Banks, the Fed and Money Creation

Money Creation Money creation (putting new money into circulation) occurs two ways: When the Federal Reserve buys bonds from the public or a financial institution (open market operations) 2. When banks make loans to the public.

Money Creation The money supply is increased when banks make loans. The more loans banks make the more money there is in circulation. A bank can loan any amount that is in excess of its required reserves. The banking system can create loans in multiples of an original loan

Money Creation Reserves or total reserves are the amount of deposits that a bank has accepted but not loaned out. Required reserves are the amount a bank must keep on hand by law. The required reserve ratio determines this amount. Excess reserves are whatever the bank has over and above the required reserves. It is the amount that a bank can loan out or use to purchase government securities (bonds).

Money Creation Total expansion of the money supply= loans X money multiplier Money multiplier = 1/reserve ratio Total money supply = money in circulation + money in demand deposit accounts

Bank balance sheets or T-Accounts Illustrates the relationship between assets and liabilities held by a bank. They can be used to explain the money creating potential of banks through the fractional reserve system. Assets – the property, possessions and claims on others held by the bank (reserves, loans, securities) Liabilities – the debts and obligations of the bank to others (demand deposits, loans from the Fed)

Bank balance sheets or T-Accounts Assets Liabilities reserves $100,000 DDA $100,000

(reserve ratio 10%) Assets Liabilities RR $10,000 DDA 100,000 ER $90,000 BANK 1 ER loans $90,000

Total Expansion of the money supply = $90,000 x 10 (1/.10) = $900,000 Assets Liabilities RR $9,000 DDA $90,000 ER $81,000 Total money supply = $100,000+90,000 BANK 2 RR $9,000 DDA 90,000 ER Loans $81,000 Total Expansion of the money supply = $90,000 x 10 (1/.10) = $900,000

Federal Reserve Tools The Federal Reserve controls the amount of excess reserves and money creation through use of its three tools. Reserve Requirements Discount Rate Open Market Operations

Federal Reserve Tools Required Reserve Ratio – the percentage of demand deposits a bank must keep on hand for customers’ withdrawals. It determines how much of a bank’s deposits are available for loans and the size of the money multiplier. The money multiplier determines the amount of new money that will be created by the banking system (1/RR) If a bank’s reserves fall unexpectedly within a day, it can borrow from another bank on an overnight basis in the federal funds market and pay an interest rate called the federal funds rate

Federal Reserve Tools Discount Rate – the interest rate the Federal Reserve will charge a bank for a loan. If the Fed lowers the discount rate banks would be encouraged to borrow from the Fed (the bank could loan that money out to the public at a higher rate and make money doing so). Least effective tool because banks primarily borrow from each other.

Federal Reserve Tools Open Market Operations – the Fed purchases or sells securities (government bonds) to banks and the public, which changes the amount of money available from the public and banks for loans. The Fed would purchase securities to pump in money to increase economic growth. The Fed would sell securities to soak up money from the economy (anti-inflationary). Banks or the public now have a bond instead of cash and spending is slowed down. Most used tool.

Macroeconomic Effects of Monetary Policy A change in the supply of money changes the interest rate. Interest rates are the cost of borrowing money. A high supply of money lowers the interest rate and gives businesses more opportunities for investment spending (buying capital goods).

Macroeconomic Effects of Monetary Policy The Fed will follow an easy money policy (an increase in the money supply) when the economy is in a recession. The Fed will follow a tight money policy (a decrease in the money supply) when the economy is experiencing inflation. The goal of stabilization policy is to smooth out fluctuations in the business cycles.

Problems of Timing If expansionary policies take effect while the economy is already expanding, the result could be higher inflation. Inside lags refer to the delay in implementing monetary policy. It is difficult to accurately identify and recognize economic problems. It takes additional time to enact the appropriate policy. (This is more of a fiscal policy problem, since the FOMC can act much more quickly)

Problems of Timing Outside lags refer to the time it takes for monetary policy to have an effect. The outside lag is short for fiscal policy but lengthy for monetary policy. Monetary policy primarily affects business investment plans which are made far in advance. Monetary policy is still preferred because of the inside lag caused by the President and Congress having to agree on budgetary matters.