The Fractional Reserve System or Banking and How Money is Created psst: it’s magic!

I. The Goldsmith’s: - The original bankers and creators of the fractional reserve system.

II. Bank Balance Sheet: - It is a snapshot of the financial condition of bank at one particular time. (see next slide)

Assets Liabilities cash also. **** Demand Deposits Are checking Cash $ 50 Demand Deposits **** $ 500 Reserves at Fed * $ 200 Time & Savings Deposits $ 500 Loans ** $ 600 Securities *** $ 150 Buildings/Equipment $ 100 Net Worth $ 100 Total $1,100 Total $1,100 Reserves at the Fed represent cash also. **** Demand Deposits Are checking accounts, Time Deposits are CD’s, and Net Worth = owner’s original investment and retained profits. ** Loans are assets because they earn money for banks. ***Securities are Govt (or Treasury Securities, not stocks and bonds. U.S. banks cannot invest in the stock market.

III. The Fractional Reserve System: - A primary function of the Federal Reserve is to limit the growth of the money supply. How do they do it? (again, this is the part where the class asks the question) A. Required Reserves: demand deposits that cannot be loaned out by banks. B. Excess Reserves: demand deposits that may be loaned out by banks. C. Actual Reserves: Required Reserves + Excess Reserves. D. The Reserve Requirement: The % of demand deposits banks may not lend. -

F. Money Destruction: When loans are paid back. E. Money Creation: When loans are made. F. Money Destruction: When loans are paid back.

IV. The Tools of Monetary Policy: A. Reserve Requirement: 1. Reducing it increases the money supply, an expansionary action (fights recession). 2. Increasing it reduces the money supply, a contractionary action (fights inflation). B. Discount Rate: (interest rate the Fed charges banks when they borrow from the Fed.)

1. Buying Treasury Securities: (mainly C. Open Market Operations: 1. Buying Treasury Securities: (mainly bonds). Buying them from the public increases the money supply, an expansionary action (fights recession). 2. Selling Treasury Securities: Selling them to the public reduces the money supply, a contractionary action (fights inflation). Here the money goes from the Fed to the public. Here the money goes from the public to the Fed.

V) Federal Funds Rate: A) The interest rate charged by banks when they borrow from each other. It is not set by the Federal Reserve, but the Federal Reserve influences the Federal Funds Rate via Open Market Operations. B) If the Fed wishes to decrease the Federal Funds Rate to fight recession, it would buy bonds from the public to increase the money supply. With more money on deposit, banks can loan out money to each other at lower interest rates.

C) If the Fed wishes to increase the Federal Funds Rate to fight inflation, it would sell bonds to the public in order to decrease the money supply. With less money on deposit, banks would only loan money out to each other at higher interest rates.