This document discusses measures of the money supply (M1 and M2) and how banks create money through the money multiplier effect. It explains that the money supply expands as banks make loans from their excess reserves. The money multiplier is equal to 1 divided by the required reserve ratio, so in this example the money multiplier is 10. When the Fed conducts open market operations by buying bonds, it increases bank reserves and allows the money supply to expand through additional lending. The Fed uses tools like open market operations, reserve requirements, and interest rates to influence the money supply and control monetary policy.

1. Chapter 14
Banking and the Money Supply

2. Narrow Definition of Money: M1
• M1: the most narrowly defined MS
– Measures purchasing power
– M1= currency held by the nonbanking public +
checkable deposits + traveler’s checks
– What are checkable deposits?
• Bank deposits that allow the account owner to write
checks to third parties.
– Is currency in bank vaults included?
• NO!!! It is not being used as a medium of exchange

3. Broader Definition of Money: M2
• M2: adding near monies to M1
– M2= M1 +near monies
• Near monies are easy to convert into currency or
checkable deposits
– Savings deposits
– Time deposits (CDs- certificates of deposit)
– Money market mutual fund accounts

4. LO1 Measures of the Money Supply
(February 2009)
Exhibit 1

5. Credit Cards and Debit Cards: What’s
the Difference
• What do credit cards offer?
– They offer an easy way to get a loan from the card
issuer.
• What do debit cards offer?
– They reduce the balance of your checking
account; thus, they are part of M1.
– It combines the functions of an ATM card and a
check.

6. Banks Are Financial Intermediaries
• By bringing together both sides of the money
market, banks serve as financial
intermediaries (go-betweens).

7. Coping with Asymmetric Information
• What borrowers do banks want?
– Willing to pay interest and are able to repay the
loan.
• Asymmetric information: an inequality in
what’s known by each party to the
transaction.
– The borrower knows more about their credit
history.

8. Reducing Risk Through Diversification
• They develop a diversified portfolio to reduce
the risk to each individual saver.

9. Starting a Bank
• First, they must apply to the state banking
authority in the case of a state bank or the U.S.
Comptroller of the Currency for a national bank.
– A charter
• The authority will decide to or not to approve the
charter.
• If approved they are established.
• Net Worth= Owners’ Equity
– Shares of Stock in the bank

10. Balance Sheet
• The balance sheet shows a balance between
the two sides of the bank’s account.
• Left-hand side= Assets
– Any physical property or financial claim owned by
the bank
– Building and equipment
– Stocks in the district Fed
• Right-hand side= Liabilities and Net Worth
– An amount the bank owes

11. What if all excess reserves are gone?

12. LO2
Exhibit 2
Home Bank’s Balance Sheet

13. Reserve Accounts
• Now what??
– They are required to hold a certain percentage of
the checkable deposits.
– This amount is the required reserve, the dollar
amount that must be held as reserves.
– The required reserve ratio dictates the minimum
proportion of deposits the bank must hold in
reserve.

14. Required Reserves for Banks
• $0 to 10.7 million – 0%
• $10.7 million to $55.2 million- 3%
• Greater than $55.2 million- 10%
– They are held as cash in the bank’s vault with NO
interest or as deposits at the Fed with some
interest

15. Excess Reserves
• Excess Reserves: The amount of checkable
deposits the bank holds over the required rate
the Fed mandates
– Starting in 2008, the Fed now gives interest on
excess reserves.
– What can they do with them?
• Make loans
• Buy government securities ( by law limited to this)

16. Liquidity vs. Profitability
• Liquidity is the ease with which an asset can
be converted into cash without a significant
loss of value.
– Selling government bonds
• The objectives of liquidity and profitability are
at odds.

