11 money creation

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Chapter 25 Money Creation

• Key Concepts• Summary• Practice Quiz• Internet Exercises

©2000 South-Western College Publishing

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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?

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In the Middle Ages, what was used for Money?

Gold was the money of choice in most European nations

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Who were the Founders of our

Modern-day Banking?Goldsmiths, people

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

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What was the first Currency?

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

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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

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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

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What areRequired Reserves?

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

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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

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What areExcess Reserves?

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

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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.

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What areTotal Reserves?

Total Reserves = required reserves + excess reserves

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Required Reserve Ratio of the Fed

Type of Deposit Required Reserve Ratio

Checkable deposits

3%0 - $46.5 million

Over $46.5 million 10%

Source: Federal Reserve Bulletin, April 1999, Table 1.15, p. A8

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Best National Bank - Balance Sheet 2

Assets LiabilitiesRequiredReserves

$10,000 Brad Rich Account

$100,000

ExcessReserves +$90,000

Total $100,000 $100,000


Total

in M1

0

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$100,000

ExcessReserves

$81,000

Loans +$90,000


Total

in M1

$90,000Connie Jones Account +$90,000

Total $190,000 $190,000

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$100,000

ExcessReserves

0

Loans $90,000


in M1

0

Connie Jones Account

0

Total $100,000 $100,000

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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


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Expansion of the Money Supply

# Bank

1 Best Nat’l Bank $100,0002

Bank A3

Total increase

Increase in Required Reserves

90,000

Total all other banks

59,049

Increase inDeposits

Increase in Excess

Reserves

456

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Yazoo Nat’l Bank

Bank BBank C

Bank DBank E

81,000

65,610

53,144

72,900

$10,0009,000

5,905

8,100

6,561

5,314

7,290

$90,00081,000

53,144

72,900

59,049

47,830

65,610

478,297 47,830 430,467

$1,000,000 $100,000 $900,000

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What is theMoney Multiplier?

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

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What is the Money Multiplier equal to?

1 / required reserve ratio

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M1 = ER x m

Actual money supply change

Initial change in excess reserves

Money multiplier

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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

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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

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What is Monetary Policy?The Fed’s use of - • open market operations in discount rate in required reserve

ratio

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What are Open Market Operations?

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

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Federal Reserve System - Balance Sheet 6

Assets Liabilities

Government securities $472 Fed notes $492

Loans to banks1

Total $548 Total $548

Source: Federal Reserve Bulletin, April 1999, Table 1.18, p. A10

Other assets 75

Deposits 34

Other liabilities and net worth 22

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Federal Reserve Bank - Balance Sheet 7

Assets Liabilities

Government securities

+$100,000 Reserves of Best Nat’l

bank

+$100,000

Note: The Fed conducted open market operations in order to increase the money supply by purchasing $100,000 in government securities.

Initial in M1

+$100,000

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Federal Reserve Bank - Balance Sheet 8

Assets Liabilities

Government securities

-$100,000 Reserves of Best Nat’l

bank

-$100,000

Note: The Fed conducted open market operations in order to decrease the money supply by selling $100,000 in government securities.

Initial in M1

-$100,000

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FedFed buys governmentsecurities and banks

gain reservesFed sells governmentsecurities and banks

loose reserves

Banks

Public

$

$$

$

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What is theDiscount Rate?

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

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What would the Fed do if we have Inflation?

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

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What would the Fed do if we have Unemployment?

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

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What is the Federal Funds Market?

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

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What is the Federal Funds Rate?

The interest rate banks charge for overnight loans to other banks

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

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What would the Fed do if we had Unemployment?

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

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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

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What is the Required Reserve Ratio?

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

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If the Reserve Ratio is one tenth, what is

the multiplier?

1 1/10 = 10

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If the Reserve Ratio is one twentieth, what is

the multiplier?

1 1/20 = 20

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Increase the reserve ratio

What would the Fed do if we had Unemployment?Decrease the reserve ratio

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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

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What are the Shortcomings of

Monetary Policy?• Money multiplier inaccuracy• Nonbanks• Which money definition

should the Fed control?• Lag effects

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Key Concepts

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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?

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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?

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Summary

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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.

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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.

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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.

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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.

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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.

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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.

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FedFed buys governmentsecurities and banks

gain reservesFed sells governmentsecurities and banks

loose reserves

Banks

Public

$

$$

$

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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.

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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.

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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.

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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 isa. $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

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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

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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

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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.

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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.

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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 toa. 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.

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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.

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Exhibit 5

Balance Sheet of Best National BankAssets Liabilities

Required Reserves$ Checkable

deposits$100,000

Excess Reserves

Total $100,000 Total $100,000

Loans 80,000

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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%

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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

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

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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

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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.

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11 money creation

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