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How Banks Create Money [ MS ] MS = Currency + DD of Public

How Banks Create Money [ MS ] MS = Currency + DD of Public Banks [thru loans] C reate M ore DD. 1. Fractional Reserve Banking System. –. a fraction of DD are kept in. reserve(say, 10%) at either the bank’s vault or at the Fed. 2. Vault cash. –. cash held. bank. by a.

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How Banks Create Money [ MS ] MS = Currency + DD of Public

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  1. How Banks CreateMoney[MS] MS = Currency + DD of Public Banks [thru loans] Create More DD

  2. 1. Fractional Reserve Banking System – a fraction of DD are kept in reserve(say, 10%) at either the bank’s vault or at the Fed. 2. Vault cash – cash held bank by a (banks rarely keep more than 2% of their in cash) 3. Required Reserve(RR) – specified percentage DD that banks RR. must keep as of 4. Excess reserves – total reserves(TR) – RR. ER is what can be loaned out. Also some ER is used to meet sudden withdrawal demands. 5. Actual(Total) reserves – RR + ER. 6. Deposit Multiplier – one/RR or 1/.10 or $1/10 cents or 10 Multipliers 1/RR[$1/5 cents = 20] 1/5% = 20 1/25% = 4 1/10% = 10 1/33.3%= 3 1/12.5% = 8 1/40 = 2.5 1/20% = 5 1/50% = 2 Balance Sheet 7. – statement of assets & liabilities[assets=liabilities]. 8. Discount Rate – when banks borrow from the Fed. [symbolic - emergencies] “wholesale price of money” Federal Funds Rate 9. – banks borrow from other banks for overnight loans. 10. Prime Rate – when a bank’s prime customers [good credit] get loans. “retail price of money” 11. Buying Bonds – “buying” bonds means “bigger ” supply of money and “lower interest rates”. [So, more “C”, “Ig”, and “Xn” ] Selling Bonds – 12. “selling” bonds mea ns “smaller” supply of money and “higher interest rates”. [So, less “C”, “Ig”, and “Xn”] How Banks Create Money [Vocabulary]

  3. FRACTIONAL RESERVE BANKING

  4. YOU deposit $1with A 10% RR .10 90 cents Excess Reserves RR Total (Actual) Reserves One Dollar One bank’s loan becomes another bank’s DD. PMC = M x ER, so 10 x .90 =$9 TMS = PMC[$9] + DD[$1] = $10 [MS= Currency+ DD of Public]

  5. Your Bank Borrows $1 From The Fed [10% RR] Bank Fed One Dollar 0 Excess Reserves RR Total(Actual) Reserves One Dollar PMC = M x ER, so 10 x $1 = $10 TMS [$10] = PMC[$10] [MS = Currency+ DD of Public]

  6. Money Creation

  7. $1,000DD[MS=Currency+DDofPublic] New Deposits [New Reserves] DD New Required Reserves RR=10% DDCreated By New Loans [equal to new ER] Bank Dog that can YoYo $1,000.00 A $100.00 900.00 900.00 One year “all u can eat” hot wings at Hooters B $90.00 900.00 810.00 C $81.00 810.00 729.00 $729.00 for a “cat bodyguard” $72.90 729.00 D 656.10 PMC = $9,000.00 PMC = ER[$900] x M[10] Smoking cat DD + PMC = TMS $1,000.00 +$9,000.00 =$10,000.00 MSgrows by multiple of10

  8. $1,000DD[MS=Currency+DDofPublic] New Deposits [New Reserves] DD New Required Reserves RR=20% DD Created By New Loans [equal to new ER] Bank $1,000.00 A $200.00 800.00 800.00 B $160.00 800.00 640.00 C $128.00 640.00 512.00 $102.40 512.00 D 409.60 PMC = $4,000.00 PMC = ER[$800 x M[5] DD + PMC = TMS $1,000.00 + $4,000.00 = $5,000.00 MSgrows by multiple of5

