1. Money Creation Simulation (or: “Where does Money Really come from?”) This simulation illustrates how money is created in our economy and how its creation is controlled by the Federal Reserve.

2. Creating Money- Reserve Requirements (20% Reserve Ratio) Initial Deposit Deposit Required Reserves Excess Reserves Money Created $5,000$4,000$3,200$2,560$2,048 $1,000$800$640$512 $409.60 $4,000$3,200$2,560$2,048 $1,638.40 $11,808 New $ $5,000 I. D. $16,808 in circulation + +++= =

3. 1. Who created the additional money? The Banks. 1. How was the money created? By lending the money.

4. 2. What is the maximum amount of money that could be created? Equations needed: 1 ÷ RR = Money Multiplier Total amount in Circulation = Initial Deposit x Money Multiplier Total New $ = Total amount in Circulation - Initial Deposit OR Total New $ = Excess Reserves x Money Multiplier

5. 2. What is the maximum amount of money that could be created? Money Multiplier = 1 ÷.20 = 5 5 x $5,000 = $25,000 total in circulation $25,000 - $5,000 = $20,000 in new $ created

6. 3. When you deposit money in the bank, what does the bank do with it? Loan it out. How much do they want to loan out? As much as possible.

7. 3. What 2 problems would be created if a bank loaned all of it out (Think about MV=PQ ). 1. No money for depositors. Think bank panics! 2. M and V would both ↑ by a lot so P would ↑ by a lot!

8. 4. To maintain control over lending by banks the Fed requires that banks keep some percentage of deposits on reserve with the Fed. These are called Required Reserves. If the Required Reserve Ratio were 10% how much money could be created? Money Multiplier = 1 ÷.10 = 10 10 x $5,000 = $50,000 total in circulation $50,000 - $5,000 = $45,000 in new $ created ↓ RR  ↑ amount of money created

9. 4. What if it were increased to 25%? (Use the equations from question #2). Money Multiplier = 1 ÷.25 = 4 4 x $5,000 = $20,000 total in circulation $20,000 - $5,000 = $15,000 in new $ created ↑ RR  ↓ amount of money created

10. 5. Why would the Federal Reserve want to control the money supply? To expand (speed up) or contract (slow down) the economy.

11. 5. How could it be controlled? ↓ RR  Banks loan out more  ↑ MS  ↓ IR  ↑ C, I,  ↑ AD  Expansionary impact ↑ RR  Banks loan out less  ↓MS  ↑ IR  ↓ C, I,  ↓ AD  Contractionary impact

12. Creating Money- The Discount Rate 6. At the end of each day some banks have more than enough money to meet their required reserves while others do not have enough. What two institutions can banks who are short of reserves borrow the money from? 1. Other Banks 2. The Fed

13. Creating Money- The Discount Rate 6. What is the interest rate banks charge each other called? The Federal Funds Rate (FFR). What is the interest rate the Fed charges banks to borrow money? The Discount Rate (DR).

14. 7. Why do banks need a “lender of last resort?” So they don’t collapse. To prevent “runs” on the bank.

15. 8. What can the Fed do to the Discount Rate to get the banks to borrow (and create!) more or less money? ↓ DR  Banks borrow/loan out more  ↑ MS  ↓ IR  ↑ C, I,  ↑ AD  Expansionary impact ↑ DR  Banks borrow/loan out less  ↓ MS  ↑ IR  ↓ C, I,  ↓ AD  Contractionary impact

16. 9. The Fed currently sets the Discount rate 1% higher the Federal Funds Rate. Which rate would the banks prefer to borrow at? Federal Funds Rate Why? 1. It’s less expensive 2. It does not alert the Fed to potential trouble.

17. Creating Money with Open Market Operations (OMO) and the Federal Funds Rate Initial DepositDeposit $5,000$3,000$1,400$2,120$2,696 Required Reserves $1,000$600$280$424 Excess Reserves $4,000$2,400$1,120$1,696 OMO- Fed Sells Bonds OMO- Fed Buys Bonds - $1,000 + $1,000 Available to Loan $3,000$1,400$2,120$2,696 Money Created $9,216 New $ +$5,000 I. D. $14,216 in circulation

18. 10. What effect did Treasury Bond (T-Bill) sales by the Fed have on the money supply? Fed Sells Bonds  ↓MS  ↑ IR  ↓ C, I  ↓ AD  Contractionary impact What effect did purchases/ buying have? Fed Buys Bonds  ↑ MS  ↓ IR  ↑ C, I  ↑ AD  Expansionary impact B uy B igger, S ell S maller

19. 11. What could Fed do to the interest rate they pay on Treasury Bonds to encourage banks to purchase or sell T-Bills? ↓ or ↑ IR What effect would this have on bond prices in each case? ↓ IR on new bonds  existing bonds have higher rates so  ↑ bond prices ↑ IR on new bonds  existing bonds have lower rates so  ↓ bond prices

20. 12. Why would Open Market Operations (Buying & Selling T- Bills) be used more often than changes in the Reserve Requirements? They are more precise and more predictable than the other tools.