17. Federal funds market
• The federal funds market provides for day-to-day
lending and borrowing among banks of
excess reserves on account at the Fed.
• They don’t leave the Fed, they shift among
accounts.
• Federal funds rate: the interest rate banks
charge one another for overnight borrowing-banks
loaning to banks

18. LO2 Exhibit 3
Home Bank’s Balance Sheet After
$1,000,000 Deposit Into Checking Account

19. LO3 Exhibit 4
Changes in Home Bank’s Balance Sheet
After Fed Buys a $1,000 Bond from
Securities Dealer

20. How Banks Create Money
 Creating money through excess reserves
LO3
– Round two
• $900 loan
• Money supply: +$900
• Required reserves: +$90
• Excess reserves: +$810

21. LO3 Exhibit 5
Changes in Home Bank’s Balance Sheet
After Lending $900 to You

22. How Banks Create Money
 Creating money through excess reserves
LO3
– Round three
• $810 loan
• Money supply: +$810
• Required reserves: +$81
• Excess reserves: +$729

23. LO3 Exhibit 6
Changes in Merchants Trust’s Balance
Sheet After Lending $810 to English Major

24. How Banks Create Money
 Creating money through excess reserves
LO3
– Round four and beyond
• Excess reserves – new loans
• Required reserves: +10% of new
checkable deposits
– Excess reserve – maximum amount for
loans
– Money supply expansion

25. How Banks Create Money
 Creating money through excess reserves
 A summary of rounds
LO3
– Fed: $1,000 injection in fresh reserves
– Increased excess reserves
– Money supply increase: Up to $10,000
• Checkable deposits
– Banking system
• Eliminates excess reserves
– Expand money supply

26. LO3 Exhibit 7
Summary of the Money Creation
Resulting from the Fed’s Purchase of
$1,000 U.S. Government Bond

27. Reserve Requirements and Money
Expansion
• The multiple by which the money supply
increases as a result of an increase in the
banking system’s reserves is called the money
multiplier.

28. The Money Multiplier
• Def: The money multiplier is equal to 1
divided by the required reserve ratio.
• In our case, it is 10
1 1
Re quired Re serve Ratio

29. The Real-World Money Multiplier
• It is much smaller than MM
• It must be observed over time
• What happens to it?
– Leakage
• Banks could let excess reserves sit idle
• Borrowers do something with the money
• People may not choose to increase their cash holdings

30. The Fed’s Tools of Monetary Control
• Open-Market Operations and the Federal
Funds Rate
• The Discount Rate
• Reserve Requirements
• Coping with Financial Crises
• The Fed is a money machine

31. Open Market Operations and the
Federal Funds Rate
• Buying and selling of U.S. Government bonds
• FOMC meet every six weeks and during
emergencies to make these decisions.
• To increase MS- the Fed directs the NY Fed to
buy U.S. bonds (open-market purchase).
• To decrease MS- the Fed directs the NY Fed to
sell U.S. bonds (open-market sale).

32. Open Market Operations and the
Federal Funds Rate
• The Federal Funds Rate is the interest rate
banks charge one another for borrowing
excess reserves at the Fed, typically just for a
day or two.
• If the Fed is buying bonds the federal funds
rate is lower because less demand for federal
funds market.
• The lower federal funds rate prompt banks to
lower short-term interest rates in general.

33. The Discount Rate
• The Discount Rate: the interest rate the Fed
charges for loans it makes to banks.
• Two discount rates:
– The primary discount rate is usually one
percentage point about the federal funds rate.
– The secondary discount rate is usually about one-half
a percentage point higher than the primary
discount rate.
• Banks that are less sound

34. Reserve Requirement
• The minimum amount of reserves that banks
must hold to back up deposits.
• If the Fed increase the reserve requirement,
then banks have less excess reserves to lend
out
– This reduces the banking system’s ability to create
money.

35. Coping with Financial Crises
• In 2001- the Fed bought all the government
securities offered for sale, purchasing a record
$150 billion worth in two days.
• In 2008- The Fed lowered the discount rate to
nearly zero and encourage banks improve
their balance sheets and a few other policies

36. The Fed is a money machine
• The Fed injected more that a trillion dollars of
liquidity into the banking system in response
to the 2008 meltdown.
• April 2009- 24% of Fed assets were U.S.
government bonds, but in more normal times
about 90% of assets.

37. LO4 Exhibit 8
Federal Reserve Bank Balance Sheet as of
April 1, 2009 (Billions)