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ECON

Designed byAmy McGuire, B-books, Ltd.

McEachern 2010-2011

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CHAPTER Banking and the Money Supply

Macro

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LO1 Measures of the Money Supply (February 2009)

Exhibit 1

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Money Aggregates

LO1

Credit cards Loan from the card issuer Repay later Dispute a charge Not part of money supply

Debit cards From checking account Part of M1

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How Banks Work

Banks earn profit Attract deposits from savers Lend to borrowers

Banks are financial intermediaries Reduce transaction costs Cope with asymmetric

information Reduce risk through

diversification

LO2

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Reserve Accounts

Required reserve Dollar amount

Must be held in reserve Required by Fed

Required reserve ratio Percentage of checkable deposits (10%)

Must be held in reserve Reserves (Earn no interest)

Cash in bank’s vault Deposits at the Fed

Excess reserves

LO2

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Liquidity vs. Profitability

Liquidity Ease to convert assets into cash Safety

Profitability Federal funds markets

Day-to-day lending and borrowing Among banks Excess reserves on account at the

Fed Interest: federal funds rate

LO2

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How Banks Create Money

LO3

Creating money through excess reserves– Round one

• Fed buys $1,000 U.S. government bond– Creates reserves

• Money supply: +$1,000• Required reserves: +$100• Excess reserves: +$900

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How Banks Create Money

LO3

Creating money through excess reserves– Round two

• $900 loan• Money supply: +$900• Required reserves: +$90• Excess reserves: +$810

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How Banks Create Money

LO3

Creating money through excess reserves– Round three

• $810 loan• Money supply: +$810• Required reserves: +$81• Excess reserves: +$729

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Reserve Requirements & Money Expansion

LO3

Assumptions– No bank holds excess

reserves– Borrowed funds don’t sit

idle– People don’t want to hold

more cash

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Reserve Requirements & Money Expansion

LO3

Required reserve ratio = r Money multiplier Simple money multiplier = 1/r Change in the money supply = Change in fresh

reserves × 1/r

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Multiple Contraction ofMoney Supply

LO3

The Fed sells a $1,000 bond– Money supply: -$1,000– Required reserves: -$900– Recall loans– Money supply: -$900– Required reserves: -$810– Maximum effect

• Decrease money supply = Original decrease in reserve requirements × 1/r

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The Fed’s Tools of Monetary Control

LO4

Open-market operations– Buy/sell U.S. government bonds

The discount rate– Interest rate, the Fed– For loans made to banks

The required reserve ratio– Minimum fraction of reserves

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Open-Market Operations

LO4

Increase money supply–The Fed buys U.S. bonds

• Open-market purchase Reduce money supply

–The Fed sells U.S. bonds• Open-market sale

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Open-Market Operations

LO4

Tool of choice for the Fed Influences bank reserves Influences federal funds rate

– Interest rate– Borrowing among banks– Of excess reserves at the

Fed

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The Discount Rate

LO4

Discount rate– Interest rate charged by the Fed– Loans to banks

Bank borrow ‘Discount window’– Satisfy reserve requirements

The Fed– Lender of last resort

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Reserve Requirements

LO4

Required reserve ratio Money creation for each dollar of

fresh reserves Disruptive

–Banking system

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The Fed Is a Money Machine

LO4

Assets– U.S. government bonds, 24%

– Earns interest Liabilities

– Federal Reserve notes, 43%– Fed pays no interest

The Fed is a money machine– Supplies Federal Reserve notes– Main asset: earns interest– Main liability: no interest payment