1. Slides by Debbie Evercloud
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CHAPTER 12 (23): MONEY CREATION AND THE FEDERAL RESERVE COREECONOMICS, 3RD EDITION BY ERIC CHIANG
Slides by Debbie Evercloud
© 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone 1

2. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone
CHAPTER OUTLINE
How Banks Create Money
The Money Multiplier and Its Leakages
The Federal Reserve System
The Federal Reserve at Work
© 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

3. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone
LEARNING OBJECTIVES
At the end of this chapter, the student will be able to:
Explain how banks create money
Define fractional reserve banking
Define banking regulations, such as reserve requirements and deposit insurance
Explain the money multiplier
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4. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone
LEARNING OBJECTIVES
At the end of this chapter, the student will be able to:
Describe the history and structure of the Federal Reserve System
Describe the Federal Reserve’s principal monetary tools
Explain open market operations
Explain why Federal Reserve policies take time to affect the economy
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EXAMPLE: MICROLOANS
Microloans have facilitated the growth of entrepreneurship in developing countries.
In both poor and wealthy countries, the presence of lenders is crucial to the process of investment.
This chapter looks at the process of money creation in which banks accept deposits from savers and channel these funds to borrowers.
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6. BY THE NUMBERS: THE MONETARY BASE
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MONEY CREATION
The primary purpose of financial markets and institutions is to act as conduits for transferring funds from lenders to borrowers.
By accepting deposits and making loans, however, banks and other financial institutions are also able to create money.
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MONEY CREATION
When you deposit cash in your checking account, the bank acquires an asset in the form of cash.
The bank also acquires a liability in the form of a checking account balance that must be honored on demand.
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MONEY CREATION
When the bank makes a loan, it does so by creating a checking account balance for the loan customer.
This balance is a liability for the bank, because it must be honored on demand.
Alongside the liability, the bank now has an asset in the form of a loan that the customer is obligated to pay.
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MONEY CREATION
A bank’s reserve ratio is the level of reserves its holds as a percentage of total deposits.
The government requires that banks maintain a minimum level of reserves called the reserve requirement.
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MONEY CREATION
Financial institutions operate as part of a fractional reserve banking system.
When someone deposits money into a bank account, the bank is required to hold part of this deposit as cash, or in an account with the regional Federal Reserve Bank.
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MONEY CREATION
Banks create money by loaning out their excess reserves.
An initial deposit of cash can be turned into loans and deposits many times over.
This demonstrates the power of the banking system to create money.
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13. CHECKPOINT: HOW BANKS CREATE MONEY
The fractional reserve system permits banks to create money through their ability to accept deposits and make loans.
The reserve ratio is the fraction of total customer deposits held as reserves.
The reserve requirement is the minimum reserve ratio banks must follow.
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MONEY CREATION
The money multiplier measures the potential or maximum amount the money supply can increase when new deposits enter the system.
The money multiplier is defined as:
Money Multiplier = 1 / Reserve Requirement
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MONEY CREATION
When the government expands the money supply, it does so by adding reserves electronically to banks in exchange for bonds and other assets.
Banks will then make loans against these excess reserves.
The expansion process is compounded by the money multiplier.
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MONEY CREATION
The potential money multiplier and the actual money multiplier are rarely the same because of money leakages.
A leakage is money that leaves the money creation process because of an action taken by a bank, an individual, or a business.
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LEAKAGES
A bank faces a solvency crisis if its liabilities exceed its assets.
Banks are exposed to the risk of becoming insolvent when borrowers default on loans.
The loan is lost as an asset, but the liabilities to depositors remain.
Consequently, banks may hold excess reserves during tough economic times to increase their ability to absorb a higher rate of defaults.
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LEAKAGES
When banks choose not to loan all of their excess reserves, the actual money multiplier is reduced.
The reduction in loans recirculates less money back through the banking system.
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19. ISSUE: THE MONEY MULTIPLIER
The consequences of the housing crisis led banks to tighten their lending practices.
As a result, the money multiplier fell dramatically from 2008 to 2009.
The Federal Reserve has compensated for the low money multiplier by injecting even more money into the banking system, dramatically increasing the monetary base.
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LEAKAGES
When individuals or businesses choose to keep money in cash rather than in bank deposits, there is a leakage in the money supply.
That money is not available to be loaned to someone else.
The actual money multiplier is reduced.
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LEAKAGES
The role that the U.S. dollar plays as the world’s most popular reserve currency causes the majority of dollars to be held outside of U.S. borders.
This has the effect of reducing the actual money multiplier relative to its potential.
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LEAKAGES
What is a leakage-adjusted money multiplier?
It takes into account the required reserve requirement along with excess reserves held by banks and cash held by individuals and businesses.
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23. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone
LEAKAGES
During the 2007–2009 recession, the money multiplier fell precipitously from 1.7 to less than 1.
A money multiplier of less than 1 means that fewer loans were being made than the new money introduced to the economy.
