Fractional Reserve Banking and the Monetary Policy

1. Fractional Reserve Banking and the Monetary Policy J.A.SACCO

2. Fractional Reserve Banking • Depository institutions are required by the Fed to maintain a specific percentage (reserve requirement) of their customers deposits as reserves Three types of reserves!

3. Fractional Reserve Banking • Legal (Total) Reserves- reserves that depository institutions are allowed by law to claims as reserves (deposits held at Federal Reserve District Bank and/or commercial bank vault cash. • Required Reserves- the value of reserves that a depository institution must hold in vault cash or with the Federal District Bank. These reserves are required to back its checkable deposits.

4. Fractional Reserve Banking • Excess Reserves- the difference between legal reserves and required reserves. These reserves can be used as new loans and/or purchase government securities. Excess Reserves = Legal Reserves- Required Reserves

5. Fractional Reserve Banking • Example: Total (Legal) Reserves is $20 B. and the Reserve Requirement is 10%. • What is the required reserves? Excess reserves? RR is $2B in deposits to be held in Fed District Bank or vault cash. ER is $18 B. in new loans or to buy gov’t securities. Why is the reserve requirement and excess reserves important?

6. Reserves and Total Deposits • SACCO KEY POINT- New reserves are not created when checks written on one bank are deposited in another bank. The bank writing the check will lose reserves, and the bank receiving the check will gain reserves. • Only when the Fed buys/sells securities from banks or the public, or when you put available cash in the bank are reserves increased/decreased and in turn the money supply.

7. Money Expansion bythe Banking System • How much will the money supply increase after you deposit $100,000 cash into a commercial bank.

8. 2 90,000 9,000 81,000 3 81,000 8,100 72,900 4 72,900 7,290 65,610 . . . . . . . . . . . . All other banks 656,100 65,610 590,490 Totals $1,000,000 $100,000 $900,000 How Money is Created? “Multiple Expansion of Checkable Deposits” Assume a 10% Reserve Requirement Maximum New Loans New Deposits New Required plus Investments Bank (new reserves) Reserves (excess reserves) 1 $100,000 $10,000 $90,000 New money/Inc. in money supply

9. Actual change in the money supply Actual money multiplier Initial change in excess reserves = x The Money Multiplier • Money Multiplier • Gives the maximum potential change in the money supply due to a change in reserves

10. Forces that Reduce the Money Multiplier • Leakages • Currency Drains- People hold money in wallet. Don’t put money in bank to allow deposit expansion. • Excess Reserves- Banks keep more as excess reserves.

11. How the Fed Controls the Money Supply Fed ToolsMacro. Effects Reserve Requirement IncreaseContractionary Money Supply Interest rate Investment Decrease Expansionary Money Supply Interest rate Investment

12. How the Fed Controls the Money Supply Fed ToolsMacro. Effects Discount/Federal Fund Rate IncreaseContractionary Money Supply Interest rate Investment Decrease Expansionary Money Supply Interest rate Investment

13. How the Fed Controls the Money Supply Fed ToolsMacro. Effects Open Market Operations Sell SecuritiesContractionary Money Supply “Sell Bonds, Small Bucks” Interest rate Investment Buy Securities “Buy Bonds, Big Bucks” Expansionary Money Supply Interest rate Investment Most used by the Fedto expand the money supply. Why?

14. The Fed and the Money Supply • What has a greater affect on the expansion of the money supply: • $100 deposit of an individual into a commercial bank? • A Fed purchase of a government bond/security from a commercial bank for a $100? Assume a 20% Reserve Requirement

15. The Fed and the Money Supply • Money Multiplier? • Individual- RR= $20, ER= $80--- Expansion of Money Supply is $400. • Fed- RR= $0, ER=$100--- Expansion of Money Supply is $500. Why the difference?

16. The Equation of Exchange • Mathematical expression of the “quantity theory of money” devised by Irving Fisher Aggregate amount spent by buyers Total value of all goods and services = MV=PQ • Equation to explain how exchange and the role • of “M” and “V” in determining the level of output (P &Q)

17. The Equation of Exchange • M = Stock of Money- M1 money supply. Currency, travelers checks, checkable deposits. • V = Velocity of Money-Income (GDP) velocity of circulation. The average number of times a dollar is spent on final goods and services per time (usually a year).

18. The Equation of Exchange • P = The average price of the final goods and services in GDP. The GDP Deflator. • Q = Real Output. The quantity of goods and services in GDP. Real GDP in dollars of the base year of the deflator.

19. The Equation of Exchange • Example- • M= $300 B and V= 5, therefore if Q = $750B then P = ? $2 per unit Why is this equation important to the money supply? • Provides insight into what would happen to • output(Q) and prices (P) when money supply changes.

20. The Equation of Exchange • Assume Velocity of Money (V) is constant. • If the Supply of Money (M) increases, then either Price (P) or Output (Q) or both must increase. The effect of the change in M on P and Q will depend on the state of the economy.

21. Crude Quantity Theory of Money and Prices • If the economy is operating well below full employment (recession), an increase in M will tend to raise Q (ouput) more than P (price) as unemployed resources are re-employed. • If the economy is already at full employment or above, any increase in M will tend to raise P more than Q. The increase in M will be purely inflationary. • Thus depending on the state of the economy will have a major impact on whether or not to increase the money supply.

22. Crude Quantity Theory of Money and Prices • So if GDP (Q) can increase 3-5% a year. • Then if Q does increase by 3-5% a year, any increase in M above 5% merely increases the price level (demand pull inflation ) • Increases of less than 3% in M means Q cannot increase by 3% so the price level will fall, recession. • The key is to grow the money supply with the growth of output (real GDP) in order to maintain economic stability.

23. Graphing Monetary Policy • Three types of “Money Demand” • Transaction Demand- hold money as a medium of exchange. National income increase, the demand for money increases • Precautionary Demand- unplanned emergencies • Asset Demand- Money as a store of value instead of other assets.

24. Graphing Monetary Policy • Demand for Money Curve • IR inc. , DM dec. • IR dec., DM inc. • Money Supply Curve • Always vertical, stock concept Key Point- Interest rate in the money market is determined by the price of bonds in the bond market

25. Expansionary Monetary Policy • Fed. Buys Bonds • Price of Bonds? • Money Supply? • Interest Rate? • Investment/Consumpt.? • GDP? • Inflation? • Unemployment? • Draw a loanable funds market graph?

27. Fed Sells Bonds • Price of Bonds? • Money Supply? • Interest rate? • Invest/Consumpt? • GDP? • Inflation? • Unemployment? • Draw graph of the loanable funds market