Module 25- Fractional Reserve Banking and the Money Multiplier J.A.SACCO

Fractional Reserve Banking Depository institutions are required by the Fed to maintain a specific percentage (reserve requirement) of their customers deposits as reserves Three types of reserves!

Fractional Reserve Banking Legal (Total) Reserves- reserves that depository institutions are allowed by law to claims as reserves (deposits held at Federal Reserve District Bank and/or commercial bank vault cash. Required Reserves- the value of reserves that a depository institution must hold in vault cash or with the Federal District Bank. These reserves are required to back its checkable deposits.

Fractional Reserve Banking Excess Reserves- the difference between legal reserves and required reserves. These reserves can be used as new loans and/or purchase government bonds & securities. Excess Reserves = Legal Reserves- Required Reserves

Fractional Reserve Banking Example: Total (Legal) Reserves is $20 B. and the Reserve Requirement is 10%. What is the required reserves? Excess reserves? RR is $2B in deposits to be held in Fed District Bank or vault cash. ER is $18 B. in new loans or to buy gov’t securities.

Reserves and Total Deposits SACCO KEY POINT- New reserves are not created when checks written on one bank are deposited in another bank. The bank writing the check will lose reserves, and the bank receiving the check will gain reserves. Only when the Fed buys/sells securities from banks or the public, or when you put available cash in the bank are reserves increased/decreased and in turn the money supply.

Money Expansion by the Banking System Why is the reserve requirement and excess reserves important? How much will the money supply increase after you deposit $100,000 cash into a commercial bank.

How Money is Created? “Multiple Expansion of Checkable Deposits” Assume a 10% Reserve Requirement Maximum New Loans New Deposits New Required plus Investments Bank (new reserves) Reserves (excess reserves) 1 $100,000 $10,000 $90,000 2 90,000 9,000 81,000 3 81,000 8,100 72,900 4 72,900 7,290 65,610 . . . . All other banks 656,100 65,610 590,490 Totals $1,000,000 $100,000 $900,000 New money/Inc. in money supply

The Money Multiplier = x Money Multiplier Gives the maximum potential change in the money supply due to a change in reserves Actual change in the money supply = Actual money multiplier Initial change in excess reserves x

Forces that Reduce the Money Multiplier Leakages Currency Drains- People hold money in wallet. Don’t put money in bank to allow deposit expansion. Excess Reserves- Banks keep more as excess reserves.

How the Fed Controls the Money Supply Fed Tools Macro. Effects Reserve Requirement Increase Contractionary Money Supply Interest rate Investment Decrease Expansionary Money Supply Interest rate Investment

How the Fed Controls the Money Supply Fed Tools Macro. Effects Discount/Federal Fund Rate Increase Contractionary Money Supply Interest rate Investment Decrease Expansionary Money Supply Interest rate Investment

How the Fed Controls the Money Supply Fed Tools Macro. Effects Open Market Operations Sell Securities Contractionary Money Supply “Sell Bonds, Small Bucks” Interest rate Investment Buy Securities “Buy Bonds, Big Bucks” Expansionary Money Supply Interest rate Investment Most used by the Fed to expand the money supply. Why?

The Fed and the Money Supply What has a greater affect on the expansion of the money supply: $100 deposit of an individual into a commercial bank? A Fed purchase of a government bond/security from a commercial bank for a $100? Assume a 20% Reserve Requirement

The Fed and the Money Supply Money Multiplier? Individual- RR= $20, ER= $80--- Expansion of Money Supply is $400. Fed- RR= $0, ER=$100--- Expansion of Money Supply is $500. Why the difference?