Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Chapter 16 Money Creation, the Demand for Money, and Monetary Policy

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Banks and Money As early as 1000 B.C., uncoined gold and silver were being used for money in Mesopotamia. Later, goldsmiths started issuing paper notes indicating that the bearers held gold or silver of given weights and on deposit with the goldsmith. These notes could be exchanged for goods and were the first paper currency.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Banks and Money (cont’d) Reserves –deposits held by Federal Reserve + the bank’s vault cash Fractional Reserve Banking –A system in which depository institutions hold reserves that are less than the amount of deposits Originated when goldsmiths issued notes that exceeded the value of gold and silver on hand

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Banks and Money (cont’d) Required Reserve Ratio –The percentage of total transactions deposits that the Fed requires depository institutions to hold in the form of vault cash or deposits with the Fed Required reserves = Transactions deposits  Required reserve ratio

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Banks and Money (cont’d) Excess Reserves –The difference between actual reserves and required reserves Excess reserves = Actual reserves – Required reserves

Copyright © 2010 Pearson Addison-Wesley. All rights reserved The Relationship Between Legal Reserves and Total Deposits Balance Sheet –Statements of assets (what is owned) and liabilities (what is owed) How a single bank reacts to an increase in reserves –We will examine the balance sheet of a single bank.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Reserve Ratio = 10% Balance Sheet 16-1 Typical Bank Now: What if someone makes a deposit of $100,000 in Typical Bank?

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Typical Bank lends $990,000……… Balance Sheet 16-3 Typical Bank

Copyright © 2010 Pearson Addison-Wesley. All rights reserved The Relationship Between Total Reserves and Total Deposits (cont'd) What do you think? –Did this loan expand the money supply?

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Money Expansion by the Banking System (cont'd) What do you think? Could Banks 4, 5, 6, etc. create even more money? How much can be created? $100,000New Deposit 90,000Loan by Bank 1 81,000Loan by Bank 2 72,900Loan by Bank 3 $343,900Total

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Table 16-1 Maximum Money Creation with 10 Percent Required Reserves

Copyright © 2010 Pearson Addison-Wesley. All rights reserved The Money Multiplier (cont'd) Actual change in the money supply = Actual money multiplier Change in total reserves  Potential money multiplier = 1 Required reserve ratio

Copyright © 2010 Pearson Addison-Wesley. All rights reserved The Money Multiplier (cont'd) Example –Fed buys $100,000 of government securities –Reserve ratio = 10% Potential change in the money supply = $100,000 = $1,000,000 x 1.10

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Monetary Policy Ways in Which the Federal Reserve Changes the Money Supply Open market operations Reserve requirement Discount rate Hint: Monetary policy involves the money supply and interest rates

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Money Expansion by the Banking System (cont'd) Open Market Operations –The purchase and sale of existing U.S. government securities (such as bonds) in the open private market by the Federal Reserve System The Federal Open Market Committee (FOMC) –Can instruct the New York Federal Reserve Bank trading desk to buy or sell bonds

Copyright © 2010 Pearson Addison-Wesley. All rights reserved The Money Multiplier (cont'd) –Increasing (decreasing) the discount rate increases (decreases) the cost of borrowed funds for depository institutions that borrow reserves. Discount Rate –The interest rate that the Federal Reserve charges for reserves it lends to depository institutions

Copyright © 2010 Pearson Addison-Wesley. All rights reserved The Money Multiplier (cont’d) Changes in the reserve requirements –An increase (decrease) in the required reserve ratio Makes it more (less) expensive for banks to meet reserve requirements Reduces (expands) bank lending

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Reserve Ratios

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Why is the money supply important? There are links between changes in the money supply and changes in GDP (short run) and the rate of inflation (long run).

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Myth #16: As for money, the more the better The more money we have, other things being equal, the more you will spend only in dollar terms (not more in quantity) -- inflation