2. Outline Organization of the Federal Reserve system Routine functions of the FED The instruments of monetary policy How banks create money The process of multiple deposit expansion The deposit multiplier

3. Board of Governors 7 members appointed by the President Federal Open Market Committee Board of Governors plus 5 Federal Reserve Presidents 12 Federal Reserve Banks 3,500 member commercial banks Appoint 3 directors Elect 6 directors

5. Consolidated balance sheet of the Federal Reserve system (August 31, 1999) AssetsLiabilities Gold certificates, coin, special drawing rights 19,593Federal Reserve Notes 511,545 Loans to Commercial Banks 338Bank reserves 18,800 Treasury securities492,773Treasury Deposits 5,559 (in millions) Source: Federal Reserve Bulletin

6. ñ The FED serves as banker to the Treasury ñThe FED holds foreign official gold reserves at its New York regional bank ñThe FED provides check clearing-house services to depository institutions

7. The instruments of monetary policy Reserve requirements The discount rate Open market operations

8. Open market operations are the purchase or sale of U.S. government securities on the open market by the Federal Reserve system

9. The FED Open Market Committee is the unit in charge of open market operations

10. Definitions Total reserves (TR): The total amount that a commercial bank (or depository institution) has in its reserve account at the Federal Reserve Bank (the “FED”). Required reserves (RR): The minimum reserve account balance that a depository institution can maintain and still be in compliance with the statutory reserve requirement. Excess reserves (ER): The difference between TR and RR.

11. Here we demonstrate the principle of multiple deposit creation based on a given excess reserve Remember that: TR = RR + ER. Thus ER = TR - RR

12. Initial points: "Banks create money." Banks create money when they credit the checking accounts of loan recipients. By making a loan, a bank is expanding its deposit liabilities--which are money and constitute the bulk of M1. The capacity of banks to make loans and hence to create money depends on their reserve position--that is, do banks have excess reserves available? Federal Reserve open market operations influence the money supply by virtue of the direct and powerful impact these operations have on the reserve position of depository institutions.

13. Assumptions of the model: The required reserve ratio (RRR) is 10% or.10 Banks begin and end "fully loaned up." All loans are re-deposited in the banking system. Cash free system, therefore:  M =  DD, where DD is deposit liabilities of the banking system.

14. Step #1: The FED purchases $100,000 in U.S. government securities from Mrs. Green, paying with a government check. Mrs. Green deposits the government check in Ozark

15. Ozark National has an excess reserve of $90,000--and no other bank has lost reserves.Therefore, Ozark is positioned to make $90,000 in new loans.

16. Step #2: Ozark National makes a $90,000 loan to "Travel are We," who plans to use the loan proceeds to purchase new computers for its travel agents.

17. "Travel are We" writes a $90,000 check to Gateway computers. Gateway deposits the check to its account at Dakota Bank. We assume that the initial statement of Dakota is identical to the initial statement of Ozark National.

19. Step 3: Dakota now has an $81,000 excess reserve. It makes an $81,000 loan to Sodbusters, Inc. The loan will be used to purchase agricultural machinery.

20. Step #4 : Sodbusters makes out a check to Case Equipment Company for $81,000. Case deposits the check in their account at Ozark National.

21. Thus the latest transaction has created a $72,900 excess reserve for Ozark National. This is the basis for further loan expansion.

22. We stop the story here. But, if Ozark made the loan, an additional $72,900 in DDs would have been created. When the proceeds of the loan were checked away, another $65, 610 in excess reserves would have been created. And so on.

23. Thus potential loan expansion and money creation as a result of the initial change in excess reserves (  ER) is given by:  DD=  M = 90,000 + 81,000 + 72,900 +... Factoring out $90,000, this becomes  DD = $90,000 + [1 + 0.9 + 0.9 2 + 0.9 3 +... ] Notice that.9 is the fraction of reserves that each bank loans out, which is equal to 1 – RRR = 1- 0.1 =.9. To find the change in deposits that results from any change in reserves and any required reserve ratio (RRR):  DD =  Reserves  [1 + (1 – RRR) + (1 – RRR) 2 + (1 – RRR) 3 +...]

24. Recall that the infinite sum H = 1 + H + H 2 + H 3 +... Always has the value 1/(1 – H), so long as H assumes a value between zero and 1. Hence the value of the deposit multiplier is given by: Using this formula, we can restate what happens when the FED injects reserves into the banking system

25. Note that  ER = $90,000 and rr =.10. Thus the deposit multiplier is 10. The multiplier declines if some loan proceeds are not re-deposited in the banking system. The same holds true if banks do not make loans equal to their holding of excess reserves.