loans 35
  • 36. What would the Fed do ifwe had Unemployment? A lower federal funds rate encourages banks to borrow reserves and make more loans 36
  • 37. What is a RequiredReserve Requirement?The Fed determines how much a financial institution must keep in reserve as a percentage of its total assets 37
  • 38. What is the Required Reserve Ratio?That percentage the Fed stipulates that financial institutions must keep in reserve to meet its reserve requirement 38
  • 39. If the Reserve Ratiois one tenth, what is the multiplier? 1 ÷ 1/10 = 10 39
  • 40. If the Reserve Ratio isone twentieth, what is the multiplier? 1 ÷ 1/20 = 20 40
  • 41. What would the Fed do if we had Inflation?Increase the reserve ratioWhat would the Fed do ifwe had Unemployment?Decrease the reserve ratio 41
  • 42. Is changing the Reserve Ratio a popular Monetary Tool?No, changing the reserve ratio is considered a heavy- handed approach and is thus infrequently used 42
  • 43. What are the Shortcomings of Monetary Policy?• Money multiplier inaccuracy• Nonbanks• Which money definition should the Fed control?• Lag effects 43
  • 44. Key Concepts 44
  • 45. Key Concepts• Who were the Founders of our Modern-day Ba• What is Fractional Reserve Banking?• What are Required Reserves?• What is a Required Reserve Ratio?• What are Excess Reserves?• What are Total Reserves?• What is the Money Multiplier?• What is the Money Multiplier equal to? 45
  • 46. Key Concepts cont.• What is Monetary Policy?• What are Open Market Operations?• What is the Discount Rate?• What is the Federal Funds Rate?• What is a Required Reserve Requirement?• What is the Required Reserve Ratio?• What are the Shortcomings of Monetary Policy? 46
  • 47. Summary 47
  • 48. Fractional reserve banking, thebasis of banking today, originatedwith the goldsmiths in the MiddleAges. Because depository institutions(banks) are not required to keep alltheir deposits in vault cash or with theFederal Reserve, banks create moneyby making loans. 48
  • 49. Required reserves are theminimum balance that the Fedrequires a bank to hold in vaultcash or on deposit with the Fed.The percentage of deposits thatmust be held as required reservesis called the required reserve ratio. 49
  • 50. Excess reserves exist when abank has more reserves thanrequired. Excess reserves allow abank to create money by exchangingloans for deposits. Money is reducedwhen excess reserves are reducedand loans are repaid. 50
  • 51. The money multiplier is used tocalculate the maximum change(positive or negative) in checkabledeposits (money supply) due to achange in excess reserves. As aformula:$ multiplier = 1/required reserve ratio. 51
  • 52. Monetary policy is actiontaken by the Fed to change themoney supply. The Fed uses threebasic tools: (1) open marketoperations, (2) changes in thediscount rate and (3) changes inthe required reserve ratio. 52
  • 53. Open-market operations are thebuying and selling of governmentsecurities by the Fed through itstrading desk at the New YorkFederal Reserve Bank. Buyinggovernment securities creates extrabank reserves and loans, therebyexpanding the money supply.Selling government securitiesreduces bank reserves and loans,thereby contracting the moneysupply. 53
  • 54. Fed Fed buys governmentFed sells government $ $ securities and bankssecurities and banks gain reserves loose reserves Banks $ $ Public 54
  • 55. Changes in the discount rate occurwhen the Fed changes the rate ofinterest it charges on loans of reservesto banks. Dropping the discount ratemakes it easier for banks to borrowreserves from the Fed and expands themoney supply. Raising the discount ratediscourages banks from borrowingreserves from the Fed and contracts themoney supply. 55
  • 56. Changes in the required reserveratio and the size of the moneymultiplier are inversely related. Thus, ifthe Fed decreases the required reserveratio the money multiplier and moneysupply increase. If the Fed increases therequired reserve ratio the moneymultiplier and money supply decrease. 56
  • 57. Monetary policy limitations includethe following: (1) The money multipliercan vary. (2) Nonbanks, such asinsurance companies, financecompanies, and Sears, can offer loansand other financial services not directlyunder the Fed’s control. (3) The Fedmight control M1 while the public canshift funds to M2, M3, or anothermoney supply definition. (4) Time lagsoccur. 57
  • 58. Chapter 25 Quiz ©2000 South-Western College Publishing 58
