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More Money!!

More Money!!. Money that is available (money supply) affects Output. 1. GDP = C + Ig + G + Xn. 2. Increased spending increases output. 3. Increased money supply increases spending. =. *. *. Q Output. V elocity. M oney. P rice. The Equation of Exchange. Q. P. M. V. Q. M. V.

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More Money!!

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  1. More Money!! Money that is available (money supply) affects Output 1. GDP = C + Ig + G + Xn 2. Increased spending increases output 3. Increased money supply increases spending

  2. = * * QOutput Velocity Money Price The Equation of Exchange Q P M V Q M V P - the actual amount of money in circulation - the number of time each $ is spent in a year (considered to be stable) - the level of prices - the actual output of goods and services

  3. = * * = * • PQ Total Sales (GDP) Q =output Money Velocity Price The Equation of Exchange Q P M V • If V and P are constant, then an increase in M will lead to a proportional increase in Q GDP increases. • but if V and Q are constant(at full employment), then an increase in M will lead to a proportional increase in P =Inflation.

  4. Creating Money • Printing Money • Making Loans • a. Key Ingredients: • Deposits – Household savings • Required Reserves – money held at the bank or at the FRS (around 10%) • Excess Reserves – loan able funds= Deposits – Required Reserves A depository institution can make loans up to the value of its excess reserves

  5. Backing Up Fractional Reserve Banking • The U.S. banking system is a fractional reserve system where banks maintain only a fraction of their assets as reserves to meet the requirements of depositors. • Under a fractional reserve system, an increase in reserves will permit banks to extend additional loans and thereby expand the money supply (by creating additional checking deposits).

  6. Loan Making Main Street Bank Situation: Demand deposits = $50,000 Reserve requirement = 10 % Actual reserves at bank = $10,000 Excess Reserves: Demand deposits = $50,000 Reserve requirement= 10 % Actual reserves = $10,000 - Required reserves = $5,000 = Excess reserves = $5,000

  7. Loan Making Excess Reserves ($5,000) can be loaned By making a loan, the bank has created money. The original deposits are still in Main Street Bank, but now there is an additional $5,000 out floating around.

  8. The Bank of the James which has a reserve ratio of 10 percent on its deposits, has calculated the following numbers as of the end of business today: total deposits = $13,500,000; • reserve account = $3,750,000; and • vault cash = $2,250,000. • Determine the following for this bank: • Actual reserves = __________________ • Required reserves = _________________ • Excess reserves = __________________ 3,750,000 + 2,250,000 = 6,000,000 13,500,000 x .10 = 1,350,000 6,000,000 -1,350,000 = 4,650,000

  9. How much in new loans can Madison Heights National Bank make if its deposits are $45,000,000, vault cash is $5,500,000, and reserve account balance is $7,750,000? MHNB’s reserve requirement is 8%. New loans = _____________________ 9,650,000 5,500,000 + 7,750,000 = 13,250,000 45,000,000 x .08 = 3,600,000 13,250,000 -3,600,000 = 9,650,000

  10. What is the amount that must be borrowed by the Smith Mountain Lake Marine Bank to cover its anticipated reserve shortfall if it has a reserve requirement of 12 percent, deposits of $27,500,000, vault cash of $2,500,000, a reserve account of $3,250,000, and it has just made a new loan of $2,500,000 that has not yet cleared? New borrowing = ___________________ -50,000 2,500,000 + 3,250,000 = 5,750,000 27,500,000 x .12 = 3,300,000 5,750,000 -3,300,000 = 2,450,000

  11. Creating Money If the Excess Reserves are loaned The borrowed money is spent and deposited at another bank. The second bank’s reserves are now up $5,000 - it must keep 10% or $500 - it can then loan out $4,500 ($5,000 – $500) This process can be repeated at each step. 10% of the money is lost at each step The more that is required to be held in reserve, the less money can be created The lower the reserve requirement, the greater the amount of money that can be created

  12. Creating Money from New Reserves New cash deposits:Actual Reserves Potential demand deposits created byextending new loans NewRequired Reserves Bank Initial deposit (bank A) $1,000.00 $200.00 $800.00 Second stage (bank B) 800.00 160.00 640.00 Third stage (bank C) 640.00 128.00 512.00 Fourth stage (bank D) 512.00 102.40 409.60 Fifth stage (bank E) 409.60 81.92 327.68 Sixth stage (bank F) 327.68 65.54 262.14 Seventh stage (bank G) 262.14 52.43 209.71 All others (other banks) 1,048.58 209.71 838.87 Total $5,000.00 $1,000.00 $4,000.00 • When banks are required to maintain 20% reserves against demand deposits, the creation of $1,000 of new reserves will potentially increase the supply of money by $5,000.

