RESERVE REQUIREMENT

With Kate Eskra

OBJECTIVES:What will you learn?

• We can classify money according to how liquid it is (M0, M1, M2).

• The FOMC is the organization in the U.S. who manages and makes decisions about the supply of money.

• The reserve requirement is one Fed tool that allows them to control how much money banks must keep on reserve.

• The Money Multiplier shows how much money can be created through loans.

Three Functions of Money

Money is anything that serves as:

1) A Medium of Exchange2) A Store of Value3) A Unit of Account

What is Money?Most people probably tend to think of bills and coins when they hear the word “money.”

If money is anything that allows to get what we want, isn’t it also checks and debit cards? What else is it?

What is Money?

• Depending on how easy or difficult it is to spend a certain type of money, we can classify it accordingly.

Some forms of money, like cash, are very easy to go out and spend right now.Others, like money in our savings count, involve a few more steps to be able to spend.

This is known as liquidity.

M0, M1, M2

• M0 = narrowest definition of money– Most liquid– Physical cash in circulation

• M1 = M0 + checking accounts– Still liquid– Checking accounts (checks and debit cards)

• M2 = M1 + Time deposits– Broadest definition of money, least liquid – Savings accounts, money market mutual funds, etc.

(Known as “time” deposits)

M0

The narrowest definition of money, includes only the stock of

physical currency.

M1

Includes demand deposits (checking account balances) + M0

(stock of physical currency).

M2

Time deposits + M1 (demand deposits +

stock of physical currency).

FOMC

• Our FOMC (Federal Open Market Committee) – is part of the Fed and meets several times a year to manage our nation’s money supply.

• The tools they use to control our M0, M1, and M2 are:– The reserve requirement– Open market operations– Fed funds market– Discount rate

A Fractional Reserve System

How do banks make money?

If they simply stored it, they would not profit.

• When we deposit money into a checking account at a bank, we are entitled to demand that at any time.

Banks make money, though, by lending out a portion of customer deposits and charging interest.

A Fractional Reserve System

For every dollar held in the vault (reserves), there could be multiple dollars in multiple checking accounts on which customers have the ability to write checks.

Is Fractional OK???

• What are the chances that everyone will show up at your bank/ATMs today and demand all of their money?

As long as the demand for cash on any given day is less than the cash held in reserve, this system works fine.Allows banks to make more loans and earn more interest. This is essentially how banks create money.

Is Fractional OK???

• However, IF banks lend out too much money or IF many people show up demanding the cash in their accounts, the bank cannot meet these demands.– The bank fails or goes bankrupt.

So the Fed regulates how much of these reserves banks must hold in their vaults or at the regional Fed bank…

RESERVES

A portion of deposits required to be held by a bank.

RESERVE REQUIREMENT

The required amount of reserves that a bank must hold.

The Fed sets this requirement and it is typically quoted as a percentage.

Reserve Requirement

• If I deposit $1,000 into my checking account, and the Reserve Requirement is 10%:

– My Bank must hold $100 as reserves– They can lend out the rest ($900).

Changes in the Reserve Requirement

• If the Reserve Requirement rises, the bank cannot lend out as much money.– If the RR rose to 20%, they would have to hold

$200 as reserves and could only lend out $800.

• If the Reserve Requirement falls, the bank can lend out more money.– If the RR fell to 5%, they would have to hold

only $50 as reserves and could lend out $950.

Lending = Money Creation

• When a bank makes a loan from money I have deposited, they have “created” money.

I still have the ability to write a check or demand that cash, but someone else now has money that they did not have before.

Reserve Requirement and Money Creation

• Let’s stick with a reserve requirement of 10% for now. Here’s how it works:– You take out a loan for $1,000.– You deposit it in a checking account.– Your bank lends out $900 of this to someone else

(holds onto required $100).– That person deposits their money into a bank.– That bank lends out $810 (holds onto required $90).– The process continues this way…

Reserve Requirement andMoney Creation

• Your initial deposit to the bank and the subsequent loans have caused the money supply to increase by $1,000 + $900 + $810 = $2,710 so far, and it will continue…

• At a 10% reserve requirement, $1,000 in M0 will lead to a potential $10,000 increase in M1.

• Multiplier = 1/R (1/.1=10)

MONEY MULTIPLIER

The increase in the money supply resulting from the ability of banks to

loan deposits; the value is equal to the reciprocal of the prevailing

reserve ratio or 1/R, where R is the reserve ratio.

Reserve Requirement and Money Creation

• What if the reserve requirement were 50%?– You take out a loan for $1,000.– You deposit it in a checking account.– Your bank lends out $500 of this to someone

else (holds onto required $500).– That person deposits their money into a bank.– That bank lends out $250 (holds onto required

$250).– The process continues this way…

Reserve Requirement and Money Creation

• At a 50% reserve requirement:

The Multiplier = 1/.50 = 2

So my initial $1,000 deposit could create up to $2,000.

Reserve Requirement and Money Creation

• If the reserve requirement were 100% (meaning banks had to hold onto all money deposited):

– There is no ability to create money.– I deposit $1,000, and my bank must hold ALL of

it. – The multiplier = 1/1 = 1 (no multiplied effect)

Reserve Requirement as a Fed Tool

The greater the supply of loanable funds, the greater the ability to increase our money supply.

If the Fed wanted to increase the money supply and make it easier for banks to make loans, they could lower the reserve requirement.If the Fed wanted to decrease (contract) the money supply and make it more difficult for banks to make loans, they could raise the reserve requirement.

Reserve Requirement as a Fed Tool

• In addition to giving the Fed the power to control the size of M1, this has been a powerful tool in history by helping to prevent bank runs.

Banks must report daily about their reserves.

Consumers can have confidence that their bank will have the money they can demand at any time.

RECAP:What did you learn?

• We can classify money according to how liquid it is (M0, M1, M2).

• The FOMC is the organization in the U.S. who manages and makes decisions about the supply of money.

• The reserve requirement is one Fed tool that allows them to control how much money banks must keep on reserve.

• The Money Multiplier shows how much money can be created through loans.