1 ECON Designed by Amy McGuire, B-books, Ltd. McEachern CHAPTER Banking and the Money Supply Macro

2 LO 1 Measures of the Money Supply (February 2009) Exhibit 1

3 Money Aggregates LO 1  Credit cards  Loan from the card issuer  Repay later  Dispute a charge  Not part of money supply  Debit cards  From checking account  Part of M1

4 How Banks Work  Banks earn profit  Attract deposits from savers  Lend to borrowers  Banks are financial intermediaries  Reduce transaction costs  Cope with asymmetric information  Reduce risk through diversification LO 2

5 Reserve Accounts  Required reserve  Dollar amount  Must be held in reserve  Required by Fed  Required reserve ratio  Percentage of checkable deposits (10%)  Must be held in reserve  Reserves (Earn no interest)  Cash in bank’s vault  Deposits at the Fed  Excess reserves LO 2

6 Liquidity vs. Profitability  Liquidity  Ease to convert assets into cash  Safety  Profitability  Federal funds markets  Day-to-day lending and borrowing  Among banks  Excess reserves on account at the Fed  Interest: federal funds rate LO 2

7 How Banks Create Money LO 3  Creating money through excess reserves –Round one Fed buys $1,000 U.S. government bond –Creates reserves Money supply: +$1,000 Required reserves: +$100 Excess reserves: +$900

8 How Banks Create Money LO 3  Creating money through excess reserves –Round two $900 loan Money supply: +$900 Required reserves: +$90 Excess reserves: +$810

9 How Banks Create Money LO 3  Creating money through excess reserves –Round three $810 loan Money supply: +$810 Required reserves: +$81 Excess reserves: +$729

10 Reserve Requirements & Money Expansion LO 3  Assumptions –No bank holds excess reserves –Borrowed funds don’t sit idle –People don’t want to hold more cash

11 Reserve Requirements & Money Expansion LO 3  Required reserve ratio = r  Money multiplier  Simple money multiplier = 1/r  Change in the money supply = Change in fresh reserves × 1/r

12 Multiple Contraction of Money Supply LO 3  The Fed sells a $1,000 bond –Money supply: -$1,000 –Required reserves: -$900 –Recall loans –Money supply: -$900 –Required reserves: -$810 –Maximum effect Decrease money supply = Original decrease in reserve requirements × 1/r

13 The Fed’s Tools of Monetary Control LO 4  Open-market operations –Buy/sell U.S. government bonds  The discount rate –Interest rate, the Fed –For loans made to banks  The required reserve ratio –Minimum fraction of reserves

14 Open-Market Operations LO 4  Increase money supply –The Fed buys U.S. bonds Open-market purchase  Reduce money supply –The Fed sells U.S. bonds Open-market sale

15 Open-Market Operations LO 4  Tool of choice for the Fed  Influences bank reserves  Influences federal funds rate –Interest rate –Borrowing among banks –Of excess reserves at the Fed

16 The Discount Rate LO 4  Discount rate –Interest rate charged by the Fed –Loans to banks  Bank borrow ‘Discount window’ –Satisfy reserve requirements  The Fed –Lender of last resort

17 Reserve Requirements LO 4  Required reserve ratio  Money creation for each dollar of fresh reserves  Disruptive –Banking system

18 The Fed Is a Money Machine LO 4  Assets –U.S. government bonds, 24% –Earns interest  Liabilities –Federal Reserve notes, 43% –Fed pays no interest  The Fed is a money machine –Supplies Federal Reserve notes –Main asset: earns interest –Main liability: no interest payment