Banks, the Fed and Money Creation

1. Banks, the Fed and Money Creation

2. Money Creation • Money creation (putting new money into circulation) occurs two ways: • When the Federal Reserve buys bonds from the public or a financial institution (open market operations) 2. When banks make loans to the public.

3. Money Creation • The money supply is increased when banks make loans. • The more loans banks make the more money there is in circulation. • A bankcan loan any amount that is in excess of its required reserves. • The banking system can create loans in multiples of an original loan

4. Money Creation • Reserves or total reserves are the amount of deposits that a bank has accepted but not loaned out. • Required reserves are the amount a bank must keep on hand by law. The required reserve ratio determines this amount. • Excess reserves are whatever the bank has over and above the required reserves. It is the amount that a bank can loan out or use to purchase government securities (bonds).

5. Money Creation Total expansion of the money supply= loans X money multiplier Money multiplier = 1/reserve ratio Total money supply = money in circulation + money in demand deposit accounts

6. Bank balance sheets or T-Accounts • Illustrates the relationship between assets and liabilities held by a bank. • They can be used to explain the money creating potential of banks through the fractional reserve system. • Assets – the property, possessions and claims on others held by the bank (reserves, loans, securities) • Liabilities – the debts and obligations of the bank to others (demand deposits, loans from the Fed)

7. Bank balance sheets or T-Accounts Assets Liabilities reserves $100,000 DDA $100,000

8. (reserve ratio 10%) Assets Liabilities RR $10,000 DDA 100,000 ER $90,000 BANK 1 Assets Liabilities RR $10,000 DDA 100,000 ER loans $90,000

9. Assets Liabilities RR $9,000 DDA $90,000 ER $81,000 Total money supply = $100,000+90,000 BANK 2 Assets Liabilities RR $9,000 DDA 90,000 ER Loans $81,000 Total Expansion of the money supply = $90,000 x 10 (1/.10) = $900,000

10. Federal Reserve Tools • The Federal Reserve controls the amount of excess reserves and money creation through use of its three tools. • Reserve Requirements • Discount Rate • Open Market Operations

11. Federal Reserve Tools • Required Reserve Ratio – the percentage of demand deposits a bank must keep on hand for customers’ withdrawals. • It determines how much of a bank’s deposits are available for loans and the size of the money multiplier. • The money multiplier determines the amount of new money that will be created by the banking system (1/RR) • If a bank’s reserves fall unexpectedly within a day, it can borrow from another bank on an overnight basis in the federal funds market and pay an interest rate called the federal funds rate

12. Federal Reserve Tools • Discount Rate – the interest rate the Federal Reserve will charge a bank for a loan. • If the Fed lowers the discount rate banks would be encouraged to borrow from the Fed (the bank could loan that money out to the public at a higher rate and make money doing so). • Least effective tool because banks primarily borrow from each other.

13. Federal Reserve Tools • Open Market Operations – the Fed purchases or sells securities (government bonds) to banks and the public, which changes the amount of money available from the public and banks for loans. • The Fed would purchase securities to pump in money to increase economic growth. • The Fed would sell securities to soak up money from the economy (anti-inflationary). Banks or the public now have a bond instead of cash and spending is slowed down. • Most used tool.

14. Macroeconomic Effects of Monetary Policy • A change in the supply of money changes the interest rate. • Interest rates are the cost of borrowing money. • A high supply of money lowers the interest rate and gives businesses more opportunities for investment spending (buying capital goods).

15. Macroeconomic Effects of Monetary Policy • The Fed will follow an easy money policy (an increase in the money supply) when the economy is in a recession. • The Fed will follow a tight money policy (a decrease in the money supply) when the economy is experiencing inflation. • The goal of stabilization policy is to smooth out fluctuations in the business cycles.

16. Problems of Timing • If expansionary policies take effect while the economy is already expanding, the result could be higher inflation. • Inside lags refer to the delay in implementing monetary policy. • It is difficult to accurately identify and recognize economic problems. • It takes additional time to enact the appropriate policy. (This is more of a fiscal policy problem, since the FOMC can act much more quickly)

17. Problems of Timing • Outside lags refer to the time it takes for monetary policy to have an effect. • The outside lag is short for fiscal policy but lengthy for monetary policy. • Monetary policy primarily affects business investment plans which are made far in advance. • Monetary policy is still preferred because of the inside lag caused by the President and Congress having to agree on budgetary matters.