chapter 32 creation of money two definitions of the money supply, january 2005 m1 = $1361 billion...
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CHAPTER 32
Creation of Money
Two Definitions of the Money Supply, January 2005
M1 = $1361 billion
CurrencyOutside banks$710 billion
Othercheckabledeposits$321 billions
Checking depositsIn commercialBanks $330 billion
M2 = $6443 billion
Money marketmutual funds$704 billion
M1$1361 billion
Savingsdeposits
$4378 billion
The Banking System
Bank Regulation Deposit insurance (FDIC)
Moral hazard Problem
The Banking System
Bank Regulation Bank Supervision
Reserve Requirements
The Origins of the Money Supply
How Bankers Keep Books Banks keep balance sheets
Assets = liabilities + net worth
Assets include:
Liabilities include:
The Money Multiplier
Banking system is not just a guard of the money supply
This multiplying effect is the work of the infamous money multiplier.
Each time a bank receives a deposit from a customer, it is required by the reserve requirement ratio set by the Fed (a.k.a. required by law) to keep in its reserves a fraction of the deposit
The rest of the deposit can be lent out to potential borrowers.
Called “fractional reserve system”
Fractional Reserve Banking
The Goldsmiths Principle Stored goldReceipts used as moneyMade loans
CharacteristicsBanks create money
Fractional Reserve System
Balance sheetAssets = Liabilities + Net Worth
Both sides balanceNecessary transactions
Reserve Requirements
9
Assets Liabilities and Net Worth
Lets create a bank… in the town of Vossdonium
Transaction #1Vault cash: cash held by the bankSold stocks to acquire operating funds
Balance Sheet 1: Vossome Bank
Cash Stock Shares
Assets Liabilities and Net Worth
Transaction 2
Acquiring property and equipment
Balance Sheet : Vossome Bank
CashStock Shares
Property
Assets Liabilities and Net Worth
Transaction 3Commercial bank functions
Accepting depositsMaking loans
Balance Sheet 3: Vossome Bank
Cash Checkable DepositsProperty
Stock Shares
Transaction 4
Depositing reserves in a Federal Reserve bank Required reserves Reserve ratio
Reserveratio =
Fed establishes and varies rr within limits set by Congress
rr helps Fed control lending abilities of commercial banks
Assets Liabilities and Net Worth
Transaction 4
Assume the bank deposits all cash on reserve at the Fed
Balance Sheet 4: Vossome Bank
Cash Checkable Deposits
Property Stock Shares
Reserves
Reserve Requirements
Excess reserves
Required reserves
Example:
Assets Liabilities and Net Worth
Transaction 5a
Granting a loan
Balance Sheet 6: Vossome Bank
Checkable Deposits
PropertyStock Shares
Reserves
Loans
Assets Liabilities and Net Worth
Transaction 6aUsing the loan
$50,000 loan cashed
Balance Sheet 6b: Vossome Bank
Checkable Deposits
PropertyStock Shares
Required Reserves
Excess Reserves
Banks can lend money in their vault that is above the minimum required reserve ratio.
Loans
Assets Liabilities and Net Worth
Transaction 6b
Bank buys government securities from dealer Deposits payment into checking
Balance Sheet 7: Vossome Bank
Checkable Deposits
PropertyStock Shares
Reserves
Securities
New money is created
The Banking System
Multiple-deposit expansionAssumptions:
A $100 bill is found and deposited
Multiple deposits can be created
Bank
(1)AcquiredReserves
and Deposits
(2)RequiredReserves
(3)Excess
Reserves(1)-(2)
(4)Amount Bank CanLend; New Money
Created = (3)
Bank A $100 $20 $80 $80Bank B $80 $16 $64 $64
Bank C $64 $12.80 $51.20 $51.20 Bank D $51.20 $10.24 $40.96 $40.96
The process will continue…
The Banking System
The Banking System
21
The Monetary Multiplier
Monetarymultiplier =
1
required reserve ratio
New Reserves$100
$20RequiredReserves
$80Excess
Reserves
$100Initial
Deposit
$400Bank System Lending
Money Created
GraphicExample
=1
R
The Monetary Multiplier
Maximum amount of new money created by single dollar of excess reserves
Higher R, lower mReversibility
Making loans creates moneyLoan repayment destroys money
Another Illustration of Money Creation
Assume 20% legal reserve requirement
Suppose Nina deposits $1,000 in her checking account at Citibank.
T-account of Citibank:
______Assets________________Liabilities____________
Reserves Demand deposits
Loans
Kevin borrows $800 from Citibank, and buys a computer at BestBuy
BestBuy deposits Kevin’s check at Fleet Bank.
Fleet Bank’s T-account:
_____Assets________________Liabilities_____________ Required Reserves Demand Deposits
Loans (Excess)
Vivian borrows $640 from Fleet Bank and buys a new outfit from Macy’s.
Macy’s deposits Vivian’s check at Bank of New York.
T-account of Bank of New York: ______Assets____________________Liabilities_______ Required Reserves Demand deposits
Loans (Excess)
Total Demand Deposits After Lending and Re-lending by banks
Banks Demand Deposits
Citibank $1,000Fleet 800Bank of New York 640 + other banks + additional deposits ___________ = $ 5,000 Total
Banks and Money Creation
The Process in Reverse: Multiple Contractions of the Money Supply
Banks reduce their loan commitments Contraction in the money supply utilizes
the same formula as for money expansion.
The Need for Monetary Policy
Left uncontrolled, banks would:
Changes in the money supply would exacerbate the business cycle
One reason for monetary policy: Prevent this behavior on the part of banks.