Chapter 16 Money Creation and Deposit Insurance

Slide 16-2 Introduction The operation of the U.S. financial system depends on electronically transmitted information about deposits and payments. How does the Federal Reserve respond when widespread power outages prevent the information network from operating?

Slide 16-3 Learning Objectives Describe how the Federal Reserve assesses reserve requirements on banks and other depository institutions Understand why the money supply is unaffected when someone deposits in a depository institution a check drawn on another depository institution

Slide 16-4 Learning Objectives Explain why the money supply changes when someone deposits in a depository institution a check drawn on the Federal Reserve System Determine the maximum potential extent to which the money supply will change following a Federal Reserve purchase or sale of government securities

Slide 16-5 Learning Objectives Describe the ways in which the Federal Reserve can potentially alter the money supply and explain the manner in which the Fed actually does conduct monetary policy Explain the essential features of federal deposit insurance

Slide 16-6 Chapter Outline Links Between Changes in the Money Supply and Other Economic Variables Links Between Changes in the Money Supply and Other Economic Variables The Origins of Fractional Reserve Banking Depository Institution Reserves The Relationship Between Reserves and Total Deposits The Relationship Between Reserves and Total Deposits

Slide 16-7 Chapter Outline The Fed’s Direct Effect on the Overall Level of Reserves The Fed’s Direct Effect on the Overall Level of Reserves Money Expansion by the Banking System Money Expansion by the Banking System The Money Multiplier Deposit Insurance

Slide 16-8 Did You Know That… Most demand deposit accounts are covered by federal deposit insurance? The banking system as a whole creates money in the process of issuing commercial and personal loans?

Slide 16-9 Links Between Changes in the Money Supply and Other Economic Variables There are links between changes in the money supply and changes in GDP. There are links between changes in the money supply and the rate of inflation.

Slide The Origins of Fractional Reserve Banking Fractional Reserve Banking –A system in which depository institutions hold reserves that are less than the amount of deposits –Origins in Mesopotamia Goldsmiths issued notes that exceeded the value of gold and silver on hand

Slide The Origins of Fractional Reserve Banking What do you think? –Can banks pay off all of their depositors? –How is it possible that they can pay them off eventually but not pay them off simultaneously?

Slide Money Supply Growth versus the Inflation Rate Figure 16-1 Source: Economic Report of the President; Federal Reserve Bulletin; Economic Indicators, various issues.

Slide Depository Institution Reserves Question –Do banks set their own reserve rate? Answer –No. The Federal Reserve sets the reserve requirement. Currently it is 10% on most checkable deposits.

Slide Depository Institution Reserves Legal Reserves –Anything that the law permits banks to claim as reserves

Slide Depository Institution Reserves Required Reserves –The value of reserves that a depository institution must hold in the form of vault cash or deposits with the Fed

Slide Depository Institution Reserves Required Reserve Ratio –The percentage of total deposits that the Fed requires depository institutions to hold in the form of vault cash or deposits with the Fed –Required reserves equal checkable deposits times the required reserve ratio

Slide Depository Institution Reserves Excess Reserves –The difference between legal reserves and required reserves Excess reserves = legal reserves - required reserves

Slide The Relationship Between Reserves and Total Deposits How a single bank reacts to an increase in reserves –We will examine the balance sheet of a single bank.

Slide The Relationship Between Reserves and Total Deposits Assumptions –Reserve ratio is 10% –Checkable deposits are the bank’s only liabilities –An individual bank can lend all it wants –Loan proceeds are deposited into checkable accounts –Zero excess reserves –Banks have zero net worth

Slide The Relationship Between Reserves and Total Deposits Description of a Balance Sheet AssetsLiabilities What are owned Reserves Loans What are owed Deposits *Also assume Net Worth = zero Net Worth = Assets - Liabilities