  13. The Money Multiplier From the table a deposit of $1000, with a 20% reserve requirement led to a $4000 expansion of the money supply Is there a pattern here? Yes!!! It just takes 3 easy steps

  14. The Steps 1. Find the reciprocal of the required reserve 1/20% = 1/1/5= 5 2. Multiply the initial change by the multiplier $1000 * 5 = $5000 3. Subtract out the the initial change $5000 - 1000 = $4000

  15. Problem 1 • Deposit of $10,000 • ________ • ________ • ________ • Required reserve 10% • Increase in the money supply? • ________ • ________ • ________ How about if the reserve requirement was 20%?

  16. Problem 2 • Deposit of $16,000 • ________ • ________ • ________ • Required reserve 25% • Increase in the money supply? • ________ • ________ • ________ How about if the reserve requirement was 20%? • ________ • ________ • ________ How about if the reserve requirement was 10%?

  17. The Effect of Loaning Money 1. Loan making changes the money supply 2. Increases in loans leads to increased spending which increases the money supply. 3. BUT, decreases in loan making, or even paying back a loan decreases the money supply.

  18. Getting a Loan 1. More or less voluntary transaction 2. The interest rate is important • Supply in the money for loans • a. Households decide to save or spend • b. Banks decide how to use the savings • Demand for the loans • a. Households how much to borrow • b. Businesses compare interest rate to expected profit

  19. InterestRate Determining the Interest Rate S .05 D Quantityof loans Q • Households and Banks supply the money based on interest rates • There is a direct relationship between interest rate and amount of $ • Household and business demand for money is based on the interest • There is an inverse relationship between interest and amount of $

  20. i = .03 D (bad expections) InterestRate Determining the Interest Rate S .05 r = D Quantityof loans Q Q • Expectation of poor economic conditions could shift the curve left • This would decrease the equilibrium interest rate

  21. S (reserves decreased) i = .07 InterestRate Determining the Interest Rate S .05 r = D Quantityof loans Q Q • A decrease in excess reserves decreases money for loans • This would shift the supply curve to the left and increase interest

  22. Excess Reserves the Level of Economic Activity and the Interest Rate Loan Making Decreases Interest rate for Borrowing Increases Ability to Lend Increasing Excess Reserves Increases Level of Spending Increases Output and Employment (or Prices) Increases Borrowing

  23. and Increases Interest rate for Borrowing Decreases Ability to Lend Decreasing Excess Reserves Decreases Level of Spending Decreases Output and Employment (or Prices) Decreases Borrowing

  24. The Federal Reserve and Monetary policy 1. Monetary Policy Tools: a. The Reserve Requirement -reducing it encourages loans and increases the money supply -increasing it discourages loans and decreases the money supply

  25. b. The Discount Rate 3 rates 1. Discount Rate 2. Federal Funds Rate 3. Prime Rate federal reserve to member banks bank to bank banks to best customers

  26. b. The Discount Rate Raising Discount Rate discourages bank borrowing decreases money supply Lowering Discount Rate encourages bank borrowing increases money supply Current Favorite

  27. The Federal Reserve and Monetary policy c. Open Market Operations Buying and Selling Securities (Bonds) -selling bonds puts bonds out and take money out of circulation What effect will this have on the economy?? -buying bonds puts money back in circulation and takes bonds in What effect will this have on the economy??

  28. Easy Money Policy a. The Reserve Requirement Increase or decrease? b. The Discount Rate Raise or Lower? c. Open Market Operations Buy or Sell?

  29. Tight Money Policy a. The Reserve Requirement Increase or decrease? b. The Discount Rate Raise or Lower? c. Open Market Operations Buy or Sell?

  30. Deficits and Borrowing a. The Government competes for money b. They offer a higher interest rate c. Businesses and Household can afford fewer loans Less investment Crowding Out

  31. Monetary Policy + quick implementation + flexible changes in rates + less political - reserve ratios and interest rates might not be enough incentive - high rates may lead to higher prices - FRS might now be too independent

  32. P 256 #7 What would be the effect of each of the following on Uptown Bank’s excess reserves and loan-making ability if the bank had $600 million in deposits, a 5% reserve requirement, and actual reserves of $40 million? a. The Federal Reserve sells $5 million in government securities to Uptown Bank. b. The reserve requirement increases from 5% to 6%. c. The discount rate is increased. d. The reserve requirement is lowered from 5% to 4%, and the Federal Reserve buys $10 million in government securities. • Increase loan-making ability • Decrease loan-making ability • Have no effect

  33. 1. In the equation of exchange, an increase in M always causes an increase in Q, and a decrease in M always causes a decrease in P. 2. If a bank has $100 million in actual reserves and $80 million in required reserves, it may make new loans of up to $20 million. 3. The size of the money multiplier is inversely related to the size of the reserve requirement. 4. With a reserve requirement of 25 percent, an injection of $100 million of new excess reserves into the economy could cause the money supply to expand by $400 million. F T T T

  34. 5. An increase in excess reserves in the economy would encourage spending. 6. Lowering the reserve requirement is a tight money policy. 7. Buying securities by the Fed would decrease excess reserves held by financial depository institutions. 8. Crowding out occurs when government borrowing forces up the interest rate and discourages households and businesses from borrowing. T F F T

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