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

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chapter 25 money creation
Chapter 25Money Creation
  • Key Concepts
  • Summary
  • Practice Quiz
  • Internet Exercises

©2000 South-Western College Publishing

in this chapter you will learn to solve these economic puzzles
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?

in the middle ages what was used for money
In the Middle Ages, what was used for Money?

Gold was the money of choice in most European nations

who were the founders of our modern day banking
Who were the Founders of our Modern-day Banking?

Goldsmiths, people who would keep other people’s gold safe for a service charge

what was the first currency
What was the first Currency?

People would use the receipts they received from goldsmiths as paper money

how did the early goldsmiths act as the first banks
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

what is fractional reserve banking
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

what are required reserves
What areRequired Reserves?

The minimum balance that the Fed requires a bank to hold in vault cash or on deposit with the Fed

what is a required reserve ratio
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

what are excess reserves
What areExcess Reserves?

Potential loan balances held in vault cash or on deposit with the Fed in excess of required reserves

slide11

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.

what are total reserves
What areTotal Reserves?

Total Reserves = required reserves + excess reserves

slide13

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

slide14

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.

slide15

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.

slide16

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.

slide17

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.

slide18

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

what is the money multiplier
What is theMoney Multiplier?

The maximum change in the money supply due to an initial change in the excess reserves banks hold

what is the money multiplier equal to
What is the Money Multiplier equal to?

1 / required reserve ratio

slide21

Actual money supply change

 M1 = ER x m

Initial change in excess reserves

Money multiplier

can the multiplier be smaller than indicated
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

what would the fed do if we had inflation
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

what is monetary policy
What is Monetary Policy?

The Fed’s use of -

  • open market operations
  •  in discount rate
  •  in required reserve ratio
what are open market operations
What are Open Market Operations?

The buying and selling of government securities by the Federal Reserve System

slide26

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

slide27

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.

slide28

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.

slide29

Fed

Fed buys governmentsecurities and banks gain reserves

Fed sells governmentsecurities and banks loose reserves

$

$

Banks

$

$

Public

what is the discount rate
What is theDiscount Rate?

The interest rate the Fed charges on loans of reserves to banks

what would the fed do if we have inflation
What would the Fed do if we have Inflation?

A higher discount rate discourages banks from borrowing reserves and making loans

what would the fed do if we have unemployment
What would the Fed do if we have Unemployment?

A lower discount rate encourages banks to borrow reserves and make more loans

what is the federal funds market
What is the Federal Funds Market?

A private market in which banks lend reserves to each other for less than 24 hours

what is the federal funds rate
What is the Federal Funds Rate?

The interest rate banks charge for overnight loans to other banks

what would the fed do if we had inflation35
What would the Fed do if we had Inflation?

A higher federal funds rate discourages banks from borrowing reserves and making loans

what would the fed do if we had unemployment
What would the Fed do if we had Unemployment?

A lower federal funds rate encourages banks to borrow reserves and make more loans

what is a required reserve requirement
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

what is the required reserve ratio
What is the Required Reserve Ratio?

That percentage the Fed stipulates that financial institutions must keep in reserve to meet its reserve requirement

what would the fed do if we had inflation41
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

is changing the reserve ratio a popular monetary tool
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

what are the shortcomings of monetary policy
What are the Shortcomings of Monetary Policy?
  • Money multiplier inaccuracy
  • Nonbanks
  • Which money definition should the Fed control?
  • Lag effects
key concepts45
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?
key concepts cont
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?
slide48

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.

slide49

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.

slide50

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.

slide51

The money multiplier is used to calculate the maximum change (positive or negative) in checkable deposits (money supply) due to a change in excess reserves. As a formula:

$ multiplier = 1/required reserve ratio.

slide52

Monetary policy is action taken by the Fed to change the money supply. The Fed uses three basic tools: (1) open market operations, (2) changes in the discount rate and (3) changes in the required reserve ratio.

slide53

Open-market operations are the buying and selling of government securities by the Fed through its trading desk at the New York Federal Reserve Bank. Buying government securities creates extra bank reserves and loans, thereby expanding the money supply. Selling government securities reduces bank reserves and loans, thereby contracting the money supply.

slide54

Fed

Fed buys governmentsecurities and banks gain reserves

Fed sells governmentsecurities and banks loose reserves

$

$

Banks

$

$

Public

slide55

Changes in the discount rate occur when the Fed changes the rate of interest it charges on loans of reserves to banks. Dropping the discount rate makes it easier for banks to borrow reserves from the Fed and expands the money supply. Raising the discount rate discourages banks from borrowing reserves from the Fed and contracts the money supply.

slide56

Changes in the required reserve ratio and the size of the money multiplier are inversely related. Thus, if the Fed decreases the required reserve ratio the money multiplier and money supply increase. If the Fed increases the required reserve ratio the money multiplier and money supply decrease.

slide57

Monetary policy limitations include the following: (1) The money multiplier can vary. (2) Nonbanks, such as insurance companies, finance companies, and Sears, can offer loans and other financial services not directly under the Fed’s control. (3) The Fed might control M1 while the public can shift funds to M2, M3, or another money supply definition. (4) Time lags occur.

chapter 25 quiz
Chapter 25 Quiz

©2000 South-Western College Publishing

slide59
1. If a bank has total deposits of $100,000 with $10,000 set aside to meet reserve requirements of the Fed, its required reserve ratio is

a. $10,000.

b. 10 percent.

c. 0.1 percent.

d. 1 percent.