Slide The Relationship Between Reserves and Total Deposits Total reserves$100,000 Required reserves$100,000 Excess reserves0 Loans$900,000 Total$1,000,000 AssetsLiabilities Balance Sheet: Typical Bank Checkable deposits$1,000,000 Total$1,000,000 Reserve Ratio = 10% Balance Sheet 16-1

Slide The Relationship Between Reserves and Total Deposits AssetsLiabilities Balance Sheet: Typical Bank Scenario A customer of Typical Bank deposits $100,000 in Typical Bank The deposit is a check drawn on another bank

Slide The Relationship Between Reserves and Total Deposits Total reserves$200,000 Required reserves$110,000 Excess reserves $90,000 Loans$900,000 Total$1,100,000 AssetsLiabilities Balance Sheet: Typical Bank Checkable deposits$1,100,000 Old deposits$1,000,000 New deposit $100,000 Total$1,100,000 Outcome Typical Bank’s deposits and reserves increase by $100,000

Slide The Relationship Between Reserves and Total Deposits Following the deposit –What are the required reserves of Typical Bank ? –Does Typical Bank have excess reserves? Required reserves =.10 x $1,100,000 = $110,000 Excess reserves = $200,000 - $110,000 = $90,000

Slide The Relationship Between Reserves and Total Deposits Total reserves$200,000 Required reserves$110,000 Excess reserves $90,000 Loans$900,000 Total$1,100,000 AssetsLiabilities Balance Sheet: Typical Bank Checkable deposits$1,100,000 Old deposits$1,000,000 New deposit $100,000 Total$1,100,000 Outcome Typical Bank has required reserves of $110,000 and excess reserves of $90,000

Slide The Relationship Between Reserves and Total Deposits Following the deposit –What will Typical Bank do with its excess reserves? Loan them out –Could Typical Bank safely loan out more than its excess reserves?

Slide The Relationship Between Reserves and Total Deposits Total reserves$200,000 Required reserves$119,000 Excess reserves $81,000 Loans$990,000 Old loans$900,000 New loans $90,000 Total$1,100,000 AssetsLiabilities Balance Sheet: Typical Bank Checkable deposits$1,100,000 Old deposits$1,000,000 New deposit $100,000 Total$1,100,000 Typical Bank’s balance sheet following a loan to another customer

Slide The Relationship Between Reserves and Total Deposits What do you think? –Did this loan expand the money supply? Hints –Have the reserves of the banking system changed? –What happened to the loan balance at the bank where the deposit came from?

Slide The Relationship Between Reserves and Total Deposits Observations –The amount of reserves in the banking system determines the lending potential of the banks, given the reserve ratio. –If the reserves increase so does the lending potential of the banks, given the reserve ratio.

Slide The Fed’s Direct Effect on the Overall Level of Reserves Federal open market committee –Can instruct the New York Federal Reserve Bank trading desk to buy or sell bonds

Slide The Fed’s Direct Effect on the Overall Level of Reserves Open Market Operations –The purchase and sale of existing U.S. government securities in the open private market by the Federal Reserve System

Slide The Fed’s Direct Effect on the Overall Level of Reserves +$100,000 U.S. government securities AssetsLiabilities Balance Sheet: The Fed +$100,000 depository institutions reserves Scenario The Fed buys $100,000 of U.S. government securities

Slide The Fed’s Direct Effect on the Overall Level of Reserves +$100,000 reserves AssetsLiabilities Balance Sheet: Bank +$100,000 checkable deposit owned by bond dealer Outcome The reserves and the money supply increase by $100,000

Slide The Fed’s Direct Effect on the Overall Level of Reserves -$100,000 U.S. government securities AssetsLiabilities Balance Sheet: The Fed -$100,000 depository institutions reserves Scenario The Fed sells $100,000 of U.S. government securities

Slide The Fed’s Direct Effect on the Overall Level of Reserves -$100,000 reserves AssetsLiabilities Balance Sheet: Bank -$100,000 checkable deposit balances Scenario The reserves and money supply fall by $100,000