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24. CHECKPOINT: THE MONEY MULTIPLIER AND ITS LEAKAGES
The potential money multiplier is equal to 1 divided by the reserve requirement.
Money leakages are caused by banks holding excess reserves and by individuals and businesses holding a portion of their funds in cash.
The leakage-adjusted money multiplier provides a more realistic estimate of the money multiplier in the economy.
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25. THE FEDERAL RESERVE SYSTEM
The Federal Reserve System is the central bank of the United States.
The Federal Reserve Act of 1913 was a compromise between proposals for a huge central bank and for no central bank at all.
The Federal Reserve is an independent central bank, in that its actions are not subject to executive branch control.
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26. THE FEDERAL RESERVE SYSTEM
The Fed is composed of:
The Board of Governors, located in Washington, D.C.
Twelve regional Federal Reserve Banks in major cities around the nation
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27. FUNCTIONS OF THE FEDERAL RESERVE
The Fed’s Board of Governors consists of seven members who are appointed by the President and confirmed by the Senate.
Twelve Federal Reserve Banks perform a variety of functions, including:
Providing a nationwide payments system
Distributing coins and currency
Regulating and supervising member banks
Serving as the banker for the U.S. Treasury
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28. OPEN MARKET OPERATIONS
The Federal Open Market Committee (FMOC) consists of:
Seven members of the Board of Governors
Five of the 12 regional Federal Reserve Bank presidents
The FOMC oversees open market operations, the main tool of monetary policy.
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LENDER OF LAST RESORT
The value of the Fed’s ability to provide loans during a financial crisis stood out during the financial panic in late 2008.
In just a few months, the Fed extended more that $2 trillion in loans.
Had the Fed and its “lender of last resort” capability not been available, the 2008–2009 recession would have been much deeper.
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30. CHECKPOINT: THE FEDERAL RESERVE SYSTEM
The Federal Reserve is the central bank of the United States.
The Federal Reserve System is structured around 12 regional banks and the Board of Governors.
The Federal Reserve serves as the lender of last resort, stepping in to loan money to banks facing emergency cash shortages.
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31. TOOLS OF THE FEDERAL RESERVE
The Federal Reserve uses three primary tools in the conduct of monetary policy:
Reserve requirements
The discount rate
Open market operations
These tools are used to increase or decrease the money supply.
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RESERVE REQUIREMENTS
The reserve requirement is the required ratio of funds that commercial banks and other depository institutions must hold in reserve against deposits.
A bank with excess reserves can loan these reserves to another bank and earn a rate of interest known as the federal funds rate.
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DISCOUNT RATE
 The discount rate is the rate regional Federal Reserve Banks charge depository institutions for short-term loans to shore up reserves. −The discount window also serves as a back-up source of liquidity.
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34. OPEN MARKET OPERATIONS
The Fed uses open market operations to inject reserves or withdraw reserves from the banking system.
Open market operations involve the Fed buying and selling U.S. government securities.
Open market operations are the most important of the Fed’s policy tools.
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35. TARGET FEDERAL FUNDS RATE
Targeting the federal funds rate through open market operations gives the Fed an ability to influence the price level and output in the economy.
The Fed uses open market operations to adjust reserves and thus change nominal interest rates, nudging the federal funds rate toward the Fed’s target.
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POLICY LAGS
Monetary policy is subject to four major time lags:
Information lag
Recognition lag
Decision lag
Implementation lag
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37. ISSUE: WHEN INTEREST RATES ARE ZERO
By December 2008, the Federal Reserve had lowered the federal funds rate target to essentially 0%.
Yet, the economy was still struggling and needed additional help to prevent a deeper recession.
The Fed developed new ways to expand the money supply without using its regular open market operations.
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38. ISSUE: WHEN INTEREST RATES ARE ZERO
Tools used by the Fed when interest rates were zero included:
The purchase of mortgage-backed securities
Lending through term auction facilities
Quantitative easing
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39. CHECKPOINT: THE FEDERAL RESERVE AT WORK
The Fed’s tools include altering reserve requirements, changing the discount rate, and open market operations.
The Fed uses open market operations to keep the federal funds rate at target levels.
The Fed’s policies are subject to information, recognition, decision, and implementation lags.
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40. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone
CHAPTER SUMMARY
Money is created when banks make loans that eventually get deposited back into the system, generating checkable deposits.
In a fractional reserve banking system, banks hold only a portion of deposits in reserves, loaning out the rest.
The money multiplier is the maximum amount the money supply can increase when new deposits enter the system.
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41. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone
CHAPTER SUMMARY
The Federal Reserve System is the central bank of the United States.
It is composed of a seven-member Board of Governors and 12 regional Federal Reserve Banks.
The Fed uses three major tools to conduct monetary policy:
Reserve requirements
Discount rate
Open market operations
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42. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone
DISCUSSION QUESTIONS
What limits the amount of money that can be created through bank loans?
Why does the level of banks’ excess reserves change over time?
Why did the Federal Reserve change some of its actions following the financial crisis of 2007–2009?
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