B. Required reserve ratio = required deposits  total deposits x 100 = $10,000  $100,000 x 100

slide60
2. Assume a simplified banking system in which all banks are subject to a uniform required reserve ratio of 30 percent and demand deposits are the only form of money. A bank that receives a new deposit of $10,000 is able to extend new loans up to a maximum of

a. $3,000.

b. $7,000.

c. $10,000.

d. $30,000.

B. Excess reserves can be loaned. Excess reserves = total reserves - required reserves = $10,000 - (0.3 x $10,000) = $10,000 - $3,000 = $7,000

slide61
3. The Best National Bank operates with a 10 percent required reserve ratio. One day a depositor withdraws $400 from his or her checking account at the bank. As a result, the bank’s excess reserves

a. fall by $400.

b. fall by $360.

c. fall by $40.

d. rise by $400.

B. Excess reserves = total reserves - required reserves = -$400 - (0.10 x $400) = -$400 + $40 = -$360

slide62
4. If an increase of $100 in excess reserves in a simplified banking system can lead to a total expansion in bank deposits of $400, the required reserve ratio must be

a. 40 percent.

b. 400 percent.

c. 25 percent.

d. 4 percent.

e. 2.5 percent.

C. $ multiplier =  in bank deposits  initial  in excess reserves = 400  $100 = 4 = 1  required reserve ratio = 1  money multiplier x 100.

slide63
5. In a simplified banking system in which all banks are subject to a 25% required reserve ratio, a $1,000 open sale by the Fed would cause the money supply to

a. increase by $1,000.

b. decrease by $1,000.

c. decrease by $4,000.

d. increase by $4,000.

C. Money supply change ( M1) = initial  in excess reserves x money multiplier (MM).

MM = 1  required reserve ratio = 1  25/100 = 4 .

 M1 = $1,000 x 4 = -$4,000.

slide64
6. In a simplified banking system in which all banks are subject to a 20% required reserve ratio, a $1,000 open market purchase by the Fed would cause the money supply to

a. increase by $100.

b. decrease by $200.

c. decrease by $5,000.

d. increase by $5,000.

D. Money supply change ( M1) = initial change in excess reserves x money multiplier (MM)

MM = 1  required reserve ratio = 1  20/100 = 5

 M1 = $1,000 x 5 = $5,000.

slide65
7. The cost to a member bank of borrowing from the Federal Reserve is measured by the

a. reserve requirement.

b. price of securities in the open market.

c. discount rate.

d. yield on government bonds.

C. The Fed provides a discount window at each of the Federal Reserve districts banks to make loans of reserves to banks and change an interest rate called the discount rate.

slide66

Exhibit 5

Balance Sheet of Best National Bank

Assets

Liabilities

$

Checkabledeposits

$100,000

Required Reserves

Excess Reserves

Loans

80,000

Total

$100,000

Total

$100,000

slide67
8. The required reserve ratio in Exhibit 5 is

a. 10%.

b. 15%.

c. 20%.

d. 25%.

C. Excess reserves = total reserves - required reserves = $80,000 = $100,000 - required reserves = $20,000

Required reserve ratio = required deposits  total deposits = $20,000  $100,000 x 100 = 20%

slide68
9. If the bank in Exhibit 5 received $100,000 in new deposits, its new required reserves would be

a. $10,000.

b. $20,000.

c. $30,000.

d. $40,000.

B. Required reserves = required reserve ratio x new deposits = .20 x $100,000 = $20,000

slide69
10. Suppose Brad Jones deposits $1,000 in the bank shown in Exhibit 5. The result would be

a. a $200 increase in excess reserves.

b. a $200 increase in required reserves.

c. a $1,200 increase in required reserves.

d. zero change in required reserves.

B. Required reserves = required reserve ratio x new deposits = .20 x $1,000 = $200

slide70
11. If all banks in the system are identical to Best National Bank in Exhibit 5. A $1,000 open market sale by the Fed would

a. 5.

b. 10.

c. 15.

d. 20.

A. Money multiplier = 1  required reserve ratio = 1  20/100 = 5

slide71
12. Assume all banks in the system are identical to Best National Bank in Exhibit 5. A $1,000 open market sale by the Fed would

a. expand the money supply by $1,000.

b. expand the money supply by $15,000.

c. contract the money supply by $1,000.

d. contract the money supply by $5,000.

D. Money supply change ( M1) = initial change in excess reserves x money multiplier (MM)

MM = 1  required reserve ratio = 1  20/100 = 5

 M1 = $1,000 x 5 = -$5,000.

internet exercises
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