  • 59. 1. If a bank has total deposits of $100,000 with $10,000 set aside to meet reserve requirements of the Fed, its required reserve ratio is a. $10,000. b. 10 percent. c. 0.1 percent. d. 1 percent.B. Required reserve ratio = required deposits ÷ total deposits x 100 = $10,000 ÷ $100,000 x 100 59
  • 60. 2. Assume a simplified banking system in which all banks are subject to a uniform required reserve ratio of 30 percent and demand deposits are the only form of money. A bank that receives a new deposit of $10,000 is able to extend new loans up to a maximum of a. $3,000. b. $7,000. c. $10,000. d. $30,000.B. Excess reserves can be loaned. Excess reserves = total reserves - required reserves = $10,000 - (0.3 x $10,000) = $10,000 - $3,000 = $7,000 60
  • 61. 3. The Best National Bank operates with a 10 percent required reserve ratio. One day a depositor withdraws $400 from his or her checking account at the bank. As a result, the bank’s excess reserves a. fall by $400. b. fall by $360. c. fall by $40. d. rise by $400. B. Excess reserves = total reserves - required reserves = -$400 - (0.10 x $400) = -$400 + $40 = -$360 61
  • 62. 4. If an increase of $100 in excess reserves in a simplified banking system can lead to a total expansion in bank deposits of $400, the required reserve ratio must be a. 40 percent. b. 400 percent. c. 25 percent. d. 4 percent. e. 2.5 percent. C. $ multiplier = ∆ in bank deposits ÷ initial ∆ in excess reserves = 400 ÷ $100 = 4 = 1 ÷ required reserve ratio = 1 ÷ money multiplier x 100. 62
  • 63. 5. In a simplified banking system in which all banks are subject to a 25% required reserve ratio, a $1,000 open sale by the Fed would cause the money supply to a. increase by $1,000. b. decrease by $1,000. c. decrease by $4,000. d. increase by $4,000.C. Money supply change (∆ M1) = initial ∆ in excess reserves x money multiplier (MM).MM = 1 ÷ required reserve ratio = 1 ÷ 25/100 = 4.∆ M1 = $1,000 x 4 = -$4,000. 63
  • 64. 6. In a simplified banking system in which all banks are subject to a 20% required reserve ratio, a $1,000 open market purchase by the Fed would cause the money supply to a. increase by $100. b. decrease by $200. c. decrease by $5,000. d. increase by $5,000.D. Money supply change (∆ M1) = initial change in excess reserves x money multiplier (MM)MM = 1 ÷ required reserve ratio = 1 ÷ 20/100 =5 ∆ M1 = $1,000 x 5 = $5,000. 64
  • 65. 7. The cost to a member bank of borrowing from the Federal Reserve is measured by the a. reserve requirement. b. price of securities in the open market. c. discount rate. d. yield on government bonds.C. The Fed provides a discount window at each of the Federal Reserve districts banks to make loans of reserves to banks and change an interest rate called the discount rate. 65
  • 66. Exhibit 5 Balance Sheet of Best National Bank Assets Liabilities $ Checkable $100,000Required Reserves depositsExcess Reserves Loans 80,000 Total $100,000 Total $100,000 66
  • 67. 8. The required reserve ratio in Exhibit 5 is a. 10%. b. 15%. c. 20%. d. 25%. C. Excess reserves = total reserves - required reserves = $80,000 = $100,000 - required reserves = $20,000 Required reserve ratio = required deposits ÷ total deposits = $20,000 ÷ $100,000 x 100 = 20% 67
  • 68. 9. If the bank in Exhibit 5 received $100,000 in new deposits, its new required reserves would be a. $10,000. b. $20,000. c. $30,000. d. $40,000.B. Required reserves = required reserve ratio x new deposits = .20 x $100,000 = $20,000 68
  • 69. 10. Suppose Brad Jones deposits $1,000 in the bank shown in Exhibit 5. The result would be a. a $200 increase in excess reserves. b. a $200 increase in required reserves. c. a $1,200 increase in required reserves. d. zero change in required reserves.B. Required reserves = required reserve ratio x new deposits = .20 x $1,000 = $200 69
  • 70. 11. If all banks in the system are identical to Best National Bank in Exhibit 5. A $1,000 open market sale by the Fed would a. 5. b. 10. c. 15. d. 20. A. Money multiplier = 1 ÷ required reserve ratio = 1 ÷ 20/100 = 5 70
  • 71. 12. Assume all banks in the system are identical to Best National Bank in Exhibit 5. A $1,000 open market sale by the Fed would a. expand the money supply by $1,000. b. expand the money supply by $15,000. c. contract the money supply by $1,000. d. contract the money supply by $5,000. D. Money supply change (∆ M1) = initial change in excess reserves x money multiplier (MM) MM = 1 ÷ required reserve ratio = 1 ÷ 20/100 =5 ∆ M1 = $1,000 x 5 = -$5,000. 71
  • 72. Internet ExercisesClick on the picture of the book, choose updates by chapter for the latest internet exercises 72
  • 73. END 73