Chapter 16 Money Creation the Demand for Money

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Chapter 16 Money Creation, the Demand for Money, and Monetary Policy Copyright © 2010

Chapter 16 Money Creation, the Demand for Money, and Monetary Policy Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

Banks and Money • As early as 1000 B. C. , uncoined gold and

Banks and Money • As early as 1000 B. C. , uncoined gold and silver were being used for money in Mesopotamia. • Later, goldsmiths started issuing paper notes indicating that the bearers held gold or silver of given weights and on deposit with the goldsmith. • These notes could be exchanged for goods and were the first paper currency. 16 -2 Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

Banks and Money (cont’d) • Reserves – deposits held by Federal Reserve + the

Banks and Money (cont’d) • Reserves – deposits held by Federal Reserve + the bank’s vault cash • Fractional Reserve Banking – A system in which depository institutions hold reserves that are less than the amount of deposits • Originated when goldsmiths issued notes that exceeded the value of gold and silver on hand 16 -3 Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

Banks and Money (cont’d) • Required Reserve Ratio – The percentage of total transactions

Banks and Money (cont’d) • Required Reserve Ratio – The percentage of total transactions deposits that the Fed requires depository institutions to hold in the form of vault cash or deposits with the Fed Required reserves = Transactions deposits Required reserve ratio 16 -4 Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

Banks and Money (cont’d) • Excess Reserves – The difference between actual reserves and

Banks and Money (cont’d) • Excess Reserves – The difference between actual reserves and required reserves Excess reserves = Actual reserves – Required reserves 16 -5 Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

The Relationship Between Legal Reserves and Total Deposits • Balance Sheet – Statements of

The Relationship Between Legal Reserves and Total Deposits • Balance Sheet – Statements of assets (what is owned) and liabilities (what is owed) • How a single bank reacts to an increase in reserves – We will examine the balance sheet of a single bank. 16 -6 Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

Balance Sheet 16 -1 Typical Bank Reserve Ratio = 10% Now: What if someone

Balance Sheet 16 -1 Typical Bank Reserve Ratio = 10% Now: What if someone makes a deposit of $100, 000 in Typical Bank? 16 -7 Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

Balance Sheet 16 -3 Typical Bank lends $990, 000……… 16 -8 Copyright © 2010

Balance Sheet 16 -3 Typical Bank lends $990, 000……… 16 -8 Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

The Relationship Between Total Reserves and Total Deposits (cont'd) • What do you think?

The Relationship Between Total Reserves and Total Deposits (cont'd) • What do you think? – Did this loan expand the money supply? 16 -9 Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

Money Expansion by the Banking System (cont'd) $100, 000 90, 000 81, 000 72,

Money Expansion by the Banking System (cont'd) $100, 000 90, 000 81, 000 72, 900 New Deposit Loan by Bank 1 Loan by Bank 2 Loan by Bank 3 $343, 900 Total What do you think? • Could Banks 4, 5, 6, etc. create even more money? • How much can be created? 16 -10 Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

Table 16 -1 Maximum Money Creation with 10 Percent Required Reserves 16 -11 Copyright

Table 16 -1 Maximum Money Creation with 10 Percent Required Reserves 16 -11 Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

The Money Multiplier (cont'd) 1 Potential money multiplier = Required reserve ratio Actual change

The Money Multiplier (cont'd) 1 Potential money multiplier = Required reserve ratio Actual change in the money supply = Actual money multiplier Change in total reserves 16 -12 Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

The Money Multiplier (cont'd) • Example – Fed buys $100, 000 of government securities

The Money Multiplier (cont'd) • Example – Fed buys $100, 000 of government securities – Reserve ratio = 10% Potential change in the money = $100, 000 x 1 = $1, 000. 10 supply 16 -13 Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

Monetary Policy Ways in Which the Federal Reserve Changes the Money Supply • Open

Monetary Policy Ways in Which the Federal Reserve Changes the Money Supply • Open market operations • Reserve requirement • Discount rate • Hint: Monetary policy involves the money supply and interest rates 16 -14 Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

Money Expansion by the Banking System (cont'd) • The Federal Open Market Committee (FOMC)

Money Expansion by the Banking System (cont'd) • The Federal Open Market Committee (FOMC) – Can instruct the New York Federal Reserve Bank trading desk to buy or sell bonds • Open Market Operations – The purchase and sale of existing U. S. government securities (such as bonds) in the open private market by the Federal Reserve System 16 -15 Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

The Money Multiplier (cont'd) • Discount Rate – The interest rate that the Federal

The Money Multiplier (cont'd) • Discount Rate – The interest rate that the Federal Reserve charges for reserves it lends to depository institutions – Increasing (decreasing) the discount rate increases (decreases) the cost of borrowed funds for depository institutions that borrow reserves. 16 -16 Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

The Money Multiplier (cont’d) • Changes in the reserve requirements – An increase (decrease)

The Money Multiplier (cont’d) • Changes in the reserve requirements – An increase (decrease) in the required reserve ratio • Makes it more (less) expensive for banks to meet reserve requirements • Reduces (expands) bank lending 16 -17 Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

Reserve Ratios 16 -18 Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

Reserve Ratios 16 -18 Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

Why is the money supply important? • There are links between changes in the

Why is the money supply important? • There are links between changes in the money supply and changes in GDP (short run) and the rate of inflation (long run). 16 -19 Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

Myth #16: As for money, the more the better • The more money we

Myth #16: As for money, the more the better • The more money we have, other things being equal, the more you will spend only in dollar terms (not more in quantity) -inflation 16 -20 Copyright © 2010 Pearson Addison-Wesley. All rights reserved.