  9. $1,000DD[MS=Currency+DDofPublic] New Deposits [New Reserves] DD New Required Reserves RR=25% DD Created By New Loans [equal to new ER] Bank $1,000.00 A $250.00 750.00 750.00 B $188.00 750.00 562.00 C $140.00 562.00 422.00 $105.00 422.00 D 317.00 E $80.00 237.00 317.00 PMC = ER[$750] x M[4] PMC = $3,000.00 DD + PMC = TMS $1,000.00 + $3,000.00 = $4,000.00 MSgrows by multiple of4

  10. MS = DD + Currency of the Public [A DD of $10,000 will increase MS by another $40,000($50,000 MS] RR=20% MS $10,000 $8,000 $6,400 $24,400 MSis $10,000 4. 2nd Bank lends Sports Shop$6,400. 1. Joe Biker deposits $10,000 in his bank. RR = 20% MS $10,000 $8,000 $18,000 2. Suzie Rah Rah borrows $8,000 5. Eventually the MS will be $50,000 Joe 3. Suzie pays $8,000 for a used car. GoNow Auto deposits the $ in 2nd Bank. $10,000+$40,000=$50,000

  11. NOTES: Banks create money by lending ERand destroy money by loan repayment. Purchasing bonds from the public also creates money.

  12. Amount bank can lend - New money created Acquired reserves and deposits Required reserves Excess reserves Bank $80.00 64.00 51.20 40.96 32.77 26.22 20.98 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.57 A B C D E F G H I J K L M N Other banks $100.00 80.00 64.00 51.20 40.96 32.77 26.22 20.98 16.78 13.42 10.74 8.59 6.87 5.50 21.97 $20.00 16.00 12.80 10.24 8.19 6.55 5.24 4.20 3.36 2.68 2.15 1.72 1.37 1.10 4.40 $80.00 64.00 51.20 40.96 32.77 26.22 20.98 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.57 MULTIPLE DEPOSIT EXPANSION PROCESS RR= 20% 1st 10 $357 of the $400 $400.00 PMC in the banking system [MxER] TMS = $500.00

  13. 1 = MM RR Maximum checkable- deposit expansion x = ER THE Money [Deposit] MULTIPLIER The MM is the reciprocal of the RR. Potential money Creation in the Banking System [PMC] MM

  14. AP Econ[MS = Currrency+ DD of Public] RR+ER=TR; TR-RR=ER;TR-ER=RR; MXER=PMC; PMC(Public)+DD=TMS; PMC(Fed)=TMS Excess Reserves prior to new currency deposit (DD) = $0 Ben Bigbucksdeposits in the banking system = $40million Legal Reserve Requirement[RR] = 20% 1. The $40 million depositof Currencyinto DDwould result in MS staying at ($8/$40/$160) million. [MS composition changed from currency to DD] 2. The $40 million deposit of currency into checking accounts will create ER of ($20/$32/$40) million. 3. The Potential Money Creation of the banking system through loans is ($40/$160/$$200) mil. The Potential TMS [all DDof the public] could be as much as ($40/$160/$200) mil. 4. The RR applies to checkable deposits at (banks/S&Ls/ credit unions/ all depository institutions). 5. If the Duck National Bank has ER of $6,000 & DDof $100,000 what is the size of the bank’s TR if the RR is 25%? ($25,000/$75,000/$31,000) [RR($____)+ER($___)+TR($____) 25,000 31,000 6,000

