Chapter 25 Money Creation

1. Chapter 25Money Creation • Key Concepts • Summary • Practice Quiz • Internet Exercises ©2000 South-Western College Publishing

2. In this chapter, you will learn to solve these economic puzzles: Exactly how is money created in the economy? That is, how does the money supply increase? What are the major tools the Federal Reserve uses to control the supply of money? Why is there nothing ‘federal’ about the federal funds rate?

3. In the Middle Ages, what was used for Money? Gold was the money of choice in most European nations

4. Who were the Founders of our Modern-day Banking? Goldsmiths, people who would keep other people’s gold safe for a service charge

5. What was the first Currency? People would use the receipts they received from goldsmiths as paper money

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

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

8. What areRequired Reserves? The minimum balance that the Fed requires a bank to hold in vault cash or on deposit with the Fed

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

10. What areExcess Reserves? Potential loan balances held in vault cash or on deposit with the Fed in excess of required reserves

11. Typical Bank - Balance Sheet 1 Assets Liabilities RequiredReserves $5 million Checkable Deposits $50 million ExcessReserves 0 Loans $45 million Total $50 million Total $50 million Note: The Fed requires the bank to keep 10% of its checkable deposits in reserve.

12. What areTotal Reserves? Total Reserves = required reserves + excess reserves

13. Required Reserve Ratio of the Fed Required Reserve Ratio Type of Deposit Checkable deposits 3% 0 - $46.5 million 10% Over $46.5 million Source: Federal Reserve Bulletin, April 1999, Table 1.15, p. A8

14. Best National Bank - Balance Sheet 2 Assets  in M1 Liabilities RequiredReserves Brad Rich Account $100,000 $10,000 0 ExcessReserves +$90,000 $100,000 Total Total $100,000 Note: The Fed requires the bank to keep 10% of its checkable deposits in reserve.

15. Best National Bank - Balance Sheet 3 Assets  in M1 Liabilities RequiredReserves Brad Rich Account $100,000 $19,000 ExcessReserves Connie Jones Account $81,000 +$90,000 $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.

16. Best National Bank - Balance Sheet 4 Assets  in M1 Liabilities RequiredReserves Brad Rich Account $100,000 $10,000 0 ExcessReserves Connie Jones Account 0 0 Loans $90,000 Total $100,000 $100,000 Note: The Fed requires the bank to keep 10% of its checkable deposits in reserve.

17. Yazoo Bank - Balance Sheet 5 Assets Liabilities RequiredReserves +$9,000 Better Health Span Account +$90,000 ExcessReserves +$81,000 Total $90,000 Total $90,000 Note: The Fed requires the bank to keep 10% of its checkable deposits in reserve.

18. Expansion of the Money Supply Increase in Required Reserves Increase in Excess Reserves Increase inDeposits # Bank $10,000 $90,000 1 $100,000 Best Nat’l Bank 81,000 9,000 90,000 2 Yazoo Nat’l Bank 8,100 72,900 81,000 Bank A 3 7,290 65,610 72,900 Bank B 4 6,561 65,610 59,049 Bank C 5 59,049 5,905 53,144 6 Bank D 53,144 7 5,314 47,830 Bank E 47,830 478,297 430,467 Total all other banks Total increase $1,000,000 $900,000 $100,000

19. What is theMoney Multiplier? The maximum change in the money supply due to an initial change in the excess reserves banks hold

20. What is the Money Multiplier equal to? 1 / required reserve ratio

21. Actual money supply change  M1 = ER x m Initial change in excess reserves Money multiplier

22. Can the Multiplier be smaller than indicated? Yes, because of cash leakages and the chance that banks will not use all of their excess reserves to make loans

23. What would the Fed do if we had Inflation? Decrease the money supply What would the Fed do if we had unemployment? Increase the money supply

24. What is Monetary Policy? The Fed’s use of - • open market operations •  in discount rate •  in required reserve ratio

25. What are Open Market Operations? The buying and selling of government securities by the Federal Reserve System

26. Federal Reserve System - Balance Sheet 6 Assets Liabilities Government securities Fed notes $472 $492 Deposits 34 Loans to banks 1 Other liabilities and net worth 75 22 Other assets Total $548 Total $548 Source: Federal Reserve Bulletin, April 1999, Table 1.18, p. A10

27. Federal Reserve Bank - Balance Sheet 7 Initial  in M1 Assets Liabilities Government securities Reserves of Best Nat’l bank +$100,000 +$100,000 +$100,000 Note: The Fed conducted open market operations in order to increase the money supply by purchasing $100,000 in government securities.

28. Federal Reserve Bank - Balance Sheet 8 Initial  in M1 Assets Liabilities Government securities Reserves of Best Nat’l bank -$100,000 -$100,000 -$100,000 Note: The Fed conducted open market operations in order to decrease the money supply by selling $100,000 in government securities.

29. Fed Fed buys governmentsecurities and banks gain reserves Fed sells governmentsecurities and banks loose reserves $ $ Banks $ $ Public

30. What is theDiscount Rate? The interest rate the Fed charges on loans of reserves to banks

31. What would the Fed do if we have Inflation? A higher discount rate discourages banks from borrowing reserves and making loans

32. What would the Fed do if we have Unemployment? A lower discount rate encourages banks to borrow reserves and make more loans

33. What is the Federal Funds Market? A private market in which banks lend reserves to each other for less than 24 hours

34. What is the Federal Funds Rate? The interest rate banks charge for overnight loans to other banks

35. What would the Fed do if we had Inflation? A higher federal funds rate discourages banks from borrowing reserves and making loans

36. What would the Fed do if we had Unemployment? A lower federal funds rate encourages banks to borrow reserves and make more loans

37. What is a Required Reserve Requirement? The Fed determines how much a financial institution must keep in reserve as a percentage of its total assets

38. What is the Required Reserve Ratio? That percentage the Fed stipulates that financial institutions must keep in reserve to meet its reserve requirement

39. If the Reserve Ratio is one tenth, what is the multiplier? 1  1/10 = 10

40. If the Reserve Ratio is one twentieth, what is the multiplier? 1  1/20 = 20

41. What would the Fed do if we had Inflation? Increase the reserve ratio What would the Fed do if we had Unemployment? Decrease the reserve ratio

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

43. What are the Shortcomings of Monetary Policy? • Money multiplier inaccuracy • Nonbanks • Which money definition should the Fed control? • Lag effects

44. Key Concepts

45. Key Concepts • Who were the Founders of our Modern-day Banking? • 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?

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?

47. Summary

48. Fractional reserve banking, the basis of banking today, originated with the goldsmiths in the Middle Ages. Because depository institutions (banks) are not required to keep all their deposits in vault cash or with the Federal Reserve, banks create money by making loans.

49. Required reserves are the minimum balance that the Fed requires a bank to hold in vault cash or on deposit with the Fed. The percentage of deposits that must be held as required reserves is called the required reserve ratio.

50. Excess reserves exist when a bank has more reserves than required. Excess reserves allow a bank to create money by exchanging loans for deposits. Money is reduced when excess reserves are reduced and loans are repaid.