Money that is available (money supply) affects Output 1. GDP = C + Ig + G + Xn 2. Increased spending increases output 3. Increased money supply increases spending

= * * M V P Q V elocity P rice Q Output - the actual amount of money in circulation - the number of time each $ is spent in a year (considered to be stable) - the actual output of goods and services - the level of prices M oney M V P Q

= * * M V P Q V elocity P rice Q =output If V and P are constant, then an increase in M will lead to a proportional increase in Q GDP increases. but if V and Q are constant(at full employment), then an increase in M will lead to a proportional increase in P =Inflation. P Q Total Sales (GDP) = *

1.Printing Money 2.Making Loans a. Key Ingredients: Deposits – Household savings Required Reserves – money held at the bank or at the FRS (around 10%) Excess Reserves – loan able funds = Deposits – Required Reserves A depository institution can make loans up to the value of its excess reserves

The U.S. banking system is a fractional reserve system where banks maintain only a fraction of their assets as reserves to meet the requirements of depositors. Under a fractional reserve system, an increase in reserves will permit banks to extend additional loans and thereby expand the money supply (by creating additional checking deposits). Fractional Reserve Banking

Main Street Bank Situation: Demand deposits = $50,000 Reserve requirement =10 % Actual reserves at bank = $10,000 Excess Reserves: Demand deposits = $50,000 Reserve requirement= 10 % Actual reserves = $10,000 - Required reserves = $5,000 = Excess reserves = $5,000

Excess Reserves ($5,000) can be loaned By making a loan, the bank has created money. The original deposits are still in Main Street Bank, but now there is an additional $5,000 out floating around.

The Bank of the James which has a reserve ratio of 10 percent on its deposits, has calculated the following numbers as of the end of business today: total deposits = $13,500,000; reserve account = $3,750,000; and vault cash = $2,250,000. Determine the following for this bank: Actual reserves = __________________ Required reserves = _________________ Excess reserves = __________________ 3,750, ,250,000 = 6,000,000 13,500,000 x.10 = 1,350,000 6,000,000 -1,350,000 = 4,650,000

How much in new loans can Madison Heights National Bank make if its deposits are $45,000,000, vault cash is $5,500,000, and reserve account balance is $7,750,000? MHNB’s reserve requirement is 8%. New loans = _____________________ 5,500, ,750,000 = 13,250,000 45,000,000 x.08 = 3,600,000 13,250,000 -3,600,000 = 9,650,000 9,650,000

What is the amount that must be borrowed by the Smith Mountain Lake Marine Bank to cover its anticipated reserve shortfall if it has a reserve requirement of 12 percent, deposits of $27,500,000, vault cash of $2,500,000, a reserve account of $3,250,000, and it has just made a new loan of $2,500,000 that has not yet cleared? New borrowing = ___________________ 2,500, ,250,000 = 5,750,000 27,500,000 x.12 = 3,300,000 5,750,000 -3,300,000 = 2,450, ,000

If the Excess Reserves are loaned The borrowed money is spent and deposited at another bank. The second bank’s reserves are now up $5,000 - it must keep 10% or $500 - it can then loan out $4,500 ($5,000 – $500) This process can be repeated at each step. 10% of the money is lost at each step The more that is required to be held in reserve, the less money can be created The lower the reserve requirement, the greater the amount of money that can be created

Bank New cash deposits: Actual Reserves New Required Reserves Potential demand deposits created by extending new loans Initial deposit (bank A) Second stage (bank B) Third stage (bank C) Fourth stage (bank D) Fifth stage (bank E) Sixth stage (bank F) Seventh stage (bank G) $1,000.00$ $ Total$5,000.00$1,000.00$4, All others (other banks)1, Creating Money from New Reserves When banks are required to maintain 20% reserves against demand deposits, the creation of $1,000 of new reserves will potentially increase the supply of money by $5,000.