  15. [MS = Currrency+DD of Public] 6. A stranger deposits$1,000 in a bank that has a RR of 10%. The maximum possible change in the dollar value of the local bank’s loans would be $______. PMC[MXER] in the banking system is $_____. Potential TMS could become as high as $_______. 7. Suppose a commercial bank hasDD of $100,000 and the RR is 10%. If the bank’s RR & ER are equal, then its TR are ($10,000/$20,000/$30,000). 8. Total Reserves (minus/plus) RR = ER. 9. Suppose the Thunderduck Bank has DDof $500,000& theRR is 10%. If the institution has ER of $4,000 then its TR are ($46,000/$54,000/$4,000). 10. If ER in a bank are $4,000, DDare$40,000, & the RR is 10%, then TR are ($4,000/$8,000). 11. The main purpose of the RR is to (have funds for emergency withdrawals/ influence the lending ability of commercial banks). 12. If I write you a check for $1 & we both have our checking accts at the Poorman Bank, the bank’s balance sheet will (increase/decrease/be unchanged). 13. Banks (create/destroy) money when they make loans and repaying bank loans (create/destroy) money. 14. When a bank loan is repaid the MS is (increased/decreased). 15. The Fed Funds rate is a loan by one bank (to another bank/from the Fed). RR+ER=TR; TR-RR=ER;TR-ER=RR; MXER=PMC; PMC(Public)+DD=TMS; PMC(Fed)=TMS 900 9,000 10,000

  16. [MS = Currrency+DD of Public] RR+ER=TR; TR-RR=ER;TR-ER=RR; MXER=PMC; PMC(Public)+DD=TMS; PMC(Fed)=TMS 16. If the RR was lowered [say, from 50% to 10%], the size of the monetary multiplier [MM] would (increase/decrease). Leakages (limitations) of the Money Creating Process 1. Cash leakages [taking part of loan in cash] 2. ER (banks don’t loan it or we don’t borrow] 17. If borrowers take a portion of their loans as cash, the maximum amount by which the banking system increases the MS by lending will (increase/decrease).

  17. Money Supply=DD +Currencyof thePublic • “PMC”“PMC” “TMS” • ER Loans Crea. In “Potential” • $100[10%RR][1st Bank][1st Bank]SystemTotal MS • Banks/PublicDD [$100] $90$90 $900 $1,000 • Fed /Public/BanksDD[$100] $90$90 $900 $1,000 • [*Fedbuys bonds frompublicwho put the money in theirDD] • Banks/FedFedLoan[$100] $100$100 $1,000 $1,000 • [or sells bonds toFed] • “PMC” “PMC” “TMS” • ER Loans Crea. In “Potential” • $100 [20%RR] [1st Bank][1st Bank]SystemTotal MS • Banks/PublicDD [$100] $80 $80 $400 $500 • Fed/Public/BanksDD[$100]$80$80 $400 $500 • [*Fed buys bonds frompublicwho put the money in theirDD] • Banks/FedFedLoan[$100] $100$100 $500 $500 • [or sells bonds toFed] Long Run Short Run

  18. Money Creation Practice Review

  19. Banksand thePublic RR+ER=TR; TR-RR=ER; TR-ER=RR; M x ER=PMC; PMC(Public)+1stDD=TMS; PMC(Fed)=TMS Banks & Public(allDD of Publicare subject to the RR; rest is ER & can be loaned out) 1. No ER & RR is 20%; DD of $10 M is made in the Thunder Bank. MS is $___million. ER increase by $___million. Potential Money Creation in the banking system is $_____M. Potential TMS is $____million. 2. There are no ER & RR is 25% & $16,000 is depositedin theDuck Bank. MS is $_______. This one bank can increase its loans by a maximum of $_______. Potential Money Creation in the banking system is $_______. Potential Total Money Supply could be $__________. 3. Econ Bankhas ER of $5,000; DD are $100,000; RR is 25%. TR are $_______. 4. DDare $10,000; ER are $1,000; TR are $3,000; RR are _________. [TR-ER=RR]. 5. Nomics Bank has ER of $10,000; DD of $100,000; RR of 40%. TR are _________. With ER above, Potential Money Creation in the banking system is $__________. 6. Friar Bank has DD of $100,000; RR is 20%; RR & ER are equal. TR are $________. 7. If ER in a bank are $10,000;DD are $200,000, & the RR are 10%. TR are $_______. 8. No ER & RR is 25%. DD of $100,000is made. MS is $_______. This single bank can increase its loans by $_______. PMC in thesystem is $________. TMS is $________. MS = currency + DD of Public 10 8 50 40 16,000 48,000 12,000 64,000 30,000 $2,000 $50,000 25,000 40,000 30,000 100,000 75,000 300,000 400,000

