+ Fractional Reserve Banking: Implications on Money Supply C-1: State the purpose of fractional banking

+ What role do these play in creating money?

+ Financial Intermediaries Bring together people who want money and people who want to loan money These institutions use liquid assets in the form of deposits (from households/firms) to finance illiquid investments of borrowers (mortgages and loans) Banks can create liquidity because they don’t need to keep all of their deposits on hand in liquid form (only the amount required by FED in the required reserve ratio) Directly contributing to an increase in M2 money supply

+ T-Accounts Summary of banks financial position by comparing assets and liabilities AssetsLiabilities Loans $1,000 (asset because they are expected to be repaid) Reserves $100 (asset because it is money in the bank or deposits at FED) Deposits $1000 (liability because must be repaid to depositors at their request) A > L Reserve ratio: % assets must be greater than liabilities (reserves value). Determined by FED.

+ Bank-Runs

+ Banks and the Money Supply: How? Money Creation and Banks Banks are the sole entity responsible for checkable deposits (the other component of M1). What they do to the money supply: 1. Remove some currency from circulation: allow people to get rid of $ in wallet and turn it into check in bank 2. Create money by taking deposits and creating loans: increasing the money supply to more than just currency in circulation!

+ Banks and the Money Supply: How? Start with an new deposit of $1,000 into checking account (from under a mattress…) No initial change in M1/M2 (change in currency = change in checkable deposits Bank holds 10% of deposit (reserves) and lends out the rest (loans) $900 new dollars in circulation from bank’s loans Assume $900 is again deposited: $90 held as reserve and $810 loaned…

+ Banks and Money Supply: Money Multiplier That process should have seemed familiar! Assumption: “checkable-deposits-only” monetary system to see the full potential impact banks can have on money supply and all banks lend out access reserves All funds borrowed (loans) immediately become new deposits Banks only hold the fractional amount the are required to by FED Money Multiplier: 1/rr rr = reserve ratio Example: $1,000 new deposits with reserve ratio of 10% 1/.1 = 10 (mm) 10 × $1,000 ( Δ deposits) = $10,000 Or…$1,000 ( Δ deposits)/.1 = $10,000

+ Leakage: Decreasing impact of money multiplier People holding cash

+ Monetary Base Money multiplier is formally defined as the ratio of the money supply to the monetary base Monetary base: the sum of currency in circulation and the reserves held by banks Money supply and monetary base are different: 1. Bank reserves (component of monetary base) are not part of money supply $1 in someone's wallet is different than $1 in bank vault or deposit at FED 2. Checkable bank deposits (component of money supply) are not part of monetary base

+ Monetary Base & Money Supply Why is the monetary base < money supply??? Bank Reserves Checkable Bank Deposits $ in circulation Monetary Base Money Supply

+ Exit Slip: What is the purpose of banks? HW: Macro Workbook Activity 4.3 & read Mod. 25 (Money Multiplier in Reality)