From the table a deposit of $1000, with a 20% reserve requirement led to a $4000 expansion of the money supply Is there a pattern here? It just takes 3 easy steps

3. Subtract out the the initial change $ = $ Find the reciprocal of the required reserve 1/20% = 1/1/5= 5 2. Multiply the initial change by the multiplier $1000 * 5 = $5000

1.Deposit of $10,000 2.Required reserve 10% 3.Increase in the money supply? How about if the reserve requirement was 20%? 1.________ 2.________ 3.________ 1.________ 2.________ 3.________

1.Deposit of $16,000 2.Required reserve 25% 3.Increase in the money supply? How about if the reserve requirement was 20%? How about if the reserve requirement was 10%? 1.________ 2.________ 3.________ 1.________ 2.________ 3.________ 1.________ 2.________ 3.________

1. Loan making changes the money supply 2. Increases in loans leads to increased spending which increases the money supply. 3. BUT, decreases in loan making, or even paying back a loan decreases the money supply.

1. More or less voluntary transaction 2. The interest rate is important 3.Supply in the money for loans a. Households decide to save or spend b. Banks decide how to use the savings 3.Demand for the loans a. Households how much to borrow b. Businesses compare interest rate to expected profit

Households and Banks supply the money based on interest rates There is a direct relationship between interest rate and amount of $ Interest Rate Quantity of loans S D Q.05 Determining the Interest Rate Household and business demand for money is based on the interest There is an inverse relationship between interest and amount of $

Expectation of poor economic conditions could shift the curve left This would decrease the equilibrium interest rate Determining the Interest Rate Quantity of loans S D Q.05 D (bad expections) r =.03 i = Q

A decrease in excess reserves decreases money for loans This would shift the supply curve to the left and increase interest Determining the Interest Rate Quantity of loans S D Q.05 S (reserves decreased) r =.07 i = Q

Increasing Excess Reserves Increases Ability to Lend Decreases Interest rate for Borrowing Increases Borrowing Increases Level of Spending Increases Output and Employment (or Prices)

Decreasing Excess Reserves Decreases Ability to Lend Increases Interest rate for Borrowing Decreases Borrowing Decreases Level of Spending Decreases Output and Employment (or Prices)

1. Monetary Policy Tools: a. The Reserve Requirement -reducing it encourages loans and increases the money supply -increasing it discourages loans and decreases the money supply

b. The Discount Rate 3 rates 1. Discount Rate 2. Federal Funds Rate 3. Prime Rate federal reserve to member banks bank to bank banks to best customers

b. The Discount Rate Raising Discount Rate discourages bank borrowing decreases money supply Lowering Discount Rate encourages bank borrowing increases money supply

c. Open Market Operations Buying and Selling Securities (Bonds) -selling bonds puts bonds out and take money out of circulation -buying bonds puts money back in circulation and takes bonds in What effect will this have on the economy??

c. Open Market Operations Buy or Sell? a. The Reserve Requirement Raise or Lower? Increase or decrease? b. The Discount Rate

c. Open Market Operations Buy or Sell? a. The Reserve Requirement Raise or Lower? Increase or decrease? b. The Discount Rate

c. Businesses and Household can afford fewer loans Less investment a. The Government competes for money b. They offer a higher interest rate

+ quick implementation - high rates may lead to higher prices + flexible changes in rates + less political - reserve ratios and interest rates might not be enough incentive - FRS might now be too independent

What would be the effect of each of the following on Uptown Bank’s excess reserves and loan-making ability if the bank had $600 million in deposits, a 5% reserve requirement, and actual reserves of $40 million? a. The Federal Reserve sells $5 million in government securities to Uptown Bank. b. The reserve requirement increases from 5% to 6%. c. The discount rate is increased. d. The reserve requirement is lowered from 5% to 4%, and the Federal Reserve buys $10 million in government securities. a.Increase loan-making ability b.Decrease loan-making ability c.Have no effect

1.In the equation of exchange, an increase in M always causes an increase in Q, and a decrease in M always causes a decrease in P. 2.If a bank has $100 million in actual reserves and $80 million in required reserves, it may make new loans of up to $20 million. 3.The size of the money multiplier is inversely related to the size of the reserve requirement. 4.With a reserve requirement of 25 percent, an injection of $100 million of new excess reserves into the economy could cause the money supply to expand by $400 million.

5.An increase in excess reserves in the economy would encourage spending. 6.Lowering the reserve requirement is a tight money policy. 7.Buying securities by the Fed would decrease excess reserves held by financial depository institutions. 8.Crowding out occurs when government borrowing forces up the interest rate and discourages households and businesses from borrowing.