  20. Banks and the Fed [RR+ER=TR; TR-RR=ER; TR-ER=RR; MxER=PMC; PMC(Public)+1stDD=TMS; PMC(Fed)=TMS] MS = Currency + DD of Public [Money borrowed from the Fed[or gained thru bond sales] is ER & can be loaned out] 9. RR is 25%; Econ Bank borrows $25,000 from the Fed; its ER are increased by $______. Potential Money Creationin thesystem is $_______. Potential TMS is $_______. 10. RR is 50%; a bank borrows $20,000 from theFed; thisone bank’s ER are increased by $_____. PotentialMoney Creationin the system is $______. Potential TMS is $______ 11. RR is 20%; the Duck Bank sells $10 M of bonds to the Fed; Duck Bank’s ER are increased by $___million. PMC in the system is $__________. TMS is $__________. 12. RR is 20%; Fed buys $50,000 of securities from Keynes Bank. Its ER are increased by $___________. Potential Money Creation in the banking system is $______________. Potential TMS is $___________. 13.25% RR; Fed buys $400 million of bonds from the Friar Bank. This one bank’s ER are increased by $_____million. 14. RR is 50%; the Fed sells $200 million of bonds to a bank; its ER are (increased/decreased) by $_______. Potential Money Creation in the banking system is (increased/decreased) by $________. 15. RR is 10%; a bank borrows $10 million from the Fed; this one bank’s ER are increased by $_______ million. PMC in the banking system is $_______million. Potential TMS is $_______million. 100,000 25,000 100,000 40,000 40,000 20,000 10 50 million 50 million 50,000 250,000 250,000 400 200 M 400 M 10 100 100

  21. Fedand thePublic [RR+ER=TR; TR-RR=ER; TR-ER=RR; MxER=PMC; PMC(Public)+1stDD=TMS; PMC(Fed)=TMS] MS = Currency + DD of the Public [When Fedbuys securities from Public, they will put the money in theirDD] 16. RR is 50%;Fedbuys $10 M of bonds from thePublic. MS isincreased by _______. ER are increased by ____. PMC in the system is _______. Potential TMS is _______. 17. RR is 25%; Fed buys $100 M of bondsfrom thePublic. The MSis increased _______. ER are increased by ______. PMC in the system is _______. Potential TMS is ________. 18. RR is 50%; Fedsells $200 Mof bonds to thePublic. The MSis (incr/decr) by __________. ER are (incr/decr) by _________. PMC in the banking system is (increased/decreased) by _______. Potential TMS is (incr/decr) by __________. 19. RR is 20%; Fedbuys $5 million of securities from thePublic. The MS is increased by _______. ER are increased by _______. Potential Money Creation in the banking system is _______. Potential TMS is _________. 20. RR is 10%; Fedbuys $50 million of bonds from the Public. The MS is increased by _______. ER are increased by _______. PMC in the banking system is __________. Potential Total Money Supply is __________. $10 M $20 M $5 M $10 M $100 M $400 M $75 M $300 M $100 M $200 M $400 M $200 M $5 M $4 M $20 M $25 M $50 M $45 M $450 M $500 M