Slide Money Expansion by the Banking System Total reserves$100,000 Required reserves$100,000 Excess reserves 0 Loans$900,000 Total$1,000,000 AssetsLiabilities Balance Sheet: Typical Bank Checkable deposits$1,000,000 Total$1,000,000 Beginning balances

Slide Money Expansion by the Banking System Total reserves$100,000 Required reserves$100,000 Excess reserves 0 Loans$900,000 Total$1,000,000 AssetsLiabilities Balance Sheet: Typical Bank Checkable deposits$1,000,000 Total$1,000,000 Scenario Fed purchases $100,000 of securities from a Typical Bank customer The funds are deposited in Typical Bank

Slide Money Expansion by the Banking System Total reserves$200,000 Old reserves$100,000 New reserves$100,000 Loans$900,000 Total$1,100,000 AssetsLiabilities Balance Sheet: Typical Bank Checkable deposits$1,100,000 Old deposits$1,000,000 New Deposits $100,000 Total$1,100,000

Slide Money Expansion by the Banking System Total reserves$200,000 Required reserves$110,000 Excess reserves $90,000 Loans$900,000 Total$1,100,000 AssetsLiabilities Balance Sheet: Typical Bank Checkable deposits$1,100,000 Old deposits$1,000,000 New Deposits $100,000 Total$1,100,000 Outcome The money supply increases by $100,000

Slide Money Expansion by the Banking System Total reserves$200,000 Required reserves$110,000 Excess reserves $90,000 Loans$900,000 Total$1,100,000 AssetsLiabilities Balance Sheet: Typical Bank Checkable deposits$1,100,000 Total$1,100,000 Scenario After the Fed’s purchase Typical Bank has excess reserves of $90,000 Typical Bank loans its excess reserves to another Typical Bank customer

Slide Money Expansion by the Banking System Total reserves$200,000 Required reserves$119,000 Excess reserves $81,000 Loans$990,000 Old loans$900,000 New loans $90,000 Total$1,190,000 AssetsLiabilities Balance Sheet: Typical Bank Checkable deposits$1,190,000 Old deposits$1,100,000 New deposits $90,000 Total$1,190,000 Scenario Does this loan impact the money supply?

Slide Money Expansion by the Banking System Total reserves$200,000 Required reserves$119,000 Excess reserves $81,000 Loans$990,000 Total$1,190,000 AssetsLiabilities Balance Sheet: Typical Bank Checkable deposits$1,190,000 Total$1,190,000 Outcome The money supply increases by $90,000, the amount of the loan

Slide Money Expansion by the Banking System Total reserves$200,000 Required reserves$119,000 Excess reserves $81,000 Loans$990,000 Total$1,190,000 AssetsLiabilities Balance Sheet: Typical Bank Checkable deposits$1,190,000 Total$1,190,000 Scenario The Borrower uses the $90,000 to purchase a Burger King franchise Burger King banks at Bank 2

Slide Money Expansion by the Banking System Total reserves$200,000 Required reserves$119,000 Excess reserves $81,000 Reduction -$90,000 New balance$110,000 Required reserves$110,000 Excess reserves 0 Loans$990,000 Total$1,100,000 AssetsLiabilities Balance Sheet: Typical Bank Checkable deposits$1,190,000 Burger King check-$90,000 New balance$1,100,000 Total$1,100,000

Slide Money Expansion by the Banking System Total reserves$110,000 Required reserves$110,000 Excess reserves 0 Loans$990,000 Total$1,100,000 AssetsLiabilities Balance Sheet: Typical Bank Checkable deposits$1,100,000 Total$1,100,000

Slide Money Expansion by the Banking System Reserves+$90,000 Total+$90,000 AssetsLiabilities Balance Sheet: Bank 2 (changes) Burger King deposit+$90,000 Total+$90,000 Scenario What impact will the Burger King deposit have on Bank 2?

