Outline

•Organization of the Federal Reserve system

•Routine functions of the FED

•The instruments of monetary policy

•How banks create money

•The process of multiple deposit expansion

•The deposit multiplier

Board of Governors

7 members appointed by the President

Federal Open Market Committee

Board of Governors plus 5 Federal Reserve Presidents

12 Federal Reserve Banks

3,500 member commercial banks

Appoint 3 directors

Elect 6 directors

Consolidated balance sheet of the Federal Reserve system (August 31, 1999)

Assets Liabilities

Gold certificates, coin, special drawing rights

19,593 Federal Reserve Notes

511,545

Loans to Commercial Banks

338 Bank reserves

18,800

Treasury securities

492,773 Treasury Deposits

5,559

(in millions)

Source: Federal Reserve Bulletin

The FED serves as banker to the Treasury

The FED holds foreign official gold reserves at its New York regional bank

The FED provides check clearing-house services to depository institutions

The instruments of monetary policy

Reserve requirementsThe discount rateOpen market operations

Open market operationsare the purchase or sale ofU.S. government securitieson the open market by the

Federal Reserve system

The FED Open Market Committee is the unit in

charge ofopen market operations

Definitions

•Total reserves (TR): The total amount that a commercial bank (or depository institution) has in its reserve account at the Federal Reserve Bank (the “FED”).

•Required reserves (RR): The minimum reserve account balance that a depository institution can maintain and still be in compliance with the statutory reserve requirement.

•Excess reserves (ER): The difference between TR and RR.

Here we demonstratethe principle ofmultiple deposit

creation based on a given excess reserve

Remember that:

TR = RR + ER. Thus

ER = TR - RR

Initial points:

"Banks create money." Banks create money when they credit the checking accounts of loan recipients.By making a loan, a bank is expanding its deposit liabilities--which are money and constitute the bulk of M1.The capacity of banks to make loans and hence to create money depends on their reserve position--that is, do banks have excess reserves available?Federal Reserve open market operations influence the money supply by virtue of the direct and powerful impact these operations have on the reserve position of depository institutions.

Assumptions of the model:

The required reserve ratio (RRR) is 10% or .10Banks begin and end "fully loaned up."All loans are re-deposited in the banking system.Cash free system, therefore: M = DD, where DD is deposit liabilities of the banking system.

We begin by with a hypothetical balance sheet for Ozark National

Ozark National

Assets Liabilities Total reserves $100,000 Required reserves $100,000 Excess reserves 0 Loans 900,000

DD $1,000,000

Total $1,000,000 Total $1,000,000

Step #1: The FED purchases $100,000 in U.S. government securities from Mrs. Green, paying with a government check. Mrs. Green deposits the government check in Ozark

Ozark National RevisedAssets Liabilities

Total reserves $200,000 (+100,000) Required reserves $110,000 (+10,000) Excess reserves 90,000 (+90,000)Loans 900,000

DD $1,100,000 (+100,000)

Total $1,100,000 Total $1,100,000

Ozark National has an excess reserve of $90,000--and no other bank has lost reserves .Therefore, Ozark is positioned to make $90,000 in new loans.

Step #2: Ozark National makes a $90,000 loan to "Travel are We," who plans to use the loan proceeds to purchase new computers for its travel agents.

Ozark National Revised: Before the proceeds of theloan are "checked away," its balance sheet will look like

this:

Assets LiabilitiesTotal reserves$200,000

Required reserves $119,000 (+9,000) Excess reserves 81,000 (-9,000)Loans 990,000(+90,000)

DD $1,190,000 (+90,000)

Total $1,190,000 Total $1,190,000

"Travel are We" writes a $90,000 check to Gateway computers. Gateway deposits the check to its account at Dakota Bank. We assume that the initial statement of Dakota is identical to the initial statement of Ozark National.

Dakota Bank

Assets LiabilitiesTotal reserves $190,000 (+90,000) Required reserves $109,000 (+9,000) Excess reserves 81,000 (+81,000)Loans 900,000

DD $1,090,000 (+90,000)

Total $1,090,000 Total $1,090,000

Ozark's Balance sheet is now adjusted for thistransaction.

Assets LiabilitiesTotal reserves $110,000 (-90,000) Required reserves $110,000 (-9,000) Excess reserves 0 (-81,000)Loans 990,000

DD $1,100,000 (-90,000)

Total $1,100,000 Total $1,100,000

Step 3: Dakota now has an $81,000 excess reserve. It makes an $81,000 loan to Sodbusters, Inc. The loan will be used to purchase agricultural machinery.

Dakota: RevisedAssets Liabilities

Total reserves $190,000

Required reserves $117,000 (+8,100) Excess reserves 72,900 (-8,100)Loans 981,000

DD $1,171,000 (+81,000)

Total $1,171,000 Total $1,171,000

Step #4 : Sodbusters makes out a check to Case Equipment Company for $81,000. Case deposits the check in their account at Ozark National.

Dakota Revised

Assets LiabilitiesTotal reserves $109,000 (-81,000) Required reserves $109,000 (-8,100) Excess reserves 0 (-72,900)Loans 981,000

DD $1,090,000 (-81,000)

Total $1,090,000 Total $1,090,000

Ozark National Revised

Assets LiabilitiesTotal reserves $191,000 (+81,000) Required reserves $118,100 (+8,100) Excess reserves 72,900 (+72,900)Loans 990,000

DD $1,181,000 (+81,000)

Total $1,181,000 Total $1,181,000

Thus the latest transaction has created a $72,900 excess reserve for Ozark National. This is the basis for further loan expansion.

We stop the story here. But, if Ozark made the loan, an additional

$72,900 in DDs would have been created. When the proceeds of the loan were

checked away, another $65, 610 in excess reserves would have been created. And so on.

Thus potential loan expansion and money creation as a result of the initial change in excess reserves (ER) is given by:DD= M = 90,000 + 81,000 + 72,900 + . . .

Factoring out $90,000, this becomes

DD = $90,000 + [1 + 0.9 + 0.92 + 0.93 + . . . ]

Notice that .9 is the fraction of reserves that each bank loans out, which is equal to 1 – RRR = 1- 0.1 = .9. To find the change in deposits that results from any change in reserves and any required reserve ratio (RRR):

DD = Reserves [1 + (1 – RRR) + (1 – RRR)2 + (1 – RRR)3 + . . .]

Recall that the infinite sum

H = 1 + H + H2 + H3 + . . .

Always has the value 1/(1 – H), so long as H assumes a value between zero and 1. Hence the value of the deposit multiplier is given by:

RRRRRR

1

)1(1

1

Using this formula, we can restate what happens when the FED injects reserves into the banking system

servesRRR

MDD Re1

Note that ER = $90,000 and rr = .10. Thus the deposit multiplier is 10.The multiplier declines if some loan proceeds are not re-deposited in the banking system.The same holds true if banks do not make loans equal to their holding of excess reserves.