  22. 1. The RR is 20% & Joe Smith deposits $10,000 in the Econ Bank that he has been saving in a coffee can in a tree. The impact of this transaction on the ER of the Econ Bank & the potential increase in the money supplywould be:[Remember: MS = Currency + DD of public] (A) ER would increase by $10,000 & the maximum increase in TMS would be $50,000. (B) ER would increase by $8,000 & the maximum increase in TMS would be $50,000 (C) ER would increase by $8,000 & the maximum increase in MS would be $40,000 (D) ER would increase by $10,000 & the maximum increase in MS would be $40,000. (E) ER would increase by $40,000 & the maximum increase in MS would be $50,000. The MS [Cash or DD of the public] was $10,000 cash. When he deposited the $10,000, the Econ Bank could loan out ER of $8,000. The $8,000 x MM of 5 became $40,000 for TMS of $50,000. So, $10,000 MS of cash increased MS by $40,000 to get the total money supply of $50,000. 1. RR is 20% & Econ Bank borrows $10,000from theFed. The impact of this loan on the bank’s ER and then TMS are: [Remember again: MS = Currency + DD of public] (A) ER would increase by $10,000 & the maximum increase in TMS would be $50,000. (B) ER would increase by $8,000 & the maximum increase in TMS would be $50,000 (C) ER would increase by $8,000 & the maximum increase in MS would be $40,000 (D) ER would increase by $10,000 & the maximum increase in MS would be $40,000. (E) ER would increase by $40,000 & the maximum increase in MS would be $50,000. All of the $10,000 loan would be ER. Econ Bank could loan it all out so it could result in a PMC and TMS of $50,000. [MM of 10 x $10,000 = $50,000]

  23. Money Creation Problems from the 2005 Macro MC Exam • (87%) 40. Under a fractional reserve banking system, banks are required to • a. keep part of their demand deposits as reserves • b. expand the money supply when requested by the central bank • c. insure their deposits against losses and bank runs • d. pay a fraction of their interest income in taxes • e. charge the same interest rate on all their loans • (72%) 41. If a commercial bank has no ER and the RR is 10%, what is the value of • new loans this single bank can issue if a new customer deposits $10,000? • a. $100,000 b. $90,333 c. $10,000 d. $9,000 e. $1,000 • AssetsLiabilities • Total Reserves: $15,000 DD: $100,000 • Securities: $70,000 • Loan: $15,000 • (37%) 42. A commercial bank is facing the conditions given above. If the RR is 12% • and the bank does not sell any of its securities, the maximum amount of • additional lending this bank can undertake is • a. $15,000 b. $12,000 c. $3,000 d. $1,800 e. 0 • (53%) 43. Assumethe RR is 20%, but banks voluntarily keep some excess reserves. • A $1 million increase in new reserves will result in • an increase in the MS of $5 million c. decrease in MS of $1 million • an increase in the MS of less than $5 million d. decrease in the MS of $5 million • e. a decrease in the MS of more than $5 million The TR: $15,000, Securities: $70,000, and Loan: $15,000 total up to the $100,000 DD. This bank would have to keep $12,000 of their $100,000 in RR. With TR of $15,000, they have $3,000 in ER to loan. They could increase MS by $5 M, but they are keeping some in ER, so MS will increase by less than $5 million.

  24. 10 7.5 5 2.5 0 10 7.5 5 2.5 0 Rate of interest, i (percent) Nominal Interest Rate Dt Da 0 50 100 150 200 250 300 0 50100150 200 250 Amount of money demanded (billions) Amount of money demanded (billions) THE Total DEMAND FOR MONEY + = Total demand for money, Dm Transactions Demand, Dt Asset Demand, Da Da [M2] – store of value money Money that we don’t need for daily, weekly, or monthly transactions. We will invest more of it the higher the interest rate. We will hold less because the opportunity cost increases. “Walking around” money M1 Dt Independent of the interest rate Da 10% 8% 6% 4% 2% 0 Interest Rate Opportunity Cost Da [hold less] Interest Rate Opportunity Cost Da [hold more] CDs or 5% Da varies inversely with the interest rate. 1% 0 50 100 150 200

