Chapter 19 Money Creation

1. Chapter 19Money Creation Survey of EconomicsIrvin B. Tucker Lecture Slides

2. What will I learn in this chapter? • You will discover that the Federal Reserve and banks work together to influence the supply of money

3. In the Middle Ages, what was used for money? • Gold was the money of choice in most European nations

4. Who were the founders of our modern-day banking? • Goldsmiths, people who would keep other people’s gold safe for a service charge

5. What was the first currency? • People would use the receipts they received from goldsmiths as paper money

6. How did the early goldsmiths act as the first banks? • Some goldsmiths made loans and received interest

7. Where do banks get their money to lend? • From depositors

8. What is fractional reserve banking? • A system in which banks keep only a small percentage of their deposits on reserve at the Fed

9. What arerequired reserves? • The minimum balance that the Fed requires a bank to hold in vault cash or on deposit with the Fed

10. What is a required reserve ratio? • The percentage of deposits that the Fed requires a bank to hold in vault cash or on deposit with the Fed

11. Exhibit 19.1 Required Reserve Ratio of the Fed Required Reserve Ratio Type of Deposit Checkable deposits 3% $10.3 - $44.4 million 10 Over $44.4 million

12. 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.

13. What areexcess reserves? • Potential loan balances held in vault cash or on deposit with the Fed in excess of required reserves

14. What money do banks use to make loans? • Banks loan money taken from their excess reserves

15. What aretotal reserves? Total reserves = required reserves + excess reserves

16. What are three steps in the multiplication of money? • accepting a new deposit • making a loan • clearing the loan check

17. Best National Bank – Balance Sheet 2 Step 1: Bank Accepts Deposit  in M1 Liabilities Assets Brad Rich Account $100,000 $10,000 0 RequiredReserves ExcessReserves +90,000 $100,000 $100,000 Total Total Note: The Fed requires the bank to keep 10% of its checkable deposits in reserve.

18. Best National Bank – Balance Sheet 3 Step 2: Bank Makes Loan Assets Liabilities  in M1 RequiredReserves $19,000 $100,000 Brad Rich Account ExcessReserves Connie Jones Account +90,000 81,000 $90,000 +90,000 Loans $190,000 $190,000 Total Total Note: The Fed requires the bank to keep 10% of its checkable deposits in reserve.

19. Best National Bank – Balance Sheet 4 Step 3: Loan Check Clears Assets Liabilities  in M1 $100,000 0 RequiredReserves Brad Rich Account $10,000 0 ExcessReserves Connie Jones Account 0 90,000 Loans $100,000 Total $100,000 Total Note: The Fed requires the bank to keep 10% of its checkable deposits in reserve.

20. Yazoo National Bank – Balance Sheet 5 Multiplier Expansion of Money Supply Liabilities Assets Better Health Spa Account +$90,000 RequiredReserves +$9,000 ExcessReserves +81,000 Total $90,000 Total $90,000 Note: The Fed requires the bank to keep 10% of its checkable deposits in reserve.

21. When will the money supply increase? • The money supply increases when banks lend money to borrowers

22. What is the money multiplier (MM)? • The maximum change in the money supply (checkable deposits) due to an initial change in the excess reserves banks hold. The money multiplier is equal to 1 divided by the required reserve ratio

23. How does the money multiplier work? • Loans are deposited as checkable deposits in banks, which creates excess reserves and new loans and checkable deposits throughout the banking system

24. What is the money multiplier equal to? MM = 1 / required reserve ratio

25. If the reserve ratio is one tenth, what is the multiplier? 1  1/10 = 10

26. If the reserve ratio is one twentieth, what is the multiplier? 1  1/20 = 20

27. What conclusion can we make? • There is an inverse relationship between the size of the required reserve ratio and the money multiplier

28. Actual money supply change  M1 = ER x MM Initial change in excess reserves Money multiplier

29. Exhibit 19.2 Expansion of the Money Supply Increase in Required Reserves Increase in Excess Reserves Round Bank Increase inDeposits $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 Bank A 81,000 3 7,290 65,610 Bank B 72,900 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 $100,000 $900,000

30. Using the data from Exhibit 19.2, compute the change in the money supply  M1 = ER x MM $900,000 = $90,000 x 10

31. What can cause money multiplier to be smaller than computed ? • Cash leakages occur when all of a loan is not deposited in another bank and for example put in a home safe • When a financial crisis causes banks not to use all their excess reserves for loans

32. What is monetary policy? • The Fed’s use of policy tools to change the money supply

33. What would the Fed do when we have a recession? • Increase the money supply

34. What would the Fed do when we have inflation? • Decrease the money supply

35. How does the Fed effect a change in the money supply? • It will use its monetary tools to influence banks

36. How does the Fed influence bank lending? • open market operations • change in the discount rate • change in the required reserve ratio

37. What are open market operations? • The buying and selling of government securities

38. What would the Fed do if we have a recession? • Buy U.S. government securities by injecting excess reserves into the banking system when the Fed pays for the securities, the money supply increases

39. What would the Fed do if we have inflation? • Sell U.S. government securities by withdrawing excess reserves from the banking system when the Fed receives payment for the securities, the money supply decreases

40. Federal Reserve System - Balance Sheet 6 MAY 13 , 2009 Liabilities Assets Government securities Fed notes $ 572 $ 866 Deposits 1,208 Loans to banks 560 Other liabilities and net worth 124 Other assets 1,066 Total $2,198 Total $2,198

41. Federal Reserve Bank - Balance Sheet 7 Initial  in M1 Liabilities Assets 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.

42. Federal Reserve Bank - Balance Sheet 8 Initial  in M1 Liabilities Assets Reserves of Best Nat’l bank -$100,000 -$100,000 Government securities -$100,000

43. Exhibit 19.3 Open Market Operations

44. What is thediscount rate? • The interest rate the Fed charges on loans to banks

45. What would the Fed do if the economy experiences inflation? • Increase the discount rate, which discourages banks from borrowing their required reserves from the Fed

46. What would the Fed do during a recession? • Decrease the discount rate, which encourages banks to borrow their required reserves from the Fed

47. What is the federal funds market? • A private market in which banks lend reserves to each other for less than 24 hours • The federal funds rate is a primary barometer of Fed policy reported in the media

48. What is thefederal funds rate? • The interest rate banks charge for overnight loans of reserves to other banks

49. What would the Fed do during a recession? • Decrease the federal funds rate What would the Fed if the economy experiences inflation? • Increase the federal funds rate

50. What is another monetary policy tool? • The required reserve ratio • Recall that the Fed determines how much a financial institution must keep in reserve as a percentage of its total assets