Slide Money Expansion by the Banking System Reserves+$90,000 Required reserves +$9,000 Excess reserves+$81,000 Total+$90,000 AssetsLiabilities Balance Sheet: Bank 2 (changes) Burger King deposit+$90,000 Total+$90,000 Outcome This deposit creates excess reserves of $81,000 in Bank 2

Slide Money Expansion by the Banking System Total reserves$90,000 Required reserves $17,100 Excess reserves $72,900 Loans+$81,000 Total$171,000 AssetsLiabilities Balance Sheet: Bank 2 (changes) Checkable deposits$171,000 Old deposits $90,000 New deposits+$81,000 Total$171,000 Scenario Bank 2 loans out the excess reserves of $81,000 Does the money supply change?

Slide Money Expansion by the Banking System Reserves$90,000 Reduction to cover check-$81,000 Total Reserves9,000 Required reserves $9,000 Excess reserves 0 Loans$81,000 Total$90,000 AssetsLiabilities Balance Sheet: Bank 2 (changes) Checkable deposits$171,000 Oil Co. check-$81,000 Total checkable deposits$90,000 Total$90,000 Scenario Assume the borrower spends the $81,000 with an oil well drilling firm that banks with Bank 3

Slide Money Expansion by the Banking System Reserves+$81,000 Required reserves +$8,100 Excess reserves+$72,900 Total$90,000 AssetsLiabilities Balance Sheet: Bank 3 (changes) Checkable deposits+$81,000 Total+$81,000 Scenario Bank 3’s deposits and reserves increase by $81,000 Can Bank 3 make a new loan? If so, will it impact the money supply

Slide Money Expansion by the Banking System Reserves+$8,100 Required reserves +$8,100 Excess reserves 0 Loans+$72,900 Total+$81,000 AssetsLiabilities Balance Sheet: Bank 3 (changes) Checkable deposits+$81,000 Total+$81,000 Outcome Bank 3’s balance sheet after it makes the loan and the loan proceeds have cleared to Bank 4

Slide Money Expansion by the Banking System How much has the money supply increased after the Fed’s $100,000 purchase of government securities and the three bank loans?

Slide Money Expansion by the Banking System $100,000Purchase by the Fed 90,000Loan by Bank 1 81,000Loan by Bank 2 72,900Loan by Bank 3 What do you think? Could Banks 4, 5, 6, etc. create even more money? How much can be created? $343,900Total

Slide Maximum Money Creation with 10 Percent Required Reserves Maximum New Loans New DepositsNew Requiredplus Investments Bank(new reserves)Reserves(excess reserves) 1$100,000$10,000$90, ,0009,00081, ,0008,10072, ,9007,29065,610 Totals$1,000,000$100,000$900, All other banks656,10065,610590,490 Table 16-1

Slide Money Expansion by the Banking System What would happen when: –The Fed sells government securities? –Borrowers pay back the loans?

Slide The Multiple Expansion in the Money Supply Due to $100,000 in New Reserves When the Required Reserve Ratio is 10% Figure 16-2

Slide The Money Multiplier Money Multiplier –Gives the maximum potential change in the money supply due to a change in reserves

Slide The Money Multiplier Actual change in the money supply = Actual money multiplier Change in total reserves x Potential money multiplier = 1 required reserve ratio

Slide The Money Multiplier 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

Slide The Money Multiplier Forces that reduce the money multiplier –Leakages Currency drains Excess reserves

Slide The Money Multiplier Real-world money multipliers –M1 multiplier = –M2 multiplier = 6.5 in the 1960s and over 12 in the 2000s

Slide Ways in Which the Federal Reserve Changes the Money Supply Open market operations Borrowed reserves and the Discount Rate –The interest rate that the Federal Reserve charges for reserves it lends to depository institutions

Slide Ways in Which the Federal Reserve Changes the Money Supply Federal Funds Market –A private market in which banks can borrow reserves from other banks that want to lend them Federal Funds Rate –The interest rate that depository institutions pay to borrow reserves in the interbank federal funds market

Slide Policy Example: The Discount Window is Open The Federal Reserve stands willing to loan funds to member banks at the discount rate. Because the discount rate is one percentage point above the federal funds rate, most banks prefer to go to the federal funds market rather than to the discount window.