  25. 10 7.5 5 2.5 10 7.5 5 2.5 Rate of interest, i (percent) Nominal Interest Rate Dt Da 0 50 100 150 200 250 300 Amount of money demanded [billions] Amount of money demanded [billions] The Demand for Money + = Transactions Demand, Dt Asset Demand,Da Total demand for money, Dm MS2 MS1 MS 10 7.5 5 2.5 0 E Rate of interest, i (percent) 5 Dm 0 50 100 150 200 250 300 0 50 100 150 200 250 300 Money market 1. At equilibrium 5% I.R., the amount of money demanded for transactions is (0/50/100) and the amount demanded as an asset is (0/50/100). 2. If the interest rate were 10%, the amount of money demanded for Dt would be (0/50/100) & the amount demanded as an asset would be (0/50/100). 3. Da slopes down because lower in. rates (incr/decr)the cost of holding money.

  26. [at “E”, money supplied ($200) = money demanded ($200)] The Money Market The Dm curve represents the quantity of money people are willing to hold at various interest rates. 7.5 5 2.5 0 MS Dm E Nominal Interest Rate 50 100 150 200 250 300 Money Market Due to a recession, suppose the money supply is increasedfrom $200 billion to $250 billion.

  27. [at “E”, money supplied ($200) = money demanded ($200)] The Money Market A temporary surplus of $50 billionbeyond which the people wish to hold, MS2 MS1 S1 S2 10 7.5 5 2.5 Dm P2 Price of Bonds P1 They react by buying bonds [pushing bond prices up] to meet the desired level of liquidity. Nominal Interest Rate E # of Bonds E 0 50 100 150 200250 300 Money Market

  28. Liquidity Trap MS1 MS2 1% LRAS SRAS Dm AD AD Nominal Interest Rate PL YD GDP E 0 500 Money Market Liquidity Trap – in a stagnant economy with interest rates near or at zero, an increase in MS fails to stimulate AD, so recession or depression gets worse. With low returns expected on financial investments, people hoard their money. Banks are unwilling to lend in a slack economy.Fiscal policy is needed here.

  29. [at “E”, money supplied ($200) = money demanded ($200)] The Money Market Due to inflation, suppose the money supply is decreased from $200 billionto $150 billion. 7.5 5 2.5 MS Dm E Nominal Interest Rate 0 50 100 150 200 250 300 Money Market

  30. The Money Market A temporary shortage of money will require the sale of some assets [bonds-which will make their price fall] to meet the money shortage need. MS2 MS1 Dm S2 S1 10 7.5 5 P1 Nominal Interest Rate Price of Bonds P2 E # of T-bills 0 50 100 150 200 250 300 Money Market

  31. Macro Free Response 2007 1. [3 pts] Assume that declining stock market prices in the U.S. cause many U.S. financial investors to sell their stocks and increase their money holdings. (a) Draw a correctly labeled graph of the money market and show the impact of the financial investors’ actions on each of the following. (i) Demand for money (ii) Nominal interest rate MS DM2 DM1 • Answers for 1. (a) (i) [2 points] • (a) (i) In an effort to preserve wealth, • investors sell off stocks when market • prices begin to decline. These new • money holdings will increase the • asset [speculative] demand for money. • In the volatile market, investors will • hold more money while determining • future needs. [2 pts: 1 pt for correct • graph and 1 pt for Dm shifting right.] r2 Nominal Interest Rate r1 Quantity of Money M Tutorial: These will shift the real Dm curve. 1. Changes in real aggregate spending, 2. Advances in banking technology. [ATMs available 24/7 decrease the need for cash (Dm)] 3. Changes in institutions [ability to get interest on checking accounts lead to an increase in Dm], 4. Riskiness of alternative stores of value [stocks]. Dm increases when stocks are not appealing. • Answers for 1. (a) (ii) [1 point for saying the interest rate increases] • (a) (ii) The nominal interest rate would increase because the demand • for money increases as the DM curve shifts up, as shown above.

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