Slide Sweep Accounts Many banks offer automatic transfer accounts, in which savings account balances are transferred to demand deposit accounts only when needed. This feature allows banks to hold fewer reserves. The required reserve ratio is lower for savings account balances.

Slide Sweep Accounts Banks use sweep accounts to shift funds from checking accounts into savings accounts until they are needed to settle check payments. Consequently, more of money supply growth has been shifted to M2, and M1 is considered a less reliable indicator of total liquidity.

Slide Payment-system risks –Liquidity Risk The risk of loss from late receipt of payment –Credit Risk The risk that the other party to an exchange may not honor its terms –Systemic Risk The risk of settlement system breakdowns P ayment Systems, Their Risks, and Deposit Insurance

Slide Deposit Insurance Federal Deposit Insurance Corporation (FDIC) –A government agency that insures the deposits held in member banks –All members of the Fed and qualifying banks can purchase insurance.

Slide Bank Failures Figure 16-4 Source: Federal Deposit Insurance Corporation

Slide Deposit Insurance The rationale for deposit insurance –Bank Runs Attempts by many of a bank’s depositors to convert checkable and time deposits into currency out of fear for the banks solvency Bank runs are prevented when depositors know they can convert their deposits to currency because of deposit insurance.

Slide Deposit Insurance How deposit insurance causes increased risk taking by bank managers –Deposit insurance premiums never have reflected all of the risks faced by a bank’s loans –Managers have an incentive to make higher risk loans

Slide Deposit Insurance Deposit insurance, adverse selection, and moral hazard –Asymmetric Information Information possessed by one side of a transaction but not the other The side with more information will be at an advantage

Slide Deposit Insurance Deposit insurance, adverse selection, and moral hazard –Adverse Selection A problem created by asymmetric information prior to a transaction Individuals who are the most undesirable from the other party’s point of view end up being the ones who are most likely to want to engage in a particular financial transaction, such as borrowing

Slide Deposit Insurance Deposit insurance, adverse selection, and moral hazard –Moral Hazard A situation in which, after a transaction has taken place, one of the parties to the transaction has an incentive to engage in behavior that will be undesirable from the other party’s point of view

Slide Deposit Insurance The results of moral hazard –The S&L crisis of the mid-1980s Thrift Bailout Act of 1989 cost taxpayers $200 billion

Slide Policy Example: Some Supervisory Examinations Never End At offices of some of the largest U.S. banks, FDIC examiners are a permanent presence. They monitor daily bank activity in an attempt to detect signs of any forthcoming problems with liquidity or soundness.

Slide Issues and Applications: Keeping Money Flowing Without Electric Power The widespread power outage in August of 2003 brought banking operations throughout the Northeast to a standstill. The Federal Reserve transmitted funds on behalf of banks, who then later repaid these temporary loans. As the lender of last resort, the Fed provides liquidity for all creditworthy banks.

Slide Summary Discussion of Learning Objectives How the Federal Reserve assesses reserve requirements Why the money supply does not change when someone deposits in a depository institution a check drawn on another depository institution

Slide Summary Discussion of Learning Objectives Why the money supply does change when someone deposits in a depository institution a check drawn on the Federal Reserve The maximum potential change in the money supply following a federal resource purchase or sale of U.S. government securities

Slide Summary Discussion of Learning Objectives The Fed influences the money supply through open market operations, the discount rate, and the reserve requirement. Federal Deposit Insurance was established to prevent bank runs. While it protects individual depositors, it also may encourage more risk-taking by bank managers.

End of Chapter 16 Money Creation and Deposit Insurance